The Most Important Themes Facing Green Investors in 2023

Welcome to The Green Investor, powered by Investopedia. I'm Caleb Silver, the editor in chief of Investopedia and your guide and fellow traveler on our journey into what it means to be a green investor today and where this investing theme is headed in the future. And welcome to 2023. We couldn't wait to meet you. In this episode, we're going to run down some of the highlights of green investing from the year that was, and we'll look ahead at the key themes that will dominate the landscape this year. Meghan Thwing Eastman of MSCI rejoins the show to break down what her team is looking for and what is on the horizon. For all of the challenges 2022 brought to investors, overall, there was significant activity and even progress on climate negotiations, action policy, and investing themes last year. Here are some of the highlights and a couple of lowlights:

The passage of the 2022 Inflation Reduction Act by U.S. lawmakers was more of a climate bill in disguise. Over $350 billion was dedicated to green energy programs, tax rebates, and infrastructure development. That put a temporary charge into solar and wind stocks as well as companies around the electric vehicle ecosystem. The COP27 summit, held in Egypt last fall, saw the last-minute adoption of an agreement by richer nations to create a loss and damage fund that is designed to send aid to vulnerable countries devastated by the irreversible harms of global warming. Details still need to be worked out, and the agreement did not go so far as to increase ambitions on lowering emissions or take any new steps to preserve the 1.5 degrees Celsius limit for warming temperatures, but still some rare progress out of a COP meeting.

At the COP15 gathering in Montreal in December, an agreement was reached to protect a third of the Earth's land and water by the end of this decade and may have the potential to shake up the regulatory landscape for the green investment industry. The landmark deal, which is called the Kunming-Montreal Global Biodiversity Framework, drew wide praise from governments that wrote and signed it as well as by the private sector, environmental organizations, and even activists. We're going to look for more details on that agreement this year.

The planet got a lot hotter in 2022. Emissions from the burning of fossil fuels and cement production rose an estimated 1% last year over 2021 to 36.6 gigatons of carbon dioxide. That's even higher than 2019 levels, the year before the pandemic, according to the Global Carbon Project. Oil use led the 2022 increase, specifically for aviation as international travel rebounded towards pre-pandemic rates. Both oil and coal finished the year in higher demand than in 2021, and Russia's invasion of Ukraine set off an energy crisis in Europe that led to the increased burning of coal by countries impacted by skyrocketing prices and shortages.

The state of California made historic investments in climate measures in 2022, as Governor Gavin Newsom signed more than 40 bills to fight climate change in September. The California Climate Commitment, as it's called, adds bolder climate pledges, including reducing oil use by 94% from 2022 levels by the year 2045. The plan also sets more aggressive goals of cutting carbon emissions by 48% below 1990 levels by the year 2030, up from the 40% by 2030 required under state law. Net zero emissions would be achieved in 2045 if these commitments are honored according to the plan. California also phased out sales of new gas-powered cars by the year 2035 and set a more stringent low-carbon fuel standard and streamlined citing and permitting of renewable energy projects. In all, the Golden State plans to spend more than $45 billion towards its climate commitments through the year 2045.

The European Union started to make good on its pledge to cut emissions by 55% in 2030 from 1990 levels. The bloc's 27 members reached a historic deal to set up the carbon border adjustment mechanism, an emissions levy on some imports. That's meant to protect Europe's carbon intensive industries that are forced to comply with the region's increasingly tougher rules. Once it takes effect, there will be additional costs imposed on imported goods from countries without the EU's restrictions on planet warming pollution.

Investments in renewables is expected to keep growing. BloombergNEF projects that 2023 will bring an 8% growth in carbon-free energy investments. That should add up to more than 500 gigawatts of wind, solar, electricity, storage, nuclear, and geothermal power in 2023. According to the U.N. Intergovernmental Panel on Climate Change, at least 18 countries lowered emissions for more than a decade, according to its most recent review.

Meet Meggin Thwing Eastman

Meggin Thwing Eastman is the research editorial director for MSCI ESG Research. She has authored numerous research insights and guidance for asset owner and asset managers seeking to incorporate ESG considerations into their investment process.

Meggin has worked in the ESG field since joining the former KLD Research & Analytics in 1998. She holds a B.A. from Williams College and an M.A. from the University of California, Berkeley.

What's in This Episode?

We are rolling into 2023 against a backdrop of sticky high inflation around the world, Russia's ongoing invasion of Ukraine, political uncertainty everywhere you look, lingering COVID chaos in the energy markets, and climate-related disasters. It's going to be another challenging year, no doubt about it. So let's get ahead of it and see what's on the horizon for green investors in the coming year. And for that, we welcome Meggin Thwing Eastman back on to the show. She's the global ESG editorial and research director at MSCI in London. And her team is out with the ESG and Climate Trends to Watch for 2023 report. Welcome back, Meghan. 

