The backlash against Environmental, Social, and Governance (ESG) expanded in the US in 2023, with the front moving to state governments where elected officials from Tallahassee to Boise put ESG on the legislative agenda. So far, more than 40 U.S. states have proposed more than 165 pieces of ESG investment-related legislation, with 30 of the states focused on anti-ESG measures that, for most part, seek to restrict or limit the use of ESG factors by financial services firms. Only half of these bills have been passed, and while many remain pending or will be pushed to 2024 legislative agendas, the political momentum against ESG seems to be leveling off. Risks remain, however, from both sides of the political aisle.
Outside the legislative arena, pro-business groups in the US are leading the effort to diffuse the ESG opposition, such as the Indiana Bankers Association and the Indiana Chamber of Commerce calling their own state’s HB1008 antithetical to free market. A less restrictive version of the bill passed the Indiana General Assembly in May.
Meanwhile, 78% of Americans are not familiar with the term “ESG.”
But outside of America, 2024 will see another modest global expansion in ESG-related capital flows and business integration.
Here are five things to watch as ESG evolves as a global capital market practice in 2024:
- Follow the money
ESG is part of a long-term investment thesis where performance, such as how decarbonization supports return on investment, cannot be measured quarter-to-quarter. By the end of 2023, total global sustainable bond issuance (including green, social, sustainable and sustainability-linked structures) is likely to reach close to $1 trillion, according to S&P Global, a five-year growth multiple of nearly 6x. The EU continues to outpace the US, with sustainable bond volumes representing 19% of the total EU bond issuance (excluding the UK) through three quarters of 2023 compared with 4.5% in North America, according to Moody’s. Despite this divergence, there is ample room for the US to follow Europe in overall issuance growth, where nearly one-fifth of all debt issued in 2023 was characterized as sustainable.
Despite a rocky 2022 in the equity markets, Morgan Stanley found that through the first half of 2023, sustainable funds’ returns were beating traditional funds (10.9% vs. 8%, respectively). At the same time, investor demand for sustainable funds (at 8% of total global AUM) was trending to reach record levels in 2021. Given additional market uncertainties, high interest rates, pressure from the US backlash and greenwashing concerns, it is hard to predict if 2024 will return to 2021 levels. It is clear, however, that the overall trend supports growth in global sustainable finance in equity and fixed income.
- EU regulation has teeth
The EU’s landmark Corporate Sustainability Reporting Directive (CSRD) which is the most stringent regulatory intervention on ESG reporting and disclosure the world has seen to date, takes effect this year. While the focus initially will be on EU-listed firms, US and global firms with significant European operations will eventually need to comply with CSRD as the spillover effect of the statute will start influencing broader stakeholder expectations on transparency. Clear and consistent reporting guided by financial (ESG risks to the business) and impact materiality (business risks on society) are required under CSRD and firms will be forced to determine how to implement this guidance and get the information assured. The lesser-known twin of CSRD, the Corporate Sustainability Due Diligence Directive (CSDDD), will also drive greater ESG integration globally. CSDDD focuses on creating a corporate mandate to prevent and mitigate negative social and environmental impacts across a firm’s operations and value chain. This includes expanded responsibilities for EU Boards to ensure that these social and environmental factors are part of their overall duties to fulfill the best interests of the company.
On the voluntary front, the International Sustainability Standards Board (ISSB) has recently taken over the responsibility for climate-relate financial disclosure standards from the TCFD, which has been disbanded. ISSB standards remain voluntary in the US but may become mandatory in other jurisdictions. The organization’s key intent is to make them “interoperable” with other frameworks across geographies and be eventually adopted by regulators.
- Don't forget about the "S"
The social issues faced by the private sector are not easily measured and vary significantly by industry and business model. While environmental transparency and disclosure are continuing to find their footing in the mainstream of business management globally as climate change concerns remain a constant, social matters (especially labor management, diversity, equity and inclusion (DEI), the evolving risks and opportunities posed by artificial intelligence (AI) and emerging human capital regulations in the US) will be an increasing area where business will need to think longer term. Many sectors of the economy, such as healthcare and transportation, face worker shortages. This suggests that the job market remains relatively tight, especially in the US, despite an overall uncertain global market. The recent move by EU regulators to reach a provisional deal to manage AI use in systems like ChatGPT and facial recognition foreshadows broader concerns of how this technology might disrupt labor markets and broader concerns over privacy and cyber risk. This will, in turn, place pressure on firms to disclose how AI is a material risk to their own business models.
Finally, DEI activities will be especially scrutinized in the aftermath of the U.S. Supreme Court’s decision to strike down affirmative action in college admissions. While there is a great deal of debate on how this relates to corporate behavior practice, political, academic and business circles will see polarizing rhetoric on both sides in 2024.
- How about the boardroom?
Overall ESG-related shareholder proposals grew again in the 2023 US proxy season, but approval rates fell. Some in the anti-ESG camp began to claim victory, but the picture is murky on winners and losers. According to Diligent, average support for ESG proposals fell to 19% from 27% in 2022. Issue-specific proxies showed positive momentum, with climate reporting adoption up to more than 20% and human right policy adoption up to more than 22% year-over-year.
On the other hand, support for anti-ESG shareholder proposals was essentially non-existent, so we cannot rely on proxy voting as an exclusive barometer of the state of ESG. In the 2024 proxy season, ESG will likely remain a contested and popular topic due to continuing strong investor demand. Overly prescriptive resolutions, such as decarbonization targets that stipulate rapid divestment (regardless of whether they are pro- or anti-ESG), are unlikely to pass. The best way for firms to avoid the reputational risk of ESG-related proxy fights is to regularly engage investors on material ESG risk factors focused on economic consequences and how they are being managed across the business. This level of calibrated transparency can help keep the Board and management focused on ESG execution and not messy public distractions. The governance of the “E” and “S” in ESG are ultimately where Boards need to stay focused.
- 2024 U.S. presidential election
With the term “ESG” now reasonably entrenched in American political discourse, it is safe to say it will be a contentious talking point in 2024. Much of the discussion will focus on the relationship between the fiduciary duty of the investors and their ESG considerations, which leads to increasing transparency of ESG information from both investors and issuers. The ESG political opposition will argue that investors taking on ESG integration and reporting – whether voluntarily or because of regulatory pressure – are abandoning fiduciary duty for non-material factors suppressing returns. The ESG political proponents will argue that ESG integration is mitigating risks, creating a long-term value to the business and positioning the country well on the geopolitical stage, including in such venues as COP28, leading by example. Ultimately, however, ESG is a framework the business world uses to manage non-financial risk and opportunity. This will not diminish in 2024 as, in the aggregate, the business world increasingly sees ESG as supporting fiduciary duty. While this view is more commonly accepted in Europe and increasingly in APAC, the debate in the US will continue to simmer.
To navigate the ESG moment in 2024, the focus should remain on tying ESG strategies and disclosures to business objectives and taking great measures to stay disciplined on material topics. The US political discourse will focus on the lens of power and how large asset managers run afoul of anti-trust laws, suppressing returns along the way. If firms can show that through current materiality analysis, ESG-aligned investments and activities can support growth, communications such as ESG reporting can be substantive and transparent. If there is not a business case behind the marketing and promotion of ESG, more work is needed to connect the dots to ensure ESG is used to improve a business from within, differentiating the value proposition from workplace to marketplace.
Lane Jost, Head of ESG Advisory (lane.jost@edelmansmithfield.com)