2024 ESG outlook

Key takeaways

• Waning interest rate pressure, policy tailwinds and improving economics strengthen the 2024 outlook for clean energy stocks, whose long-term prospects remain attractive despite recent macroeconomic headwinds.
• Global decarbonization efforts remain a priority as global consensus builds and acknowledges the necessary role some heavier-emitting sectors can play.
• Innovation from public companies is key to improving life on earth and continually creates markets for long-term viable solutions, making sustainability investing as impactful as ever.

Market forces a clear tailwind for clean energy

Entering 2023, we anticipated inflation and rising interest rates would keep pressure on equities. It turned out to be a lopsided market, with challenges for sustainability-focused investors in particular, as a host of clean energy stocks sold off while a very few AI-related stocks drove most of the market’s returns. Higher interest rates pressured valuations for clean energy stocks, many of which are long-duration growth companies (Exhibit 1), and competed with income-oriented utilities, where there are several renewables developers. Higher rates also raised costs for renewables projects and crimped consumer spending on a variety of green purchases, such as residential solar and electric vehicles (EV).

Reducing carbon emissions remains a major global priority, however, and growth trends and fundamentals   remain strong. Solar, wind, batteries and electrolyzers should enjoy an estimated 10%–30% compound annual growth rate for the next 30 years, with costs for solar and batteries falling as scale increases and select valuations undemanding.¹

From a macro perspective, based on the forward curve, short-term interest rates are likely at peaks and 10-year Treasury yields may come down further in 2024, offering a macro tailwind for clean energy. The timing could be fortuitous, as it would occur just as significant delayed cash flows from the Inflation Reduction Act (IRA) begin to fill balance sheets.

Importantly, the IRA’s guidance for billions of dollars of subsidies for hydrogen production, as well as details on investment tax credits for energy storage technology, is just becoming clear, with more details to come in 2024.

While policy will continue to drive the energy transition broadly, clean energy is becoming more economically attractive fundamentally, as evidenced by the growth in market-driven procurement of solar PV and wind. Seventeen percent of the world’s utility solar and wind growth is through market-driven structures such as purchase power agreements (PPA), where the U.S. leads, and most of this is corporates (Exhibit 2). Excluding China, this percentage is much higher.

COP28 agreement adds to positive momentum

The location of COP28—in the UAE, a large oil producer—was the source of some skepticism about the conference’s intentionality this year. But results look to be more positive than expected. The agreement to transition away from fossil fuels in a just, orderly and equitable manner entails cutting back on all fossil fuels and should further spur spending on clean energy, which continues to outgrow spending on fossil fuels (Exhibit 3). More members from the Middle East have joined alliances for net zero, which are building best practices for global financial institutions still developing transition plans.

The first day of COP28 talks also brought about a climate finance deal, in the form of the Loss and Damage Fund intended to help the world’s poorest and most vulnerable countries cope with the impacts of climate change, with initial funding of over $400 million. Another success of COP28 was the addition of new members to the Powering Past Coal Alliance, notably the U.S. and the Czech Republic.

Climate finance will remain a major issue going forward, with new initiatives paving the way. The Partnership for Carbon Accounting Financials (PCAF) is a global partnership of financial institutions who have committed to measure and disclose one-third of the greenhouse gas (GHG) emissions associated with their capital market loans and investments. The PCAF has developed GHG accounting methodologies that apply to the following asset classes: listed equity and corporate bonds, business loans and unlisted equity, project finance, mortgages, commercial real estate, and motor vehicle loans. Currently, there are 458 financial institutions working toward aligning their portfolios with the Paris Climate Agreement. To assist, PCAF has developed an open-source global GHG accounting standard, the Global GHG Accounting and Reporting Standard for the Financial Industry.

