ESG: 10 Environmental Trends to Watch in 2023

Amid the focus on environmental, social, and governance (ESG) frameworks, we continue to watch for new developments and expectations across the investment and regulatory spaces. Significant in 2022 was that the Russia-Ukraine war heightened awareness of energy security, and the Inflation Reduction Act (IRA) supported meaningful industry environmental programs. Here are 10 key environmental trends to watch in 2023.

1 – Numerous carbon reduction efforts continue throughout the economy to:

• Reduce carbon emissions in energy production

• Develop carbon capture and sequestration

• Develop a variety of batteries with a consideration of material constraints

• Develop battery recycling paths

• Add small-scale nuclear

• Develop hydrogen power sources

• Grow efficiency efforts

• Potentially drive more hybrid powerplants in vehicles relative to pure electric vehicles

Even without a visible downward trend in atmospheric carbon, hope persists for a cumulative impact over time. We may also see higher spending on climate adaptation as more people pivot to a revised climate goal to limit the Earth’s warming to 2.0 degrees Celsius/3.6 Fahrenheit.

2 – Efforts continue to standardize metrics, filing requirements, and scales. Mandatory reporting requirements need sorting given the diverse regulatory ask to date have the potential to be overwhelming and expensive. Ultimately, the market wants consistent reporting from all participants. Blockers to this, however, have been:

• Misunderstanding the expense and reporting complexity of proposed regulatory regimes

• Disparate reporting requirements among the many global ESG standard setters

• Lack of accommodations for less wealthy and developing countries to afford climate spending

• Incomplete understanding of relationships between various topics, such as biodiversity and climate change

3 – Pressure on fund companies will remain high for greenwashing, fund naming, and tightening holdings and risk analysis. Consistent definitions among global regulators of what risks are and how to measure avoidance could help. In addition to a greater definition of key exposures or material factors, the relatively new development of risks described as Principal Adverse Impact Indicators (PAIs) for application in 2024 will initially layer more complexity on understanding exposures.

4 – Lower returns and a price on carbon. Not all efforts to reduce carbon are high-return economic investments, but companies may have to participate in some expenditures for carbon reduction. By itself, this could depress returns at least temporarily, a drag on stock performance. This highlights two conflicting points of view in the market among companies that either solve for:

• Maximizing earnings and returns such that carbon reduction expenditures may not be seen as fiduciary

• Prioritizing carbon reduction at any cost

These two opposing points of view can be brought together by considering the potential dollar cost of material risks. The adoption of a formal carbon transfer price could be a more explicit, mandatory consideration to make carbon and its cost much more transparent for both points of view.

Some companies are considering an informal internal transfer price of carbon to understand issues and motivate improvements. Engine No. 1 and SustainEx are examples of two outside firms attempting to put consistent dollar measurements on corporate “E” risks/returns, a trend that should continue absent a federally mandated carbon cost.

5 – Less reported data, more “sensing data.” Company-reported ESG criteria are seen as too numerous and inconsistent across material issues, which contributes to the incomparability of results across standards. Efforts to distill key metrics or define material items down to fewer, more consistent standards should continue.

At the same time, as corporate reports become more consistent—albeit potentially limited in scope to fewer metrics—we expect expanded use of additional outside sensed data (e.g., satellite analysis) and dataset mapping analysis (e.g., emissions and biodiversity pairings). In addition, continued use of AI will help analyze text (e.g., FactSet’s Truvalue) to also contribute to the overall ESG picture.

6 – More differentiation for developing economies. As overall standards evolve, the ecosystem is recognizing that many smaller and/or emerging economies need:

• Financial and technology support for lower-carbon energy sources

• Help to adapt to continued climate change

This requires a continued understanding of the significant differences between developed and developing economies. In some regimes, this may lead to entry-level standards—which are less demanding and expensive to report—for smaller companies and less ESG-developed countries.

7 – Blockchain and ESG increasingly intersect. The blockchain technology that enables any asset to be tokenized (think electronic title) can help with the transfer of assets at lower transaction costs. The inexpensiveness of blockchain technology—and digital technology’s environmental improvement from proof-of-work (power-hungry computer calculations) to proof-of-stake (more simply tracking ownership) blockchain technology—will increasingly enable 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 on its own elsewhere.

The blockchain (a shared digital ledger for transactions) would track the asset—for example, a carbon credit or a renewable gas certification—through the system. Being able to track tokenized carbon emissions or carbon offsets would allow more accurate tracking of carbon footprints through supply chains and could help address charges of greenwashing.

In addition to blockchain developments, there should be continued evolution of digital policy in areas such as the Corporate Sustainability Reporting Directive (CSRD) and the UK’s digital asset consultation paper.

8 – Private companies continue to develop their ESG focus. The lack of a consistent ESG data collection and reporting framework across the private equity industry has made it challenging for GPs to:

• Assure investors and financiers that their portfolio companies are making ESG progress

• Share meaningful ESG metrics with their LPs who have their own ESG investment goals

• Assess the link between ESG and financial performance

LPs, in turn, have not been able to benchmark the ESG performance of the managers in which they invest. And portfolio companies have not been able to prioritize their own ESG efforts without a clear understanding of their likely impact and value.

9 – More corporate restructuring and refinancing events are likely, and the environmental component of ESG could be a consideration and added motivation. Restructuring assets should primarily be driven by weakening credit amid higher interest rates and slower economic activity, but the choice to reduce exposure to low environmental-scoring assets and add businesses with high environmental scores could be a consideration.

On the corporate finance side, we could see continued growth in green bond issuance. However, it might be slower growth given a limited availability of funds in 2023 due to tighter credit conditions.

Specific to banks, climate stress tests will continue to spread. The value of these tests will strengthen over time with more consistent and universal standards. The various test results will likely steer additional efforts to meet standards via investment, restructuring, and capital availability.

Insurance company portfolios also sit at the nexus of many “E” topics on risk and adaptation exposures. We would expect this industry to be on the vanguard of reflecting new data and risks in their portfolios.

10 – Specifics matter. The interrelated complexity of supply chains, carbon energy, the environment, and global variability require an understanding of specific country, industry, company, and location factors. For example, simplistic mandates to add batteries everywhere or eliminate oil, gas, coal, and plastics are insufficient. Instead, we should see a greater understanding of specific steps needed in industries such as agriculture, buildings, or recycling as well as the uniqueness of India’s position compared to the U.S., for example.

In Conclusion

Just as technology has washed over industry after industry throughout the past 40 years, so will climate understanding and adaptation in the future. In 2023, we should see further understanding of ESG factors, their interrelatedness, and more transparency and consistency in what is being measured and scored. The impact on corporate structures and investment should continue to be buffered by a greater understanding, the evolution of standards, greater transparency, and iterative supply-chain adjustments.

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