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ESG Focus: Big Trends for 2023

ESG Focus | Feb 01 2023

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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: Big trends for 2023

FNArena scans broker research, academic forecasts, and ratings agencies views to glean its top ESG trends for 2023 – and we start with the most impactful of them all.

-Recapping 2022
-Impact investment the stand-out theme for 2023
-Switch from virtue signalling to strategic alignment, and results
-ASX-listed impact stocks

By Sarah Mills

Energy fatigue might be the best way to describe ESG sentiment heading into 2023.

The Ukraine conflict, rising energy prices and rising interest rates put many ESG imperatives onto the backburner in 2022.

Combined, they triggered a sharp slump in sustainable bond issuance and a sell-off in ESG stocks (excluding green commodities) as investors scurried to reduce exposure to fossil fuels; build more renewables plants; and hasten the shift to battery-driven technologies. 

Add China lockdowns and the resulting global shortage of polysilicon for solar panels and supply-chain disruption into the mix, and it was a challenging year, a year in which the only ESG highlight appeared to be green battery commodities such as lithium and rare earths (for those mines already in production given emerging producers faced a withdrawal of capital).

Emerging bruised and battered from 2022 and wary of further interest rate hikes and their impact on commodities demand, and with the Ukraine conflict set to rattle on, ESG investors face a dilemma.

Step in now at 2022-induced lows, taking a punt on the China reopening and the roll out of US Inflation Reduction Act funding, or wait another six months, given the interest-rate tightening cycle is forecast to halt sometime in the months ahead.

Perhaps there is a third path – shifting the focus to impact. 

Impact Investing Could Prove The Driving ESG Imprimatur In FY23

FNArena has compiled its list of the most frequently cited, or most interesting ESG trends for 2023 to pass its desk, scanning at least 20 reports that might offer investors some guidance.

Many will equally impact the non-ESG market given the inverse relationship between ESG and non-ESG stocks. 

They are listed in no particular order of importance or timing, save for one, which was largely cited across nearly all ESG forecasts; that of impact investing.

That is because impact investing affects nearly every other trend forecast for FY23. 

As a result, we have devoted this article specifically to impact investment principles and forecasts, and will deliver the balance of ESG trends in a separate article soon to follow.

Switch From Virtue Signalling to Impact Investment

Over the past two years, much of the focus has been on preparing the corporate sector, particularly listed companies, to report on the sustainability of their businesses.

This has largely been achieved with nearly 90% (by some estimates) of large listed companies globally establishing ESG reporting.

The verity of much of this reporting is considered questionable or at best unhelpful, and analysts expect a further tightening of the screw in 2023 after the US Securities Exchange Commission's 10K disclosure mandates in 2022. Big capital is ready to start sorting the ESG wheat from the chaff.

Many leading research houses are now forecasting that big capital will move this year from rewarding virtue signalling to rewarding impact, particularly in the emissions department.

This is expected to have a considerable impact on markets, sparking several other trends in 2023, such as a crackdown on greenwashing, which we discuss in our next article.

It is also likely to involve quite a bit of shuffling of capital and an increased focus on companies’ individual strategies, as opposed to their compliance with reporting on broad-based ESG metrics. 

The most obvious affect is likely to be a growing visible, material gap between achievers and laggards.

The Argument In Favour Of Impact

Research houses and academics now argue that, without innovation, the world has no chance of displacing fossil fuels within the required timeframe based on the current trajectory.

“Therefore the incentive structure should align more with management teams who can simultaneously display attractive financial returns and improves emissions, safety, waste and water profiles,” says Harvard Law in a recent report. “The data indicates this is already taking place.”

The institution believes pursuing net zero for net zero’s sake (which often involves a lot of virtue signalling and carbon offset purchases) will increase the cost of capital “and the scarcity value of capital to the point which impedes the long-term ability to foster innovative capabilities”. 

“In other words, we should not prioritise rhetoric, marketing and biased agendas over innovation, capital discipline, and sound policy.”

Harvard Law advocates for “a greater emphasis on capital deployment strategies that result in material improvement in emissions performance as opposed to superficial goals”.

The academics argue this will affect global capital deployment strategies in 2023, cascading into equity, commodities, real-estate and fixed income markets.

Morgan Stanley believes this trend is likely to drive a focus on ESG Rate of Change investing, which we discuss in our next article.

ESG Rate Of Change Investing is related to impact investing and outlines a path for chasing alpha, which Morgan Stanley expects will be deployed in 2023.

What Is Impact Investing

Just to recap on previous articles, impact investing requires the creation of additional social or environmental benefits beyond those that would have occurred without the investment, and usually requires some degree of innovation.

Impact stocks should broadly fall into areas supportive of the UN Sustainable Development Goals, and tend to include investments in agriculture (plenty of M&A here in 2022), decarbonisation, water and health. (Note: not all companies in these sectors are impactful).

