Capital Ideas^TM

How can just three letters encompass such a vast array of crucial topics for investors? It’s a question I often ask myself. Of course, environmental, social and governance (ESG) issues move in and out of focus — often leaving a flurry of activity in their wake. And yet, the sheer number of these issues that investors are grappling with just seems to keep growing.

As one long-serving corporate leader recently explained to me, fifteen years ago, most questions he fielded were focused on volumes and margins. Fast forward to the present, and investors expect him to “know everything about everything.” From diversity policies on boards, to safety records among suppliers, or even geopolitics in the Middle East — it’s all on the table.

When considering what’s in store for the coming year and beyond, dozens of pivotal issues register on my own “ESG radar.” Five of the most important developments on the horizon are, in my view, related to supply chains, AI, energy transition, sovereigns (government issuers of bonds) and biodiversity.

Some of these topics could appear niche. Others are clearly more front and center. Each of the five has the potential to create meaningful opportunities and risks and should, therefore, be on investors’ radars for 2024 and beyond.

1. Regulators put more intense spotlight on supply chains 

When buying something, do you like to know the details of how and where it was made? Like curious consumers everywhere, governments and regulators want answers, too.

New efforts to enhance transparency across corporate supply chains are prompting many businesses to revisit their operations and associated reporting. In certain industries, improvements in the availability and quality of data at different stages of the supply chain are greatly aiding transparency.

For investors, compliance costs, operational changes and regulatory fines can all have meaningful effects on bottom lines. Notable recent developments include the European Union (EU) Deforestation Regulation (proposals still under development), as well as forced labour and supply chain due diligence laws in the U.S. and Germany, respectively.

Another EU initiative is, in my view, likely to be among the most transformative. The Corporate Sustainability Due Diligence Directive (CSDDD) will have global repercussions. It will compel companies to establish due diligence practices that address negative environmental and human rights impacts from their own operations and their subsidiaries, and across the entire value chain.

Details are still being finalised, but as per the latest agreed proposal published by the Council of the European Union in March 2024, the directive is expected to be phased in, starting as early as 2027. In-scope companies with at least 5,000 employees and a turnover exceeding €1.5 billion will be the first cohort. Under the original proposal, non-compliance fines equivalent to as much as 5% of global gross revenue were suggested. The March 2024 rule text indicated that “member states should ensure that the pecuniary penalty is commensurate to the company’s worldwide net turnover when being imposed.”

2. Corporates recognise the challenge of AI governance

Thinking through the transformative effects of artificial intelligence (AI) on the economy and society has preoccupied many corporate leaders, government policymakers and investors — especially since the public release of ChatGPT in late 2022.

Regulators, the judicial system, companies, workers and users are racing to keep pace with new developments. Recently, many stakeholders have begun to pay closer attention to the technology’s complex implications for corporate governance.

A slew of legal cases around copyright infringement, data privacy and other issues have hit the headlines recently. Recent proxy seasons have included AI-related shareholder resolutions, and those could proliferate in coming years.

Political scrutiny has also increased. For example, OpenAI, Microsoft, Meta, Inflection, Google, Anthropic and Amazon agreed to implement guiderails and commit to certain standards at a high-profile July 2023 meeting at the White House.

The companies using AI are also under increasing scrutiny. AI governance frameworks have been developed by the EU, United Nations, Organisation for Economic Co-operation and Development (OECD) and U.S. National Institute of Standards and Technology (NIST), among others.

The EU AI Act, which is expected to become law this year is wide-ranging. Details are being finalised, but possible rules include mandatory disclosure when content is AI-generated, inclusion of risk assessment and information on training data used by advanced AI models, adherence to EU copyright law, no scraping of facial images from the internet or security cameras, banning AI models from inferring political, religious, or philosophical leanings, race or sexuality, human oversight of AI models, and authority to ban higher-risk AI.

Frameworks and proposed regulation are serving as a North Star for nascent corporate efforts centered on AI governance. As trial and full-fledged commercial deployments of AI ratchet up, privacy, data protection, responsible use and human safety are just some of the key issues. Firms that aren’t ensuring their governance is fit for purpose may be exposing themselves to substantial legal and regulatory risks.

