Sustainable Finance Finds Balance

The global ESG market has arguably experienced more see-saw action than any other sector. Thanks to new regulations, a steadier future may be in store.

After rising an astonishing 53% year-on-year in 2021, last year the market for environmental, social and governance (ESG) investments was especially hard hit by a confluence of factors, including the war in Ukraine and consequent energy crunch, higher capital costs,and dwindling global liquidity, prompting corporates and investors to flee to more traditional assets. Resulting capital outflows from ESG funds reached a dismal 76% on the year, according to Morningstar, a negative milestone for this lightning-rod of an asset class.

As the European Union starts to enforce its new Corporate Sustainability Reporting Directive (CSRD), however, and financial conditions appear to improve once again, the old adage “One step backward, two steps forward” could prove more appropriate than ever to the global ESG market.

“These new regulations represent a transformational change in ESG practices,” says Bart Wesselink, CFO at Amsterdam-based STX Group, “with requirements to adhere to accounting principles, including the provision of a clear statement of compliance and requirements for assurance. 2023 is expected to have a significant return after a dip last year due to broader market turmoil.”

There are signs the markets agree. Year to date, ESG stocks and bonds are up about 5%, according to the Institute of International Finance.

Will It Change the Market?

In effect since January, the CSRD is the first regulation of its kind, promising to mark a pivotal step toward a global reconfiguration of ESG reporting and ultimately leading to greater adherence from corporates and investors to long-term sustainability goals.

The CSRD sets a strict, broad, unified legal sustainability guideline for all companies operating within the EU. It aligns with the broader objectives outlined by the European Union Commission’s Sustainable Financing Package and will replace its predecessor, known as Non-Financial Reporting Directive (NFRD). The overarching—and rather ambitious—objective behind these standards is to achieve zero emissions in the EU by 2050 by ensuring a complete shift to renewable energy sources.

“The process of preparing for the required disclosures will also give companies themselves more and new insights in how sustainable they are,” says Maureen Schuller, head of Financials Sector Strategy at ING. “From a societal and investable perspective, companies have a substantial incentive to make sure they look good on their sustainability metrics.

The directive also aims to effectively end “greenwashing”: the creation of a false sense that a company is committed to sustainability when it may not be. By standardizing reporting directives, lawmakers argue that regulators and investors will be able to more easily spot irregularities in the ESG reporting process and punish them accordingly.

“In the medium and long run, we believe that companies will make sure to avoid greenwashing accusations,” says Schuller. “This means they will be cautious when it comes to disclosing how sustainable they are.”

Such measures might even be welcomed by investors and corporates. “Investors are calling for these new rules, complaining about a lack of consistency, reliability and comparability in current corporate ESG disclosure practices,” says Wesselink. “They will not be driven away by ESG financial products,” while corporates “are now also calling for standardization, hoping it will also save costs.”

ESG Globalizes

Another reason the CSRD could promote growth in the global sustainability market is that it forces all companies with a significant presence in the EU and with annual generation of $150 million or more in gross revenues, to comply with the same set of rules. According to Refinitv, nearly 50,000 European and 10,000 other non-European companies will be obliged to operate under the CSRD by 2025, which is when the legislation comes into effect for foreign companies. Among the non-EU companies affected, 31% are American, 13% Canadian, 11% British, and 8% Japanese.

This number is highly likely to grow as the directive is updated to be more comprehensive, says Elena Philipova, Refinitiv’s director of sustainable finance. This comes as the US Securities and Exchange Commission works to finalize its own regulations aimed at boosting ESG disclosure.

While similar to the CSRD, the proposed SEC regulations met with fierce opposition from corporates and legislators when they were unveiled last June. But the SEC still expects to finalize the 490-page regulation this year.

Last year, too, the Biden administration pushed through a $390 billion bill promoting a transition to clean energy across various sectors, which should help boost the US’s efforts to catch up with Europe in the sustainability race. Between the semi-coordinated action between the EU and the US, companies could find themselves boxed in, should they attempt to flee sustainability regulations by moving between geographies and markets.

“The absence of verification and the failure of reporting to meet the needs of investors are exactly the gaps that new regulations, such as the CSRD and US SEC regulation, are aiming to close,” says Wesselink. They “represent a transformational change in ESG practices, with requirements to adhere to accounting principles, including the provision of a clear statement of compliance and requirements for assurance.”

Bluer Skies Ahead?

After a forgettable 2022, the current combination of stricter regulation and improved macroeconomic conditions suggests that the ESG resurgence is for real. In light of the recent trend, research and consulting firm PwC has improved its long-term outlook for the ESG market, with institutional investors driving projected growth of 84% by 2026. That translates to a total of $33.9 trillion in new ESG investments worldwide, equating to roughly 21.5% of total global sssets under management (AUM).

The world is nevertheless still lagging behind Europe by a hefty margin when it comes to investment in corporate sustainability. According to Morningstar, nearly 65% of all flows into European exchange-traded funds last year was directed to ESG-aligned funds, up from 51% in 2021. Furthermore, ESG-related holdings in Europe accounted for some 20% of all ETF assets, while the corresponding figure in the US was just 1%.

That dichotomy may also be on the verge of a major change, however. A recent study by PwC’s Olwyn Alexander and Dariush Yazdani revealed that attitudes towards ESG investment strategies are becoming more closely aligned between the United States and Europe than previously believed.

According to Alexander and Yazdani’s survey, over the next two years, 81% of US institutional investors plan to increase allocations to ESG products: a figure nearly equal to Europe’s commitment at 83.6%. The study projects that ESG-related AUM in the US will more than double, from $4.5 trillion in 2021 to an impressive $10.5 trillion by 2026. The rest of the world may not be that far behind. ESG investment is rapidly expanding in the Asia-Pacific region, PwC found, with assets predicted to reach $3.3 trillion by 2026.

The Middle East and Africa are also experiencing a boost in ESG investing as institutions build on already established foundations within Shariah-compliant funds, although overall growth remains relatively small. Likewise, Latin America has seen a surge in investor interest in ESG offerings. Currently, AUM for these products across the region totals roughly $20 billion, and Brazil is preparing to issue its first-ever green government bond later this year.

But it’s the CSRD, and the prospect of ESG-friendly regulation in the US, that has ESG looking like a steadier part of the corporate and investment landscape. “This scenario will lead to higher ESG data transparency and standardization, which means a more effective allocation of capital to companies or projects with higher performance or greater progress in managing sustainability,” explains Schuller. “In the long run, the ESG markets will continue to expand, especially since legislation such as the CSRD will continue to emphasize the importance of ESG issues.”