ESG Focus: The Little Big Things – 06-03-2024

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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: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

Little Big Things – 06-03-2024

The drums of war are beating and ESG is finding it harder to attract funding in a tighter capital market as big capital’s focus shifts to onshoring, restructuring of supply relationships, military investments, global elections and AI; but it’s full steam ahead for decarbonisation.

-Geopolitics muscling out ESG
-So where will the ESG money go?
-Sustainability is the new ESG
-COP28 backpedals on ESG
-Morgan Stanley lays its bets
-Westpac’s five themes for Australia
-Macquarie goes local

Compiled by Sarah Mills

 “There is now a 50% chance of WWIII as the Israel Hamas conflict threatens to spread.”

Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund

“This is the most dangerous time that the world has seen in decades.”

Jamie Dimon, chairman and CEO of JPMorgan Chase at the NYT DealBook Summit 2023

These two quotes are possibly the most apt description of the mood towards ESG in 2024.

With more than 50 elections scheduled for 2024, including the US, ESG is likely to be relatively sidelined in 2024 as big capital shifts its sights to the geopolitical stage.

Conflicts in the Middle East and Ukraine are likely to continue to underpin inflation and interest rates (both the Suez Canal and Panama Canals have been closed), and as tighter capital policies hold sway, funds are parsed.

The world has been moving to onshoring and restructuring of trade relationships (also inflationary) for a few years and these imprimaturs are likely to continue to attract a large chunk of available capital.

Governments are showing no appetite to retreat from conflicts, suggesting inflation might be engineered higher for longer, regardless of movements in the economy or a retreat in EV rollouts. 

There is likely to be some areas of strong growth, as we discuss below, but all save the most “essential” investments (such as renewables, critical minerals and green steel) are likely to struggle.

Jamie Dimon’s final tip: If China invades Taiwan, “it’s all bets off”.

Global Shift Out of ESG Funds

The smart money was already shifting out of ESG in 2023, according to Calstone’s Global Funds Report.

“After a three-year boom from 2020 to 2022 that attracted US$51.2bn, six times more than non-ESG funds, ESG funds shed US$10.2bn last year,” says the report

Europe led the charge, followed by global peers.

“Our data shows a determined focus on selling, given sizeable redemptions from smaller pools of ESG funds relative to non-ESG. 

A plethora of other reports expect ESG to remain sidelined (temporarily) in 2024.

Calstone’s Report also revealed a massive shift over 2023 into fixed income from equity and Australia became net sellers of equities for the first time in the Report’s history.

So Where Will The Straitened ESG Money Go

Given ESG appears likely to emerge as the runt of litter in the battle for capital in a capital-constrained world, but destined to survive none-the-less, where will its reduced funding go?

Research suggests proven renewable energy and battery technologies will be the major beneficiaries, while new investments in low-prospective carbon capture storage projects are likely to be put on ice. Prospective carbon capture projects appear to exist in the construction and building materials sector.

A report by Oxford Economics says rolling out energy CCS through the economy doesn’t make financial sense (it would cost -US$1trn a year out to 2050) and that it should be contained to a handful of essential sectors. The analysis states the cost of CCS has not fallen in 40 years.

EVs appear set to take a breather (but still find reasonable sales), beset by geological trade tensions; and investments are likely to roll into EV-supportive projects such as charging infrastructure.

All this suggests demand for critical minerals will continue, although certain commodities such as lithium and nickel are likely to struggle until the supply overhang clears. As was the case in 2023, established, large, low-cost producers are likely to win the day.

Decarbonisation of steel, building and construction is also likely to continue, and green (even just clean) hydrogen (to replace grey hydrogen) and possibly biofuels, should find support.

Overall, investors are expected to take a tough approach, pruning ESG portfolios, culling the weak and reinforcing the strong, and opportunistically buying attractive companies.

Technologies supporting distributed energy are also forecast to gain ground as big capital uses the year to improve the capacity of existing renewables infrastructure. 

Otherwise, the focus is likely to be on emissions standards, disclosure nets, industry guidelines and accounting standards.

“Sustainability Is The New ESG”

There have also been rumblings the term ESG is itself on the nose (particularly in the US) and may be shouldered out for temporarily by the vaguer term of “sustainability”.

