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2023, the Year When ESG Comes of Age

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If the past 12 months tested the resilience of the global ESG project, then 2023 is likely to be the turning point from which it becomes an irreversible part of the financial landscape.

Data quality will improve as regulations toughen and as disclosures and reporting standards become codified internationally, market experts predict for the new year.

That, in turn, will heal some of the weaknesses that have given critics ammunition to attack sustainable investing, particularly the opacity within the ESG ratings sector. Further shoring up the trustworthiness of ESG will be leaps in the quality and accuracy of analytical tools – largely thanks to the application of artificial intelligence and machine learning – that will help investors make better-informed decisions on where best to allocate their capital, and from where they should remove it.

“It is clear that ESG will remain a key item on the agenda for regulators and financial institutions as we head into 2023, particularly in relation to sustainable finance,” John Byrne, chief executive of RegTech provider Corlytics tells ESG Insight.

ESG suffered a blow early in 2022 when Russia invaded Ukraine and turned off the oil and gas pipelines to its perceived enemies in the West. The strain that put on global energy markets, with shortages threatening the lives and livelihoods of many thousands, led to a recasting of fossil fuel companies by some as heroic freedom fighters ready to plug critical supply gaps.

Arms manufacturers even got a bump as they too were regarded by a few as key agents of humanitarian assistance amid calls to provide ammunition to Ukrainian forces defending their homeland.

All of this provided critics of ESG – mostly right-wing US politicians and allies of the fossil fuel industries ­ – with the opportunity to accuse sustainability investors either of treachery for shunning the newly elevated heroes of oil and gas, or of hypocrisy when their clients returned some capital to those sectors.

The numbers, however, showed the popularity and demand for ESG products remained. An expected tsunami of anti-sustainability board votes during this year’s proxy season failed to materialise and as markets tumbled and broad funds saw net redemptions, ESG-focused funds continued to grow, albeit at a slower pace. Morningstar data at the half-year mark found US$120 billion flowed into ESG funds, while $139bn was taken out of general funds.

The trend appears to have continued throughout the second half, and that’s likely to accelerate again in the next year. So, what can we expect to drive that?

Regulation

The most noticeable effort to improve and strengthen ESG in the past year came through the signalling of tougher regulations. Both the US’ Securities and Exchanges Commission (SEC) and the UK’s Financial Conduct Authority (FCA) announced solid plans to introduce ESG disclosure rules as they seek to end greenwashing.

Also, the European Union’s Markets in Financial Instruments Directive (MiFID II) was updated to enforce financial institutions’ discussion of sustainable investment opportunities with clients, a measure aimed at exposing more investors to green finance.

The next 12 months are forecast to see some of those pledges turned into action. Corlytics’ Byrne predicts that the focus will fall on labelling of green products, with rules tightened to ensure that funds live up to the sustainability claims within their mandates.

That will go hand-in-hand with efforts to establish codes of conduct for companies that produce ESG ratings, encouraging them to provide greater transparency into their methodologies – or data “black boxes”, as Tanya Seajay, chief executive of data provide Orenda, a SIX company, describes them. The objective of such codes would be to clear the mists of suspicion that surround ratings, which often give widely different scores to the same asset because they all work to different assessment frameworks.

Regulators may even go a step further and impose oversight on compilers, argues Elisabeth Seep, head of ESG product management at RIMES Technologies. Already the FCA has established a working group to look into possible regulation of rates setters.

Japan is looking likely to be first out of the blocks in formulating a code, while the US and UK have said they’ll begin the process in the coming year, too.

“As firms integrate ESG considerations into their activities, they are increasingly reliant on unregulated third-party ESG data and ratings ****providers,” says Byrne. “Transparency regarding the methodologies utilised by these providers and the quality of ratings and data is critical to the issue of trust around ESG claims.”

What we do know of the upcoming regulatory calendar is that the year will kick off with the EU implementing level 2 regulatory technical standards for the Sustainable Finance Disclosure Regulation (SFDR) in January. In June, it will be further expanded when firms will be expected to begin reporting on how their investments affect the environment as proscribed by the Principle Adverse Impacts (PAI) tests.

The FCA is expected to present its plans for a Sustainability Disclosures Regulation (SDR) mid-year. Hopes that the SEC will follow suit in 202 may have been slowed by some US states legislating against ESG investments, Byrne says.

And expect to see a flurry of decisive announcements from the Asia Pacific region, where a number of regulators, including Singapore’s and Hong Kong’s, are devising their own green taxonomies.

Data and Technology

The growth in regulations is being driven in large part by the need to shore up the quality and availability of data for use by financial institutions. The continuation of this is likely to lead to an improvement to the data challenges that have dogged asset managers and owners in the past.

Encouraged also by growing demand from investors and consumers for sustainable financial products, data volumes will continue to expand at a rapid pace, enriching datasets that had hitherto been full of gaping holes and providing the impetus for reporting companies to up their game in terms of the quality of data they disclose.

