As environmental, social and governance (ESG) values go mainstream, they urge a rethinking of how corporations and the financial industry operate.

MSCI has published their 2022 ESG Trends to Watch paper, outlining 10 trends to watch in the year ahead as the sustainability agenda reaches critical mass.

“In recent years, climate change has come to surpass corporate governance as the most pressing ESG issue commanding investors’ attention, and ESG investing truly has gone mainstream,” reads MSCI’s report. “Yet, there are new risks emerging for companies, investors and the planet in the coming decade that will test how well we have learned the lessons of the past.”

1. The New ‘Amazon Effect’: Corporates pushing corporates for net zero supply chains

Everyone buys from Amazon, but whom does Amazon buy from? In corporate boardrooms the world over, the push to set a net zero target is eliciting a common refrain: What do we do about our suppliers?

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As the world’s biggest companies work to go net zero, downward pressure on greenhouse gas (GHG) emissions may become as familiar to suppliers as downward pressure on pricing.

“Take, for example, the top cloud-services providers: Amazon, MicrosoftAlphabet and Alibaba Group Holding. Together, these four companies own two-thirds of the cloud market,” says MSCI.

“Almost everyone uses at least one of them, and cloud adoption is still growing fast. If these companies were to go net zero in their direct and energy use emissions (Scope 1 and 2), they would reduce the upstream value chain’s emissions (Scope 3 categories 1 and 2, also known as purchased goods and services and capital goods) for other companies across the economy, and about 0.5% of total global emissions.”

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With regulators and standard setters proposing tougher rules for carbon reporting, many companies are now taking their first steps to understand their value-chain emissions, says MSCI.

Amazon, Microsoft, Alphabet and Alibaba have all set net zero commitments. “Some are more comprehensive than others in how they define net zero. But none of them can make a dent in their upstream supply chain emissions without getting their server and chip purveyors to follow suit,” says MSCI.

2. Private company emissions under public scrutiny

Critics argue that privately held companies are becoming an opaque refuge for carbon-intensive fossil fuel assets. But are those charges true? The jury is out, because the private equity funds that own these companies are not saying much.

Today, even the largest private equity funds, including those that are publicly listed, have revealed little about the emissions footprint of their portfolio companies.

Private equity funds have raised capital totaling almost US$557 billion in the energy and utilities sectors from 2010 to Nov 11, 2021. Almost 80% of that was reportedly in non-renewables, according to an advocacy group’s report.

In a sample of roughly 120,000 transactions between 2010 and November 2021, we found that deals for energy-related assets comprised 12.1% of total transaction value, with only 12.4% of those transactions designated as renewable-energy-related.

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On the other hand, some argue that growth in private equity funds has not been in the most carbon-intensive sectors. “Energy, utilities and materials accounted for only 12.3% of our private company set of 18,562 firms by revenue, compared to 20.5% for the public company set of 9,225 firms in the MSCI ACWI Investable Market Index (IMI).”

“Iff we compare the five years through 2015 against 2016 to November 2021, the portion of energy-related transactions for private equity as a percentage of total transaction value fell by more than half, from 19.5% to 8.5%.”

3. The coal conundrum: rethinking divestment

If the goal is a net zero portfolio, divesting might seem the path of least resistance, especially when it comes to coal. But it may hardly move the needle on achieving a net zero economy. To do that, investors will likely look to expand their toolbox: engage where they can exert leverage, divest where they can’t, plus insert themselves collectively into policy discussions to change the context, says MSCI.

Coal has got to go, according to the consensus from the United Nations and others aiming to limit warming to 1.5°C to 2°C.

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But five key markets — the US, Australia, China, Russia and India, together accounting for 75% of global coal consumption — were notably absent from new phase-out pledges made at COP26 in Glasgow.

If their coal usage continues apace, a 1.5°C world is almost certainly out of reach, says MSCI.

Three of these big markets are heavily dependent on coal for electricity production, according to the International Energy Agency — China (60% coal-based), India (70%) and Australia (54%) — and two may have more political, or other motivations, to keep the coal fires burning — the US (19% coal-based) and Russia (15%).

Their dependence is apparent in this group of five’s utilities’ fuel mix: 47% coal-based for the MSCI ACWI Index utilities constituents in these countries, versus 14% for constituents located elsewhere.

4. No Planet B: Financing climate adaptation

Extreme natural disasters loom even if we succeed in limiting global warming to 1.5°C to 2°C above pre-industrial levels. There will be no escaping the need for projects that help us adapt to a changing climate. As governments and supranationals issue bonds to pay for them, they could drive a large-scale expansion of the market for green bonds, says MSCI.

