Climate change, cybersecurity (including privacy), technological advancements and demographic changes were altering the investment management landscape before COVID-19. In our view, the pandemic has helped hasten the shift in mindset toward sustainable investing and elevate the social dimension of the environmental, social and governance (ESG) criteria used to screen potential investments.
The coronavirus has not only altered the global economy but affected investment theory as well. As evidenced by their interest in responsible investing, cited in a 2020 UBS Investor Watch survey, millennials poised for the “Great Wealth Transfer" increasingly believe neo-classical economic theory should evolve past its sole focus of maximizing firm profits. What is good for the long-term viability of our economic system and society also has the potential to lead to positive investment outcomes. More investors are now measuring company performance beyond just profit and loss. It is no longer about what makes a good stock but what makes a good company.
Last year, investors purchased a record US$490 billion in green, social and sustainability bonds. A further US$347 billion poured into ESG-focused investment funds, marking an all-time high, and more than 700 new funds launched globally.1
We’ve identified six key trends to monitor during 2021. We believe successfully addressing these trends should not only contribute toward managing ESG-related risks and opportunities, but also help investment managers adjust to the shifting mindset toward sustainable investing.
As the world simultaneously fights the pandemic and the negative effects of climate change, we believe investors will increasingly consider the environment, public health and the global economy intertwined. As we identified in 2020, more investors are seeking exposure to the circular economy theme.3
Investors’ appetites are growing for companies that are rethinking their resource consumption, supply chains, energy usage and manufacturing processes to eliminate waste, address modern-day slavery issues and generate renewable outputs. Circularity can contribute to solving energy poverty, access to basic needs and biodiversity problems.
While ESG issues, such as human rights, are often deemed risks, they also offer opportunities in the investment screening process. American Century Investments’ impact generation framework4 aims to find investment opportunities that help advance human rights, especially in emerging markets.5 These countries, where living standards are lower and socioeconomic inequalities typically significant, have fragile ecosystems that make them more vulnerable to environmental damage and epidemics than the developed world.
Our investment teams have identified long-term growth trends and improving corporate practices in emerging markets that we believe offer various investment opportunities. Such businesses may contribute to progress in reaching the following U.N. Sustainable Development Goals (SDGs):
As global investment markets expand and globalized flows heighten, investors’ returns will become more closely tied to the global economy’s success. Not accomplishing the SDGs could add to avoidable macroeconomic risks. At the same time, all investable SDGs drive progress on human rights, while advances in human rights drive the SDGs. So, we refer to this as “sine qua non SDG mapping.”6 We believe it is in investors’ best interests to seek investments in companies that contribute to sustainable economies and improved human rights conditions.
As we make progress on eradicating the coronavirus, businesses exposed to the stay-at-home digital economy remain attractive investment opportunities. We expect software, data centers, and cloud-based and 5G networking companies to continue thriving despite a pickup in demand for consumer goods cyclicals. However, pandemic-led “digitized” companies will face heightened data privacy and security risks. This will accelerate the focus from data collection and mining (“know your customer” [KYC]) to data security (“protect your customer” [PYC]) that we identified in 2020.3
We expect cybersecurity and associated privacy issues to continue growing in importance for investors in 2021, as consumers and regulators grow wary of Big Tech watching us.
We believe investors focused on decarbonizing their portfolios will redouble their efforts. Continued improvement in technological learning curves, toughened environmental regulations and shifts in investment mentalities will continue to support the transition to a lower-carbon economy. This shift can be achieved despite the cyclical recovery and improving consumer confidence that may support a rebound for the energy sector.
Investors can still use tactical fossil fuel divestment to reduce climate change-related risks. This is especially true for assets deemed harmful to human health and the environment (e.g., coal, tar sands). But we believe investors will choose to focus their energy sector allocation rather than choose full-fledged divestment.3 We anticipate a combination of clean technology (e.g., negative-emissions technologies, batteries, green hydrogen, renewables and bioenergy), thematic tilting and active ownership (e.g., engagement and proxy voting).
