No.1

A maturing ESG landscape moves past primary issues

As witnessed by an exponential increase in the use of the term ‘ESG’ in the media and its inclusion in mainstream discourse, ESG’s ‘low-hanging fruit’ are being picked (and sometimes immediately discarded) by a broadening range of participants. As a result, there has been more movement recently to address derivative and more complex ESG issues (e.g., financing policies, securities lending, incentive compensation, etc.) as stakeholder demands become more targeted and asset managers take proactive steps to realize genuine differentiation. Amongst our more sophisticated clients, it is increasingly understood that value-add ESG needs to demonstrate incremental and specific advancements towards detailed goals that have developed beyond an ‘everything for everyone’ approach. ESG integration is dynamic and these clients are addressing complex challenges, as well as identifying opportunities, via well-executed ESG strategy and integration.

No.2

Real estate investors and owners look beyond physical asset credentials

Whereas historically the real estate sector relied on meeting sustainability and environmental requirements of physical assets to address ESG, there is growing demand for property asset owners, managers, and investors to engage with a fuller spectrum of material ESG issues including taking meaningful action to mitigate climate risk. We have seen stakeholders in the sector requiring participants to address a wider set of questions on environmental, social, and governance track records and plans, including on supply chain, human capital, diversity and inclusion, and transparency issues. As capital providers focus more on ESG as part of their due diligence and investment processes, real estate investors and operators need to respond adequately or be left behind by their more proactive competitors. It is no longer enough to have the correct building certificates and address green requirements, which remain important aspects of ESG – material ESG issues must also become an integral part of core strategy.

No.3

Climate change impacts will transform business models

With 2023 set to be the hottest year on record, leading organizations understand that old business models may no longer be fit for purpose. Historical data and loss estimates are no longer sufficient to identify future risks. Resiliency in 2023 and beyond means adapting business models to face multiple climate-related risks including resource scarcity and biodiversity and societal impacts, both directly and indirectly throughout value chains. Addressing climate risks may, however, also create follow-on effects on other ESG issues, potentially increasing the risks of the organization. Therefore, a more sophisticated and multi-faceted approach to strategy and business model adaptation is needed to address climate change and all other derivative and associated risks.

No.4

ESG integration is 100% not going away

Recent events may have caused investment managers to rethink their marketing and communications strategies around ESG (see “Regulatory Divide Poses challenges for asset managers”), but the integration of ESG factors as part of core risk management and value creation strategies for managers and investors has shown no signs of abating. Despite the rhetoric and politics in public discourse, identifying, assessing, and managing the material issues of an investment strategy and understanding the strategy’s alignment to global megatrends (such as decarbonization, resource scarcity, and labor shortages), simply remains a means to better risk mitigation, longer-term resilient returns, and more positive outcomes. Acronyms may change and political agendas will continue to create debate amongst market participants but sound investment management will always prevail.

No.5

More understanding of the “ESG intention” of a fund

Integrating ESG into an investment strategy is about widening the aperture you look through when assessing an investment for both expanded due diligence and value creation. There is no clear consensus, however, on how, where, or when to integrate ESG issues into an investment strategy, although this is key to understanding fund-specific ESG integration. For example, take two low-carbon or net zero funds. They can have different outcomes depending on the “carbon intention” of the strategy. If the intention is to reduce the carbon risk of the strategy, this could be achieved by shorting high carbon emitters. If the fund’s intention, however, is to reduce carbon emissions in the real economy, shorting will not provide a reduction in real-world emissions (more on this here: “Can short selling be used as a carbon offset?”). Clearly stating the ESG intention of a strategy will help clarify how a fund expects to manage ESG issues. As investors and allocators increasingly commit to ESG integrated portfolios, including net zero emissions, understanding the ESG intention of a strategy will increasingly become a core part of future capital allocation decisions.

