The past several years have seen tensions, especially in the US, around sustainable investing: everything from the politicization of certain issues to greenwashing concerns and increasing regulation. However, as investors, we are committed to integrating sustainability considerations across our business. In our view, sustainability analysis is firstly about understanding the strength of companies’ relationships with the stakeholders on which their business models rely, their exposure to emerging social and environmental pressures and their readiness to adapt to them. Secondly, it is about understanding how to best incorporate the conclusions of that assessment into investment decisions. Insofar as these trends are themselves becoming more powerful competitive drivers, considering sustainability is effectively nothing more than expanding the scope of investment analysis to reflect the environment in which companies today compete. All of this, we believe, is very much here to stay long term.
It is important to note that sustainable investing continues to evolve. Many of the trends we see shaping the new year reflect that fact, as we are moving past the early stages in the adoption of sustainable principles into a period that reflects a deeper understanding of, and more nuanced approach to, investing sustainably.
1. An evolution from ESG integration to an increasing focus on sustainable themes
As investors have become more comfortable with sustainability as an investment discipline, we are seeing demand mature. Investors are ready for the next step, beyond the integration of environmental, social and governance (ESG) considerations into their investment process as a risk-mitigation tool, a task many have already accomplished. They are now looking for more specific approaches that could directly benefit from some of the longer-term trends that are reshaping the global economy and thereby presenting new potential investment themes. Our study of institutional investors demonstrated this shift. Focusing on themes was the most preferred approach to sustainable investing for institutions across the globe, and even more so for those in the United States.
Thematic approaches to sustainable investing are the most preferred approach of US investors
Source: Institutional Investor Study 2023, Notes: Respondents were asked to rank their top three, most-preferred approaches. Results show how many listed each approach among their top three. Some opted for “other” when an unnamed approach ranked in their top three.
A macroeconomic regime shift is occurring, driven by the three key long-term trends of demographic change, deglobalization and decarbonization, which Schroders characterizes as the 3D Reset. With decarbonization, for example, investors are seeking to tap directly into market tailwinds for companies that are leaders in, or enablers of, the transition to renewable energy.
A subset of mainly non-pension investors has also become more focused on achieving true impact along with financial returns, especially as the ability to measure impact and to access it across asset classes, including via public markets, has continued to improve.
All of this represents an evolution in what investors expect of ESG and a more nuanced understanding of how this analysis can be used more efficiently to meet investment objectives. The shift to a more pragmatic approach also extends to investors’ perspectives on active ownership, which is increasingly focused on how engagement with companies can lead to tangible, real-world outcomes that could potentially drive better financial performance.1
2. Sustainability will be central to the challenges companies must navigate in the 3D Reset
For multiple industries and sectors, we believe the sustainable themes that investors are eager to address all roll up to the 3D Reset trends of decarbonization, deglobalization, and demographics. (See illustration below.) All of these issues now have critical business consequences, and addressing them is essential for economies across the globe and for individual companies.
At the company level, there are many factors that need to be considered in this regime shift. For example, is your business model structurally going to be successful in a very different demographic environment? How can you attract and retain workers when your supply chains are pressured or must be shifted? How are you changing your operations to meet net-zero commitments?
We believe sustainability factors are increasingly becoming front and center, along with all the other issues that active managers and fundamental investors must consider and address. In our view, sustainability considerations are a critical part of the calculus that must be performed to determine what the viability and longevity of businesses are, how future-proof each business will be in an environment of considerable change, and what the comfort level is with having clients’ assets invested in particular companies over the long term.
The 3D Reset impacts many sustainability themes across multiple industries
Source: Schroders, 2023. The views and opinions are those of the Schroders Sustainability team and are subject to change as market conditions evolve.
3. Investors – and the public – will better understand what the energy transition requires
The energy transition encompasses much more than expanding the capacity to generate energy from renewable sources like wind and solar. The infrastructure needed to deliver the energy to source also requires large amounts of investment to avoid problems like grid congestion. It will require buildings to be overhauled so that energy can be more efficiently used when heating, cooling and lighting our offices, shops and homes. The push to decarbonize also means a fundamental change in how we produce and consume goods, shifting from linear “take-use-discard” to a circular “re-cycle” economic model.
