ENVIRONMENTAL TRENDS

INTRODUCTION

We continue to monitor new developments and expectations in the investment and regulatory areas as we focus on environmental, social, and governance (ESG) frameworks. The Russia-Ukraine war raised awareness of energy security in 2022, and the Inflation Reduction Act (IRA) encouraged meaningful industrial environmental programmes. 

ENVIRONMENTAL TRENDS

1) Throughout the economy, numerous carbon reduction measures are ongoing to: Reduce carbon emissions in energy production

• Develop carbon capture and sequestration technologies.
• Create a variety of batteries while keeping material limits in mind.
• Create battery recycling routes.
• Include small-scale nuclear power.
• Create hydrogen power sources.
• Increase your efficiency efforts.
• Drive more hybrid power plants in vehicles versus pure electric vehicles

Even in the absence of a discernible decrease trend in atmospheric carbon, there is still hope for a long-term influence. We may also see increased spending on climate adaptation if more individuals shift their focus to a revised climate target of limiting global warming to 2.0 degrees Celsius/3.6 degrees Fahrenheit.

2) Efforts to standardize measurements, filing requirements, and scales continue. Mandatory reporting requirements must be sorted out because the numerous regulatory requests received to date have the potential to be onerous and costly. Finally, the market expects all participants to provide consistent reporting. However, there have been roadblocks:

• Misunderstanding the proposed regulatory regimes' cost and reporting complexity
• Different reporting criteria among the several worldwide ESG standard setters
• Inability of less wealthy and developing countries to afford climate-related spending
• Relationships between many topics, such as biodiversity and climate change, are not fully understood.

3) Fund companies will face continued pressure for green-washing, fund name, and tightened holdings and risk analyses. Consistent definitions of what hazards are and how to prevent them among worldwide authorities could be beneficial.

In addition to a more precise characterization of essential exposures or material variables, the relatively new discovery of risks known as Principal Adverse Impact Indicators (PAIs) for implementation in 2024 may initially complicate comprehension of exposures.

4) Lower returns and a carbon tax. Not all carbon-reduction measures are high-return economic investments, but businesses may be required to contribute to some carbon-reduction expenditures. This might lower returns temporarily, putting a damper on stock performance. This shows two competing market perspectives among corporations that either solve for:

• Maximising earnings and returns to the point that carbon reduction expenditures are not regarded as fiduciary
• Carbon reduction must be prioritised at any costs.

These two opposed viewpoints can be reconciled by evaluating the potential monetary cost of material risks. Adopting a formal carbon transfer price could be a more explicit, necessary consideration for making carbon and its cost much more transparent for consumers.

Some businesses are considering an informal internal carbon transfer price to better assess problems and promote solutions. Outside firms such as Engine No. 1 and SustainEx are striving to put consistent financial values on company "E" risks/returns, a practise that should continue in the absence of a nationally mandated carbon fee.

5) Less data reported, more "sensing data." Company-reported ESG criteria are perceived as being very numerous and inconsistent across major issues, contributing to the incomparability of performance across standards. Efforts should be made to reduce essential measurements or define material components to fewer, more consistent standards.

Simultaneously, as corporate reports become more consistent—albeit potentially limited in scope to fewer metrics—we anticipate increased use of outside sensed data (e.g., satellite analysis) and dataset mapping analysis (e.g., emissions and biodiversity pairings). Furthermore, continued usage of AI will aid in text analysis (e.g., FactSet's Truvalue) to contribute to the overall ESG picture.

6) Greater differentiation for emerging economies. As broad standards emerge, the ecosystem recognises that many smaller and/or emerging economies require the following:

• Financial and technological assistance for low-carbon energy sources
• Assist in the adaptation to ongoing climate change

This necessitates a continuing appreciation for the fundamental disparities between industrialized and developing economies. In some regimes, this may result in entry-level norms for smaller enterprises and less ESG-developed countries, which are less rigorous and costly to disclose.

7) Blockchain and ESG are increasingly coming together. The blockchain technology, which allows any asset to be tokenized (think electronic title), can aid in asset transfers at lower transaction costs. The low cost of blockchain technology, as well as the environmental improvement of digital technology from proof-of-work (power-hungry computer calculations) to proof-of-stake (more simply tracking ownership) blockchain technology, will increasingly allow the attachment of some sort of carbon metric (or other "E" metric) to a product that can either track it through the system or be sliced off and traded separately elsewhere.

The blockchain (a shared digital ledger for transactions) would trace the commodity through the system, for example, a carbon credit or a renewable gas certification. The ability to track tokenized carbon emissions or carbon offsets would allow for more accurate tracking of emissions. Carbon footprints along supply chains could help answer allegations of green-washing.

In addition to blockchain advancements, digital policy should continue to evolve in areas such as the Corporate Sustainability Reporting Directive (CSRD) and the UK's digital asset consultation paper.

8) Private enterprises are expanding their ESG focus. Due to the lack of a consistent ESG data collecting and reporting methodology across the private equity industry, GPs have found it difficult to:

Assure investors and financiers that the companies in their portfolio are making ESG progress.

Share significant ESG metrics with their limited partners who have their own ESG investing objectives.

Examine the relationship between ESG and financial performance.

In turn, limited partners (LPs) have been unable to benchmark the ESG performance of the managers in which they invest. And without a clear knowledge of their potential impact and value, portfolio firms have been unable to prioritise their own ESG activities.

9) There will be more corporate restructuring and refinancing events, and the environmental component of ESG may be a concern and added motivation. Asset restructuring should be driven mostly by declining credit amid higher interest rates and weaker economic activity, although the option to minimise exposure to low-scoring assets and add enterprises with good environmental scores may be considered.

On the corporate finance front, green bond issuance may continue to rise. However, given the limited availability of money in 2023 as a result of tighter lending conditions, growth may be slower. 

Climate stress testing for banks will continue to spread. With more consistent and universal standards, the value of these assessments will grow with time. The findings of the various tests will most likely direct additional attempts to fulfill standards through investment, restructuring, and financial availability.

Portfolios of insurance companies are also at the crossroads of numerous "E" topics concerning risk and adaptability exposures. We anticipate that this industry will be at the forefront of incorporating new data and risks into their portfolios.

10) Specifics matter- Because of the interconnected intricacy of supply chains, carbon energy, the environment, and global variability, specific country, industry, company, and geographical aspects must be understood. Simple mandates such as adding batteries everywhere or eliminating oil, gas, coal and plastics are insufficient. Instead, we should see a better knowledge of the precise procedures required in industries such as agriculture, construction, and recycling, as well as the distinctiveness of India's position in comparison to, say, the United States.

CONCLUSION

Climate understanding and adaptation will evolve in the same way that technology has swept over industry after industry over the last 40 years. By 2023, we should have a better knowledge of ESG elements, their interdependence, and more transparency and consistency in what is evaluated and scored. 

The impact on business structures and investment should be mitigated by increased awareness, the evolution of standards, greater transparency, and iterative supply-chain modifications.