5 ESG Themes For Next Year

Michael Jantzi is chief executive of Morningstar company Sustainalytics. In this article, adapted from his end-of-year report, he looks at key ESG trends for 2022.

Theme One: The Just Transition

We will now see a continuing proliferation of social issues intertwined with climate, such as the Just Transition. The Just Transition Declaration, signed by more than 30 countries at COP 26, reflects International Labour Organization guidelines and commits them to find strategies that support communities through the shift to a more sustainable economy. You will see more efforts, such as the EU's €17.5 billion Just Transition Fund, as well as investor initiatives like the World Benchmarking Alliance, which will assess how well 180 companies are managing the process.

The climate crisis also encompasses a range of other issues, including deforestation, biodiversity, pollution, and human rights. Ultimately, these are about the health and resiliency of the planet, which underpins the health and wellbeing of those who inhabit it.

Humans are part of, not separate from, nature. While climate change and weather-related events will dominate the coverage, discussions will be much broader. For example, there is evidence that air pollution worsens the severity of Covid-19. In October, the medical journal The Lancet, predicted that climate change would be the dedefining narrative of human health. All these discussions will gain momentum.

Theme Two: Net Zero Stays

The Net-zero transition isn't simply about reducing carbon though; it's a business model transformation akin to the industrial revolution. There will be winners, survivors, and casualties. If you're on a board of directors, in the C-suite, or allocating capital as an investor, you are trying to figure out what you need to do to be in the winner's circle, or at the very least to avoid being a casualty.

The investor community, a pillar of the capital markets, must absolutely focus on driving meaningful outcomes through their investments. I read a humorous article that poked fun at the net-zero movement. It was about an Australian man who set an ambitious target to quit drinking by 2050, when he turns 101. He didn't see that he needed to stop drinking in the short- or medium-term. That won't work here. We need to have meaningful progress now.

Theme Three: Divestment And Engagement

One of the most critical questions of our time is how we can decarbonise investment portfolios. Should we divest from high-carbon emitters or engage with them?

Divestment decisions are looking very different from the past. Consider Dutch pension fund ABP, which announced in October that it would divest from fossil-fuel producers, citing “insufficient opportunity for us as a shareholder to push for the necessary, significant acceleration of the energy transition at these companies." Critics of divestment argue that the assets simply end up in the hands of people who care less about sustainability.

State-owned enterprises, for their part, will surely require political will to change. But even private equity and venture capital are increasingly paying attention to sustainability issues. More and more, owners of capital will demand that their private assets are also engaged in ESG.

On engagement, the tools have to be varied, and effective. Instead of simple letter writing, those who engage with companies need to fundamentally challenge them on their underlying business models and call for significant change, which requires commitment and resources. Engine No. 1, the activist that elected three candidates to Exxon's board this year, has a very different model of engagement.

Theme Four: ESG Will Become Much More Normal

As more investors in both public and private assets insist on greater sustainability, a screaming need for consistent, shared disclosure and reporting standards has arisen. Imagine a world without generally accepted accounting principles. It would be chaos. That's essentially where we are now.

Today, the infrastructure for sustainable finance is falling into place. Recently, the IFRS Foundation announced the formation of the International Sustainability Standards Board, or ISSB, which merges two important standards-setting entities. Meanwhile, efforts by Morningstar and others to clarify the terms used for sustainable investing can also help new investors who worry about greenwashing and other potential problems.

In 2022, as the influence of sustainability considerations on long-standing financial reporting, oversight, risk, and regulatory frameworks gain steam, I expect that our habit of speaking about sustainable and responsible investing, ESG, and sustainable finance will begin to fall by the wayside.

Increasingly, we will simply refer to the work we do as investment or finance--a choice prefix will no longer be necessary as sustainability becomes the norm.

Theme Five: Critical Mass

As Morningstar CEO Kunal Kapoor has noted, the number of ESG ETFs has exploded more than sixfold, even as active ESG fund assets keep growing. That, alongside record-breaking asset flows into sustainable funds, may speak to the interest of retail investors who are traditionally last to the party--and whose arrival, to cynical investors, heralds the top of the market.

This might be true if sustainable investing were simply a fad, but investors are adopting ESG as part of the transition to a net-zero world. Individuals in North America are a powerful client base for large institutional investors. More growth may come, in fact, as individual investors start investing in sustainable funds through their retirement plans.

I'd argue that retail investors have dual expectations: they care about a secure retirement, financial goals, and risk, but they also care about whether air pollution is giving their children asthma, or whether increased incidence of wildfires means home insurers are curtailing coverage.

How ironic it might be that the final people to join this party may be a critical catalyst for moving the conversation toward the impact of portfolios to address these issues. In doing so, they could be the force that creates change.