While the technological, regulatory and legal landscape surrounding AI is shifting, corporate boards will likely become the de facto AI arbitrators at many firms. Board members with AI expertise will likely be in high demand.

3. Reality bites for the energy transition

In recent months, I’ve had several revealing conversations with companies that have laid bare a key challenge around energy transition. For many firms, making further progress on decarbonisation after plucking the low-hanging fruit of managing their own Scope 2 (purchased electricity, typically) emissions is not easy.

Much more challenging energy-efficiency measures are coming into focus. At the UN Climate Change Conference (COP28 in December 2023), countries agreed to an aspirational target of doubling the pace of annual energy-efficiency improvements, to reach 4% by 2030. To be successful, the International Energy Agency estimated average annual efficiency-related investment will need to triple — rising to US$1.8 trillion by the end of the decade. 

With higher electricity prices, the typical payback times for energy-efficiency solutions (upgrading equipment or installing steam traps, for example) have shortened from a few years to less than 18 months.

Other noteworthy areas for efficiency gains include electric vehicles (power efficiency is typically a multiple of what’s possible with internal combustion engines), moving away from use of natural gas for heating, and moving toward electrification in heavy industries. We may be entering a critical period where large upfront price tags are no longer viewed as a reason for inaction — especially as governments use incentives to mitigate costs.

4. Further financial innovations for sovereigns

If you’re not living and breathing ESG every day, you might be surprised to learn that sovereign (government) issuers are at the nexus of some really interesting innovations.

For instance, a group of academics and institutional investors recently launched a new framework designed to help investors better understand nuanced environmental-related risks and opportunities. The number of countries included initially is limited, but ASCOR (Assessing Sovereign Climate-related Opportunities and Risks) could grow to be a potentially useful data source.

Beyond the reporting and analysis, there are other fascinating developments around the ways that sovereigns are financing their sustainability efforts. Among emerging markets, for example, ESG-labelled bonds have accounted for around 20% of overall hard-currency issuance in recent years.

Ecuador’s record-breaking “debt-for-nature” swap in 2023 has, I suspect, provided real food for thought among governments that are looking to prioritise conservation. Put simply, these financial contracts forgive some portion of an issuer’s debt in exchange for the government pledging to protect the environment in some specified way. Ecuador, for example, was able to buy back US$1.6 billion of its debt at a steep discount. The Latin American sovereign then issued new “blue bonds” whose proceeds will help it direct at least US$12 million a year toward conserving the unique ecosystems of the Galapagos Islands.  

5. Biodiversity is maturing

As highlighted in my discussion of sovereigns, issuers are turning to bonds to help finance their protection and enhancement of biodiversity. At the same time, biodiversity is becoming a much higher priority for investors amid growing concern about the erosion of natural capital (basically the world's “stock” of soil, air, water, living things — and the benefits derived from it).

Relative to 2023, our most recent annual ESG Global Study, which is available on our website, found that nearly twice as many surveyed investors said they expected to have a dedicated biodiversity policy in place by 2025.

Publication of the long-awaited Taskforce on Nature-related Financial Disclosures (TNFD) reporting framework in 2023 is accelerating recognition of biodiversity’s importance. In January 2024, 320 organisations from 46 countries committed to start making nature-related disclosures based on the TNFD recommendations. It will be interesting to see how TNFD is incorporated into global accounting standards and regulation in coming years.

At Capital Group, we are looking forward to seeing further guidance on nature-related disclosures to help us better understand the risk. Nature is arguably an even more complex issue than climate, where company-specific considerations have historically centered on emissions data.  Recently, we have spent considerable time examining biodiversity data providers to see where third-party data could help us to assess biodiversity-related dependencies and influences on our investments.

It’s no exaggeration to say the details of how and where policymakers act to protect natural capital in the next year or two could have profound implications for many businesses’ operations and reporting for decades to come.