Last year was dominated by state-led industrial policy focused on the need to accelerate the green transition and mitigate the effects of climate change, including the Inflation Reduction Act in the US and the European Union’s Green Deal Industrial Plan. If the major agreements announced at COP28 at the end of the year – notably the ambition to triple global renewable capacity and double the rate of energy efficiency improvements by 2030 – are to be implemented, government policy will need to continue to support companies that are enabling the construction of efficient, clean energy systems.

However, supportive policy is not the only requirement to enable the energy transition. The regulatory environment will need to develop and become more supportive of energy transition objectives as well. We are starting to see welcome signs that the issue of regulatory fragmentation across jurisdictions is being addressed; for example, with the establishment and initial adoption of the International Sustainability Standards Board’s (ISSB’s) sustainability and climate disclosure standards. Meanwhile, investment product labelling regimes, such as the UK Financial Conduct Authority’s (FCA’s) Sustainable Disclosure Requirements (UK SDR) have begun to surpass first generation disclosure regulations on sustainability-related topics, such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR). Importantly, the UK SDR’s recognition of “transition” as a viable sustainable investment objective should better position companies that are not yet “green”, but which are on a pathway to become more sustainable. This recognition will help clarify the different approaches that investors can use to contribute meaningfully to sustainable objectives. In 2024, our focus will be on providing avenues to direct capital towards these various sustainable investing categories, including transition objectives, for those clients that want to.

Well-designed standards for sustainability disclosures also have an important part to play in supporting the growth of sustainable investing. Without meaningful disclosures, investors don’t have the information they need to measure a company’s sustainability performance. In 2024, we expect to see greater adoption of the ISSB’s sustainability and climate disclosure standards, with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) having been fully integrated into the ISSB’s standards. Debate over the disclosure of Scope 3 carbon emissions will continue, with the European Union’s Corporate Sustainability Reporting Directive (CSRD) leading calls for in-scope companies to account for their value chain emissions and, over time, begin to disclose them. However, it remains to be seen how regulators in other jurisdictions, including the US, will deal with this issue. The sustainability information available for investors from these disclosures should improve further over time and support the channelling of capital towards their sustainable objectives, where they wish to do so.

Another area where standardisation is increasing is in the carbon markets, which can be an important tool for investors looking to encourage further decarbonisation of the economy. A number of standard-setting organizations, including the International Organisation of Securities Commissions (IOSCO), have proposed both demand- and supply-side standards which, if widely followed, should help to improve credibility after the turbulence of 2023, when a number of revelations undermined confidence in the voluntary carbon market. Carbon credit providers themselves are also working to assure the integrity of their projects, with six of the largest carbon credit registries having signed a pledge to improve transparency at COP28. Against this backdrop, we’ll continue to monitor the opportunities linked to evolving global carbon markets, as well as the development of the broader sustainable regulatory landscape.

With many climate-aware investors setting their own net zero investment targets, the focus has begun to shift towards implementation. However, it’s becoming clear that practical implementation can be complex, often requiring a nuanced and customised approach. In seeking to implement their own commitments, clients who have net zero targets should consider three main issues.

First, investors with net zero targets should consider how they can support companies as they develop their own plans to address climate risks. While holding higher-emitting companies can have consequences for the emissions profile of a portfolio, investors also recognize the importance of holding these companies as a key part of the climate transition. An investor’s interactions with transitioning companies can focus, for example, on encouraging the company to consider establishing and following science-based transition pathways, which can be externally validated by organizations such as the Science-Based Targets Initiative (SBTi).

Second, it’s important for investors to consider monitoring investee companies’ decarbonisation progress when it comes to insulating portfolios from potential financially material transition risks, including as a result of regulatory change and shifts in consumer preferences. Third, investors should consider that decarbonisation can be net positive for returns, in view of transition-related risks and opportunities. Over 90% of global GDP is now covered by a national net zero target,¹ and the global shift to a low carbon economy is being encouraged by a significant policy-backed reallocation of capital towards innovative climate technologies and solutions. Investors who buy into the energy transition have the potential for investment upside, besides reaping the climate and economic benefits of supporting the shift to a low carbon economy. In 2024, our focus will be on providing forward-looking portfolios, which recognize both the challenges and opportunities of implementing net zero commitments, to clients that want them.

