What 2022 Has in Store for Finance Professionals

Key Takeaways

• 2022 will be marked by far-reaching regulatory developments and voluntary commitments in the finance sector.
• The current focus on Net Zero commitments will extend to include consideration of biodiversity risks.
• The market will see an ever-widening range of new ESG strategies and approaches, will broaden geographically and thematically, and see new participants helping to shape the ESG discourse.
• The banking sector’s role in financing solutions to climate change will be extended to ensuring that their loan books stand up to climate stress testing.
• Transparency will be key as more investors become active owners, both in the passive and actively managed space.
• Latin American and Asian markets will play an increasingly influential role in global responsible investment.
• ESG data and service providers will be more heavily scrutinized, and be called on to serve an increasingly diverse client base of financial market participants worldwide.

ESG Trends in the Next 12 Months

2022 will be a year in which financial market participants take an even deeper and broader look at ESG. So far, so predictable, as this has been a safe forecast at the beginning of every year for several years now—although even the boldest expectations have regularly been exceeded. But which ESG areas will merit particular attention in the year ahead? At ISS ESG, we have been looking at this very question each year for some thirty years now, and in 2022 our 500+ ESG specialists expect these three areas to dominate the responsible investment headlines:

1. Regulation and self-regulation
2. New ESG strategies and approaches
3. New ESG voices and market participants

1. Regulation and self-regulation

Disclosure Requirements and Taxonomies

The European Union’s action plan aimed at making the financial system more sustainable has already given the market a sense of the journey ahead in 2022. The self-classification of funds under the Sustainable Finance Disclosure Regulation (SFDR) and the first applications of the EU Taxonomy for recording the climate orientation of investment strategies were a small aperitif. 2022 will bring both a thematic deepening and geographical spread to sustainable finance regulation. After all, only a small part of the EU action plan has been implemented, and many countries from North America to Asia are waiting in the wings with their own financial market regulations. Anyone hoping for a simple extension of the EU Taxonomy to the rest of the world, for example, is set to be disappointed—the signs point more to different definitions of sustainability than to harmonization. The International Platform on Sustainable Finance is already working on a ‘common ground taxonomy’, but it remains to be seen how much overlap there will be and how strongly the regional and national differences will influence the ultimate regulatory structures.

Biodiversity

Do you see a pattern? ESG veterans may recall how the climate issue started to gain momentum in 2015—politicians and investors in France made climate reporting mandatory, then other jurisdictions followed. Responsible investment market watchers will now be noting that France extended climate reporting to include biodiversity in 2021, and other countries such as the Netherlands are now taking up the topic. Is biodiversity the new topic after climate for investors?

Or another parallel: in December 2015, the Task Force on Climate-Related Financial Disclosures (TCFD) was established and is now a globally recognized reporting standard in the climate field. This year, the Taskforce on Nature-related Financial Disclosures (TNFD), its biodiversity counterpart, was launched. The growth in regulatory interest in the biodiversity topic may not match that of climate change in the immediate future, but it is becoming highly relevant to investors worldwide. 196 nations have ratified the Convention on Biological Diversity, so it is not surprising that financial market participants place a lot of emphasis on the topic.

Net Zero

Self-regulate before the regulator gets it right? The Glasgow Financial Alliance for Net Zero was officially constituted at the international climate conference COP26 in Glasgow. Hundreds of asset managers, asset owners, banks, insurance companies, service providers, and investment consultants have set themselves the goal of emitting “net zero” greenhouse gases through their investments by 2050. In doing so, they are following states, regions, cities, and companies that have made similar commitments.

2022 will see many more of these voluntary commitments in the financial market—with the small but not insignificant catch that at the moment no one knows whether and how Net Zero can really be achieved. The current focus is on reducing emissions, but that is only part of the equation. Actual Net Zero requires the large-scale removal of already emitted greenhouse gases from the atmosphere, which can only be done with technology that doesn’t exist or work at scale today.

2. New ESG strategies and approaches

Active vs. passive investment strategies

ESG is stepping out of the ‘risk’ shadows and increasingly becoming an opportunity. This isn’t only because ESG indicators help to identify tomorrow’s potential investment winners. ESG also offers an opportunity for fund managers and asset managers to develop attractive ESG investment strategies. ISS ESG expects exponential growth in these strategies to continue in 2022. Thematic and geographical differentiation will play a role, as will the extension of ESG to new asset classes. Active managers, always under pressure from low-cost passive strategies, will also be seeking to capitalize on opportunities ESG offers for produce differentiation and alignment with client interests.

Integrated stewardship, engagement & voting approaches

There has recently been a major uptick in global ESG equity strategies, with a 55 percent increase over the last four years seeing the category now account for more than 36 percent of all equity investments. Nevertheless, there remains an open question as to why the global economy is not yet reflecting these improvements through real-world outcomes.

While there is little doubt that the world changes when investments are linked to sustainability criteria—this is after all a basic premise of the EU Sustainable Finance Action Plan—every market participant knows that the purchase or sale of a share only indirectly influences a company, as stock exchanges are secondary markets: A company does not flourish or disappear just because an investor buys or sells a share.