Megan:

"Thanks. Great to be here again, Caleb."

Caleb:

"Your team's report is packed with great information across a wide range of ESG and climate-related topics. But I want to dig into a few of the key areas investors should be focused on for next year. And let's start with the big thorny problem around ESG as an investing theme. Just the name 'ESG,' what it stands for, the politicization of it, tighter regulations, the anti-greenwashing movement,and how that might all play out in 2023."

Megan:

"So there is definitely a lot going on there. You mentioned several different themes that are related, but also they're playing out in their own way. So maybe if we start with regulation. This is going to affect ESG investors, it's also going to be affecting companies quite a bit. So if we start there, I would say while environmental issues won't be the only target that we'll see for regulators in 2023, companies in particular can expect to see new proposals and requirements in a lot of different jurisdictions around the globe focusing in on climate change and biodiversity. We're going to see that from Scope 3 emissions disclosures to climate stress test requirements for banks."

"And I think one of the key things that companies, and consequently investors, should be paying attention to here is that it's not just about disclosure requirements or tests. Some of these new regulations that we're going to start to see going into effect this year and next year are going to require changes to how firms operate over time. So if we take just one example for that, the European Union's new deforestation-free market-access law, for example, means that companies that want to keep selling into the European Union over the coming years need to start getting their supply chains in order now because it affects a lot of companies, and it's going to require some pretty serious documentation."

"And yet when we looked into this in our research, and you can see this in the ESG and Climate Trends to Watch paper, we found that a majority of companies lacked even basic policies here, even in the most obviously exposed industries like food and forest products. So there's a lot that's going to have to change and waiting is going to make it more difficult."

Caleb:

"Our standards are going to be very important this year too, right?"

Megan:

"Yes, absolutely. So then if we turn to banks and investors, we've got this looming stress test requirement of central banks getting much more active. And when we looked at banks, globally, big banks that would be affected, they're not ready. Some are more ready than others, but nobody is totally ready."

"For investors, you've got European requirements coming into effect this year, coming from the SFDR legislation that are going to require reporting on what are called principal adverse indicators metrics—about portfolio holdings—that the companies that make up those holdings don't yet have to report for themselves. So this is a bit of a sticky situation for investors who are scrambling around to try and find reasonable proxies and at least get a sense of measuring where they stand so that, as they go forward, they can measure progress."

"There could also be some good news in this deluge of regulation, and I think that that gets at some of the other points you're raising in your first question there, Caleb, about greenwashing and about arguments about ESG as a concept itself, the anti-ESG movement, all of that. And that's not to say that regulations are going to be some sort of savior panacea here. But in my view, I spend a lot of time talking to people about these issues, and I think while you've definitely got political considerations going on, they're driving a lot of activity, there's also just a great deal of confusion and mutual misunderstanding. People use the same word to mean different things. They use different words to mean the same thing. Two people can say that they're doing ESG investing or they're doing climate change investing. And actually what they're doing, once you get underneath that, is two totally different things."

"And so if we can get a bit further along with some of these regulations that require not just disclosure of metrics and exposures and that sort of thing, So those are helpful, but also in describing features and fund names and things like that, which will give a bit more transparency about what is actually meant by the words being used. That could cut down on greenwashing itself, but also on all of the allegations of greenwashing, which I've found in a lot of cases are less about something not doing what it says but something not doing what somebody thinks it should, which is not the same thing at all."

Caleb:

"Words matter, and the perception of what those words mean matter. We've done our own green investing survey here at Investopedia with our partners at greenhouse.com, and a lot of people think certain companies represent ESG or climate friendly and they don't really understand what it all means. Let's talk about net zero target credibility in general. We know this has been a big deal at the COP summits. We know it came up in a lot of those conversations and in some of those agreements. But are the targets actually achievable when we're talking about net zero credibility a lot of these companies and countries are setting out there? And is everybody measuring all the emissions the same way? There's so many different things going on in that dynamic."

Megan

"So there are a lot of different pieces at play there. So measuring emissions the same way is probably the first piece, and I think that's especially important when you're talking about Scope 3, so all of those emissions that are outside the operational envelope of a company. And that's going to be true for investors measuring for their portfolios as well as for companies measuring their own footprints, companies dealing with suppliers, or customers who require this kind of information for their own reporting, their own targets. You can have what you call a net zero target. But if you don't actually detail what's covered in it, how much of your operations, how much of that Scope 3, it is very difficult to compare one to another."

