In a recent interview in The New York Times, the CEO of Patagonia, Ryan Gellert, describes a tri-party view of how to tackle climate change, arguably the biggest sustainability issue of our time. He notes that government plays a major role in helping to solve the problem, individuals make decisions in their lives that have an impact, and businesses need to step up and plug the gap between what they say and what they do. On the latter, he goes on to say that he’s not optimistic.
Well, he should be. For those of us that are long-time ESG practitioners, we have witnessed 2021 as a pivotal year for businesses “stepping up.” There has never been more research, product development, analysis, target setting, scoring, disclosures, benchmarking, screening, implementation, or measurement of ESG. There are efforts driving standardization, regulating reporting, and fostering integration. There is an intense competition for experienced ESG talent with compensation levels for senior level roles 2-3x where they were just a few years ago. This diffuse engagement with ESG has brought increased scrutiny (which we wholeheartedly welcome) but make no mistake: ESG has never been more firmly embedded in business culture. This global re-orientation around ESG is and will continue to be transformative. Yes, there is much more hard work to do, but we’ve finally got the wind at our backs.
With this momentum in place, we are pleased to present our Top 10 list of ESG trends for 2022. Our list reflects the widespread nature of ESG and touches upon the themes of further simplicity, transparency and intentionality. It’s in no particular order, admittedly a bit aspirational, and certainly not comprehensive. We appreciate your interest in reading through our list, thank you in advance for your engagement, and welcome your feedback.
1. ESG ratings will remain uncorrelated and that’s ok!
One of the most common refrains when it comes to critiquing ESG ratings is that they lack standardization, are confusing and complex, and therefore lack applicability. However, we, along with others, don’t see this as inherently an issue of concern. ESG ratings are the resulting opinion born from an analysis based on proprietary methodologies and should be taken as one of many inputs into the process it is being plugged into. We will never have perfect ESG data, and ESG ratings will never be as correlated as credit ratings. In fact, with increased regulations to disclose ESG information, we will see even more ESG, yet, the expertise and alpha will continue to lie in the ability to navigate through this complexity.
2. Who should be driving the ESG car? Strategy
The popular saying “what gets measured gets managed” is tossed around quite often in management circles when it comes to ESG reporting. It certainly does make sense in this context, but with increased stakeholder expectations and a regulatory environment mandating ESG disclosures, we have inevitably seen ESG reporting driving the sustainability strategy at organizations rather than the otherway around. However, with increased awareness and a better understanding of material ESG issues at all levels of an organization, we now see sustainability not only being managed as a risk mitigation strategy, but also as a value driver essential to both maintaining and increasing competitive differentiation. With this level of engagement from the top on down, we fully expect to see strategy start to drive ESG reporting in 2022.
3. Hunting down greenwashing
Arguably the top ESG story of the year was Desiree Fixler’s dismissal from DWS, the German asset manager. She was previously the firm’s first group sustainability officer and was let go in March after objecting to the veracity of certain ESG information in DWS’ annual report, which stated that the asset manager put ESG at the core of everything it does and that more than half of its AUM is invested using ESG criteria.
DWS, of course, objected to Ms. Fixler’s objections and stood by the language in its annual report. How do we solve this impasse? Pretty easily actually: ESG verification. European policymakers have attempted to drive (i.e., via SFDR) this nascent market aiming to help investors better understand the sustainability characteristics of investment funds by sorting them into different categories based on their investment approach.
However, delayed reporting requirements and confusion around classifications has created the need for an independent, third party verification of an asset manager’s ESG integration claims. This is further supported by the explicit recognition that ESG integration is not binary, and that UN PRI scores and investment consultant ratings, while perhaps sufficient in the past, leave much to be desired when seeking to parse a sophisticated ESG integration strategy from an initiated one. With the potential for SEC ESG audits now looming on the horizon and increasing litigation risks around greenwashing, it couldn’t be a more opportune time for ESG verification.
4. Zero-washing or how to address a portfolio’s carbon intention
There are many ways to get to a net zero portfolio, but not all actually reduce carbon emissions in the real economy. To avoid being accused of being a “zero-washer,” asset managers need to be absolutely clear on the “carbon intention” of their portfolio or fund: is it to reduce carbon risk or exposure in the portfolio, reduce emissions in the real economy, or both?
Portfolio metrics such as carbon footprinting and weighted average carbon intensities (WACI) reveal static carbon metrics for a portfolio but don’t tell us about the intention behind a net zero strategy.
Investment strategies that reduce carbon risk but may not reduce absolute emissions include short selling, divestment, and purchasing carbon offsets (although these can be used to get to a net zero portfolio if they remove carbon emissions from the atmosphere with long-lived storage).
Strategies that can reduce absolute emissions include security selection (investing in companies that are implementing a true net zero strategy) and “strategic” engagement (engaging with companies that are transforming their business models to help reduce global emissions).
In 2022, as capital allocators define their net zero strategies, it will be essential for asset managers to identify and declare the carbon intention behind a portfolio or fund. Added benefit: killing the “zero-washing” trend before it firmly takes root.