Investors who want to have an even greater impact on the real economy cannot avoid two tools that will continue to gain focus among sustainable financial market participants in 2022: Engagement and Voting.

Engagement is about making a shareholder’s own stance on ESG issues clear in exchanges with companies. This can mean, for example, setting out an expectation on the climate strategy of the company invested in—an approach to which Net Zero financial market participants have committed. Such engagement can be undertaken individually or collectively by investors.

If a company falls short of investor expectations despite engagement on certain ESG issues, shareholders have a several next steps to contemplate, including escalation of the engagement, strategic voting at AGMs, all way through to divestment. Next year, voting rights in particular will play a bigger role. We can expect directors who fall short of investors’ climate expectations to be under pressure at company AGMs when it comes to time for re-election.

ESG transparency for retail investors

ESG is no longer a concern just for sophisticated institutional investors, it is now on the radar of the finance sector’s end customers. This poses new challenges for asset owners and managers, however. How can highly complex ESG considerations be communicated to experienced analysts in London bank towers in such a way that they are also understood by small investors at the counter of a bank in a small town somewhere in England? How can ESG company reports, which for professional investors can be as long as 100 pages per company and (for ISS ESG reports at least) contain more than 8,000 data points per company, be summarized into one key statement? What presentation style is appropriate in a report covering topics as diverse as climate change, child labor, or arms production? Is, for example, ‘tonnes of CO₂’ the right figure for an investment product if very few people know whether the figure calculated means a lot or a little?

The perfect answer to these questions is yet to be found, but it is very likely that the year 2022 will see increased pressure for sustainability communication to be relevant to the end investor. Various proposals for this are already on the table or are still being refined, such as the sustainability traffic light of the Sustainable Finance Advisory Board or the Bafin recommendation in Germany, the home of the next G8 presidency.

3. New ESG voices and participants

The Banking sector: “stress tests” and ESG in lending

Since the first ESG approaches in financial markets began over thirty years ago, the focus has mostly been on investors and on equities. ESG approaches are increasingly expanding to all asset classes, however, and one area in particular will be in the spotlight in 2022: the banking sector and lending.

This has to do with two developments driven by the regulator.

On the one hand, climate stress tests are increasingly being mandated, which call for the examination of the extent to which climate change can lead to borrowers being unable to repay their loans. No fewer than ten central banks worldwide, including the ECB, began requiring such climate stress tests from banks in their jurisdiction in 2020. Other banking regulators are following suit.

On the other hand, there is an effort in many countries for credit institutions to understand the ESG profile of their lending customers. Who are they lending money to, for what purpose, and what is the social benefit or harm that can come with it?

Regulation of data and ESG providers

As the use of ESG data by financial market participants increases, questions about data quality and provenance become more pressing. For 2022, this means that regulators are also increasingly concerned with the question of how data reliability can be achieved, and what role data providers such as ISS ESG play in this. There is a risk that well-meaning assurance of certain basic standards will be mixed with the idea that regulators could be the better rating providers.

The reason for this is often the misleading comparison of ESG ratings with credit ratings. The two are not comparable, however. This is not just because ESG ratings are paid for by the user and not by the rated company. Credit ratings also usually answer a single question: what is the probability that the rated company can repay a loan? An ESG rating, on the other hand, aggregates hundreds of indicators to answer the complex question of how sustainable a company is. Sustainability here can be defined and thematically weighted in highly different ways. Experienced ESG investors do not see the lack of comparability as a problem, but rather as healthy competition for innovative and robust approaches for different applications.

Just as a minibus differs from a sports car, ESG ratings differ depending on their application and approach. Regulators should be cautious in dictating how ESG ratings should be designed. Their energy is better spent in developing frameworks that foster competition between top-quality ESG solutions, allowing for the highest level of data and rating quality.

Asia and Latin America on the rise

One trend that will continue in 2022 is the global spread of investing using ESG criteria. While in recent decades ESG was particularly at home in Northern and Central Europe, Australia and the financial capitals of the US East and West Coasts, it is now spreading throughout Europe and North America, and also increasingly conquering Latin America and especially Asia.

Sustainable equity investments in China and India quadrupled between June 2019 and 2021, nearly tripled in South Korea, and more than tenfold in Taiwan. Overall, sustainable investments in Asia (ex Japan) stood at less than USD 10 billion at the beginning of 2019 and were over USD 35 billion in June 2021.

Regulatory pressure is also increasingly being felt in Asia, although the big wave is still to come: The climate agreement between China and the USA, which was surprisingly concluded at the COP26 climate conference in Glasgow, is likely to be clearly felt in their respective financial markets in 2022.

Outlook

For financial market participants, 2022 will be marked by far-reaching regulatory developments and voluntary commitments. The market will see an ever-widening range of new ESG strategies and approaches, will broaden geographically and thematically, and see new participants helping to shape the ESG discourse.

For ESG data and service partners, this means serving an increasingly diverse client base of financial market participants worldwide as a trusted and innovative ESG solutions partner with the best professionals in the market.

After all, nothing is more constant than change, many things are unpredictable, and in December 2022 the financial world will certainly look very different from what we expect today. It is therefore important for both financial market participants and ESG providers to focus on flexibility and quality—because this will be the key to success in the long term, even in the fast-moving ESG market.