At COP28, the 2023 United Nations’ (UN) Climate Change Conference, participants reached an agreement to “transition away from fossil fuels in energy systems.”2 While some were disappointed that there wasn’t stronger language calling for a phaseout of fossil fuels such as oil, gas and coal, the agreement still represented a significant milestone. No such agreement was ever reached at any of the previous 27 climate conferences, and COP28 was the first time that the term “fossil fuel” was even used in the statements that emerged from the annual conference.
The final COP28 agreement also called for “tripling renewable energy capacity globally and doubling the global average annual rate of energy efficiency improvements by 2030.”2 All of these efforts are likely to gain momentum now that there is a global focus behind them.
To support one of the key Paris Climate Agreement goals of limiting the average increase in global temperatures to 1.5°C above pre-industrial levels, the COP28 agreement also called for “accelerating zero- and low-emission technologies, including inter alia, renewals, nuclear, abatement and removement technologies, such as carbon capture and utilization and storage.” It also called for accelerating and substantially reducing non-carbon-dioxide emissions, and methane emissions in particular, globally by 2030.
Additional steps were taken to address the toll climate change has on humans, particularly in countries that may not have the resources to address the displacement caused by climate-related disasters like severe hurricanes and rising sea levels. Progress was made on the Loss and Damage Fund that was initially discussed at COP27. At the December 2023 Conference in Dubai, many wealthy nations, which have been a major source of greenhouse gas emissions, pledged to support the fund. The pledges have surpassed $700 million.3 That may represent only a small fraction of what addressing climate change impacts will cost, but COP28 still brought progress on this effort.
4. The value of natural capital in addressing climate change will be increasingly recognized
Political discussions and negotiations on nature and climate will continue to become more closely connected. The climate crisis is in many ways a subset of the broader nature challenge, created by the growing demands of a wealthier, hungrier global population on the planet’s finite resources. Investment in nature is a cost-effective way to reduce net global emissions. Still, while nature-based solutions could deliver up to 30% of the reduction in emissions needed to put the world on track for the commitments made in the Paris Climate Agreement, they currently attract only 2%-3% of global climate finance.
The integrity of carbon markets will remain a key concern. While COP26 in Glasgow laid out some clearer plans to introduce more rigor and oversight into these markets, progress has been slow. Many had hoped COP28 would bring some forward momentum, but negotiations on how to implement the details of those plans broke down. The US was in favor of a “light touch” to regulations while the European Union led the charge for more checks and balances and greater scrutiny of carbon markets. A compromise could not be reached in Dubai.
Still, establishing a globally connected and consistent approach and framework for carbon trading will be important to unlocking the potential of natural capital. Nature provides a myriad of other benefits to society beyond carbon sequestration, and we anticipate there will be more focus on capturing that social value in financial accounting.
Nature-based solutions to climate change did receive heightened attention at COP28. Commitments were made to provide $2.5 billion to support the protection and restoration of nature. The Nature, Land Use and Ocean Day at COP28 brought pledges totaling an additional $186.6 million to fund initiatives supporting forests, mangroves and the ocean.4 Countries also agreed to work harder at coordinating and simultaneously implementing their nature and climate strategies.
5. Real challenges to change will persist amid an increasing need for committed action
It’s impossible to ignore the stressed financial and economic conditions of many countries, and the continuing cost-of-living challenges many people face. These challenges have stalled action on climate policies in some countries. There will be an increased need for solutions that can ensure a just transition away from carbon markets.
Many of the initiatives announced at COP28 were in response to the report the United Nations issued in September 2023 on the Global Stocktake, which is an assessment of the progress being made to mitigate global warming since the Paris Climate Agreement of 2015. The report clearly signaled that efforts were falling short. To reach the Paris Agreement’s goal of have net-zero carbon dioxide emissions by 2050, global greenhouse emissions will have to be cut by 43% by 2030 and by 60% by 2035, relative to their 2019 levels.5
To meet those goals, action will be needed in every area. No single initiative will be sufficient, and clarity on global leaders’ commitment to action will be key. Meeting the commitments that global leaders made in Paris will require capital reallocation on a huge scale and policy incentives and penalties to encourage transition. These efforts will continue to reshape growth and change the competitive drivers across markets. That picture has not changed, but clear signals from governments that they will deliver the policy changes needed to meet the commitments they have made will help financial markets differentiate beneficiaries from losers. It may take some time for clarity on these issues to emerge. Still, the inevitable threats climate change poses mean disruption looks unavoidable. The structural need to decarbonize the global economy, industries and portfolios remains. At Schroders, we remain focused on identifying the risks and opportunities that this transition will create. We are not waiting for these risks to crystallize and are instead managing portfolios in anticipation of them.
