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Commentary

Focus on the Signals, not the Noise

Jennifer Wu, Global Head of Sustainable Investing at J.P. Morgan Asset Management, offers five reasons why sustainable investing will matter even more in 2023.

2022 saw sustainable investing go through extensive scrutiny. And the debate on what ESG is/isn’t is expected to continue this year. But, as 2023 gets started, it’s clear that ESG is here to stay and there continues to be growing appetite for investing in a more sustainable future. This year, a bigger question is what ESG will look like after a decade-long bull market, against a backdrop of rising anti-ESG sentiment. The key in 2023 will be to maintain focus on the signals, not the noise. Here are five areas we’re watching out for:

1. Growth in sustainable investing will continue despite market volatility

A noticeable change in the driver of demand in Europe over the last 12 months has been the growing importance of ESG-related regulation such as the Sustainable Finance Disclosure Regulation (SFDR) and the EU Sustainable Taxonomy. Alignment of economies, including corporate activities as well as capital flows to green, sustainable-focused policies, is already a focus in Europe and we expect to see a similar level of focus in major markets in Asia. In the US, policy measures such as the Inflation Reduction Act provide incentives for more capital to be redirected to green and sustainable businesses that will help boost economic growth and jobs.

2. Different shades of ESG investing matters

ESG, at its core, is about data and information. But how it is used, and for what objective, differs by individual: there isn’t a universally defined set of sustainability criteria. ESG integration is not about saving the world and exclusionary investing isn’t the only way to deliver an ESG outcome. Investing in innovative technologies and solutions that will play a part and benefit from the transition to a more sustainable future is not the same as excluding companies purely based on values or political views. And investing in the low-carbon transition does not, importantly, mean having zero exposure to fossil fuels.

3. Credible sustainable solutions can have a real-world impact

Reaching a net zero world is only possible if there’s a significant reduction in greenhouse gas (GHG) emissions, as well as the growth and development of carbon removal technologies. There is growing interest in investing in negative emissions beyond mechanical technologies such as carbon capture and storage, including forestry and other nature-based carbon offsetting solutions. And while there is an ongoing and important debate around when carbon offsets can be used in an investment portfolio, to account for progress towards net zero emissions alignment, and international efforts to standardise offsets accounting and traceability are ongoing, at the end of the day a tree is still a tree. No-one should disregard the many environmental (and social) benefits trees provide.

4. The energy transition is inflationary, but failing to adapt is even more inflationary

Extreme weather events create extra stress on economies, with the impact multi-faceted. They put a squeeze on the supply side of our economy, affecting factors such as labour and natural systems, as well as core infrastructure. The result is that operating costs in sectors such as construction, real estate and agriculture will increase as companies look to enhance their resilience and, in cases where level of adaptation is low, compensate for the loss in labour or assets. Existing infrastructure will also need to be retrofitted or replaced to build up resilience. In cities where the risk of an urban heat island effect is high, the use of air conditioners and cooling equipment is expected to rise, which will result in more electricity usage. While there is no silver bullet solution, policy makers have an important role to play in climate adaptation financing by, for example, following up on the loss and damage fund discussions at COP27. Climate adaptation is financially material to investors not only from a risk management standpoint, but also because of the opportunities it provides for investing in new climate-resilient solutions.

5. Becoming green at the expense of children’s lives is not an option

The clean energy transition requires a wide variety of minerals and metals which are not all widely available. Some can only be found in a few places around the world. Cobalt, for example, is a core input into the battery production for electric vehicles, but it can only be sourced from a handful of countries. The Democratic Republic of Congo (DRC) currently accounts for over 70% global cobalt production and human rights and child labour issues remain prevalent in the cobalt supply chain. While investors are demanding companies conduct rigorous due diligence and regularly audit their suppliers from the DRC, the problems of child labour cannot easily be eradicated. Active investment research and stewardship will play a critical role in helping to prevent the violation of children’s rights in the course of the low-carbon transition That said, the call to action is not only for investors, but also policy makers and the broader financial industry to recognise the full costs of the energy transition and work together quickly to find a solution.

Returns and outcomes

The transition to a more sustainable future can no longer be considered separately from day-to-day investing. The paradigm shift that’s already under way in how we produce, consume and move about creates risks and opportunities for all investors, not just sustainable investors.

Investors should be careful with how ESG is applied to ensure that it is used in such a way that is additive to the investment objectives. For example, a company’s ESG score based on a variety of financially material ESG factors may not be the best tool to use in a portfolio that’s intended to generate a specific sustainable outcome or a direct real-world change, such as removing GHGs from the atmosphere, or preserving biodiversity.

At a macro level, if we fail to transition to a more sustainable economy, the cost of capital could go up significantly for all. Every investor should aim to gain a clear understanding of their own portfolio’s exposure to climate change risks today and proactively take steps to allocate capital to new, more climate-resilient solutions.

At the end of the day, ESG is not one single thing: how the multiple dimensions of ESG impact returns and outcomes will continue to be top of mind for investors in 2023.

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