By Andrew Wetzlel, CFA®, Managing Director of Sustainable Investing
As we look back on the sustainable investing market in 2023, it is easy to recount challenges such as the politicization of ESG and valuation compression in clean-tech companies, but there were also a few positive structural developments that should provide a more stable foundation going forward. While we expect an improved foundation, the road will likely remain bumpy heading into the presidential election in November, creating both risk and opportunity for investors.
The big story from 2023 was the politicization of ESG at both the federal and state levels, a dynamic we covered in our July webinar. As we noted then, confusion around ESG had been building for a long time and spilled over into the mainstream media over just the last couple of years. While there are other contributing factors, a significant driver of that confusion is the lack of standards around reporting and language used by the investment industry. Encouragingly, there have been two important developments in recent months.
The first big breakthrough was in June with the launch of corporate sustainability disclosure standards from the ISSB, a division of IFRS, the international accounting standards setting organization. The launch of ISSB standards will reduce the number of reporting frameworks that corporations have to contend with, driving efficiency, improved consistency, and comparability across corporate reporting as standards are adopted.
The second breakthrough in November was the launch of sustainable investment approach definitions from the CFA Institute, the GSIA, and PRI. Inconsistent use of terms such as SRI, ESG, and ‘impact’ has been one of the core drivers of confusion both within and outside the investment management industry. As we note often, ESG integration is about risk management within an investment process, something very different from exclusionary screening based on values (SRI) or thematic emphasis intended to capture growth opportunities. The CFA Institute definitions represent an important first step to create consistent communication around approaches that have distinct risk and return characteristics, implementations, and objectives. Creating transparency and consistency in corporate reporting and clear delineation between sustainable investment approaches should help reduce confusion for investors.
The other major topic in headlines, particularly in the second half of 2023, was valuation compression of clean-tech related companies. As noted last quarter, private manufacturing construction spending trends have accelerated over the last two years as clean-tech related supply chains are developed in the US. Much of this is early stage with construction work lasting quarters or years. The outlook for businesses tied to this growth remains attractive, with expected multi-year annualized earnings growth of the S&P Global Clean Energy (SPGCE) Index above 12%, more than double the rate expected for the broad market. A combination of high interest rates and a slow and staggered rollout of Inflation Reduction Act (IRA) incentives have contributed to lower valuations in the clean-tech space. The SPGCE trades at 12x forward cash flow compared to the S&P500 at just over 14x. Part of this discrepancy is clearly related to the outlook for 2024.
As we look forward to 2024, there are five items we expect will be top of mind for sustainable investors.
- There will be continued work on the regulatory front globally to launch and refine reporting requirements for corporations. In Europe, the EU Sustainability Reporting Standards, aligned with ISSB, have been adopted and will be a requirement for large, listed companies for 2024 reporting. In the US, California issued climate disclosure laws in October with reporting starting 2026. The SEC is expected to release final climate risk reporting requirements early in 2024. While there will be political blowback around final SEC rules, US corporations generally will be better off with a clear US standard that will supersede state-level and international reporting regulations.
- Data providers are expected to launch analytics to aid investor efforts in better assessing climate target credibility. Companies such as MSCI and Bloomberg are working to improve comparability of company-level climate targets and roadmaps, with transparency into drivers of decarbonization and action on past targets. This level of detail will help investors separate companies taking real action from those less likely to hit targets.
- While climate remains a central consideration for sustainable investors, the launch of final Taskforce on Nature-related Financial Disclosures (TNFD) recommendations in September of 2023 should lead to a broader focus around risks and opportunities tied to natural capital and biodiversity in 2024. As with climate, data providers are expected to launch more tools for investors to assess nature-related risks and opportunities.
- The industry will hang on every shift in polls heading into the election in November. Government support for a more sustainable future is at stake. While there will be a tremendous amount of noise in 2024, we remain confident that in the end money and economics will matter and the IRA will stay largely intact even in a Republican sweep. This view is based on the flow of investment into GOP-led states, where supply chains of the future are being built and jobs are being created.
- Lastly, we see a compelling opportunity in companies focused on environmental sustainability. Political noise will create volatility in this part of the market, though with the view that the IRA stays mostly intact, revenue and earnings growth should be well supported. A combination of strong growth and attractive valuations make clean tech-related companies worth watching in 2024.