Welcome to the second year of the era of chaos, where interest rates are no longer negative and inflation is no longer a textbook concept. In this brave new world, there continues to be a growing appetite for investing in a more sustainable future. However, sustainable investing has – for the first time – begun to come under extensive scrutiny from not only investors and activists, but also from regulators and policymakers.
The debate around what sustainable investing is, and particularly around what it isn’t, is expected to continue into 2023. There is no doubt that sustainable investing is here to stay, but the question is what it will look like after a decade long bull market, attacks from anti-ESG (environmental, social and governance) movements, and greenwashing allegations. Amid all the chaos, the key is to focus on the signals, not the noise.
Here are the five sustainable investing themes that we believe will matter most to investors in the year ahead:
1. Growth in sustainable investing will continue despite market volatility
Global ESG equity funds enjoyed net inflows in the year to November 2022, contrasting with outflows from non-ESG funds over the same period. Europe dominated, receiving more than 90% of global net ESG fund flows.1 A noticeable influence on demand over the last 12 months was the growing importance of ESG-related regulations, such as the European Union’s Sustainable Finance Disclosure Regulation and Taxonomy Regulation. We expect regulations to continue to be a key demand driver in 2023.
As well as capital flows, the alignment of the broader economy – including corporate activity – to green and sustainable-focused policies is already a key development in Europe. We expect to see a similar alignment in the major Asian markets, which will serve as a critical catalyst in driving the growth of the sustainable investing market in the region. In the US, the political and regulatory landscape is on a different course. However, recent policy measures, such as the Inflation Reduction Act, mean that tangible and attractive investment opportunities can be expected to encourage companies and investors to redirect capital to greener and more sustainable businesses.
2. Understanding the different shades of sustainable investing will matter
ESG is, at its core, about data and information. How this data and information is used, and for what objective, can differ widely, as there isn’t a universally defined set of sustainability criteria. However, a failure to differentiate has led to some misconceptions – for example, that ESG integration is about saving the world, or that exclusionary investing is the only way to deliver sustainable outcomes. The upshot has been to fuel some of the anti-ESG movements and greenwashing allegations that we’ve seen emerge over the last year.
Investors are now beginning to understand that there is a difference between ESG strategies targeting innovative solutions with the potential to benefit from the transition to a more sustainable future, and those strategies that exclude companies purely based on values or political views. In addition, there is a greater recognition that investing in the low-carbon transition does not mean having zero exposure to fossil fuels. We believe that investors’ understanding of these concepts will become clearer in 2023.
3. Credible sustainable solutions can have a real-world impact
Reaching Net Zero requires a significant reduction in global greenhouse gas emissions. But that alone is not enough: it will also require massive investment in carbon offsetting and removal. As the world approaches 2030 (the critical year by which a 50% reduction in global emissions is required, according to the Intergovernmental Panel on Climate Change) the need for action is growing.
As a result, investors are actively looking at ways to achieve negative portfolio emissions, through either mechanical carbon removal technologies, such as carbon capture and storage, or – increasingly – through nature-based carbon offsetting solutions, such as forestry. There is an ongoing and important debate around how carbon offsets should be accounted for when calculating an investment portfolio’s alignment to Net Zero emissions; international efforts are ongoing to standardise carbon offset accounting and traceability, as well as to promote the integrity of nature-based carbon offset projects. At the end of the day, however, a tree is still a tree. No-one should disregard the many environmental (and social) benefits that trees provide.
4. The energy transition will continue to have an impact on inflation, but failing to adapt to the climate crisis will be even more inflationary
We need to acknowledge that the transition to an economy powered by clean energy is likely to have some inflationary impact, given robust fiscal support and the high level of new investment flowing into technologies such as wind, solar and electric vehicles. But it’s also crucial to recognise that if the world fails to act on adapting to climate change, the effects could ultimately be even more inflationary.
Extreme weather events, such as the European heatwave in the summer of 2022, place multiple extra stresses on the economy, squeezing the supply side through their impact on labour markets and natural ecosystems, as well as disrupting core infrastructure. The result is that operating costs in many sectors, including construction, real estate and agriculture, will increase as companies look to enhance climate resilience and, in cases where the level of climate adaptation is low, compensate for labour losses or damage to assets. For example, the International Labour Organization projects that total working hours worldwide could be reduced by 2.2% and global GDP by USD 2.4 trillion by 2030 as a result of heat stress alone.2
Cities, because of the risk from the urban heat island effect, are expected to be among the worst hit in a warming world, with the resulting increased use of air conditioners and cooling equipment boosting electricity usage and putting further stress on the energy market. It’s not just extreme heat, however, that is having an economic cost. Increased drought, flooding and periods of extreme cold can also have a significant impact on crop yields and drive up food and commodity prices. At the same time, existing infrastructure will need to be retrofitted or replaced in order to build climate resilience.
There is no silver bullet solution to these challenges, but policy makers have an important role to play in encouraging investment and providing finance to climate adaptation projects. For investors, gaining exposure to the adaptation theme will be crucial, not only from a risk management standpoint, but also because of the opportunities it provides for investing in new climate-resilient solutions.
5. The human cost of going green will need to be confronted
The clean energy transition is crucial to reaching Net Zero goals. But many of the new greener technologies being developed require substantial inputs of a variety of minerals which are often found in only a few places around the world. As a result, investors in the energy transition face additional sustainability challenges that also need to be addressed.
A good example is cobalt, which is a core input for battery production for electric vehicles, but which can only be sourced from a handful of countries. The Democratic Republic of Congo (DRC) accounts for over 70% of global cobalt production3, and is increasing its market share as it seeks to replace Russian supply following the war in Ukraine. Given the human rights and child labour issues that are rampant in the cobalt supply chain, investors are increasingly demanding that companies conduct rigorous due diligence on DRC suppliers, including regular audits.
However, this intervention on its own is not sufficient to eradicate child labour from cobalt production, especially in light of the growing number of informal, small-scale mines that many families rely on. There is, so far, no realistic timeline for these issues to be resolved. Meanwhile, demand for batteries is expected to grow by as much as 30% a year through to 2030, as the energy transition accelerates.4
At J.P. Morgan Asset Management, we will stay focused on engaging with individual companies on these important issues. However, finding a broad solution will require a joint effort by the international community, which is why we will also continue to partner with our peers, policy makers and the broader financial industry to determine the full costs and implications of the energy transition.
1 Morningstar, year to November 2022.
2 ILO, ‘Working on a warmer planet: The impact of heat stress on labour productivity and decent work’ 2019
3 Cobalt Institute, Cobalt Market Report, 2021
4 McKinsey: Battery 2030: Resilient, sustainable, and circular, January 2023