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In terms of assets under management and registered inflows as well as in terms of global regulatory progress, ESG and sustainable investments experienced an incredible year last year. This positive ESG momentum is likely to continue in 2021, bringing with it all manner of risks and opportunities. Both will need to be carefully and closely monitored to demonstrate that ESG factors go hand in hand with sustainable performance. The main ESG related risks to monitor in 2021 include firstly the impact of COVID (and particularly its connection to other ESG risks on the radar), and secondly the geopolitical risk as an important factor in major ESG challenges with regards to supply chains, climate change transition, digitalisation and technologies.
2020, DEFINITIVELY AN INCREDIBLE YEAR, PARTICULARLY SUPPORTIVE FOR ESG INVESTMENTS
The data is clear: ESG-identified funds registered positive inflows last year, including in February and March 2020. According to Morningstar data, assets in sustainable funds hit a record high of USD 1.25 trillion during the first three quarters of 2020, in which Europe achieved a symbolic USD 1 trillion.
On top of this, several researches have demonstrated the greater resilience of ESG factors during this volatile year. These factors have provided relevant signals for earnings volatility, price volatility, and bankruptcy risk. Controversies related to ESG facts and issues have been increasingly monitored, as these turn out to be long-lived and costly.
ESG MOMENTUM : THE RISKS TO MONITOR IN 2021
The greater the focus on sustainability, the higher the associated reputational risk. Combined with pending regulation which seeks to curb green-washing, we face a considerable challenge. Indeed, there is a high risk that the additional workload, cost and complexity will further complicate matters for investors who are already finding their way around the expansive universe of sustainable investing.
Although Europe remains the leader when it comes to the creation of ESG laws and policies, all parts of the world have woken up. Various governments are launching ambitious regulations, including their own taxonomies, as in Japan or Canada. Singapore, Hong Kong or Malaysia have also catalysed ESG disclosure. However, the proliferation of single and local taxonomies and the absence of universal standards and definitions will not help in terms of opacity and diversification.
The latest regulatory initiatives from the European Commission (EC) are facing several headwinds. Indeed, the EU Taxonomy or the Sustainability Disclosure Regulation are subject to criticism regarding their technicality and the amount of required data. Indeed, it might be relevant to remember that corporates are currently not reporting their revenues according to “green” and “brown” activities. Too much regulation risks to inhibit innovation and to create costs for investors.
Valuation and potential underperformance constitute a second risk which might hamper ESG’s momentum. Underperformance could damage enthusiasm for this segment. Indeed, sustainable corporates have seen a spectacular expansion in their multiples over the recent years in terms of P/E, EV/Ebitda and EV/Sales, etc. This could be explained notably by the late global rush to so-called “green” issuers. The recent regulation, and its generalisation across the world, could accentuate this preference for greener corporates and investments (see below). This is why it will be key to actively select and review the investments in the portfolios.
ESG MOMENTUM : THE OPPORTUNITIES TO EXPLOIT IN 2021
The trend and the worldwide regulation are supportive of demand for capital allocation towards more green and sustainable solutions.
On one hand, there are the texts to regulate sustainable investments. On the other hand, there are the various ESG regulations to regulate sustainability at corporate level. ESG investing no longer only concerns European companies and investors; it has become a global priority. Indeed, most of the key APAC markets (China, Hong Kong, Japan, South Korea, New Zealand or Singapore) have committed to ESG regulation. The coming year will give us more details on the implementation. The regulations refer not only to climate change but also strengthening the financial ecosystem for ESG investments.
In the USA, the new presidency could represent a pivotal year for the country in terms of climate change targets and ambitions. It will also be important to follow up the declaration of the US Federal Reserve to join the Network of Greening the Financial System (NGFS). This network of 75 central banks and regulatory authorities formally recognises climate change as a systemic financial risk. Since November 2020, the Fed, whose actions are followed by billions of investors, has included climate change as a financial stability risk in its semi-annual Financial Stability Report. Furthermore, the elections could be an important catalyst for sustainable finances in the US. Rumour has hit that the Biden-Harris Administration plans on mandating and standardising ESG disclosure by issuers. It might also modernise fiduciary duties to integrate ESG factors, and incorporate these into financial safety and soundness regulation.
Finally, let’s not forget about the Latin American continent. Although it is still lagging behind compared to other parts of the world, its developments in ESG regulation have been steadily progressing thanks to increasing interest from investors. Of note, Brazil might adopt mandatory reporting and disclosure standards similar to the TCFD recommendations. Smaller countries, like Mexico, Chile, Colombia or Peru are also expected to adopt ESG regulations. The question is rather whether they will develop their own national standards, or if they will adopt the global existing ones instead. The latter option could put us on the road towards universal standardisation.
GREATER TRACTION FOR GREEN AND SOCIAL LABELS IN 2021
We have been highlighting the record issuances of green bonds for several years. 2021 will not be an exception in this regard, though it will likely witness a diversification towards social and sustainable bonds as well. In Europe, we expect close to EUR 75-100 billion of labelled corporate bonds, compared to over EUR 50 billion in the first eleven months of 2020. The issuing sectors are likely to consist of consumer goods, health care and telecoms. These would present a welcome diversification to the current dominance of utilities and banks.
It is also worth noticing that the pandemic and racial tensions have led to a huge pick up in the social bond market, which grew tenfold since last year. The social bonds still represent only a minor part of labelled bonds (less than 30%). Still, following their 2020 pickup, they will become increasingly important.
Global decarbonisation is expected to require USD 150 trillion; there is no doubt that green bond issuance will not slow down. However, regulations regarding green bonds (and in particular reporting) will continue to strengthen transparency, climate-related key performance indicators and coverage of achieved targets.
THE PANDEMIC HITS THE SDG’S FINANCING GAP
The sanitary crisis has increased the financing needs for the sustainable development goals. In some cases, 2020 has suppressed years of recent progress. The needs were originally impressive: around USD 2,5 trillion per year. The impact of the COVID crisis and the subsequent lockdowns is estimated to have cost an additional USD 1 trillion in 2020. In parallel to these increasing needs, the financing sources decreased in 2020 (around USD 700 billion for external private resources).
Source: Global Outlook on financing for sustainable development 2021 © OECD 2020
Although the plans to relaunch the economy have been adopted everywhere, it is important that they are consistent with these objectives. The UN has already raised the alarm about the risk of inconsistency. Indeed, several support programs are invested in sectors which are highly dependent on fossil fuels. Meanwhile, the Paris Agreement urgently requires a decrease of 6% per year until 2030 to achieve a +1,5° scenario. The Paris Agreement conducted a review of the current results in 2020, and concluded that these were not at all aligned with the agreement’s goals. This year also witnessed the upwards revision of national ambitions. As of today, around 20 signatory countries have increased their targets. Unfortunately, since these countries are mainly emerging economies, they account for less than 5% of the total emissions.