Human rights and a just transition

That the energy transition should happen in a “just, orderly and equitable manner,” as the COP28 agreement puts it, speaks to the impacts of climate change and decarbonization on society, with biodiversity a key component. To this end, corporate disclosure regulations are increasingly integrating social topics like human rights. We expect more regulatory focus on human rights and supply chain due diligence, such as the International Sustainability Standards Board’s public consultation on human capital and human rights, the European Union’s corporate sustainability due diligence directive, and Canada’s Bill S-211 on forced labor and child labor, will heighten awareness around social supply chain risks.

This focus should help bolster the environmental, social and governance (ESG) data available to investors to help solve social data and disclosure challenges. The case for social data and disclosure is also connected to company performance, as effective human capital management factors—such as diversity, equity and inclusion, recruitment and retention, supply chain labor management and union relations—can suggest how likely they are to perform well (Exhibit 4). We expect Indigenous rights to be a focus for 2024, as well as the role of responsible artificial intelligence (AI), which will factor more into human capital management-related engagements and shareholder proposals.

AI potential comes with responsibility

The rapid ascension of large-language model AI in 2023 has made the technology central to companies’ futures in nearly every sector. AI offers social and environmental benefits, including potential efficiencies in simple repetitive tasks, helping health care broadly, and in AI’s ability to address areas such as improving monitoring of carbon emissions, even deforestation, and the development of decarbonization strategies for businesses.

AI has also sparked many debates. Potential social harms include discrimination, misinformation, harmful content, cybersecurity risks and copyright and intellectual property theft (among many others). AI will also be contentious from a labor standpoint as companies craft automation strategies. AI is also energy-intensive, creating environmental risks. Technology companies have typically been perceived as asset-light, lower-emission investment options, but this could change. Similar to cryptocurrency, AI requires immense compute power, which means more demand for data centers, which are already responsible for 2%–3% of global GHG emissions.² A generative AI query could use 5x the amount of computing power as a search engine query.³ AI’s safety and energy efficiency will dominate discussions with our holdings across sectors in the coming quarters and years.

Global regulation marches on

While we noted the foretelling growth of global regulation in late 2022, the drumbeat continues, but with more drums. As ISS surmised in its annual Global Regulatory Update for 2023, fragmentation of regulation across regions around the world is causing consternation among issuers of investment products and fund managers who work with clients in multiple jurisdictions.⁴ Maintaining varyingly complex, yet not dissimilar, disclosure and qualifying standards country by country and burgeoning frameworks can feel like “a labyrinthine landscape for financial market participants to navigate.” It has also been taxing for the policy makers to comparably define the terms while setting classifications that will be comprehensive.

In addition, the Institutional Shareholder Services (ISS) ESG report describes the challenges for companies due to different ESG disclosure and reporting frameworks, and how regulators are considering broaching corporate due diligence obligations in the supply chain.

A role for both leaders and improvers

There are several ways for investors to seek attractive returns while building a better and more sustainable world, and we are pleased to see more practical approaches to investing in sustainability improvers alongside sustainability leaders. Improvers, such as companies in heavier-emitting yet generally indispensable sectors (e.g., utilities, transportation fuel and materials) that are genuinely making efforts to lower emissions, can have an outsize impact if the improvement targets are credible with ties to portfolio actions. Both leaders and improvers are needed and can be complementary—leaders offer best practices, provide solutions and often have large-scale impact, while growth in improver strategies deepens the bench, helps progress toward climate objectives by tackling the most challenging industries, and could even be more forward-looking, focusing on green capex rather than revenue, for example.

One major improvers category might be oil and gas companies. While there are legitimate concerns about these companies from sustainability investors, they are delivering credible improvements in methane emissions—a relatively easy but powerful fix—and are the biggest scalers in terms of carbon capture, whose infrastructure one way or another will be crucial in global decarbonization efforts.

Innovation key to sustaining sustainability

In a challenging year for performance, and one in which sustainability’s motives have been misconstrued in a contentious political environment, it is important to reflect on how central public companies are to the innovation that improves life on earth. Three-quarters of emission reductions needed for net zero will be from technology that is not yet commercial (Exhibit 5).