ESG and investment decisions to converge as new issues emerge

The line between ESG considerations and investment decisions will keep blurring in 2024, as asset owners and managers expect to continue bringing the two together.

"ESG factors are increasingly driving investment decisions," said Kris Tomasovic Nelson, senior director and head of ESG investment management for Russell Investments, with $291.9 billion under management. The firm's 2023 global survey of asset managers found only 7% of them saying that ESG factors do not drive investment decisions, compared to 22% one year earlier.

That is expected to mean more hiring of dedicated ESG personnel, particularly for data analytics and compliance — with the latter expected to be a bigger factor next year amid increasing regulation in many jurisdictions, continued vigilance against greenwashing, and political strains in the U.S. that show no signs of disappearing.

"The rhetoric is here to stay for a while," Nelson said. "Asset managers will continue to be more careful" in how they discuss ESG issues but on the asset owner side, "we are still seeing large U.S. corporate plans wanting to learn more about ESG. I do think the door is open to different terminology, and outside of the U.S., I don't see any slowing of momentum," she said.

The new year could also see asset owners spending more time and internal resources on evaluating the impacts of sustainability issues like climate change on portfolios, with less dependence on third-party providers of data and analysis. Frustrated by available climate scenarios, for example, officials with Universities Superannuation Scheme Investment Management, the main manager and adviser to the U.K.'s largest defined benefit pension fund, the £75.5 billion ($93.4 billion) Universities Superannuation Scheme, London, are now working with the University of Exeter on new scenario analysis methodologies for addressing climate risk in its portfolio.

With the recently concluded COP28 world climate negotiations fresh in investors' minds, climate will continue to dominate sustainable investing next year. An historic agreement reached to transition away from fossil fuels recognized the need to drastically reduce global greenhouse gas emissions, while calling for tripling renewable energy capacity and doubling energy efficiency improvements by 2030.

The latest COP agreement also recognized the need to reverse biodiversity loss to help solve the climate crisis, boosting the importance of biodiversity risk and opportunities for investors and policymakers alike.

"It was obvious to scientists, but it is new to policymakers. (Climate and nature loss) have led parallel lives and now they are converging a bit," said Sylvain Vanston, executive director of climate investment research at MSCI, who works with investor clients on climate risk reporting and management, portfolio management and, increasingly, biodiversity. The latter "is definitely a very dynamic space. A lot of clients are asking us to help them identify how their portfolios impact nature risk. They want increasingly sophisticated ways to measure that," said Vanston, who expects 2024 to see a boom of geospatial technology to analyze climate data and impact, and "a lot more development of nature-based opportunities."

Biodiversity also got a boost in September, with final recommendations from the Taskforce on Nature-related Financial Disclosures for companies and asset managers to manage and disclose nature-related risks to portfolios. Investors welcomed the move, but worry that the voluntary guidelines' lack of data standardization will make it tricky to integrate nature-related considerations into investment decisions. A push for more decision-useful data has begun and the first TNFD reports by companies and asset managers under a 14-metric framework will start showing up in the spring.

European pension funds have also joined financial institutions from 24 countries with a combined €21.4 trillion ($22.6 trillion) in assets taking the Finance for Biodiversity Pledge, committing to five steps to protect and restore biodiversity through their finance activities and investments. Their reports will start coming in 2024, and "it will be interesting to see who is coming out with real" actions and which asset classes are addressed, said Vanston, who thinks the first hard targets are likely to come from asset owners.

The new year will also see the 190-member investor initiative Nature Action 100 leveraging a collective $23.6 trillion in assets as they engage with 100 companies in key sectors to drive corporate action on nature and biodiversity loss. Investors will also be watching COP16, the U.N.-convened biodiversity counterpart to COP28, hosted by Colombia in October, to see how COP15's historic agreement and framework for global action to halt and reverse the loss of nature can be advanced.

The interplay of sustainability challenges like climate and biodiversity has also made investors more cognizant of systemic risk.

