Another busy year expected with more regulation, investor activity

It will be hard to top 2021 when it comes to ESG news, but 2022 promises to be equally busy, with more regulation and increasingly active institutional investors.

For investors, climate change will continue to dominate ESG priorities in 2022 as they ramp up efforts to decarbonize portfolios and embrace opportunities in the transition to clean energy. Other issues like biodiversity, boardroom and workforce diversity, and human capital management will also be on many investors' radars.

In November, the United Nations' climate change conference, COP26, in Glasgow captured the world's attention with the enormity and urgency of the climate crisis. It also sent the message to institutional investors that meaningful progress depends on them more than ever.

Many pension funds and asset managers are taking that to heart, moving even faster to reach net-zero emissions in their portfolios by 2050 or sooner. Groups like the Net-Zero Asset Owner Alliance, with a collective $10 trillion in assets, and similar ones for asset managers and consultants, have made that pledge. More than half of its members, including the $500 billion California Public Employees' Retirement System, Sacramento, have pledged 25% cuts or more by 2025, and similar pledges keep rolling in.

To reach their net-zero goals, pension funds like the C$114 billion ($89 billion) Ontario Municipal Employees' Retirement System, Toronto, will spend the coming year calculating their portfolios' total carbon footprint to come up with net-zero plans.

Early in 2022, more asset owners and managers will also be producing individual climate action plans, predicted Rev. Kirsten Snow Spalding, senior program director of the Ceres Investor Network in Berkeley, Calif., whose 200-plus institutional investors manage more than $47 trillion in assets. That will place more emphasis on accountability, she said. "It is not enough to have targets without plans. You've got to hold everybody accountable," Ms. Spalding said.

Asset owners' net-zero plans are making them more aggressive with the companies they invest in, or increasingly, divest from. On Dec. 20, the same day the £20 billion ($26.8 billion) National Employment Savings Trust, London, committed to a 30% reduction by 2025 in the carbon footprint of its portfolio of publicly traded stocks and bonds, it sold holdings in five energy companies it did not see working fast enough to address climate risk.

The $267.8 billion New York State Common Retirement Fund, Albany, has pledged to divest energy companies without a plan to cut emissions and transition away from fossil fuels. In December, the pension fund confirmed that it will internally manage a $2 billion passive fund pegged to an FTSE Russell climate-change risk index.

A perceived lack of progress on energy transition plans led the €523 billion ($591.3 billion) pension fund Stichting Pensioenfonds ABP, Heerlen, Netherlands, to pledge to spend 2022 divesting all its holdings in fossil-fuel companies, worth €15 billion, and reinvest that in renewable energy strategies. Other pension funds, like three public ones in Baltimore, are being told by legislators to divest from fossil fuels.

COP26 also brought good news for investors that global standards for climate disclosure in financial markets are in the works. The International Sustainability Standards Board, unveiled by the global accounting body International Financial Reporting Standards Foundation, is aiming to issue some standards by mid-2022 that local jurisdictions and public or private companies could adopt voluntarily.

"That is a very important and positive development. Alignment around what is relevant to investors and how to measure it is everything," said Ken Mehlman, partner and global head of public affairs at KKR & Co. Inc. and co-head of KKR Global Impact in New York. KKR Global Impact invests in scalable commercial solutions to solve critical global challenges.

KKR helps lead a Ceres private equity working group helping general partners and limited partners address the impacts, risks, and opportunities of climate change in alignment with Paris Agreement goals.

Europe is taking the mandatory approach to tackling climate change in investments. Starting Jan. 1, European investors have to report the climate-related impact of their portfolios under the European Union's Sustainable Finance Disclosure Regulation taxonomy approved in December.

The taxonomy was designed to set a common language for investors, companies and managers to assess environmentally sustainable activities, although further details are expected throughout the year. In addition to disclosing the degree to which their ESG investments are aligned with the taxonomy, investors will have to report on the carbon emissions of their overall portfolios.

In the U.K., pension trustees will have new standards for climate-related governance and reporting of both risks and opportunities. The new reporting rules apply to pension funds with assets of £5 billion and will be expanded to funds with £1 billion or more in October 2022.

In the U.S., the Securities and Exchange Commission is expected to unveil mandatory climate-risk disclosure rules in early 2022 to give investors "consistency, comparability and reliability," Chairman Gary Gensler said in several speeches this past summer and fall. Such disclosure would also tackle the risk of greenwashing through inadequate or misleading reporting, Mr. Gensler said.

"We are moving into a world where climate-related reporting is no longer a 'nice-to-have,'" said Brian Deese, director of the National Economic Council in Washington and former sustainability leader with BlackRock Inc., in a webinar last month. With SEC action, recognition of climate risk by the Financial Stability Oversight Council and proposed rules from the U.S. Department of Labor to clarify that fiduciaries should consider climate risk pertinent to financial performance, "you can expect the U.S. to move from laggard to middle of the pack," he said.

Matt Orsagh, senior director of capital markets policy at the CFA Institute in Charlottesville, Va., predicts more pressure by investors on public and private companies to disclose climate risks and solutions, and to ensure their lobbying and political activities don't counteract those efforts. "Everybody knows this is material now. You are seeing a lot more discussion by investors. I can see more votes against directors and companies and lawsuits," he said.

The 2022 proxy season should see more resolutions from large asset owners demanding that companies show their energy transition plans, said Ms. Spalding of Ceres Investor Network. "We do know that when companies get a majority vote, they act," she said. Corporate directors and executive compensation structures will also be scrutinized for climate plans, advocates say.

The "S" in ESG will get a boost in 2022 when the EU releases a draft social taxonomy to provide a framework for standards that mirror those for the existing EU environmental ones. The draft social taxonomy is expected to identify activities that deliver a "substantial contribution" or "significant harm" to social objectives.

While presenting European companies with yet another reporting challenge, the resulting taxonomy could help investors identify opportunities to invest in solutions such as affordable health care and housing or sustainable communities.

Spurred by that, ESG research firm Sustainable Fitch predicts that more investors will combine climate and social objectives under single investment mandates, as ESG integration progresses.

Diversity and inclusion will be another priority for institutional investors in 2022, including more disclosure of corporate board demographics and more diverse boards, said Illinois Treasurer Michael Frerichs. He co-leads the Midwest Investors Diversity Initiative, an alliance of pension funds and other institutional investors with a collective $820 billion in assets dedicated to increasing diversity within the asset management industry.

Whether it is climate change, human capital management or diversity, "we as investors want more standardization and disclosure. I think companies also benefit," he said.

With more than half the world's economic output dependent on nature, according to a World Bank study, biodiversity will move center stage, driven by the Taskforce on Nature-related Financial Disclosures, which plans to release a beta framework in the first quarter.

"In 2022, more private-sector players will realize that their race towards net-zero emissions will only succeed if they race equally fast towards nature-positive," said the TNFD in a December news release.