Outlook 2025
15 Nov 2024
24 May 2024
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We spoke to Jake Hennessey, our ESG Analyst, about the relevance of environmental, social and governance factors for investors, and some of the latest ESG trends.
What is ESG and why does it matter for investors?
JH: ESG stands for Environmental, Social and Governance, and represents a range of non-financial factors that can influence company performance. Environmental factors can include a company’s carbon footprint, its reliance and impact on biodiversity, or its water usage, particularly if it is operating in areas of extreme water stress. Social factors are things such as company culture, diversity in the workforce, and working conditions in the supply chain, while governance considerations include board structure, executive remuneration, and tax compliance.
ESG factors can have a direct impact on company financials, and therefore investment performance. Companies that can better manage material ESG issues may be less prone to severe incidents, such as fraud, litigation or reputational issues. As a result, companies with strong ESG credentials may benefit from a stronger reputation and/or lower cost of capital, which can in turn help to protect or even increase shareholder value.
How can ESG factors affect a company’s financials?
JH: Let’s take a look at an industrial gases company, as this is an industry which faces significant ESG risks, but also sizeable opportunities from the transition to a low-carbon economy. The nature of the industrial gases industry means that this company is extremely carbon-intensive. According to the company’s disclosure, its total carbon footprint across all three scopes in 2022 was nearly 65 million tons of CO2e, equivalent to driving the average petrol-powered passenger vehicle for over 165 billion miles1.
As of April 2023, there are 73 carbon taxes or Emissions Trading Schemes (ETS) in operation, and 23% of the world’s emissions are now subject to a carbon pricing regime, up from under 10% just 10 years ago2. The World Bank estimates that carbon prices will have to reach $61-$122 by 2030 (in 2023 dollars) to limit global warming to below 2°C, provided a supportive policy environment is in place2. Applying a theoretical carbon cost of $90 (i.e. the mid-point of this range), would eliminate the company’s entire 2022 profits and more. Suddenly, this company’s large carbon footprint can be seen as a very real risk to its financials.
However, further analysis of company disclosure reveals that the company reserves the right to pass on these price increases incurred by carbon legislation to customers over the terms of its standard contracts in most cases. The company also discloses that for its industry, regulatory bodies acknowledge the required reductions in emissions cannot happen in the short term and need to be balanced with economic viability. As such, it receives free allowances from regulators for a substantial part of its emissions that are subject to emissions trading schemes3.
On the opportunities side, the company has exposure to two key decarbonisation trends: hydrogen and carbon capture, utilisation and storage (CCUS). The company is one of the world’s largest producers of hydrogen and is also investing heavily in its CCUS capabilities, recently announcing projects with planned storage capacity of over 17 million tons CO2e annually. The Inflation Reduction Act provides tax credits for both the production of green hydrogen, and CCUS projects to the tune of up to $3 per kilogram produced4 and $85 per tonne stored5, respectively. These credits have the potential to incentivise the acceleration and scaling up of R&D spend in these areas, which could help to drive future growth and profitability for the company.
What are some of the challenges when assessing ESG factors?
JH: As a growing discipline, ESG considerations are receiving more attention from regulators, investors and companies alike, meaning items such as disclosure, data and analysis methods are ever changing. The spectrum of ESG factors is very broad, often involving hundreds of different data points. Material ESG factors also diverge significantly between industries – from data privacy and security in Technology, to supply chain human rights in Consumer Staples.
Disclosure is a common limitation when it comes to analysing individual companies, and equally there are some areas where clean data simply does not yet exist. Areas such as a company’s physical risk exposure or its impact and reliance on biodiversity are difficult to quantify, and there is a lack of widely accepted and adopted data points. These factors could be crucial in determining a company’s future operating performance, but as we stand today, they are very challenging to model and analyse in detail.
What key ESG regulatory developments do you expect this year – and what could they mean for investors?
JH: New supply chain regulation is due to come into effect in 2024, which could bring additional challenges for companies, but greater transparency for investors. The EU Deforestation Regulation will require all companies selling products in the EU (or exporting out of the EU) to ensure inputs are not from forests that have been cleared since 31 December 2020. They will need to demonstrate adherence right through the supply chain.
It will be interesting to see how companies attempt to comply with the regulations, and the scale of the associated costs. Some will likely carve out their European supply chains, while others may aim to make their entire global supply chain compliant, given the potential for similar regulation to be introduced elsewhere.
Businesses that have already invested significantly into their supply chain – be that on sourcing transparency, human rights, or labour conditions – are likely to be more agile in responding to the new regulations and incur fewer one-off set up costs to comply. However, any company required to shift their supply chains due to actual or potential risks is likely to occur significant costs to do so. Companies with diverse/complex supply chains are likely to face the greatest compliance costs.
Can we expect to see any changes to company reporting standards next year?
JH: The EU Corporate Sustainability Reporting Directive (CSRD) is also coming into effect in 2024. The directive applies to around 50,000 EU companies (although not all will be required to report this year) and contains 1,178 potential data-points across 10 ESG topics.
Disclosure under this regulation should enable better analysis of the financial materiality of ESG topics, as companies will be required to disclose the current and anticipated financial effects of material ESG risks and opportunities on financial position, financial performance, and cash flows over the short, medium, and long term. We also expect this regulation to spur greater levels of engagement and activism from shareholders, and widen the disclosure gap between EU and US companies.
Biodiversity is another area of increasing focus for companies and investors alike. The Taskforce on Nature-related Financial Disclosures (TNFD) published its final recommendations in September 2023. This is likely to spark increased disclosure, with 320 organisations across 46 countries already committed to disclosing in line with the recommendations by the end of FY246.
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United States Environmental Protection Agency, July 2023Return to reference
‘State and Trends of Carbon Pricing 2023’, World BankReturn to reference
Company’s Carbon Disclosure Project Response, 2023Return to reference
‘The Inflation Reduction Act: Here’s what’s in it’, McKinsey & Company, October 2022Return to reference
International Energy Agency, ‘Inflation Reduction Act 2022: Sec. 13104 Extension and Modification of Credit for Carbon Oxide Sequestration’, 17 November 2022Return to reference
‘320 companies and financial institutions to start TNFD nature-related corporate reporting’, Taskforce on Nature-related Financial Disclosures press release, 16 January 2024Return to reference