Recent academic research has also shown that energy-producing firms—which are often explicitly excluded from ESG funds’ investment universe—can be key innovators.7 This could potentially support the global BTU green transition. That is why we believe investors will continue to forge constructive dialogues with energy players that may have room for improvement but have a strategic direction for adapting to a carbon-constrained energy system.
Global investors will need to strike a balance between accelerating the clean energy transition and managing increasing risks. Risks include human rights/labor violations and negative environmental consequences of using lower carbon enabling metals (e.g., copper, lithium, cobalt and nickel). Economic decarbonization is likely to drive growth for electric vehicles and renewable energy in 2021.
The production of minerals such as graphite, lithium and cobalt could increase by 500% by 2050, according to a new World Bank Group report.8 Yet, concerns have surfaced about the negative impact of acquiring these materials. Also from the World Bank: “Simply put, a green technology future is materially intensive and, if not properly managed, could belie the efforts and policies of supplying countries to meet their objectives of meeting climate and related Sustainable Development Goals.”9
For example, lithium, a key component in the lithium-ion battery, is water-intensive. Cobalt has been associated with child labor and human rights issues in the Democratic Republic of Congo. Moves to use less cobalt have led to using more nickel, which has been associated with negative environmental issues, including toxic byproducts.
In this context, we believe investors will focus on alternative supply sources for the minerals critical to building renewable infrastructure without dialing back ESG risks. New research shows polymetallic rocks found on the deep-ocean floor can supply the clean energy value chain (e.g., EVs and power storage), with far less impact on the climate than mining the same metals from the land.10
Investment managers with exposure to the European Union must comply with the new Sustainable Finance Disclosure Regulation (SFDR) and associated EU Taxonomy.11 These regulations will have a positive effect by making greenwashing more difficult.
Greater transparency and clarity will raise the barriers to entry, so it will be harder for investment managers to stick ESG labels on their investment products. Such cleanup (pun intended) is to be welcomed because it gives competitive advantages to investment managers with stronger ESG capabilities.
Whether ESG regulations in Europe reverberate globally depends on the regional context and the policy priorities of respective countries. The imperative for addressing ESG puffery in fund disclosures and promoting climate-conscious capital allocations is gaining consensus in the investor community. For example, the U.S. Securities and Exchange Commission recently established a Climate and ESG Task Force, and Japan’s Financial Services Agency reviewed new rules for mutual funds to protect investors from possible ESG washing.12 We believe the U.S., as well as some east Asian and Australasian markets, will look at western Europe for guidance on ESG investing best practices.
Overall, as we stated in 2020, investors will increasingly demand clear, verifiable evidence that ESG considerations are formally integrated into a manager’s investment process.3
In our view, ESG momentum will continue as trends become ingrained with economic realities. Digitalization and decarbonization are structural themes increasingly compared to the internet revolution. While there’s an argument to make around ESG issues being “asset class agnostic,” it is harder to make the same argument about the implementation of ESG at the individual strategy level.
Time horizon, turnover, risk appetite, sector allocation and investable universe are important characteristics to consider in ESG capital allocations. Some strategies, by the nature of their design and investment objectives, might be forced out of the scope of “ESG love stories” and ESG regulatory schemes. This increases the risk of an overcrowded ESG trade (i.e., overpricing) as managers create similar products and own the same securities.
As ESG demand grows, investors should be mindful of the potential risk around ESG investments, as many of these are already overweight sectors such as technology, renewable energy and health care.13 While we believe many of these ESG-friendly investments have strong growth potential in the longer term, they warrant caution. Investment managers should redouble efforts to be creative in unearthing ESG rising stars (i.e., companies in earlier stages of change) at the onset of their ESG disclosure journeys or on the verge of improvement following business misconduct controversies.
