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After two years of explosive growth, investments incorporating environmental, social, and governance (ESG) criteria endured a challenging market environment throughout 2022. The combination of elevated inflationary pressures, geopolitical tensions, and an energy crisis following Russia’s invasion of Ukraine precipitated a challenging backdrop for sustainable investments. Furthermore, skepticism in the U.S. around the efficacy of ESG—due to greenwashing and heightened politicization—slowed the pace of progress compared to that experienced in 2020 and 2021. But as investors turn the page on a volatile 2022, what does the path forward for ESG investments look like?
Regulatory Clarity Ahead
Following the pronounced demand for ESG and sustainable investments in 2021 and 2022, concerns around greenwashing—or misleading claims regarding the sustainability of a company or asset manager’s products—prompted regulatory bodies in the U.S. to focus on addressing those misleading ESG claims. Their proposals were aimed at providing investors with greater clarity and consistency when defining ESG investment approaches (i.e., ESG integration vs. impact funds) and standardizing the disclosure and reporting requirements for funds that incorporate ESG criteria into their investment process. An additional proposal focused on climate-related disclosures (i.e., greenhouse gas emissions), which could become a requirement for public companies going forward. Governing bodies will continue to clamp down on ESG in 2023—by clearly defining ESG approaches, mandating disclosure requirements, and providing greater transparency and consistency—from an ESG data and ratings perspective.
In fact, we are already starting to see greater regulatory scrutiny surrounding climate-related data in other areas of the world. In the UK, for example, the Task Force on Climate-Related Financial Disclosures’ (TCFD) reporting recommendations are already becoming the norm.
A Focus on Renewables
The renewable energy transition is likely to continue accelerating in 2023. Russia’s invasion of Ukraine precipitated surging energy prices in 2022, while highlighting the economic and geopolitical risks of the global economy’s reliance on fossil fuels. This was most notable in Europe, where inflation accelerated energy and food costs, resulting in an economic slowdown and causing governments to implement costly energy packages. As a result, countries will continue to focus on energy affordability and security. Renewables will play an integral part in helping to resolve the challenges of energy costs associated with fossil fuels, while reducing carbon emissions and aligning with new net-zero targets.
In addition, over the past decade, the costs of renewable energy generation (e.g., solar and onshore and offshore winds) have become more attractive than natural gas sources, especially in regions like Europe. Ultimately, companies that are well-positioned to align with secular growth trends, such as the transition to a more sustainable global economy by creating products or facilities that capture and store energy, will continue to garner market share, while upending many sectors and industries in the process.
Clearer Skies Ahead?
In the U.S., ESG investments faced the perfect storm of politically charged headwinds and relative underperformance in 2022. The politicization of ESG, including increased skepticism on the underlying merits of ESG investing, precipitated states to divest from funds and asset managers with dedicated ESG strategies or sustainability commitments. Still, the private sector is poised to aid the progression of ESG initiatives, such as the transition to net-zero, through investments in renewables. From a performance profile perspective, ESG strategies with allocations to growth sectors (e.g., technology) and strategic underweights to the energy sector lagged their traditional counterparts across many asset classes in 2022.
Despite the backlash and performance headwinds, the ESG space continued to garner assets throughout 2022. In fact, U.S. sustainable funds garnered net inflows of $459 million, compared to the $86 billion in outflows across the universe of U.S. funds and ETFs, as of Q3 data from Morningstar. Additionally, the space experienced an active shareholder resolution, stewardship, and proxy voting period in 2022. Trends including the emphasis on stakeholder capitalism, the continual rise of investors’ preference for passive ESG investments, and the generational wealth transfer to younger generations of Americans—who exhibit a greater propensity to invest according to their personal values and/or with ESG-related objectives in mind—should continue driving growth and awareness in the space.
An Evolving Space
Despite experiencing its fair share of growing pains in 2022, the sustainable investing space is well-positioned to participate—and evolve—in the market environment from a performance perspective throughout 2023. For starters, greater regulatory clarity and standards will empower investors to appropriately identify the sustainable investing approaches that meet their financial goals, while helping to mitigate the impact of greenwashing. Furthermore, investors interested in incorporating ESG criteria into their investment process will benefit from forthcoming transparency on measuring and disclosing climate-related risks, coupled with greater transparency on the ongoing transition to renewable energy.
Looking back, if 2022 taught us anything, it’s that ESG investing is here to stay. For many, ESG investing is a sensible component of business, given the ability to assess a company or industry’s long-term risks and opportunities. For others, the ability to garner a more complete, well-rounded view of how a company operates will continue to drive the demand for ESG investments. While the space is still evolving—and remains far from perfect—those interested in ESG investing are in a better place entering 2023 than ever before.
Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.
Investments are subject to risk, including the loss of principal. Environmental, social, and governance (ESG) criteria are a set of non-financial principles and standards used to evaluate potential investments. The incorporation of ESG principles provides a qualitative assessment that can factor heavily into the security selection process. The investment’s socially responsible focus may limit the investment options available to the investor. Past performance is no guarantee of future results.
