Analysis

Sustainable Standpoint: The ESG premium is dissipating – providing better opportunities

In the final part of this series, commentators reflect on the 'teenage years' of ESG and share their predictions for the year ahead

Sustainable Standpoint is a new ESG Clarity series focusing on reflections of developments in ESG investing over the past year, and predictions for potential milestones in 2023.

In final part of this series, Mikkel Bates, Margarita Pirovska, Dan Kemp and Vicki Bakhshi discuss 2023 regulations, continued collaboration, direct indexing and physical climate risk.

‘We foresaw the mass reclassification of Article 9 funds’

Mikkel Bates, regulatory manager at FE fundinfo and ESG Clarity Committee member

Reflecting on what has been a tumultuous 2022 for ESG and markets in general, what has been your biggest challenge and how have you overcome it?

We have said it every year for the last three or four years that the previous one was huge for ESG investment and disclosures, but 2022 easily caps all previous years!

As a data solutions provider, our biggest challenge has been keeping up with the many changes to the disclosure rules, particularly in the EU, and making sure that we can consume and disseminate the latest version of the disclosure templates.

Things have not been helped by the Q&As published by the regulators in November, just six weeks before the Level 2 live date.  There were 60 questions covering PAI disclosures, product disclosures and taxonomy-aligned disclosures, but, fortunately, our disclosure solution is independent of the client’s choice of ESG rating provider. So our challenge has been to ensure we can receive the latest version of the European ESG Template (EET) and populate the current disclosure templates.

On the other side, I like to feel we foresaw the mass reclassification of Article 9 funds in September, following confirmation from the regulators that these funds could only invest in sustainable assets, as the first wave of EETs we received had most of them stating a minimum commitment, if at all, of much less than that.

Please provide one prediction for the ESG investment world for 2023. 

We probably see the world differently from many others. To us, the ESG investment world is about the development of disclosure requirements, the clarity of definitions and the availability of useful and meaningful data. In that context, there are several things we already know will be happening in 2023.

In the EU, the SFDR Level 2 templates will be mandatory for Article 8 and 9 and PAI disclosures.

In the UK, the consultation on sustainability disclosure requirements and investment labels (CP22/20) will end in January, the FCA will publish its policy statement in the middle of the year, and its general anti-greenwashing rule will come into effect at the same time.

Being optimistic, I would predict that, despite the delay announced in Parliament just before Christmas, there will be at least a first draft of a UK green taxonomy published during 2023. Even more optimistically, I hope it will more than ‘build on’ the EU taxonomy, but will look very similar. This isn’t because I think the EU taxonomy is perfect, but because it’s already out there and the more similarity there is the better it will be for international companies and funds that need to report their alignment.

‘A global reporting framework is finally in sight’

Margarita Pirovska, director of policy at the PRI

Reflecting on what has been a tumultuous 2022 for ESG and markets in general, what has been your biggest challenge and how have you overcome it? 

2022 was unexpected in many ways – with a number of disruptions finding their root cause in Russia’s war in Ukraine. The conflict has disrupted energy markets, hit macroeconomic stability and deeply affected global geopolitical relations. This has been the most negative blow to efforts to mitigate climate change and address ever-increasing social and economic crises.

The good news has been the ongoing rise of the adoption of responsible investment practices by investors. Responsible investment has come of age and is now firmly rooted in the mainstream. With this comes responsibility for investors: to fulfil duties to beneficiaries, to demonstrate claims of sustainability, and to navigate a changing regulatory landscape despite the risk of fragmentation at global level.

We see positive signals for the future: the establishment of a global reporting framework is finally in sight, for example, with the potential to unite the world behind a single sustainability reporting standard endeavour. We need more of this cooperation, including by multilaterals such as the OECD, to set a modern interpretation of fiduciary duty centred around responsible investment and managing real world outcomes as a global standard.

Please provide one prediction for the ESG investment world for 2023. 

In the future, more focus on disclosures, from both corporates and investors alike, will be integral to delivering greater accountability.

Corporate disclosures will be the first financial policy to fully and unequivocally embed key sustainability issues such as climate and social KPIs. With the work of the ISSB, alongside national and regional regulators, this work is already well underway in 2022. Despite challenges in some markets to the validity of such policy changes, investors do need access to more and better data, and regulators are working hard to make that happen.

On the investor side, despite challenges around how different regulations are being designed, we expect that the beneficiary and client expectation for investors to substantiate their sustainability claims will remain. Therefore it will be increasingly important for investors to engage with and understand policy changes, to ensure better accountability across the whole industry. That means embracing the need for accountability, and constructively challenging policy reform on investor disclosures.