Climate change creates physical risks that can translate into financial risks. However, correctly quantifying the risk that climate change poses to the economy and investor assets is an ongoing challenge. A 2023 report from Carbon Tracker, “Loading the DICE against Pension Funds”, argued that existing ways of integrating climate risk into economic models understate the potential future GDP impact from climate change, and therefore the consequences for investor portfolios.² Investors might wish to consider how they can develop a top-down view that embeds a clearer and more accurate understanding of the level of climate risk at strategic asset allocation level.

Investors may face even greater challenges with another risk factor: nature. While seeking to understand physical climate risks to investment portfolios presents challenges, nature-related risks are even more complex, fragmented and harder to measure. The result is a lack of accurate and comprehensive data on biodiversity risks in certain areas. However, 2024 may come to be seen as the year when work on quantifying the financial materiality of nature-based risk began in earnest. The release of the recommendations of the Taskforce on Nature-related Financial Disclosures (TNFD) in 2023, along with an increasing array of nature-related data and metrics, may lead to improving data and information on the topic. These developments would help investors to better recognize nature’s economic contribution and the long-term risks to investment portfolios caused by nature’s destruction. In 2024, we will be focused on how investors can begin to integrate the consideration of nature-related risks into their portfolios, where appropriate for their objectives.

At the beginning of 2023, I wrote that it’s critical to have a clear understanding of what sustainable investing is really about. This need has become even more important as the spectrum of sustainable investment approaches has continued to widen to incorporate different investment goals, from purely seeking to maximize financial return, to balancing financial return targets with better environmental or social outcomes, to actively prioritising sustainable outcomes. As the space has evolved, sustainable investing can now be more nuanced and forward-looking. Even those investors whose priority is to target a sustainable objective may choose to stay invested in high-emitting companies and actively participate in the opportunities related to their transition rather than opting out through exclusions.

By contrast, investors whose sole concern is delivering better risk-adjusted returns can rely on environmental, social and governance (ESG) integration to help them understand how long-term financial returns may be impacted by financially material ESG factors. Even where investors have no sustainable objective, it makes sense to consider financially material, long-term sustainability-related shifts that could impact a company’s competitiveness and ability to generate long-term returns. These factors can include changing consumer preferences and behaviours, government policy and regulation supporting the low-carbon transition, and technological innovation. This style of investing is not about exclusions, or seeking to achieve a secondary outcome other than financial return, but sound risk management. The distinction between ESG integration and investing with a sustainable outcome in mind is something we’d like to see become more widely appreciated over the course of 2024.

Sustainable investing does not exist in a vacuum: regional economic outlooks, sector and company fundamentals, structural themes, and investment product innovation are factors that our portfolio managers need to take into account, additionally, when making decisions for their sustainable portfolios. Below are the views on the sustainable investing outlook from a broad selection of our sustainable portfolio managers. Their insights highlight the variety of approaches that are employed by our active managers to navigate the economic landscape using sustainability considerations as a guide.

In our public equity and fixed income sustainable strategies, we marry our long-established fundamental investment process with a proprietary sustainability approach, which can be tailored to the scope and objectives of sustainable strategies. Across alternatives, this combination of active fundamental research overlaid with relevant sustainability considerations also applies, with the approach varying according to the specific investment style or the characteristics of each asset type.

Emerging markets: Amit Mehta, Portfolio Manager

While emerging markets have been volatile, there are reasons to be optimistic: falling global inflation provides emerging market central banks room to cut aggressively, the US dollar is down substantially and China’s economy is growing, albeit slower than most previously thought. Valuations have moved down, and expectations are for double-digit earnings growth in 2024/5.

In contrast to China, prospects in other regions look to be more encouraging. For example, in Latin America, and in Europe, the Middle East and Africa (EMEA), falling rates should lead to improvements in economic activity, bolstering consumer sentiment, and benefiting financials and consumer stocks. Given our belief that a full consideration of a business’s sustainability must also consider the sustainability of its economic model, these kinds of cash-flow generative, high return, capital-light domestic companies lend themselves well to sustainable portfolios, where their environmental and social credentials are also in line with the portfolio’s stated objectives.