6. Understanding the impact of climate change will still demand a focus on fundamentals
We believe it’s essential to understand not only what impact climate transition will have on companies, but also whether companies’ valuations accurately reflect the risks or the benefits the transition creates for each company. As an example of this, the contraction in valuations of some of the clearest beneficiaries of climate change over the past 12-18 months has left clean technology sectors with less-demanding multiples and reduced their susceptibility to the risks of contracting multiples.
We expect that selectivity in climate investing will become more important than ever in the clean technology sectors. The rising tide that lifted (and then lowered) companies in the most obviously exposed industries in recent years was unusual. Now identifying the businesses able to benefit from the structural growth that the market offers will be increasingly critical.
7. Amid heightened US politicization of ESG, there will be greater attention paid to sustainability approaches that can unlock opportunities as well as mitigate risk
The politicization of sustainability messaging is likely to continue in the US during a year of presidential and state elections. Still, the efficacy of those efforts appears to have peaked. The reality is that no matter what certain politicians or the media say, the sponsors of pension plans across all states are faced with the same issues. Regardless of the politics of their state, they all must consider ESG factors, such as the physical risks of climate change, or stranded asset risk, or human capital and governance best practices, from a strictly financial materiality standpoint. At the same time, they all need to focus on what is best for their beneficiaries and cannot concede any returns for principles or “values” considerations. So, there isn’t much actual distance between the plan sponsors across all states. We do expect that regulation in the US will solidify further in 2024. That will require increased ESG disclosure, which will allow for better assessment of companies and more informed investment decisions.
We believe that sustainability as an investment and engagement discipline will persist, but continue to mature and evolve. Passive approaches that conflate “ESG” with US large-cap growth in a few sectors like technology, communications and consumer discretionary, which performed well and gathered assets pre-2022, are likely to give way to more targeted thematic and impact approaches that are anchored to durable trends reflecting environmental and social change, as investors seek to both mitigate risk and, importantly, benefit from the opportunities that stem from these trends.
Despite ongoing arguments about the role of ESG in portfolios, US investors continue to see value in this framework. In fact, 74% of the US institutional investors surveyed by Schroders said that a top-three reason for investing in sustainability and impact strategies was the belief that doing so is required to achieve long-term financial returns.
As investors’ understanding of sustainability as an investment discipline has matured, there has been increased interest in thematic approaches that directly target long-term global economic themes, including decarbonization. Investors see these trends as real investment opportunities. They also recognize that harnessing the principles of sustainable investing will enable them to build more resilient portfolios.
We are focused on satisfying the interests investors express for a range of sustainable investment options, including innovative thematic and impact solutions, especially those centered on climate and energy transition. We are also finding strong demand from clients for education and support with transition planning and net-zero implementation, in particular. Clients are also looking for pragmatic multi-asset portfolio decarbonization. The asset managers that succeed in the new year will be those that can deliver these objectives for clients in customized solutions.
1 Note: All investments involve risk including the loss of principal. Past performance is not a guide to future results. The views shared are those of Schroders and are subject to change. Schroders has produced recent research on the efficacy of active ownership in preserving and enhancing shareholder value [Active ownership: how does engagement work and does it impact returns? (schroders.com), Active ownership: three ways to improve investor engagement (schroders.com)] and we continue to believe that it is critical that we engage with our investee companies to ensure they successfully adapt to an ever-escalating pace of policy and regulatory change [Active ownership and policy: how it works and what we ask of policymakers (schroders.com)].
2 Source: “COP28 Agreement Signals ‘Beginning of the End’ of the Fossil Fuel Era,” United Climate Change Conference, 12/13/23
3 Source: “$700m pledged to loss and damage fund at Cop28 covers less than 0.2% needed,” TheGuardian.com, 12/6/23
4 Source: “United for Nature: COP28 Mobilizes Action to Protect and Restore Forests, Mangroves, Land and Ocean,” COP28UAE, 12/10/23
5 Source: “Global Stocktake reports highlight urgent need for accelerated action to reach climate goals,” United Nations Climate Action
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