"So we've done quite a bit of work at MSCI here in trying to make those commitments into apples and apples comparisons for our clients. But it still leaves open this question of how achievable is it? Company can have a great target. If they follow it, it's going to mean that they're in line for net zero emissions and a 1.5 degree rise in climate temperature. But can they get there? And so I think we've gone over the last couple of years from a situation where hardly anyone had targets. And so the first order of business was just to bring the attention there, investors to set targets, companies to set targets, to say, 'Look, this matters, this is financially relevant, this is relevant to all of us who want to live on planet Earth. We've got to do this.'"

"But now that that's in place for a lot of companies, a lot of investors (not all, but a lot), the next step is then, 'Okay, it's a nice target, but can you get there? And how do you measure whether you can get there or not?' Nobody's got a crystal ball here, obviously, but there are a lot of questions of feasibility that you can look at to say, 'What's the track record? Has this company met targets before? What kind of strategy does it articulate? Is there a clear plan to transform the business? Is it all just about divesting dirty assets or what is the actual plan to get there? And do you see funds allocated? Do you see oversight allocated? Do you see interim check-in points where there isn't just one big goal for 2050, but there's a goal for 2025 and 2030 and 2040 to get there along the way and recalibrate if necessary.' So we believe that that's something that companies and very much investors and the standard setting and reporting parties are going to be looking at in 2023 and beyond."

Caleb:

"It's going to be a busy year for regulators. Europe a little further along in terms of the EU and the standards they've set. But the SEC promising a clamp down on this industry as well. And the reporting standards are a big part of it but greenwashing obviously a huge part of that as well. Let's talk about energy security. First, the clean energy transition. You could arguably say that the bull market in commodities in 2022, some of which was amplified by Russia's invasion of Ukraine, but for other reasons as well, coming out of the pandemic that may have set back at least spending and investment and transition in general into clean energy. What does that look like in 2023? We're still going to have relatively high commodity prices."

Megan:

"Yes, and I would say we don't know for sure. Obviously, the war in Ukraine is top of mind for a lot of people. And if we're thinking about the climate crisis, like you said, that worry's created both more demand for and more pressure on fossil fuels as economies, countries, economies look to see how they can transition, but at the same time, how they can keep their population warm, how they can ensure that people have affordable energy."

"So there is potentially a real tradeoff, especially in the short term at the sovereign policy level. And so if you're thinking, as a sovereign investor, this is the kind of thing you want to be looking at, not just the simple policy question, but the overall transition plan, because we did take a look at countries around the world and looked at their positioning of their energy security but also their transition. And it looks like it's not impossible to balance those out. There are some examples that stand out of countries that have really leaned into the energy transition to ensure that they don't have to rely too much on imports of fossil fuels. But I think it's also quite interesting to take this as context, knowing that there is this policy dilemma out there, how can sovereigns incentivize the transition that they need to see? But then at the same time, an awful lot of that is going to be aimed at companies, companies that provide the energy, companies that extract the energy and provide it as utilities."

"And so that context is really putting a finer point on all of these discussions. And so in 2023, we're watching a number of potential turning points for the energy transition. And they're all about where companies are investing or not investing for future energy supply. And that is the sort of thing that can be influenced pretty heavily by sovereign policy. And this is a key question for a lot of investors at the sovereign level, but again, at the company level. Fossil fuels are a problem in a variety of different ways, but the world still needs energy. So which of the companies in the industry is perhaps incentivized by which sovereign nations, sovereign governments to drive the transition and set themselves up to lead versus those that are maybe waiting to see where everyone else goes and not make the necessary changes until the last minute?"

"So renewable power is obviously the thing a lot of people are thinking about here, and it has seen some short-term headwinds recently. You've got renewable companies that have been hit with some of those same windfall taxes as their fossil fuel peers, which might be a bit counterproductive. You've had supply chain bottlenecks making headaches and so forth. But if you look at the CapEx plans of major utilities, you can see they are still mostly leaning into renewable generation for the future. So on average, they're looking at this and saying, 'Yes, that's the direction we have to go.' If you look at their investments, renewables represented (we looked at this this year) the single largest chunk of change after network infrastructure, and by a really sizable margin. It's not so clear for the energy extraction companies though. We looked at their patent filing data for the biggest players in the energy industry and oil and gas companies to see where they might be placing future bets because to make the energy transition happen, those companies have got to turn their business from what they're doing now into something else. And these companies had filed loads of patents related to reducing carbon emissions, but mostly they were for technologies that would help them do fossil fuel activities more efficiently, not for a radical shift away."

"But there were a handful of exceptions. There are some companies there that are clearly innovating and investing in technologies like solar and batteries that are, again, as they said, looking to transform their business. Stay in energy, but the energy of the future, not the energy of today, a little more efficiently. And then maybe the biggest question of all is nuclear power because between accidents and the waste disposal dilemma, the high cost, the long lead times for project, nuclear's been pretty out of favor in a lot of markets for a long time. And for a lot of people it really remains controversial because of all of this, especially the accidents and the waste. But we're seeing as the climate crisis becomes more pressing and other energy supplies are constrained, as we've seen with the war, there are some signs that that calculus might be changing for the first time in a long time, and that investors who have long said no on principle to nuclear that they need to try a more nuanced approach."

