The Sustainable Investor – Top ESG investing themes to watch amid volatile markets

The desk believes that ESG investing will increasingly shape market dynamics as sustainable investment requirements surge. Per the full note from Standard Chartered, these requirements are projected to exceed $200 trillion by 2050, indicating a significant shift in capital allocation towards sustainable assets. This trend is likely to influence currency valuations, particularly for those linked to green investments. As institutional traders adjust their portfolios in response to these themes, we anticipate a growing emphasis on currencies that align with sustainable practices.

What the desk is arguing

The desk posits that the ESG investment landscape will become a critical driver of market behavior, particularly in foreign exchange. Per the full note from Standard Chartered, the anticipated $200 trillion in sustainable investments needed by 2050 underscores the urgency for capital to flow into environmentally and socially responsible projects.

This shift is expected to create new opportunities and challenges for traders, as currencies tied to sustainable initiatives may appreciate in value. The desk is particularly focused on how this trend could reshape investor sentiment and positioning in the FX markets.

Where it sits in our coverage

Our consensus target for the EUR/USD stands at 1.075, with a range between 1.04 and 1.12. Notable firms contributing to this consensus include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)

The desk's view aligns with the upper bound of the consensus range, suggesting a bullish outlook on currencies that are increasingly linked to sustainable investment themes.

How other firms see it

Firms aligned with this bullish perspective include jpmorgan and citi, both emphasizing the importance of ESG factors in their forecasts. Conversely, bofa presents a more cautious stance, suggesting potential headwinds for currencies not aligned with sustainable practices.

Traders should keep an eye on the EUR/USD trajectory, as it may reflect broader market sentiment regarding ESG investments. Additionally, the actions of central banks in response to climate-related policies could further influence currency movements.

What the calendar says

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Hello, I'm Aneesha Tank. Welcome to this podcast from the global research team at Standard Chartered. This episode is particularly special as it's our first deep dive into environmental, social and governance investing or ESG investing.

It's a topic likely to dominate the investor agenda in coming years. According to Standard Chartered, sustainable investment requirements are expected to reach 218 trillion US dollars between 2023 and 2050. And that's just one theme in the ESG agenda.

Well, there are definitely many opportunities as governments embrace the UN Sustainable Development Goals, also well known as SDGs, as well as respond to the urgent problem of climate change. That said, our guest today also warns that pushback against regulation is a key risk to the outlook, as documented in the bank's special report on ESG investing themes. This launches a series which deep dives into a range of topics around the outlook for ESG investing.

Where does this all leave investors? That's exactly what we're about to find out. Eugene Cleric recently joined the team as the head of ESG research and he's on the line with me now.

Eugene, hello. Welcome. How are you?

Very well. Thank you very much, Manisha, for allowing me to spread the gospel of ESG. Excellent.

Well, I think there are lots out there who would agree that this is the topic of the moment and it very well should be. First of all, I want to get the definition straight. Many people throw ESG in with the word sustainability and then they just assume it's all the same.

Of course it isn't. Can you explain why it's important that we understand this from the get-go? You're absolutely right.

I think a lot of people do mix up the terminology. Originally, ESG referred to effectively the sustainability of the company as it's run internally. So think about the efficiency of its production processes.

What's the social policy like that the company adopts vis-à-vis its employees, for example? So ESG effectively relates to intra-company performance. Sustainability is something that is predominantly focused on the externalities almost of a company.

In other words, how does a product, how does a service, how does our behaviour impact the world at large? Then maybe just to make this really clear, sometimes people find it quite peculiar that, for example, tobacco companies can be seen as doing incredibly well from an ESG perspective because a tobacco company may have incredibly efficient production processes. It may have really good social policies for its staff and indeed may have really good governance policies.

So from an ESG perspective, from an intra-company perspective, a tobacco company may be a great company. From an impact perspective, however, in terms of the impact of its products and services, that may be a different story. So there's a difference between ESG and sustainability.

So it's good to get that off first. That's probably one of the best explanations I have heard to date. So thank you very much for making sure we're in the right place on the map.

So now that we are, let's talk about this special report. It's pretty extensive. What are some of the big themes that you're focusing on that were highlighted there?

I think there is no end to the range of topics that investors with a sustainable view might be drawn towards. However, within that whole universe of themes, we believe that there are three areas in particular that are relevant. One is, needless to say, the energy transition.

We need to transition to a more energy efficient economy globally. So one can think of whether it's renewable themes, one can think of energy efficiency themes or indeed something like energy storage. The second area that we focus on are natural capital related themes.

And the reason why that is relevant is that for a very long time, natural capital basically was an area that investors and analysts didn't really focus on. Now, that's unfortunate because natural capital or the natural world in its holistic form accounts for probably about a third of greenhouse gas emissions. So therefore, themes such as the food system, such as the blue economy, things like deforestation are all hugely relevant from a sustainable perspective.

