ESG Outlook 2022 – the A.S.A.P. year

Unlike the uncertain outlook for equity markets, we have no doubts when it comes to ESG and sustainability, 2022 will be another banner year with accelerating levels of activity on many fronts, from corporations, governments, consumers, and investors. We hope the year will be looked back on as the one where the world moves away from sweeping statements, long-term targets and greenwash (or greenwish) and moves towards concrete actions accompanied by clear metrics to measure the outcomes of such actions.

Check out our webinar on key trends that will shape the world of ESG in 2022 or read a summary below. 

The flows will continue…

Investment flows into ESG funds have continued unabated during 2021 (Figure 1), something we expect to continue in 2022. In 2021, USD 3 of every USD 10 of inflows into global equity funds have gone into so called “sustainable” funds, as have USD 2.3 of every USD 10 of flows into global emerging market funds. ESG assets now make up 11% of total GEM assets under management (AuM), up from just 3% three years ago, partly due to managers repurposing (or relabelling) their funds as sustainable. Regrettably many funds’ ESG credentials mainly consist of sector exclusions. When investors avoid sectors (such as fossil fuel) and / or put pressure on companies to divest their more polluting assets, it will likely lead to the “worst” assets being pushed out of public ownership (as companies are forced to disinvest “dirty” assets to private owners or decide to delist altogether) and hence out of scrutiny. This will have clearly negative impacts on the actual transition to a low-carbon economic model because these assets keep polluting but belong to shareholders who just want to gain financial returns without any consideration for the planet.

More generally, these numbers significantly understate the true value of the importance of ESG for the investment community, and we have, for instance, anecdotal evidence from investor questions during group meetings with companies. Most asset managers (at least those in Europe, which dominates the sustainable fund space with 88% of total AuM and 77% of Q3-2021 flows) now take ESG into consideration in some way or another. The best question we’ve heard started with the fantastically grudging “I work for a European investor, I have to ask a question on ESG”. Perhaps a better way to look at it is that AuM of signatories to the UN Principles for Responsible Investment (PRI) have increased by USD 24 trillion YoY up until March 2021 (PRI’s calendar year) to USD 150 trillion, some 19% YoY. This trend includes asset owners, which are highly important as pension funds, foundations and sovereign wealth funds represent an important source of long-term capital which is required for the energy transition. Having said that, we would hope for more emerging markets-based asset owners to follow suit; for instance, the PRI does not have any asset owner signatories in Russia, only 1 in India, 3 in China and 14 on the whole African continent!

Finding new gems

Of course, these record flows make ESG investing somewhat of a self-fulfilling prophecy, and stocks of ESG darlings have performed very well as the swelling amount of AuM tends to chase the same few stocks. Hence, one area we think will characterise 2022 is that investors start looking across the supply chain beyond the obvious names in order to get exposure to the same structural growth stories at much more reasonable valuations. For example, we don’t think many investors are aware that for every ton of CO2 that semiconductor companies emit, they help avoid five times more emissions by enabling more power and greener power. Clearly, this has a huge impact and something sustainable funds should want exposure to, assuming that other material ESG issues, such as water use and minerals sourcing, are managed properly.

Forward-looking

The other evolution in ESG investing is that we expect investors will become more focused on the forward-looking developments in companies, in order to catch the future “ESG stars”. This is why we include a separate ESG momentum assessment in our ESG scorecards and also a forward-looking part of our SDG Value Chain Analysis tool, which has a 50% weight in the overall score. For example, one of our China A-shares holdings is a mining company which plans to increase its copper revenues from 20% in 2020 to 41% in 2025, and the company is very active in reducing its operating emissions. Among other things, it is targeting to run the world’s first net-zero mine at its anchor project in DRC, the Kamoa-Kakula Copper project, a joint venture with Ivanhoe, a Canadian mining company. While the company might not look very exciting at the moment, we are sure that when the transformation becomes clear, the stock will receive a lot more attention from investors.

Do your homework

This increased interest has also led to an explosion in ESG data providers, who will provide funds with temperature alignment, carbon footprint or other metrics. While we generally welcome this development, there is a real risk that such tools are used by investors without actually considering their usefulness in their investment process or in terms of real-world impact. For example, we buy external carbon footprint analysis for our funds to show our investors, but the investment teams find them neither useful nor insightful. However, when we started asking analysts and PMs to run their own models to assess transition risk in companies under various carbon pricing scenarios (see figure 2 for an example), we saw much more real-world application of these numbers, including robust dialogues with companies and engagement on transition risk management.

A for Accountability

COP26 catalysed a barrage of announcements and climate pledges from governments, investors, lenders and companies. This is obviously positive, but 2022 will be the year where we need to go from “talking the talk” to “walking the walk”. Investors like us are looking for companies with robust transition plans detailing clear actions that will result in the short-term emissions reductions that are crucial in keeping global warming well below 2C.