COP28 at the end of 2023 also held points of interest for sustainability-focused investors. It was called “the most inclusive COP ever” and provided an opportunity to further bring emerging market countries into the climate dialogue. Major emerging market economies, such as China, India, South Africa and Brazil, were particularly prominent in negotiations, while the topic of climate finance for a just and clean energy transition in emerging markets gained increased attention. With more domestic, and international, policy and financial support for energy transition investment in these countries, the opportunities should solidify and expand. We believe climate action has moved higher up the agenda in India, but conversely moved down in China given current domestic concerns.

India has under-invested in capital formation over the last decade, but both the government and the private sector have now realised that capex is essential if the country is to achieve its target of 6% GDP growth over the next decade. We expect the next stage of government infrastructure spending to be more focused on renewables, notably wind and solar. In a similar vein, in the Middle East the desire to move away from being so heavily oil dependent is spurring ambitious investment plans in renewable energy.

In China, we expect rising electric vehicle (EV) penetration, stricter emission standards and control, and ongoing adoption of renewable energy to continue. China is a clear global leader in a number of raw materials, or components, required for the generation of renewable energy, such as polysilicon, solar glass and water. Additionally, EV penetration is high and already exceeds the government’s 20% target for 2025. Consequently, we expect EVs to continue to be a big theme in China as the country continues to scale up and companies pursue ambitions to export.

Irrespective of the macroeconomic backdrop, at their core our sustainable investment strategies are looking to find good companies, with good fundamentals, that are making a positive contribution to sustainability objectives, at the right price. We continue to find lots of these opportunities in emerging markets.

Europe: Joanna Crompton, Portfolio Manager

We believe 2024 will see renewed interest in global sustainability challenges, particularly from a climate perspective. As national climate pledges draw closer, the reduction in carbon emissions would need to accelerate to meet these targets. Many European companies are already at the forefront of this transition: as of January 2024, nearly 70% of all companies that had set or committed to set a science-based target were based in G20 countries, and over half were based in Europe.

While we have seen a rapid acceleration in renewables investment, global spending on electricity grids has remained relatively flat. The International Energy Agency forecasts that grid spending needs to nearly double to over $600 billion per year by 2030 for countries to implement their national targets. All the way down the value chain from high voltage and transmission through to smart meters, European companies are global leaders in their fields.

The World Obesity Federation projects that four billion people—half of everyone over five—are likely to be overweight or obese by 2035. This issue is clearly a huge societal challenge and one that European companies are making investments to try to address. Of course, the use of anti-obesity medications presents its own challenges for the companies involved from a social perspective, and this is one of the reasons why we continue to collaborate closely with our Investment Stewardship team on engaging to understand the complexities of this issue.

Data transparency is key to assessing corporate commitments and progress on environmental and societal issues for our sustainable strategies. In 2024, we seek to continue to push for progress on the availability of ESG data. We expect the Science-Based Targets Network to finalise its guidance for biodiversity-specific targets, helping early moving companies to structure their pledges and for investors to be able to assess their ambitions and progress. While this development will be a step in the right direction, there remains a long way to go.

Against this backdrop, there is a strong case for focusing on Europe, given attractive valuations, backed by strong earnings growth forecasts for the year and sector-leading companies when it comes to certain sustainability topics.

US: Danielle Hines, Portfolio Manager

Despite widespread pessimism heading into 2023, the S&P 500 had a very strong year as the widely predicted US recession did not arrive and profits proved much more resilient than investors had feared. For 2024, our analysts are forecasting ~12% earnings growth for the S&P 500, with growth expected to be more broad-based across the universe than it was in 2023 despite the continued dominance of the Magnificent Seven. Even with the narrow market and the geopolitical events over the last year, which were particularly tricky for sustainable investing managers to navigate, it proved beneficial to focus on fundamentally sound companies that we deem as sustainable based on our internal frameworks.

This approach takes a forward-looking view on sustainability, looking to identify companies that are either already sustainable leaders, or that are on course to become leaders in the future, at the same time as seeking attractive risk-adjusted returns. In these strategies, we continue to target secular sustainability trends across sectors, such as decarbonisation, innovative medicine, companies with diverse talent, clean buildings, and precision agriculture.