1Lars Erik Taraldsen and Ott Ummelas, “World’s Biggest Wealth Fund Draws Dot-Com Parallel With ESG,” Bloomberg, February 25, 2021. https://www.bloomberg.com/news/articles/2021-02-25/world-s-biggest-wealth-fund-draws-dot-com-parallel-with-esg
2Global Sustainable Fund Flows: Q4 2020 in Review, Morningstar, January 28, 2021.
3Guillaume Mascotto, “ESG Outlook: Five Key Trends That Are Driving Momentum in 2020,” American Century Investments, March 2020. https://institutional.americancentury.com/content/institutional/en/insights/topic/esg-sustainable/esg-outlook.html
4Guillaume Mascotto, “Making a real impact,” Funds Europe ESG Report, Winter 2020. https://www.funds-europe.com/esg-report-winter-2020/sponsored-feature-making-a-real-impact
5Patricia Ribeiro, “Sustainable Investing in Emerging Markets,” American Century Investments, First Quarter 2020. https://institutional.americancentury.com/content/institutional/en/insights/topic/esg-sustainable/emerging-markets-sustainable-investing.html
6Guillaume Mascotto, “Investors will embrace their role in accomplishing the SDGs and upholding human rights,” 2021 ESG Playbook: Stability and sustainability in the investment community,” Refinitiv. https://www.refinitiv.com/en/resources/special-report/2021-esg-playbook
7Lauren Cohen, et al., “The ESG-Innovation Disconnect: Evidence from Green Patenting,” October 25, 2020. Available at SSRN: https://dx.doi.org/10.2139/ssrn.3718682
8Kirsten Hund, et al. “Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition,” World Bank Group, 2020. http://pubdocs.worldbank.org/en/961711588875536384/Minerals-for-Climate-Action-The-Mineral-Intensity-of-the-Clean-Energy-Transition.pdf
9Daniele La Porta Arrobas, et al. “The Growing Role of Minerals and Metals for a Low Carbon Future,” The World Bank, June 30, 2017. https://documents.worldbank.org/en/publication/documents-reports/documentdetail/207371500386458722/the-growing-role-of-minerals-and-metals-for-a-low-carbon-future
10 “DeepGreen: EV batteries made from deep-sea rocks dramatically reduce carbon,” Battery Industry, December 29, 2020. https://batteryindustry.tech/deepgreen-ev-batteries-made-from-deep-sea-rocks-dramatically-reduce-carbon/
11Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector. EUR-Lex, December 7, 2020. https://eur-lex.europa.eu/eli/reg/2019/2088/oj
12Takashi Nakamichi and Takako Taniguchi, “A $9 Billion Mizuho Fund Sparks Review of ESG Labels in Japan,” Bloomberg, March 3, 2021. https://www.bloomberg.com/news/articles/2021-03-02/a-9-billion-mizuho-fund-sparks-review-of-esg-labels-in-japan
13Camilla Hodgson, “Funds branded ‘ESG’ are laden with technology stocks,” Financial Times, August 14, 2020. https://www.ft.com/content/ea295d51-d5c2-4916-8c63-017c352ea577 and Katherine Lynch, “The Best-Performing ESG International-Equity Funds,” Morningstar, February 3, 20121. https://www.morningstar.com/articles/1020641/the-best-performing-esg-international-equity-funds
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
A strategy or emphasis on environmental, social and governance factors ("ESG") may limit the investment opportunities available to a portfolio. Therefore, the portfolio may underperform or perform differently than other portfolios that do not have an ESG investment focus. A portfolio's ESG investment focus may also result in the portfolio investing in securities or industry sectors that perform differently or maintain a different risk profile than the market generally or compared to underlying holdings that are not screened for ESG standards.
Sustainable Development Goals (SDGs) are a collection of 17 global goals set by the United Nations General Assembly. They were developed by a global team of industry and government leaders and adopted by all 193 member states. The SDGs include 17 goals and 169 attendant targets aimed at solving some of the world’s most pressing problems by 2030. The goals include eradicating poverty, providing environmental resources and achieving gender and income equality.
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