Caleb:

"That it should be fascinating to watch. While a lot of what you were talking about is also adaptation, this is one of the biggest challenges in the industry, company to company, industry to industry, but also country to country, and no one really seems to want to address it head-on. It really didn't come up at COP26. Your team writes that less than one-quarter of companies have adaptation plans, which brings up operational risk, which gets back to what we were talking about at the top here of the conversation, which is there's a lot of underlying risk here without adaptation plans to make changes now that you will need five, 10 years out, companies and industries could be in a lot of trouble."

Megan: "That's right. And it really is that foresight matter because it might not bite too much next year. It might be five, 10, 25 years down the line. And yet the types of adaptation that you might need to make, whether it's to business models or to operations, you kind of have to start getting those ducks in a row now because if you wait until it's a problem, then is really too late to do it efficiently or cost effectively. And so this is something we've highlighted actually for a couple of years now, because there's a fair amount of investor interest in finding ways to invest in and finance climate change adaptation. The need is so clear."

"And and frankly, if you just look at the weather that we've had over the last couple of years... we just have got another heat wave in Europe, a winter heat wave, which might be some relief, but it speaks to the issues, reminds you back to last summer when we're seeing heat waves that really were not okay, that were creating problems for human beings, but also for businesses reliant on human beings, reliant on infrastructure. Transit can't run because the rails buckle when it's too hot. People who can't work because it's unsafe, that sort of thing. And so thinking now about adaptation for companies' own business operations really is essential, especially those that are more exposed—not just to things like tropical cyclones, hurricanes, which is what we tend to think of, floods but also things like drought, excessive rain, excessive heat that chip away at productivity and people's ability to work."

"And then, of course, there's the much bigger and more macro adaptation question, which again, investors are interested in, but are kind of waiting for the right structures to come into being, to let them invest in that, because most of that needs to be done by governments. So here we're talking about flood barriers, we're talking about relocating people if they need to be relocated, we're talking about urban environments that can handle more rainwater, that can be more cool when the heat waves come. And so there's only a certain amount that individual companies can do there. And so that really is going to have to be about more of these creative arrangements between large institutional investors who have the assets and the interest, but not necessarily get the access into those projects."

Caleb:

"Is climate risk going to be one of those special risk factors we read about in SEC filings? We're starting to see it in some industries, but is this going to be sort of mandated now?"

Megan:

"Will it be mandated? Well, I can't say for sure. I can't make a prediction about regulation there. But I do think over time we're going to see more of that. It may eventually be mandated, certainly in some markets, maybe not in all. But it's also going to be the sort of thing that is too big to ignore, whether you're a company trying to be straight with your shareholders, that they understand your position, or whether you're an investor wanting to make sure that you understand the position of your holdings." 

Caleb:

"Let's talk about the cotton and the clothing industry. I found this part of your report fascinating: About 35% of all clothes are made of cotton, but cotton requires a lot of water, destroys soil. So the industry has slowly been developing this so-called sustainable cotton. Tell us more about that and how will it sort of 'grow' there next year and beyond?"

Megan:

"The sustainable cotton question is a great one because you're right, we all wear a lot of cotton. Cotton is used for all sorts of household linens and so forth, and yet a lot of it is reliant on child labor or reliant on forced labor, highly polluting (lots of pesticides used), and they're very water intensive. And so for some time now, the apparel industry in particular has been trying to grow better cotton. In fact, the Better Cotton coalition is one of the organizations out there that does some certifications of effectively better cotton, not perfect cotton, but better. However, a lot of it is grown in particular regions, and we found this here that in Pakistan, the devastating floods there wiped out a great deal of the cotton harvest, including this more sustainable cotton. And so now we're looking at shortages of the fiber overall, but especially shortages of this more sustainable, responsibly sourced cotton that apparel retailers have come to really rely on in their marketing. And so there is a question there's just not going to be enough to go around in 2023 for the sort of marketing that these retailers would like to do. And so it's not necessarily something that they can solve in 2023, but it is kind of a kick in the pants to the industry to continue investing into alternative fibers as well as diversifying their supplies of the more sustainably grown cotton."

Caleb:

"Every industry will be subject to some sort of risk and subject to some sort of change as climate continues to become the center issue here. So many good things inside your report. That's Meggin Thwing Eastman. She is the global ESG editorial and research director at MSCI in London. And we will link again to the ESG and Climate Trends to Watch for 2023 report from you and your team. Thanks so much for coming back to the Green Investor. It was so nice to talk to you again." 

Megan:

"Thank you. Always a pleasure."