The shifting priorities of Sustainable Investing in an uncertain ecosystem

The multi-speed growth pattern of Sustainable Investing

Amid a volatile investment ecosystem fraught with economic fragility, and geopolitical fragmentation, sustainable investing exhibits signs of resilience with the continued growth of ESG assets globally. Following a phase of brisk growth observed during 2016-2020, ESG assets attained a size of $30+ trillion in 2022, according to the Global Sustainable Investment Review report. The report also underlined the two-speed growth pattern forming in the global ESG markets. Notably, the ESG assets under management (AUM) in the US witnessed a marked decline - almost halved from $17 trillion in 2020 to $ 8.4 trillion in 2022. At the same time, sustainable AUM in non-US markets has shown a remarkable double-digit growth since 2020.

With improved signs of credibility and market maturity, ESG assets are expected to grow at a lowered CAGR of 3.5% in the intervening years – after a record growth during the pre-2020 period. The Feb 2024 projection from Bloomberg Intelligence highlights that the global ESG market size will surpass $40 trillion by 2030. Not only increase in AUM size, but sustainable funds have also outperformed their traditional peers across all major asset classes and regions in 2023 – with median returns of 12.6%, almost 50% ahead of the 8.6% returns of traditional funds, according to Sustainable Reality report from the Morgan Stanley Institute for Sustainable Investing.

Persistent sentiment of global asset owners

Within a volatile investment ecosystem, despite the challenges of uneasy macroeconomic scenarios and tepid growth outlook, the dominating sentiment amongst global asset owners about their considerations of sustainable investment strategies remains persistent. What is more important is that reckoning with the negative consequences of greenwashing and potential reputational risk, asset owners have grown wiser and more diligent in pursuing their sustainable investment decisions by making these strategies more transparent and rigorous.

Findings from the FTSE Russell 2023 global survey involving 350 asset owners underlined their commitment to their maturing sustainable investment strategies. The survey report observed that the main motivations for implementing or considering sustainable investments for asset owners are - external demand from members and clients (52% of respondents), mitigating long-term investment risk (51% of respondents) and avoiding the reputational risk of greenwashing (37% of respondents) amongst others.

Emerging realm of Double Materiality

As more and more corporates worldwide recognize the adoption of sustainability strategies as a primary value creation opportunity, it also enables them access to capital at a lower cost than their peers. Beyond expectations of financial advantages, a related concept of double materiality gains more prominence given increased attention from both investors and regulators. Given the interconnectedness of a company's impacts on society and the environment with its financial performance, double materiality assessment considers impacts, risks, and opportunities from the activities of a company with a dual-lens approach.

Firstly, it requires companies to look at their activities across the entire value chain with an inside-out perspective as to how these impact people and natural resources and assess the ‘impact materiality,’ reckoning both positive and negative impacts. Further, keeping an outside-in view in the next stage, the ‘financial materiality’ relating to sustainability risks and opportunities is evaluated, which can potentially affect the company financially across time horizons. In recent times, the EU Corporate Sustainability Reporting Directive (CSRD) has stipulated requirements for EU companies to follow new double materiality assessment of their activities across the value chain and ecosystem. While immediate compliance becomes a priority, it requires companies to holistically integrate double materiality considerations within their core business strategies.

Continued spate of ESG regulations and rulemaking

Even after distractions of politics and polarized views in an election year in many countries, ESG considerations remain high on the regulatory agenda. The setting of regulatory standards and rulemaking has witnessed advancement in different jurisdictions - albeit with differing scopes and varying speeds. Rulemaking progress in the EU has taken a significant lead with a variety of formulations already under implementation – i.e., Sustainable Finance Disclosure Regulation (SFDR) covering ESG investing focused transparency rules and disclosure requirements for financial services firms, Corporate Sustainability Reporting Directive (CSRD) for companies as well as Green Asset Ratio (GAR) KPIs and Pillar 3 disclosures on ESG Risks for EU banks, stipulated by European Banking Authority. The EU Carbon Border Adjustment Mechanism (CBAM) also has an implicit reporting requirement for the EU importers.

In the UK, the FCA stipulation regarding Sustainability Disclosure Requirements (SDR) sets out anti-greenwashing rules, investment product labelling, naming, and marketing rules, requirements for distributors as well as product and entity-level disclosures and detailed information to the customers. Starting from June 2024, full implementation of the SDR provisions is expected in 2026. In the USA, after rounds of push and pull, the SEC has adopted the final rules for climate disclosure requirements in annual reports and registration statements of the companies starting from the year ending December 31, 2025. SEC also considers finalizing rulemaking for certain investment advisers and investment companies to provide enhanced disclosures on ESG investment practices.

Meanwhile, the international standards regulatory setting body IOSCO in its final report of Dec 2023 has published supervisory practices across its members to address greenwashing. The report presents the challenges hindering the implementation of IOSCO Nov 2021 recommendations including data gaps at the corporate level, concerns around the transparency, quality, and reliability of ESG ratings and data products providers, consistency in labelling and classification of sustainability-related products, evolving regulatory approaches and gaps in skills and expertise needs amongst others.

Global disclosure standards: a step in the right direction

After the issuance of ISSB global sustainability-related disclosure standards - IFRS S1 and IFRS S2 in June 2023, few jurisdictions – including Australia, Singapore, and Japan, are keeping plans to implement ISSB-aligned reporting framework in early 2025 or 2026 timelines. The EU-adopted European Sustainability Reporting Standards will support interoperability with the ISSB. Amongst other large economies, while the USA and China are yet to decide about their adoption plan for the ISSB-aligned reporting frameworks, the UK is developing its own ISSB-aligned disclosure standards – expected to be introduced in Q1 2025.

Amid a maze of overlapping and less consistent disclosure regimes in present times, it is too early to predict a perfectly harmonized state of disclosures for the companies – more so, the adoption of standards runs on multi-speed tracks with jurisdiction-specific variations. Certainly, an increased adoption of an ISSB-aligned reporting framework will minimize the fragmentation and associated overheads involved in multi-jurisdictional reporting. The good thing is that the disclosure recommendation from the TNFD Framework announced in Sep 2023 is designed to be interoperable with the ISSB disclosure standards.

The way forward: Augmenting the pivot of Governance

As the ESG markets come out from the shadows of greenwashing and political backlash, the focus decisively shifts to strengthening the governance facets. Reckoning the emerging sustainability themes, the governance priorities become more pronounced to recalibrate corporate strategies and cohesively integrate core sustainability tenets in product design, operational processes, and stakeholders' engagement. It also entails striking a fine balance between the overlapping regulatory requirements and current market practices across jurisdictions to chart the enterprise sustainability agenda. The good thing is that enhanced governance and supervision not only improve the integrity of compliance but also foster the corporate reputation.

A proactive stance of governance can amply empower business managers to drive vigorous implementation of risk mitigation measures and safeguarding interventions while keeping business KPIs under vigilant oversight. All the while, the top leaders’ attention can be directed to upshifting the people and stakeholders' practices to positively influence aimed business outcomes. Given the onerous progress of regulatory initiatives and industry standards setting, the evolution of a well-developed global sustainability framework is going to be a long-haul process. However, investment firms by keeping a governance compass aligned with a strategic direction would be in a better position to reap the benefits - beyond the ambit of green-labelled products and increased returns.