Morgan Stanley reports while ESG investment is down, sustainable investing is up.

“The Energy Transition has clearly suffered something of a crisis of confidence in 2023,” says Morgan Stanley.

The analyst cites writedowns and/or downgrades from sustainability darlings such as Orsted, Siemens and NextEra Energy Partners; destocking for US residential solar companies; project delays; and balance sheet concerns for Plug Power.

The S&P Global Clean Energy Index fell -20% in 2023. 

But the energy transition is far from dead. In fact, it is full steam ahead and decarbonisation is likely to gain the lion’s share of ESG funding given the deflationary impact of green solar. 

The amount of planned renewables installations planned for 2024 is breathtaking and follows on from an equally impressive 2023. It’s a race.

Unfortunately, save for critical minerals, which are a bit hit and miss at the moment, Australian public investors have few opportunities to invest in the boom. 

The only listed renewables company Genex Power ((GNX)) recently received a takeover bid from the Japanese-owned Electric Power Development Co. (J-Power), a common fate for prospective ASX-listed companies at the moment.

Morgan Stanley Identifies Green Growth Areas

Within renewables, Morgan Stanley says the decarbonisation focus has shifted from buying darlings to "identifying high quality, highly profitable business models generating healthy cash flows and solid balance sheets".

The analyst identifies its favourite “Green and Lean” stocks (mostly international), which include Acerinox, Ashtead, Norsk Hydro ASA, Outokupu Oyj, Stellantis, Total Energies, Technip Energies and Vinci.

Morgan Stanley says the main headwinds for renewables include interest rates and project financing (but observes the demand path remains clear); supply chain disruptions, which are likely to have a disproportionate affect on wind investments; and "friendly shoring".

Cash flow constrained companies and/or those exposed to significant execution risks will struggle, says the analyst.

Permitting and interconnections, it says, are likely to be fast-tracked.

Morgan Stanley Optimistic On CCS And Nuclear Energy

Along with the standard contenders for funding dollars, Morgan Stanley includes carbon capture storage (CCS) as a winner.

This seems anti-intuitive in a capital constrained environment given the exorbitant cost and low effectiveness.

My guess is most investment in carbon capture storage will likely be for “low-hanging fruit” in areas such as construction materials.

Morgan Stanley is also backing nuclear energy, citing developments at COP28.

COP28 Backpedals

If any event supported a backpedalling from ESG, it was COP28, late last year.

The only truly green agreement was the COP‘s pledge to triple renewable energy capacity by 2030. 

Otherwise, the read-between-the-lines was business as usual.

The countries agreed to phase out fossil fuels in a just and orderly and equitable manner and that “transitional fuels” such as natural gas “can play a role”. For how long remains the big question.

All up, 22 nations committed to triple nuclear power by 2050.

Macquarie expects this will particularly be the case in the US should the presidential election result in the rollback of the Inflation Reduction Act.

In this humble journo’s opinion, nuclear energy does not make economic sense and makes even less so in a capital constrained environment.

To illustrate, cloudy old Brussels recently made an announcement it plans this year to roll out an ambitious 320GW solar grid and rooftop project that will yield as much energy as one nuclear plant – a project that is likely to experience relatively limited time blowouts (one year is budgeted) and at a fraction of the cost of nuclear energy. 

This is breathtaking. How can nuclear possibly compete? Politics at the cost of taxpayers would be the most likely answer.

Goldman Sachs, meanwhile, doubts the geopolitical uncertainty will disrupt secular trends such as green capital expenditure or the move from aspiration to action.

Rather, the analyst predicts the rollout of more refined and transparent sustainable investors strategies and a refocus on stock performance.

Macquarie’s Observations

Renewables are alive and well in Australia, observes Macquarie.

AEMO’s 2024 Integrated System Plan calls for a tripling of grid-scale variable renewable energy by 2030 and to meet demand and retiring coal capacity.

The organisation also identifies the need for 10,000km of new transmission lines to facilitate the transition – this column has been placing its bets on transmission technology for solar and batteries for some time.

Macquarie predicts fast-tracking of environmental approvals. 

This journalist suspects this could prove problematic for proposals with strong public and environmental impacts, such as wind farms in Port Stephens and in other areas of NSW’s spectacular and largely pristine coast. 