No.6

More awareness of diversity, equity, and inclusion

In 2020, many companies made commitments to improve diversity, equity, and inclusion (DEI) in response to social justice movements. However, three years later, it is clear that many firms still struggle to fully understand the meaning and importance of DEI for their organizations and how to make a meaningful impact. Smaller investment firms, in particular, may feel limited by their size and may give up on setting diversity goals and targets because they believe they cannot find diverse candidates. However, in today's market, this is no longer an acceptable excuse for inaction on DEI. Stakeholders, including capital providers, are increasing the pressure on organizations to demonstrate progress on DEI, and there is a growing demand for DEI training programs to create a more consistent understanding of DEI and drive action, rather than just passive observations and support from the sidelines.

No.7

A stronger focus on ESG due diligence

As we continue through a period of volatile markets with complex geopolitical factors and macroeconomic headwinds, we expect to see more restrictive capital allocation decisions. Deals and capital will seek high-quality and resilient companies. Robust pre-investment ESG due diligence will help identify sustainable companies that are managing ESG  issues to support stronger financials, are more resilient irrespective of the economic cycle, and are able to attract more capital in the future, allowing for higher valuations and multiples. Investment managers, general partners, and deal teams that have put ESG due diligence programs in place will see increased scrutiny into the depth and breadth of these programs. In addition, managers and GPs can also expect to see heightened focus on ESG reporting and analytics to demonstrate the link between ESG due diligence practices and the outcomes of a strategy or fund. 

No.8

A further expansion of corporate ESG roles

2022 saw the cementing of corporate ESG through both an expansion of dedicated in-house ESG roles and a diffusion of sustainability responsibilities across functions. An example: a recent publicly traded firm’s ESG roadshow included representatives from their investor relations, governance, corporate responsibility, human resources, sustainability, supply chain, and responsible AI teams. We have also seen job postings advertising dedicated ESG roles in HR, finance, enterprise risk management, communications, and transaction advisory. We expect the depth and breadth of ESG roles to continue to expand in 2023, subsequently leading to more ESG/sustainability policies instituted and targets set + better measuring, monitoring, and reporting of sustainability performance. This growing demand for ESG professionals will expose the scarcity of individuals with the experience necessary, in particular at the leadership level, prompting a ‘talent arms race’ as more organizations recognize the importance of ESG to core strategy.

No.9

Impact confusion is coming (and you thought ESG was opaque)

At the root of the politicization of ESG has been the conflation between ESG integration and impact investing. We view ESG integration primarily as the identification, assessment, and management of material E, S, and G issues that may affect the financial performance of an investment. Impact investing, on the other hand, is investing with the intention to create a positive and measurable social and / or environmental impact alongside a financial return. Regulatory attempts to provide guidance have sometimes ended up bucketing the two concepts, adding to the confusion, and we anticipate there will be even more uncertainty in 2023 about what constitutes “real” impact. For example, SFDR Article 9 funds are defined as funds that have sustainable investment objectives. These funds are required to disclose information about the sustainability risks and impacts of investments as well as the integration of sustainability considerations into investment processes. Not all SFDR Article 9 funds will be viewed as true impact investing funds, however, as they do not necessarily meet all the requirements of true impact funds, e.g., additionality (the idea that an investment should create additional social or environmental benefits beyond those that would have occurred without the investment). Whether an investment fund is considered lowercase i “impact” or uppercase i “Impact” will depend on the specific goals and criteria of the investor or the asset manager. Stating the fund’s impact (and ESG) intention up front, including how impact will be measured and if certain standards of additionality will be met, will go a long way towards clearing up the confusion.

No.10

A push towards higher quality ESG funds

The mislabeling and misuse of ESG to promote and sell products has caught the attention of regulators as well as ESG naysayers, leading to provocative headlines and dramatic predictions of the death of ESG further demonstrating a need to recalibrate. In recent years, incidents of greenwashing have accelerated, with many funds claiming ESG credentials and using existing exclusions and engagement practices as justification. As we enter 2023, we expect to see a rebalancing of what it means to be “ESG integrated” towards a better demonstration of how ESG is part of strategic planning. This is certain to reduce the quantity of ESG-labelled funds in the short term as lower-quality ESG funds are forced to double down or bail out. In parallel, as ESG regulation takes hold, definitions in marketing materials will become more standardized and less opaque, benefitting market participants and contributing towards an evolving clarity around what constitutes authentic ESG integration.