To date, it has been a rather nebulous area, given some argue that investment by its definition is “impactful”. Even fossil fuel companies are providing energy to drive the transition, for example. As a result, market value estimates range into the high tens of trillions of dollars.

So what we are likely to see going forward is a narrowing of the definition of impact to include a skew towards innovation, which over time will also be informed by the “do no harm” principle.

As this plays out, pundits say this shift from ESG reporting to impact investment will result in “impact confusion” – the intent to create a positive and measurable social and/or environmental impact ALONGSIDE A FINANCIAL RETURN.  

It will certainly require a higher degree of research on behalf of investors, which thought leaders say is best-guided by positive intent – “intention” being a key concept within impact investing.

Another key element of impact investing is time-to-commercialisation for emerging innovations/producers, particularly in a rising interest-rate environment. Proven innovations ready for market are generally considered more impactful than those in the development phase. 

The good thing about 2022 is that many impactful/innovative growth stocks retreated in the order of -70%, with price-to-book ratios often falling below 1. The fall in share prices and withdrawal of capital also caused many tech-oriented impact companies to tighten their belts, cut costs and move closer to being at least cash-flow positive, if not profitable.

When it comes to the majors, strategic alignment of ESG imperatives, execution and pace of implementation are considered the key paths to value creation.

Disparate Examples of Impactful Stocks

To give readers an insight into what might constitute impact, I will highlight a few of the stocks in my own portfolio, which have already made a run (I am still trying to quietly grow positions in some of my other stocks). 

Polynovo ((PNV)) is an example of a health stock (which aligns with SDG imprimaturs) that I consider to be impactful. Unlike single-disease cures or treatments, Polynovo’s impact reaches into many areas, such as burns, diabetic ulcers, hernias, etc, generating vastly improved health outcomes compared with existing technologies. 

Above and beyond that, this company provides a sharp reduction in the demand for hospital beds, and, in a system creaking under the weight of underfunding and profiteering, this is a solution that is highly impactful in a manner that doubly dovetails with SDG imprimaturs. Polynovo is a relatively low-emissions company that can promise to further reduce emission by cutting the number of hospital visits. On top of that, it is in the commercial phase.

Fortescue Metals ((FMG)) is another kettle of fish altogether. As a large commodities company it routinely provides materials that feed the transition, which is impactful in itself, not to mention financially rewarding. 

Chairman Andrew Forrest has committed 10% of profits to impactful  innovation in decarbonisation (and agriculture), such as green hydrogen and renewables, which dovetails with the company’s own need to decarbonise (strategic alignment being deemed a key determiner of impact), while opening new industry opportunities. 

While this heightens the company's risk-reward dynamics, it has a secondary financial impact of increasing the likelihood of retaining the favour of big capital in a volatile market, one would assume placing a floor under the company’s share price. Add to that the company’s China-first policy (and China’s commitment to the transition, not to mention its size), and the impact starts to add up. 

While the company is unlikely to post the kind of stellar increases enjoyed by many smaller growth companies (at least not in the near term), it genuinely qualifies as an impact stock. In the near term, big capital will be seeking results (referring to the rate-of-change issue), and perhaps more transparency around Fortescue Future Industries’ investments, but at face value the company appears to offer greater impact prospects than many of its peers. Much will depend on China this year.

Bluglass ((BLG)) is a listed minnow operating loosely in the decarbonisation space, and is a simpler, less ambitious example of impact investing. Bluglass is too small to be considered impactful in the larger scale of things, but the markets it serves are large. It is a fledgling laser manufacturer with technology that improves the efficiency of the laser making process and reduces emissions.

Bluglass recently bought a US laser manufacturing facility and is now selling into the US semiconductor industry, which is in the process of receiving massive development subsidies as part of the nation’s onshoring push. The shift to commercialisation from development fulfils the financial aspect of impact – profitability is the next step.

Sims ((SGM)) sits at the heart of the impact matrix, offering decarbonisation impact through recycled metals, and it also offers circularity impact.

While circularity is taking a backseat in investment circles, decarbonisation is on the money and should provide both a share-price floor in an impact-focused market, and a near-term growth opportunity. The alignment of impact with the company’s strategy is almost a given. Much will depend on the scale of the company’s ambition, the success of the company’s M&A, its innovation and pace of execution, but it shouldn’t find itself too short of capital providing it rates strongly on governance.

It’s All In The Timing

While impact has been nominated as a key driver of capital-market trends for 2023, the timing of its affect on capital markets is yet to be determined.

The early January rally has driven increases in many ESG impact-oriented companies (many of which have also rallied in the December half).

Many share-market punters are banking on commodities essential to the transition, such as copper and iron ore, as China reopens. Others are turning to impactful small caps and minnows. 

Others are keeping their powder dry, expecting a resurgence of focus on interest rates and another sharemarket retreat. 

Others are quietly seeking alpha through other strategies, which we discuss in our next article.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

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