Why wind farms are being placed on some of the world’s most spectacular natural coastal resources in a land overflowing with solar power just as batteries are about to hit on scale is puzzling.

On the critical minerals front, the US Inflation Reduction Act has introduced Foreign Entity of Concern prohibitions associated with the Clean Vehicle Tax Credit. 

From 2024 any vehicles manufactured by an FEOC will not qualify for a subsidy. The same applies to battery critical minerals. 

Aussie producers may have to wait. To qualify for the tax credit, manufacturers will be required to conduct due diligence starting in 2024 for components and 2025 for critical minerals.

On top of that, Macquarie expects this will have a limited affect on upstream lithium production in Australia and South America.

The broker suspects IGO Ltd's ((IGO)) and Mineral Resources’ ((MIN)) projects and other others could be ineligible for IRA credits during processing through FEOC refineries, but observes large markets remain outside of the US.

The analyst also observes downstream processing diversification is well under way by miners in both countries, although no miracles are expected in 2024.

Foreign entities of concern include China, Russia, North Korea, and Iran.

Westpac’s Five ESG Themes for Australia in 2024

Westpac’s newsletter ESG Impact: 5 themes and developments to watch in 2024 nominates five ESG focus areas for 2024 which revolve around policy, legislation and disclosure rather than investment, but which perhaps presage a return to investment in 2025:

–Climate reporting: The Australian government is publishing draft legislation on climate reporting; and the Australian Accounting Standards Board (AASB) released its exposure draft on Australian Sustainability Reporting Standards last year (comments were due by March 1).

-The government is likely to finalise sector-specific decarbonisation guidelines for: Electricity and Energy; Industry (including waste); the built environment; Agriculture and Land; Transport; and Resources – to be delivered by August 1 to stimulate investment (suggesting investment will be stimulated after this date?).

-Work towards the introduction of a Carbon Border Adjustment Mechanism to support the Safeguard Mechanism (focusing mainly on steel and cement – think Boral ((BLD)) and BlueScope Steel ((BSL)) ), with a Carbon Leakage Review due in September.

–Standards for Australian vehicles (on the drawing board with a draft of new fuel efficiency standards and Westpac says EV drivers are likely to be delivered more charging opportunities via the Driving the Nation Fund which has allocated $39.3m for 117 chargers on major highway at intervals of 160km. Another $80m has been co-invested with governments to roll out hydrogen refuelling networks on key freight routes, suggesting hydrogen is far from dead in the water.

-An Australian sustainable finance taxonomy is in the making following the publication of two methodology papers in December. 

While not immediately impactful, investors are likely to be taking notes for later decisions.

Macquarie’s Top ESG Themes For 2024

Macquarie in its February Australian Equity Strategy expects the key ESG themes for 2024 to be:

–A ramp-up of renewable and grid investment to meet the government’s 82% ASX100 net zero target. This would require fast-tracking of environmental approvals for clean energy projects posits the broker.

Macquarie identifies AGL Energy ((AGL)), APA Group ((APA)), Incitec Pivot ((IPL)), Origin Energy ((ORG)), Orica ((ORI)) and Worley ((WOR)) in this respect.

–Cybersecurity budgets to rise with a focus on responsible data and generative AI for cyber defence and boards may need to watch out, advises the broker.

–Emphasis on a just transition – Macquarie predicts companies will need to spend on reskilling staff, addressing labour shortages of electricians and engineering roles, and tackling barriers to minorities. 

–Growing environmental due diligence across operations and supply chain as regulations tighten. Macquarie expects increased Scope 3 reporting and biodiversity supply chain impacts.

– Taskforce on Nature-related Financial Disclosures report is due to be finalised and the analysts expects it will include a biodiversity target, kicking off the biodiversity theme. 

Macquarie observes Brambles ((BXB)) GPT Group ((GPT)) Transurban ((TCL)), Telstra ((TLS)) and Vulcan Energy Resources ((VUL)) have committed to report in line with TNFD this year.

-Deepening human rights supply chain due diligence. The broker forecasts “enhanced” engagement with suppliers, which could possibly allude to software and other innovations.

–Diversification of critical minerals out of China. Macquarie identifies likely beneficiaries on these subjects, which we will save for another story.

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: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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