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R. Scott Arnell is Founding Partner of Geneva Capital S.A. in Geneva, Switzerland and host of the SRI 360º Podcast.
Environmental, social and governance (ESG) investment strategies suffered a black eye this past year due to skyrocketing fossil fuel share prices that put a damper on ESG fund returns combined with increased politicization in the U.S.
The term ESG became more established in the early 2000s when the United Nations Environment Programme Finance Initiative commissioned an international law firm to assess if ESG factors can be considered by institutional investors. They concluded they could and were arguably part of their fiduciary responsibility.
Since then, ESG-related assets under management (AUM) rose to $18.4 trillion in 2021 and are projected to hit $33.9 trillion by 2026, representing 21.5% of total global AUM in less than five years according to a recent PwC analysis.
While the United States experienced the strongest expansion of ESG AUM in 2021, the EU has always been ahead and accounts for half of all global ESG investments.
Greater acceptance of ESG in the EU is largely due to its regulatory environment, as historically, it's been much more proactive compared to the U.S. In 2018, the EU adopted an Action Plan for Sustainable Finance that included legislative measures on a unified EU classification system, low carbon benchmarks and strict disclosure requirements. Additionally, the EU Parliament has passed laws requiring EU countries to comply with the Paris Climate Accord.
But the U.S. Congress has yet to pass any substantial laws specifically addressing climate change. The Federal Reserve and Office of the Comptroller of the Currency have yet to issue any meaningful directives in this regard.
By contrast, the European Central Bank and European Securities and Markets Authority have already created climate-related stress tests for the institutions they govern. But without stronger regulation, the U.S. ESG market remains susceptible to greenwashing -- or the practice of misleading investors by promoting ESG-labeled investments that don't meet ESG standards.
Lately, legislative issues have imperiled ESG momentum in the U.S. The Economist reported that a rule proposed by the SEC requiring major corporations to disclose climate change risks is facing opposition from lawmakers on both sides of the aisle. The U.S. Supreme Court also recently limited the EPA's authority to curb power plant emissions.
But the most dramatic development is that ESG is drawing political heat. Opponents argue that pursuing ESG goals distracts from fiduciary obligations, increases "unnecessary red tape" on independent businesses and undermines the best interests of shareholders.
Many lawmakers are actively resisting ESG initiatives, and some have delivered major speeches promoting anti-ESG initiatives. More than 30 states have introduced anti-ESG legislation. According to Capital Monitor analysis, most of it seeks to prohibit state agencies from "doing business with financial institutions that have exclusion policies for fossil fuels or firearms," arguing that such policies harm industries in their respective jurisdictions.
Vanguard recently withdrew from the Net Zero Asset Managers (NZAM) initiative and other companies are taking a wary approach to ESG, fearing reprisal. Missouri is investigating Morningstar to determine whether the rating agency's ESG scores violate consumer protection laws, and other states are conducting similar investigations into S&P Global. The state of Texas recently banned JPMorgan, Goldman Sachs and BlackRock from working with Texas state entities due to their lack of support for the fossil fuel industry.
ESG fund returns suffered in 2022 due to the high returns on fossil fuel shares that are underrepresented in ESG funds, a short-term phenomenon related to geopolitical conflicts. Despite those challenges, ESG funds continued to deliver competitive returns, with some outperforming, as reported by Morningstar. Funds focused on sustainability generated $22.5 billion in net inflows in Q3 2022, even as the overall market was hit by $198 billion in outflows.
Recognizing that the legal basis underpinning the integration of ESG differs in the U.S. from the U.K. or EU, it will take some time for the regulatory environments, mandatory ESG reporting requirements and integration of ESG factors in the investment process to shake out in the different jurisdictions. Nevertheless, companies can proactively take steps now to strike the right level of ESG integration and comparable, cohesive disclosures for their investors and stakeholders. Here are some of these steps:
* Increasing Transparency: Clearly define how ESG factors affect your company or fund in practical, understandable terms. Articulate how these factors are incorporated into your decision-making process.
* Identifying ESG Goals: Set clear ESG performance goals and integrate them into your overall business strategy.
* Voluntary Reporting: Historically, financial disclosures of risks associated with sustainability issues have not been a priority within the financial reporting community. In Europe, this is changing somewhat with the Sustainable Finance Disclosure Regulation (SFDR) for the financial industry and the Corporate Sustainability Reporting Directive (CSRD) that stipulates new EU rules that companies will have to report for the first time in the financial year 2024. Companies and funds can start adopting international reporting frameworks like those established by the Sustainability Accounting Standards Board (SASB) or Task Force on Climate-related Financial Disclosures (TCFD). Companies can also start to familiarize themselves with recent developments of the IFRS' international reporting standard initiative, the ISSB (International Sustainability Standards Board).
* Engagement: Companies can engage with stakeholders to understand their concerns regarding ESG issues that will help identify areas for improvement. Investment funds can engage the management of portfolio companies to positively influence their ESG performance.
* Independent Verification: Obtaining reputable third-party verification of ESG performance will help provide assurances to stakeholders that your ESG practices are credible and aligned with stated goals.
The trend is clear: more and more, investors believe that considering ESG factors leads to better insights into long-term potential returns. A recent survey conducted by PwC Luxembourg found that more than two-thirds of European asset managers are now contemplating the halt of new products that don't meet ESG standards. Last month, President Biden vetoed legislation passed by the U.S. Congress blocking a new Department of Labor rule that would allow retirement plan fiduciaries to consider ESG factors when selecting investments. Despite the current pendulum swinging back and forth between the U.S. and Europe, ESG in some form is certainly here to stay.
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