One theme that we believe will have a clear impact on the economics for certain businesses in 2024 is the Inflation Reduction Act (IRA). The IRA is an important fiscal policy that will accelerate capital spending over the next 10 years in areas aimed at the energy transition, providing meaningful tailwinds for many companies that are attractive in our universe. This policy directly benefits providers of clean energy and also provides incentives for electric vehicles, a secular trend that was already well underway prior to the IRA. While the obvious investment opportunity here might be electric vehicle manufacturers, our analysts have looked for opportunities across the entire transportation and energy ecosystem, from the battery technology required to power vehicles and the renewable energy generation that will be needed to service increased demand, through to the grid infrastructure required to handle increased load and the charging stations that will need to be built over the next decade.

Japan: Michiko Sakai, Portfolio Manager

Japan continues to provide attractive opportunities for investors focused on sustainability. While shareholder focus on social and environmental issues has been growing slowly compared to many other regions, a recent increase in the number of female directors appointed to company boards suggests that Japanese companies are starting to react to engagement on these issues.

We have also noted an ongoing increase in shareholder proposals targeting climate risk, not just from environmental organizations, but also from investors. For example, investors are increasingly asking Japanese companies to inform them on how they are addressing climate related risks. They may also ask companies to consider, where appropriate, setting greenhouse gas emissions-reduction targets in line with the Paris Agreement, and to disclose the progress they are making.

While these examples provide evidence of helpful developments on environmental and social topics, corporate governance reform provides the most exciting development in the outlook for Japanese equities. The move by Japanese companies to adopt higher governance standards, and boost dividends and buybacks, is being driven by several factors, including the implementation of a stewardship code in 2014 as well as the more recent action by the Tokyo Stock Exchange to ask companies to explore the ways in which they could further improve their governance. We believe that improving corporate governance could help close Japan’s structural discount to other markets, over time.

The positive effects are already being seen. Both dividend payouts and share buybacks have risen sharply over the last few years from a low base, with dividend payout ratios expected to rise further as corporate governance reforms accelerate, while further share buybacks could be funded by the unwinding of corporate equity holdings, which could in turn help boost Japan’s return on equity (ROE).

For investors, the improving corporate governance trend appears to have a long way to run, with Japanese companies still sitting on vast piles of net cash, underused land and redundant shareholdings. Take cash holdings, for example, where around 40% of the companies in the MSCI Japan Index hold positive net cash positions on their balance sheets – a level that is much higher than in the US or Europe. These improvements in shareholder returns and the subsequent improvements in ROE could therefore play out for many years to come.

Sustainable bonds: Stephanie Dontas, Portfolio Manager

The combination of moderate growth, slowing inflation and central bank bias towards easing creates a very different macro backdrop from recent years and, in our view, a powerful tailwind to bond markets.

Within this context, we see a continued growth in demand for sustainable fixed income, with EMEA assets totalling USD 0.5 trillion at the end of 2023.³ Sustainable versions of core building blocks – global aggregate and EUR-denominated corporate bonds – have led recent sustainable fixed income demand, while green bond funds also continue to attract flows. ETFs make up USD 75 billion of the total, led by passive vehicles – specifically those with a climate mandate. Recent industry product developments include extending green bond strategies to include social and sustainable elements, as well as net zero solutions.

Transition investing is gaining prominence: for example, managing against Paris-aligned benchmarks or investing in issuers that score favourably based on the Science-Based Targets initiative (SBTi). Investors are also developing more nuanced, forward-looking approaches when it comes to exclusionary frameworks. Rather than blanket negative screens, some strategies focus on investing in, engaging with, and supporting issuers that are actively shifting towards more sustainable practices. This approach can be implemented via frameworks that focus on improving issuers, or on green, social and sustainability (GSS) bonds.

The GSS bond market should continue to grow. Green bond issuance (bonds specifically funding environmentally beneficial projects) amounted to USD 163 billion in 2017. Last year, the market digested more than USD 500 billion of issuance, bringing total green debt outstanding to USD 2.4 trillion. Social bonds (where the use of proceeds fund socially-beneficial projects) and sustainability bonds (which fund a mix of green and social projects) have also recently gained traction. Total GSS debt now stands at around USD 3.9 trillion, which makes this a big enough market to facilitate a core allocation in a portfolio.