The advent of direct indexing

Dan Kemp, global chief investment officer at Morningstar Investment Management and ESG Clarity Committee member.

Reflecting on what has been a tumultuous 2022 for ESG and markets in general, what has been your biggest challenge and how have you overcome it? 

The challenge for all ESG portfolio managers is to help investors understand that 2022 was a good year for most investors. While it is psychologically challenging to witness the value of your current portfolio falling, especially when it is falling faster than a conventional portfolio, it is important to remember that 2022 has provided an opportunity for investors to acquire assets at lower prices. In recent years, assets with favourable ESG characteristics have been expensive both in absolute terms and relative to their conventional peers. This premium valuation lowered the expected return to ESG investors. Fortunately, that ESG premium is dissipating, providing better opportunities for ESG investment.

See also: – ESG 2.0: Changing gear

We overcame this problem as we address all investing challenges by eschewing macro forecasts and focusing on value of assets available for investment. This led us to lower the exposure of our ESG portfolios to the most expensive parts of the equity market, an approach that reduced the impact of the market decline. Alongside this, we were clear in our communication of the relative unattractiveness of ESG assets and partnered with advisers to reduce the surprise suffered by investors when ESG assets underperformed. This has provided us with a good opportunity to increase the exposure of our investors to the most attractive assets as we entered the new year.

Please provide one prediction for the ESG investment world for 2023.

Since the advent of ethical investment, most investors have had to accept a ‘best fit’ approach to aligning their portfolio with their values as they have had a limited number of collective investment products from which to choose. Although this range of products has grown markedly over the last few years, the need to compromise either your values or your investment universe remains unchanged. Now, with portfolio personalisation and transform investing, investors can express their values through their investments.

The advent of ‘direct indexing’ in the US coupled with the availability of fractional share ownership is transforming this situation. For those unfamiliar with this innovation, direct indexing is simply a way of personalising a portfolio by investing directly in securities using an optimisation process. This personal optimisation can be used to reduce the tax drag on a portfolio, apply specific ESG considerations or exclude/include holdings for non-investment purposes.

It is similar in many ways to traditional bespoke portfolio management, but is far less expensive to manage and hence these strategies are being made available to a larger group of investors. When coupled with fractional shares, investors with modest portfolios can own a portfolio that is precisely aligned to their values and requirements.

2022 was the awkward teenage years for ESG

Vicki Bakhshi, director in the responsible investment team at Columbia Threadneedle

Reflecting on what has been a tumultuous year for ESG and markets in general, what has been your biggest challenge and how have you overcome it? 

In common with many peers in the investment industry, we have faced challenges in managing the rapid increase in demand from regulators and clients for expanded ESG data. 2022 in many ways can be viewed as the awkward teenage years of ESG – from a period of rapid, almost unbridled growth in responsible investing, we went through a painful period of questioning the purpose and validity of ESG investing, which we see as a necessary phase ahead of full maturity. We saw regulators and investors question over-inflated claims, leading to the backlash against greenwash.

We have dealt with this in two key ways. One, we have invested the effort and resource into meeting data requirements. This has involved expertise well outside our responsible investment team, and the key to success has been to bring the weight of the full organisation to bear on the challenge of ramping up our data outputs. And second, where standards are still evolving, we have worked to develop our own in-house methodologies and to be transparent about these.

Please provide one prediction for the ESG investment world for 2023.

Our prediction is that we will end 2023 more optimistic on the prospects for tackling climate change than many are now fearing. There are two key reasons for this. First, it is likely that higher energy prices are here for the medium term, rather than just being a temporary blip following the Ukraine invasion. Whilst the initial reaction of some governments was to retrench back to coal, we now think prolonged high prices will be a catalyst for an upsurge in renewable energy investment and associated infrastructure, as well as for fresh efforts to get lasting improvements in energy efficiency. The focus on energy security could also favour investments in local renewable energy infrastructure, which can provide long-term national energy autonomy.

Second, physical climate risk will again make its presence felt. The summer of 2022 lay bare the realities of climate change impacts, as heatwaves, floods and extreme weather challenged global supply chains. 2023 is already predicted to be one of the hottest years on record, according to the UK Met Office, and we expect to see increased focus on how companies and investors manage the increasing physical risks of climate change both via short-term adaptation and long-term adaptation and mitigation planning. This could provide a catalyst for fresh political impetus behind steps to speed up mitigation efforts.

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Natalie Kenway

Natalie is global head of ESG insight for ESG Clarity and has been an investment journalist for 16 years. She won Editor of the Year at the Aviva Investors Sustainability Media Awards 2021, and was Winner...