Europe cements its leadership, while politicization of ESG in the U.S. is slowing progress.
For Morningstar Sustainalytics, despite a year of market turbulence, it was a year of growth. That growth for our company and for the sustainable-investment industry is likely to continue in the coming years, driven by the swiftly changing regulatory environment. I expect 2023 will be a year in which regulators and industry standard-setters catch up with the market to provide much-needed structure and guardrails. As president of Morningstar Sustainalytics, I’m seeing four key trends that will meaningfully shape sustainable investing in the coming years.
1. Expect Europe to gain significant ground. Europe’s environmental, social, and governance leadership is being propelled primarily by the EU Action Plan regulatory initiative launched in 2018 for financing sustainable growth, including creating an EU taxonomy for sustainability activities and standards for green financial products. This has created a complicated set of opportunities and challenges both for our clients, who are leveraging ESG to create wealth or manage risk over the long haul, and for the entire sustainable-investing ecosystem. It will certainly make life more complicated for ESG ratings providers like Sustainalytics, as the EU will likely begin regulating this industry. I expect this to come to fruition more fully in the next three years. (In July, the European Commission asked for feedback about transparency and methodology from ESG ratings providers.) Recently, the United Kingdom government announced it will open a similar consultation in the first quarter of 2023. In their most rigid form, these regulations could resemble those that govern credit rating agencies, though I don’t think such rigidity will serve investors well.
Regulations will increase costs. For businesses in leadership positions, the required structural changes will result in higher operating costs but will also create much bigger competitive advantages, similar to those for the credit rating agencies. While Morningstar Sustainalytics is well-positioned to adapt to new regulatory requirements, my concern is that rigid regulation akin to the credit ratings industry’s will stymie innovation in the ESG space. The dilemma for regulators is how to implement rules that both protect investors and foster investment.
Increased regulation has regional implications, too. Europe has long been the world’s ESG leader, with the majority of ESG business being done therein. I suspect Europe will want to cement its leadership position in the medium term and use ESG as a competitive advantage in continuing to shape the financial-services industry over the longer term.
In the United States, where the conversation around ESG and climate has become politicized, progress is slower. I firmly believe demand for sustainable investing in the U.S. will continue to grow unless there’s a regulatory push to constrain the use of ESG. Unfortunately, I do think politicization hinders the U.S. from being able to demonstrate meaningful leadership in this growing field of investment. With its scale advantage, the U.S. asset-management industry has provided lower costs, more choices, and generally higher transparency for investors. However, the political backlash against ESG in the U.S., as my colleague Don Phillips has pointed out, is creating collateral damage for American investors and the U.S. asset-management industry, “as the scale advantage that made American mutual funds the model for the rest of the world may be unintentionally undermined by these warring parties.”
2. The need for climate data and analytics will grow quickly. This will be driven by the EU Action Plan and the reporting requirements for the Task Force on Climate-related Financial Disclosures. In many jurisdictions, such as the U.K., TCFD reporting requirements are becoming standard regulatory reporting requirements. The U.S. SEC has proposed a climate disclosure framework for companies based in part on the TCFD framework. While the percentage of companies disclosing TCFD-aligned information continues to increase, consistent and complete reporting remains limited. In fiscal 2021, according to the Financial Stability Board, 80% of companies disclosed in line with at least one of the 11 recommended disclosures. However, only 4% disclosed in line with all 11 recommended disclosures, and only around 40% disclosed in line with at least five.
For investors of any size, making sense of unstructured climate data is challenging at best. Hence, the opportunity is broad: Sustainalytics, for example, offers robust data metrics and will soon provide assessments of corporate transition risk and physical climate risk.
I don’t need to work hard to convince myself that for portfolio managers, and the ecosystem that serves them, climate considerations represent an authentic opportunity. If you run a narrow, long-only equity portfolio, you can possibly avoid it. If you manage money for a pension fund that is more widely exposed, you cannot (and should not).
3. Concerns about greenwashing will start to recede as regulators act. Some 50% of the sustainable-investments market is institutional, sophisticated enough to identify greenwashing and manage decision-making accordingly. But regulators are concerned about the explosion of ESG interest in the wealth-management and retail investing community, where investors are more exposed to misrepresentation of product characteristics. Europe is well on its way to tackling greenwashing: A main focus of the EU Action Plan is to remove fund greenwashing by providing a taxonomy that clearly sets out what makes an investment green. It has also outlined the ESG information that companies need to disclose. In tandem, these definitions and associated disclosure requirements can achieve a reasonably high probability of successful standardization. Elsewhere in the world, I don’t see the same commitment to addressing greenwashing. I think it’s a U.S. conversation that needs to occur. It’s true the SEC has fined companies, but I believe the U.S. needs a more systematic approach to stamping out greenwashing.
In sum, I think there is enough regulatory focus in most major markets to eliminate greenwashing, but it will likely take three to four years.
4. The great wealth transfer continues, bolstering the popularity of sustainable investing for individuals, especially in the area of impact investing. In the U.S., inheritors of wealth will increasingly consider their personal values as they make investment decisions. In this phase of the personalization process, investment advisors are engaging with clients, understanding portfolios, and ensuring they are aligned with clients’ values. There is an even higher bar in Europe, where wealth managers and retail investors are investing according to societal shifts and a desire to more systematically focus capital on the transition to a sustainable future. In both cases, impact investing supports that proposition. Sustainalytics already provides thousands of impact metrics across thousands of companies. Next year, we will launch a robust and comprehensive impact rating that will ultimately cover 12,000 firms.
I am often asked, “When will sustainable investing go mainstream for individuals? I would argue that it is already mainstream. The market has moved faster than I thought it would. In Europe, investors are already incorporating the risks and opportunities of the changing climate into their investment decision-making. I suspect that within five years, the full scope of ESG considerations will be well understood in wealth management globally.
There is enormous potential for ESG to be integral in the generational wealth transfer. As my colleague Kunal Kapoor has said, ESG has potential because it engages people with their money. That leads to better outcomes for them when they get closer to retirement. And we are seeing younger investors express a higher interest in understanding how to align their investments with their personal interests and values.
Given these key trends and the dynamics I’m seeing across the sustainable-investing space globally, my outlook for continued adoption is exceptionally positive.
As always, Morningstar Sustainalytics is about empowering investors, and we look forward to continuing to do that for many years to come.
Happy New Year to all.
This is one of a series of quarterly letters from Bob Mann, president of Morningstar Sustainalytics.
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