Reporting metrics

A key part of measuring the results from these plans, or any other sustainability impact, is clear reporting standards, in particular SASB (Sustainability Accounting Standards Board, housed under the Value Reporting Foundation or VRF), which we have selected as our preferred framework. In 2021 we rolled out a SASB-based SDG Value Chain Analysis tool for our global emerging markets portfolio and it is remarkable how much easier it becomes to compare and contrast companies' outcomes. For example, we were recently discussing a number of healthcare providers in various emerging markets. One of the material sustainability issues our tool highlights is energy use, because the healthcare industry accounts for 4.4% of global CO2 emissions¹. While every company claims they have made large strides in reducing emissions and increasing energy efficiency, it is important to take the analysis one step further: for instance, looking at energy consumption per sqm of hospital space over time and comparing it to peers makes it very easy to assess how much each company has really achieved. Once we have a clear view on this, we can engage with companies on the topic and trigger some real improvement. We think this style of analysis will become increasingly common and this is what we are building East Capital ESG Scorecard 3.0 around. We already do this for the more obvious metrics. For example, for Russian steel companies our Moscow colleagues will know the projected dividend yield, free cash flow yield and the carbon intensity per ton for each of the large producers.

New tools and higher standards

One interesting area we are following closely is the emergence of more tools that help investors and companies measure and report on these metrics. This includes spatial finance, satellites (very important for methane emissions) and blockchain-based reporting solutions. Accountability will be driven by data and standards, and it would be remiss of us not to highlight some of this “alphabet soup” because it will take a lot of investors’ time in the coming year whether we like it or not. The various European regulatory initiatives will now really start impacting the world of ESG investing. These are the EU Taxonomy, the SFDR (Sustainable Finance Disclosure Regulation), which sets out obligations for asset managers and the CSRD (Corporate Sustainability Reporting Directive), which regulates how all companies listed on European regulated markets report on sustainability and tag information into a European single access point. Besides, in 2022, we will closely follow how two recently announced initiatives will play out: the ESG Book, a new open-source for ESG data, and the International Sustainability Standards Board (ISSB), which will hopefully see audited material sustainability metrics become part of IFRS-type reporting.

S for Subtleties

Given the breathtaking pace at which ESG investing has developed, the market has tended to fall back to some relatively (overly)simplistic axioms, such as “all oil/mining companies are bad”.

However, we expect that the market will gradually adapt to the level of nuance required when thinking of these issues. For example, at face value, it is objectively great that Shell was ordered to reduce Scope 1-3 emissions by 45% by 2030 in a recent court order, or that BP sold off their Alaskan assets and hence reduced CO2e emissions by some 8MT. However, does that mean the demand for oil will be less? If not, who will produce that oil? Most likely countries, such as Iran or Venezuela, which care much less about the environment, or companies which are beyond reach of shareholder activism. BP’s Alaskan assets were bought by a non-transparent privately owned company and emissions increased by 8% the year after they were acquired². Such actions by oil majors are usually well-intentioned and justified, but most likely it would have made more sense for these highly transparent best-in-class companies to be controlling oil production and winding down their fields in a sustainable and gradual manner. The same is true for coal, and hence it was a logical and welcome step to see the Asian Development Bank announcing plans to buy out and retire coal power plants, running them in a responsible way until they repay the debt. For those of us who have always paid attention to the ownership of any business we invest in (we call it KYO – Know Your Owner³), the question of shareholder’s responsibility is interconnected with real-world impact.

Individual approaches matter

Our sense is that over the last few years there has been a fallacy that ESG will homogenise (partly thanks to data like ESG ratings or implied temperature rise metrics) and hence it would be easier for fund selectors and asset owners to select good ESG funds. However, we believe that assessing an ESG approach is like assessing overall investment processes of funds. Every manager will end up with a slightly different approach and investors need to think smartly about the real word impact of their investments.

From our perspective the most important thing managers can do is to be fully transparent with what they do and how they do it. For example, if a client has an ESG-related question on a company in one of our portfolios, we can get the analyst or portfolio manager who has completed the scorecard or value-chain assessment to explain exactly what we were thinking, what sort of engagement we have with the company and our expectations for future developments on any issue.

We also strongly believe that both good and bad examples of strong ESG/SDG practice and impact can be found in any sector. For example, we own an Indian movie theater chain that has eliminated single-use plastic from their operations, reducing 100,000 kilos of plastic demand per year, and is targeting fully renewable power use as soon as practically possible.

A for Adaptation

Regardless of the efforts put into mitigating the effect of climate change, scientific evidence and recent extreme weather events from Siberian, Californian or Greek fires to German, Chinese and Indonesian floods remind us of the fact that climate change is already a fact. Companies need to prepare for the impact of climate change because these events do have an impact on profitability for those effected.