"It is how these issues will affect everything, not just one issue," said Stephen Miles, head of sustainability for Willis Towers Watson. Something like antimicrobial resistance "may not impact one company but it poses wider risk" for asset owners, and in terms of the financial relevance, "it could lead to a breakdown of the entire system," Miles said. "Asset managers are going to be called to be able to talk to these issues. They need to be doing some things to show risks are being managed."

John Hoeppner, head of U.S. stewardship and sustainable investments at Legal & General Investment Management America with $221 billion under management, agrees. "The idea of systemic risk has been slowly emerging over decades, but over the next year or two it will really bust into the forefront. There will be a shift from corporate value to portfolio value. It will be interesting because most company engagements are at corporate level, not at a system level," Hoeppner said. With many ESG-focused investor groups starting to zero in on systemic risk, "there is going to be a huge question on passive investment," he said.

Asset owners are also showing more interest in long-term trends and how to tap into them.

"We've come around from fear to how harness it," said Marina Severinovsky, head of sustainability, North America for Schroders, with $923.1 billion under management. She sees 2024 as the year of "3D – decarbonizing, demographics and deglobalization."

That means more focus on human capital, addressing supply chain challenges, and investing in clean energy companies that are now more affordable. "And, because we are moving from a place of making commitments to doing the real work, it's going to be bespoke for many folks. The personalization of (ESG) solutions is probably a trend for 2024," Severinovsky said.

The year should also see more emphasis on active ownership, through engagement or proxy voting.

"Even in clients who are wary of ESG, we are seeing more emphasis on governance. They know that voting is part of their toolkit," said Nelson of Russell Investments.

LGIM America's Hoeppner expects to see "an evolution of proxy voting" that questions how effective it is versus engagement. "I think we are going see lot of innovations. We don't know what that looks like yet, but there is building tension in the proxy voting process, and it's going to be exciting," Hoeppner said.

He also sees more open discussions among asset owners and managers about the "difficult tradeoffs on ESG topics and issues," such as chemicals that are harmful to people or the environment, but are critical for energy efficiency. "These tradeoff conversations that people have danced around before are starting to emerge. Forcing tradeoff conversations is the next generation of where ESG is going," Hoeppner said.

One corporate governance issue expected to heat up in 2024 is dual-class shares, or unequal voting rights that protect management and boards from the views of independent investors. Members of the Investor Coalition for Equal Votes representing $2.5 trillion in assets and chaired by Railpen, the in-house manager of the £34 billion ($42.4 billion) Railways Pension Scheme, London, and the Council of Institutional Investors, promise to speak more about phasing those out, officials there said.

And they will be paying particular attention in the U.K., where an effort to attract more listings led the Financial Conduct Authority in December to propose changes that include allowing dual-class share structures. If adopted, the changes could be in place by the second half of 2024.

As asset owners increasingly tune into sustainability issues like climate and diversity, they are also getting more critical of how their asset managers respond to — or ignore — their wishes.

Groups like the U.K. Asset Owner Roundtable, which brings together large U.K. local authority pension pools, the £3.2 billion ($4 billion) Church of England Pensions Board, London, and USS, studied external asset managers' stewardship and proxy voting activities with respect to major oil and gas companies, and found significant misalignments between words and actions.

Other groups, like The Interfaith Center on Corporate Responsibility, a coalition of more than 300 institutional investors with a collective $4 trillion in invested capital, have recently been raising concerns about asset managers' declining proxy voting on ESG shareholder proposals, and some are even filing shareholder resolutions at BlackRock, State Street, Goldman Sachs and J.P. Morgan over perceived misalignments.

One of the biggest unknowns for ESG is the role of artificial intelligence, and the potential to upend asset manager practices. "We have been approached by many really thoughtful entrepreneurs showing us cases where we are going to be using AI in our work flow," said Hoeppner of LGIM America. He predicts that in a matter of months, traditional ESG research on investee companies "is going to be automated. That's a big deal because that takes a lot of time." While it will speed up managers' ESG-related research, so far it is "unclear how it will change the market," he said.