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The UN estimates that the annual amount spent globally on adapting to climate change needs to be five to 10 times higher than that currently spent.

As capital flows toward necessary projects, investors will demand not only an accounting of the financial risk and returns, but measures of their impact — and ways to qualify these investments as “green”. “That could drive a virtuous circle of green assurance and capital flow toward shoring up the resilience of our communities,” says MSCI.

5. Greenwashing recedes as common ESG language emerges

Today’s investors wrestle with confusing ESG terminology, definitions and labels. Ask 10 portfolio managers to define “green investment” and you are likely to get 10 different answers, says MSCI.

“The good news is that we see an emerging common vocabulary that should aid transparency and, more importantly, clarify choice,” they add.

MSCI’s research suggests the EU’s mandated Sustainable Finance Disclosure Regulation (SFDR) classifications (Articles 6, 8 and 9) are strengthening the quality of disclosures in Europe’s ESG funds.

In the US, the Securities and Exchange Commission has put the investment industry on notice with pronouncements and bulletins highlighting deficiencies in disclosure and practices in its examinations of funds’ ESG claims.

6. Regulation at a crossroads: convergence or fragmentation?

With at least 34 regulatory bodies and standard setters in 12 markets undertaking official consultations on ESG in 2021 alone, it’s no wonder that companies’ and investors’ heads are spinning. “We see convergence in some core areas, yet there are signs of further fragmentation, driven by differing regional priorities,” says MSCI.

Proposed stringency of compliance requirements varies but currently appears weakest in the US and Canada. For uniformity of reporting, the EU favours data templates, while other regions showed a mix of potential approaches.

Definitions of materiality, however, form one of the clearest fault lines. Agencies in the US, Singapore and Japan have focused on disclosures specifically relevant to financial materiality, while the EU, UK and Hong Kong explicitly include disclosures on broader societal impact.

“Such differences could prove to be a persistent obstacle to global convergence on ESG-related regulations,” says MSCI.

7. Putting ESG ratings in their rightful place

A decade ago, only a handful of investors understood and used ESG ratings. Today, investors, companies, news media and the public all expect them to help answer a multitude of questions.

Soon, both regulations and market forces could encourage codes of conduct for constructing ESG ratings, making clear what they capture and what they do not.

“In the coming years, we will likely see ESG ratings move back to their intended purpose of improving the investment process and as one part of the larger ESG ecosystem,” says MSCI.

8. Biodiversity and the future of food

The COP26 Sustainable Agriculture Agenda and the targets of the Kunming Conference scheduled for spring 2022 reflect a dire reality, says MSCI.

“If we don’t drastically change food production and eating habits, climate change and biodiversity loss will change them both for us. Either way, the food and agriculture industries are in for a radical reshaping,” they add.

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Take coffee as an example. The largest producer and exporter of coffee is Brazil, a fact that has to do, at least in part, with the Amazon rainforest. But the Amazon continues to be burned or cut down to produce beef and soy.

That means the “lungs of the planet” are taking in less carbon dioxide every day, accelerating climate change. But those lungs don’t just pump oxygen and CO2 — they also pump water vapour from the oceans inland, bringing essential moisture for crops like coffee. Or at least they used to.

In 2021, Brazil saw its worst droughts in a century, making for a poor coffee harvest and raising the price on your daily dose of caffeine. Coffee beans need special conditions to grow — warm and humid, not too cool, not too hot — and by 2050, the amount of suitable land globally could be cut in half.

9. Bacteria rising: another health crisis looms

Even as we continue to battle Covid-19, the next global health crisis already threatens: By 2050, 10 million people a year could die from previously treatable bacterial infections.

To meet this challenge, we need major investment in new antibiotics and a drastic reduction in their quotidian use over the next few years, especially in agriculture, says MSCI.

On the positive side, the pandemic has shown how fast we can invent a solution given global collaboration and the right financial incentives.

10. Just transition: finding the nexus of need and investability

As the captains of private finance begin to steer global capital toward achieving net zero, many are realising that efforts to stem climate risk are unlikely to succeed on the systemic level if we leave behind the most vulnerable populations, communities and countries.

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The core concern is that the populations that could suffer the most are also least able to bear the cost, finding their job skills no longer relevant, livelihoods gone and homes wiped out by extreme weather and sea-level rise.

This concern goes beyond these populations. Suffering on such a large scale could trigger mass unemployment and migration, civil unrest and political instability. And policies to support the climate transition could be next to impossible to implement against such a backdrop.

Climate change takes centrestage in MSCI's 2022 ESG trends

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