Naturally, investors and other capital providers will want to take these risks into account when analysing companies, though for the time being it is difficult to do this in a systematic way, which is clearly unnerving. We hope, and expect, that more tools will become available to really assess these risks in a structured way, particularly around geo-tagging and weather modelling.

The same issue is true for biodiversity. We know that human-induced changes to ecosystems have contributed to a significant loss in biodiversity, which will impact our portfolio companies, for example through higher operating expenses due to increases in input prices in the food sector. However, for the time being it is very difficult to assess companies’ exposure to these risks in a systematic way, partly because we do not see them affecting our companies’ value chains to the same extent as physical and transitional risks of climate change. Therefore, we are very excited that the first beta version of the Taskforce on Nature-related Financial Disclosures (TNFD) will be released in Q1 2022, which will hopefully provide a clear framework to improve and increase reporting about nature and biodiversity loss that we can discuss with portfolio holdings.

Double-materiality

Adapting to a world where the effects of climate change and biodiversity loss are already felt and will become a fait accompli everywhere, requires a focus on “double-materiality” assessment. The concept of double-materiality, which emerged a few years back, is about defining the environmental and social impact a company has and how the company itself is impacted by these factors. The concept also requires the exploration of the interconnectivity of the two. A big part of the double materiality assessment work will be centered around adaptation and the idea that climate change already has an impact on many businesses and sectors, may it be the price of soft commodities or the concept of setting a “true price” on inputs, such as fossil fuels (which we discuss in the commodities section of our 2022 Outlook⁴).

P for People

One of our fundamental ESG beliefs has always been that the “G” is central to the “E” and the “S”, i.e. companies with high quality governance, usually display better environmental and social practices. Nowadays, we notice that the importance of “S” is increasing, and we think that it will accelerate.

Some incredibly challenging times, partly driven by Covid-19, have taken a toll on mental and physical health, leading to investors and companies focusing more on decent pay and work conditions, as well as health and safety issues. Many companies are now fielding extensive questions from investors on health & safety and talent retention; and other labour-related issues, which, in some sectors, have become a real headache due to labour market disruptions. As examples of how this social focus can impact companies, we see that construction projects in China are suspended to protect workers from poor air quality and tech companies in Asia no longer dare to boast about their 6-9-9 work culture (6 days a week, from 9am to 9pm). Employers’ responsibility is becoming increasingly in focus. Only once in our 25-year history of investing in frontier and emerging markets were we hosted by the Head of HR on a company visit, it was a ready-made garment factory in Bangladesh, 3 years after the Rana Plaza tragedy. We are convinced that more companies will bring their head of HR to speak to investors going forward.

New paradigm for social relationships

The pandemic has sped up some transformations with profound impact on people, for instance how we interact with other individuals, colleagues and clients we have never met in person, how city landscapes have been transformed (forever, some argue), new modes of entertainment, travelling and socializing where digitalization has reduced human contacts and increased human interaction. Companies, which understand these profound changes and adapt their client value proposition, will outperform their peers. Gamification of the user experience of consumer goods companies is one such example. We look for these attributes when screening for investment ideas.

Further changes related to the pandemic is the unprecedented amount of social welfare which was distributed as part of the economic recovery programs in many countries. We see some societies adopting a welfare state model which has huge implications on consumption. The social checks handed out by governments in developed markets has led to explosive demand for consumer goods, which often are manufactured in emerging markets, and for digital services for which some emerging markets companies are ahead of the curve.

Of course, we would be remiss to not mention the standards and data that will drive disclosure (and hence action) on the general “social” topic. As part of the EU Sustainable Action Plan, a social taxonomy might be forthcoming in Europe and already now the minimum social safeguards implemented in the EU taxonomy will drive more focus on how companies behave towards their communities. A new initiative by the PRI regarding human rights is about to be launched and is modelled around the Climate Action 100+, i.e. an investor led initiative to engage with the worst companies and push them for better disclosure and proper management of the issues. Questions on human rights in the value chains of our portfolio companies will become more frequent.

Conclusion

Accountability, Subtleties, Adaptation and People are four main dimensions, which we think will shape the world of ESG in 2022. A.S.A.P is also a symbol of another key conviction we have that we are at a turning point for ESG and responsible finance. 2030 is only nine years away, and six years have already passed since the Paris Agreement, where the SDGs were enacted. The journey has started slowly but will accelerate massively going forward.

¹ ”Healthcare’s Climate Footprint”, Health Care Without Harm, September 2019
² https://www.bloomberg.com/graphics/2021-tracking-carbon-emissions-BP-hilcorp/
³ Key success factor for emerging markets investors: the KYO approach
⁴ 2022 outlook – an “alpha year” or a headache for active managers?