The outlook for ESG investing

ESG investment continues to face several challenges – but also plenty of opportunities. We review five big themes for ESG investing in 2023 and ask: what do these mean for asset management firms, and in particular alternative investment funds?

ESG investing has been on a rollercoaster ride over the past few years. The boost to environmental funds seen in 2021 gave way to a drop in net inflows in the first three quarters of 2022 following the invasion of Ukraine.[1] Yet by the end of the year annual returns from sustainable investing were comparable to those generated by the whole market.[2]

1) The race for clean energy

Since the invasion of Ukraine in early 2022, national leaders have been trying to balance investing in clean energy as part of the transition to a net zero future with the need to protect communities and businesses from the steep inflation caused by soaring energy costs.

Does this mean a slowing down in the move to renewables? The International Energy Agency doesn’t think so. It predicts that global renewable energy production over the next 5 years will equal that of the last 20.[3]

“We cannot tackle climate change without protecting against nature loss – the two are interdependent”

Bradley Davidson,  Director and Climate & ESG Lead, RBS International

The need for secure, cheap, and green energy has never been clearer, says Bradley Davidson, Director and Climate & ESG Lead, RBS International. “The new market dynamics seem to have caused leaders to question their dependency on other nations and in many cases, they are using national clean energy production as a hedge. Initiatives such as the REPower EU plan and the US Inflation Reduction Act are creating opportunities for fund managers in both regions.”

However increased financing costs, often reactive public policy, and tight supply chains can make capital-intensive clean energy investments seem unattractive. More mature technologies such as solar and wind technology continue to dominate; investment in emerging technologies, such as green hydrogen, remain comparatively muted.

“Funds will have to find an equilibrium between established and emerging clean energy technology investments to safeguard future returns while capitalising on reducing capital requirements for mature solutions,” says Davidson.

2) Change in disclosure rules

While the EU Sustainable Financial Disclosures Regulation (SDFR) aimed to bring clarity and transparency to the market, these new rules continue to cause confusion across the investment community. At the end of Q3 2022 an estimated 4.3% of all EU investment products held the esteemed Article 9 designation. However, this number fell rapidly as fund managers downgraded, fearing they could not meet stringent reporting requirements. Close to 300 funds, representing about €170 billion assets under management, were downgraded to Article 8 in Q4 2022, according to Morningstar.[4]

Davidson sees this as a short-term pivot rather than a fundamental shift in investment volumes. “Fund managers will need to continue to react to evolving regulation. But this should lead to improved disclosures that support investor decision making and improve market efficiency.

“Funds that can confirm their environmental credentials using robust data and measurement processes may be able to use the regulation to their advantage and attract more capital as investors look for opportunities aligned with the transition to net zero."

3) Searching out opportunities

Ambitious ESG targets alone may no longer give funds a competitive advantage as managers continued to develop transition plans in 2022. Fund managers will need to show they have the expertise to meet investors’ environmental and social needs while continuing to provide sustainable returns, says Davidson.

“While 2023 started with a focus on regulatory issues I expect to see more fund managers shifting from a climate-risk based approach to evidencing how their strategy will allow the fund to thrive during the transition and seize opportunities from the transition to provide the returns investors expect,” he says.

The REPower EU plan aims to optimise energy savings, diversify energy supplies and increase the share of renewables in the EU’s energy mix, and encourages member states to use tax measures to incentivise investment and remove regulatory barriers. In the US, the Inflation Reduction Act introduces tax credits to reduce barriers to entry for emerging green technology and to stimulate green securitisation. And in the UK, the work of the Transition Plan Taskforce, established last year, is set to pick up speed. 

“As national policies emerge, the reliance on public and private capital collaboration is increasingly evident. The path to net zero will place a heavy dependency on enabling policies and global leaders will need to demonstrate they are creating a favourable environment for private market investment,” says Davidson. “It is our expectation that those funds aligning their own transition plans with national demands will be able to unlock greater potential.”

4) Integrating biodiversity

Biodiversity and nature have often been seen as separate from carbon emissions. The focus on COP 15 last year has hopefully gone some way to deepening an understanding of the symbiotic relationship between them.

“We cannot tackle climate change without protecting against nature loss – the two are interdependent,” says Davidson.

European regulation continues to integrate wider environmental concerns alongside carbon reduction, and fund managers may face evolving global rules that do the same.

Meanwhile the latest iteration of the Task Force on Nature-related Financial Disclosures (TFND), due out in March, is likely to highlight the impending financial risk of nature loss. It uses the same pillars as the Task Force on Climate-related Financial Disclosures to support the management and publication of nature-related risks, impacts and opportunities. 

Carbon emissions are relatively straightforward, given the relatively simple, single unifying measurement metric. Nature and biodiversity are, by contrast, far more complex. “The issue is how funds that are only just adapting to carbon requirements will tackle the more complex and often idiosyncratic topics of biodiversity and natural capital,” says Davidson.

The TFND addresses the complexities of specific ecosystems and different stresses on water and biodiversity with a revised framework to guide fund managers through this process. “As companies outline their climate transition plans, it’s the perfect time for them to review the nature-related risks facing assets and set objectives to protect and restore the environment. Many of the best solutions to decarbonisation are nature-based and seeking opportunities across both elements can unlock further efficiencies and possibilities,” says Davidson.

5) ESG in an economic downturn

Fund managers contending with high inflation and an economic downturn may reduce their appetite for ESG investment. The impact, Davidson thinks, will most likely be felt in two areas. One is volumes of ESG-aligned investment; the other is in internal spending to drive activity such as strategy development and measurement tools.

If we are to meet society’s ambition for a truly sustainable economy, ESG integration must be seen as a long-term value driver rather than a “nice to have” option, he says.

“ESG is increasingly a way to evaluate a fund’s ability to weather external shocks. That has not changed. Fund managers need to show progress and demonstrate how ESG strategies form part of their overall investment approach – those who do best will identify the value-add ESG opportunities presented by these testing times. Funds that don’t could seem uncompetitive and fall behind their peers.”