Investors in this space must remain vigilant. International frameworks, such as the International Capital Markets Association (ICMA) green and social bond principles and the European Union Green Bond Standard, guide issuers towards high standards. Issuers will typically seek a second-party review from specialist research and data providers, to add further assurances. However, adherence to such conventions remain voluntary, which increases the risk of greenwashing. As a result, active management is particularly important in the GSS market, and investors with sustainable objectives should apply heightened due diligence in their own investment process to be confident that such bonds are being issued in good faith.⁴

Global macro: Shrenick Shah and Rose Thomas, Portfolio Managers

We expect the landscape of regulations and directives driving the transition to a low carbon global economy to become increasingly complex. At the same time, we anticipate increased opportunity to identify pockets of development.

In order to approach this backdrop from a macro and sustainable investing lens, we aim to navigate this environment from the top-down and bottom-up. In our top-down macro analysis, we look to identify structural shifts, such as those being caused by increased focus on sustainability risks and opportunities across industries globally. One of the macro themes that we consider within our sustainable strategy is climate change response. As mentioned above, the COP28 summit in 2023 saw an agreement to transition away from fossil fuels. In view of this, we are investing in opportunities related to building efficiency and electrification. The increasingly complex regulatory backdrop and focus on transition should cause disruption this year, and opportunities in select companies that stand to benefit.

From the bottom-up, we focus on areas that are most relevant to a particular industry or activity, as well as company or country-specific issues. As well as assessing risks, we continue to see opportunity through this lens, such as investing in financial services in select emerging countries, where improved access to financial products supports social advancement and the fundamental backdrop is strong. We also see opportunities in healthcare that support better wellbeing globally. This year will see elections in over 40 countries that together account for 41% of the global population,⁵ which may provide a stage to highlight an increased focus on sustainability. We expect these issues to remain highly relevant this year against the backdrop of regulatory, and potential leadership change.

Timberland: Lee Lawrence, Executive Director at Campbell Global

Timberland can be an attractive and important asset class for investors, especially those with sustainable objectives, as it combines strong risk-adjusted returns with environmental and social benefits.

In the US, pent-up housing demand, low levels of available homes on the market, and an expected reduction in mortgage interest rates should drive wood product demand via robust new home construction and repair/remodeling activities in 2024 and beyond. Simultaneously, demand for high-quality carbon offsets is likely to increase as we approach 2030 decarbonisation goals set by governments and companies across sectors. While carbon capture and storage technologies are becoming more prominent, the demand for nature-based, high-quality carbon offset projects that demonstrate true additionality is accelerating, driving the creation of afforestation (AR) and/or improved forest management (IFM) projects.

IFM projects generate carbon offsets typically by extending the rotation age of forests (for instance, by delaying harvests) or by reducing harvest levels, which may restrict log supply for wood product manufacturers. This dynamic should benefit timberland owners through increased log prices and additional revenue from carbon offset sales, supporting strong income and capital appreciation. Forestry investments also provide diversification from uncorrelated market exposure as trees grow independently of market fluctuations.

In addition to these economic factors, actively managed forests provide sustainability-focused investors as well as communities local to forest areas with tangible climate, nature, and biodiversity co-benefits that align with certain United Nations Sustainable Development goals. A growing tree sequesters carbon dioxide, storing it in its biomass and releasing oxygen into the atmosphere. On an actively-managed property, when trees are harvested, new ones are planted within 12-18 months to continue the sequestration cycle. Meanwhile, harvested trees continue to store carbon where they are made into wood products not used for combustion, making wood a sustainable, renewable, and low carbon material.

In addition to providing clean air, managed forestry assets can protect and enhance the quality of water, soil, and wildlife habitat. Compliance with third-party sustainable forest certifications, often more strict than local regulations, requires investment managers to mitigate the impact of human activity on the environment and promote the health and vitality of habitats and species. Timberland also provides living wage jobs in rural communities and, through the recreation leases, provides local communities access to outdoor activities.

Timberland is unique in that economic, climate, nature, and social objectives have a mutualistic relationship. As these attributes are increasingly required or assessed in capital markets, we believe timberland as a real asset class will garner more attention.