5. ESG throughout the financing lifecycle of a firm (from VC to IPO): an implication
Through our ESG advisory engagements with clients, we have been firsthand witness to the burgeoning spread of ESG. Most surprising and encouraging to us in 2021 has been the integration of ESG throughout the financing lifecycle of a firm. We have seen ESG come to venture capital – both in the form of the funds themselves applying ESG criteria in investment processes and having their portfolio companies define ESG objectives (there are various initiatives across the VC community that are creating tools for entrepreneurs to track progress on their ESG journeys – one example is here).
Similarly, ESG has taken a place centerstage within private equity firms. We have also seen ESG come with intensity to private debt, where the issuance of sustainability-linked loans is tying ESG issues to the ability of borrowers to pay back and service debt. We now see ESG in pre-IPO transactions, dedicated ESG presentations on roadshows, ESG on the agenda for earnings calls, and ESG in various types of incentive compensation packages. We believe that this linear connection of ESG across the full financing lifecycle is a clear indication that the integration of ESG into the business model and strategy of a firm, no matter the stage, will become a core component of any valuation process in 2022.
6. Who’s winning the race to advance ESG maturity? Private markets
Asset managers, or general partners, who invest in the private markets have long been accustomed to conducting in-depth analysis without the benefit of complete data or standardized reporting. When it comes to ESG, this comfort with overcoming imperfect data is leading to what we view as private asset managers overtaking public managers when it comes to ESG integration maturity.
A few other private market challenges that help cement strong ESG analysis skills: (1) the relative illiquidity of private markets means investments can’t easily be disposed of if a significant ESG risk surfaces and (2) less influence (sometimes) over management necessitates deeper analysis at the pre-investment stage.
We expect private market ESG evaluation models to continue evolving and becoming multi-dimensional and deeper at the asset class level. Given that the complexities of ESG data and ratings will not disappear in 2022 and may indeed increase (see #1), we foresee public managers that want to stay ahead undertake ESG analysis methodologies similar to their private market manager counterparts.
7. Fund metrics: Return, Risk and now ESG
We have always measured ESG integration on a maturity scale (see #3, #6, our website, client references, etc.), meeting our clients at their current state and developing customized target state plans to advance ESG maturity. For our asset manager clients that are already quite advanced, the conversation has turned to what’s next on that maturity scale – an indication of their commitment to ESG and a recognition of the increasingly competitive ESG business environment and desire to differentiate from peers.
Inevitably, this conversation turns to how to better demonstrate the level of ESG integration of their funds. Besides providing ESG integration assessment scores (see #3), managers can report on the top ESG exposures within their funds, whether risks or opportunities. Similar to reporting on sector and industry exposures, we expect to see more funds disclose the top ESG exposures of their funds. Sophisticated ESG managers will have performed internal assessments of these issues and will be able to provide a detailed narrative to their investor clients. Funds can then become more comparable on risk adjusted returns and their exposures to ESG issues.
8. ESG investing just becomes “investing”
With mainstream ESG integration practices now focused on both investment risk management and business strategy, we have seen portfolio managers getting comfortable with qualitative measures of risk and the lack of comprehensive quantitative ESG data. As investment leaders in ESG emerge, we predict this development will lead to a streamlining of investing terminology in 2022. The distinctions between “responsible” and “sustainable” investing will fall by the wayside as “investing” and “ESG investing” become synonymous. However, strategies and funds with a particular focus (e.g., thematic ESG, impact funds, Article 9 funds) will have ESG integration and be classified by intent. These funds, of course, will need to have clear measurement and reporting of the outcomes or impact that the fund has had, no easy task.
9. Circular technology in the 4th Industrial Revolution
Much has been written about a 4th Industrial Revolution that builds on the digital revolution of the 3rd and will likely combine the interconnectivity of the world with the physical, digital, and biological spheres. This combination of forces will foster and enable systemic change. With ESG integration practices embedded across the economy, ESG disclosure and reporting requirements becoming more common, and more robust methods to measure and report on impact, the expectations for the way business gets done is rapidly changing.
We anticipate this momentum will lead to more tools, practices, and measures focusing on the circular economy to to emerge in 2022. A more widespread circular system is the ultimate sustainability goal and, make no mistake, we’ll need unprecedented tri-party cooperation (see intro) across industries and geographies to be successful. And if we need even more of an incentive: a circular economy might even be an antidote to the global supply chain issues we are all currently experiencing.
10. Asset owners as a catalyst for change
We cannot over emphasize how important the ESG foundation laid in 2021will be to the action we anticipate seeing in 2022. With over 660 asset owner signatories to PRI combined with the over $10 trillion in AUM that have signed on to the Net Zero Asset Owners Alliance, asset owners as a collective force with long term patient capital have the power to drastically change the investment landscape. And we will see many of them use their influence in 2022:
-Pension Funds will “level shift” their purpose and mandate beyond just an “investment only” legal mandate, with pension retirement capital invested for the benefit of global society.
-Asset owners will demand radical transparency into the ESG integration practices of their external managers (see #3).
-Beyond the current initiatives that exist, we expect a never-before-seen level of collaboration between asset owners, to leverage collective intellectual capital to apply systems level thinking for beta activism and to direct and support industry transformations to net zero.
Asset owners have always been catalysts for change in investment management. With more of them fully integrating ESG into their investment processes and asset allocation decisions, and reallocating capital to sustainable solutions and sophisticated ESG managers, in 2022 we expect them to be acritical driver for sustainability outcomes both for their beneficiaries and for the global economy.