The EU’s creation of its long-awaited Corporate Sustainability Reporting Directive (CSRD) for implementation in 2024 will provide the fillip that will see more firms put data-discovery and disclosure processes in place. A key piece of the legislation will be the requirement for companies to obtain third-party assurance of the data they provide, says Samantha Duncan, founder of Net Purpose.

“The CSRD is set to mandate at least a limited assurance requirement over companies and therefore we can expect to see enhanced processes being put in place to enhance data quality and rigour,” Duncan tells ESG Insight.

Adding to the quality of data will be improvements in analytical tools, argues Orenda’s Seajay. She sees scenario analysis coming into sharper view through 2023 as companies deploy AI and ML to divine the future from past trends.

“Being able to use the past to predict the future will be such a massive undertaking, it will take the industry’s brightest and bravest to get it right,” Seajay tells ESG Insight. “Bright, because they will need access to the cleanest data, advanced maths skills, machine learning and statistical capabilities – and even then, they will be making educated guesses. And brave because they will be among the first to look into the future and see just how deeply climate events will financially impact our global society and report that to shareholders.”

Demand for better ESG data from and for private markets was a trend that also gained traction in 2022. It’s likely to accelerate in 2023, argues RIMES’ Seep.

“It’s what everyone wants and cannot find,” she says. “Consortiums are popping up by asset class to acquire this data and monetise it, but there aren’t clear winners yet in the race.”

Disclosures and Standards

Regulations are toothless without clear rules on how to comply with them. This has long been a weak link for ESG, a space that not only has many questions about what it is – coalesced around the exact meaning of sustainability – but also has a wide range of competing interests that are trying to provide an answer.

Those organisations, reporting standards setters such as the Taskforce for Climate-related Financial Disclosures (TCFD), began a process of convergence with the establishment of the International Sustainability Standards Board (ISSB) in 2021. Over the following year it incorporated a number of standards setters, including the Value Reporting Foundation and SASB.

The continuation of that momentum will probably continue in 2023, removing more layers of contradiction and complexity from data disclosures that have fuelled criticism of the validity of reported data.

“We are expecting the ISSB to issue its standards on sustainability and climate-related disclosures, which aims to develop a comprehensive global baseline of sustainability disclosures for capital markets,” says Byrne. “These are likely to be widely adopted globally and it is critical for firms to be getting ready now.”

ESG Pillars

ESG data demand will “continue to explode, for what third-party vendors provide and what’s publicly available”, says Seep. As that fills gaps in the data record, an imbalance of information attributed to the three pillars of ESG – environment, social and governance – can be redressed.

Because of the need for immediate action to mitigate climate change, demand has been naturally focused on “E”. Growing understanding of the impact that climate change has on societies and a deepening sense that something needs to be done about already-existing social ills will see “S” better represented in the data. That will also come as regulators step up demands for social disclosures; the EU devoted much time to discussing the creation of a social taxonomy in 2022.

According to Seajay, whose Orenda obtains sentiment data by scraping social media and other non-financial sources, believes this to be one of the most important objectives of the next year.

“More and more, investors and issuers are being asked to meet social reporting requirements to protect investors’ dollars against harm caused by companies being outed for human rights issues, poor working conditions, employees not being treated equally, as well as LGBTQ+ rights and more,” she says. “This change, the need to assess risk in real time and to anticipate that risk, has intensified since the pandemic. The financial industry will find it difficult to navigate this dynamic social space without more data.”

More forward-looking standards and the use of ever-more sophisticated analytics will aid that transition, she argues.

“These forward-looking frameworks, with interconnected risks mapped out and measurable, will lead to global ESG risk indicators that no type of government will be able to hide from in the future.”

Year of Hope

The combination of tougher regulations and greater public awareness of the need to act to solve global ills means that ESG will begin to be more widely viewed in 2023 as the force for good its proponents believe it to be. That will largely come as a result of the improvements to data likely to result from the predicted changes predicted already discussed.

“As the understanding of ESG data grows more sophisticated, we expect ESG to be deconstructed into its parts, and we can expect more fund managers to focus on impact rather than the simple box-ticking or risk-mitigation exercises,” says Net Purpose’s Duncan.

For Orenda’s Seajay, the strengthening of trust in ESG through better data will be beneficial, also, to the companies and industries that find themselves censured by sustainability investors.

“No one wants companies to greenwash to get access to capital, but we do want them to disclose that they are ugly now and have real plans to be much better,” she says. “We don’t want these industries excluded ****from a sustainable future because there are entire communities relying on them for their livelihood.

“There needs to be balance and a clear transition strategy that includes them in a sustainable future, with remediation, reclamation, and restoration one of many paths forward.”

The time may come in the next year when half-hearted commitments by companies and vague promises of “doing the right thing” will no longer cut it with investors. Companies will face the prospect, then, of getting fully on board or risking financial and reputational decline by turning their back on the sustainability project.

“2023 is the year where asset managers, asset owners and banks have to evidence their various commitments – or step away,” says RIMES’ Seep.

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