And certainly, if one looks to achieve long term climate change targets. The final area that we focus on in the report that we think will drive the investor agenda for years to come is regulation. And so that historically was very much a European topic.

However, more recently, it has certainly grown to touch pretty much every area in the world. And so we dive into that in the report as well. Of the themes that you mentioned, what would you say is the most resilient in terms of the outlook?

What we look for in terms of market exposure is predictability of returns. We also look for returns that are not volatile. So we'd like returns to be steady.

And we also like returns to be above the cost of capital. What we tend to find is that the energy efficiency related themes offer that. And so one has to think about building energy efficiency, for example, installation.

Other areas include transport energy efficiency or industrial energy efficiency or automation. So those are the areas with, in our view, the more attractive or more resilient return profiles. OK, Eugene, so we know that climate change is driving most of the relevant themes that you've already talked about.

Let's zero in on sustainability, debt and equity as sources of financing. Where will the emphasis be, do you think? Historically speaking, the focus has always been on corporates.

Both investors and analysts started looking at this space from an equity and corporate perspective. Data was mostly available for corporates. And so therefore, it has always been a bit of an equity focus.

Now, clearly, equity will remain relevant. But you mentioned at the very start of the podcast some of the numbers that we have around the financing requirements. And just to put things in context, we believe that over 200 trillion dollars is needed over the next couple of decades to meet long-term climate change targets.

And if you break that down by asset class, about 88 trillion dollars will have to be issued through debt instruments, the majority of which from governments. And so in other words, the debt mark will be far more relevant, in our view, to meet long-term climate change targets. The run rate of debt versus equity issuance is also interesting because if you think about the equity issuance that's needed over the next few decades, on an annual basis, about four times the IPO volume is required.

Now, that's a significant number, and particularly even in current market conditions, highly unlikely in our view. If you look at the debt markets, although the run rate needs to go up two and a half times, the market is far bigger. So we believe that the increase in the run rate of debt issuance is easier to achieve than it will be on the equity side.

We also believe that the debt market will be able to support the issuance required. Okay, so then let's get into some of the tailwinds. That shortfall that you were talking about, that feels like a bit of a tailwind.

There are five drivers supporting growth. You mentioned carbon markets in the report, energy transition needs, the UN SDGs. But what of your five drivers do you feel is most influencing the outlook?

I think if you look at the various drivers that we highlight in the report, there are certain factors driving these drivers, as it were, that are different between them. So, for example, the SDGs, Sustainable Development Goals, are goals that probably are the broadest in nature and require the most amount of funding going forward, but ultimately rely on government intervention slash regulation. In the absence of government regulation, the SDGs are unlikely going to be met, in my view.

That is different from the energy transition per se, because that is much more technology driven. If technology develops strong enough, if the cost of production falls quick enough, demand for these new forms of generating energy will increase organically, because people will gravitate towards the lowest cost producer. Therefore, the energy transition probably is an easier tailwind going forward than the SDGs.

Now, carbon markets, I think, is a really interesting phenomenon, because there are a few aspects that are developing in relation to the carbon market that make me really optimistic. One is the fact that there is a growing sense of acceptance that carbon pricing is needed, but that is not just growing across the developed world. It is increasingly being adopted by developing nations, not least Africa.

We've seen more recently an increasing level of rhetoric from a number of African countries around their desire to develop nature-based carbon offset markets. I think that is coming from their realisation that the natural world, or natural capital, has a value to them and can be used to help drive economic growth. So, the development of the carbon market, I think, is a really interesting area to continue to focus upon.

It will also potentially have significant implications for the climate agenda more broadly. Since you're talking about natural capital there, I thought it would be a good juncture actually to jump to talking about the ocean, to the blue economy. This is widely underestimated, but it's a foundational aspect, of course, of life on earth, and I think people are really waking up to this.

Blue bonds, these are relatively new for the time that investment has been happening, but they're evolving, issuance is increasing. What is the trajectory of this asset class, especially in the context of what you were just saying about the value of natural capital? I think you're right.

I think the blue economy has been an underrated area of sustainability, and that is probably due to the greater difficulty with measuring sustainability in the ocean. Nevertheless, if one thinks about carbon storage in the ocean versus elsewhere on the globe, then it is of huge importance and relevance. Warming of the ocean has all sorts of negative implications that need to be addressed, so the focus will increasingly be on the blue economy, as far as we're concerned.

We're expecting COP28 to have a significant focus on the blue economy as well, and so demand for blue bonds will increase because in order to restore and grow a healthier ocean and healthier coastal communities, that requires funding. Now, it does require, however, a greater regulatory framework. There are developments in this space to establish frameworks, which is really positive, but that needs to continue in order for investors to feel secure and confident about investing in blue bonds.

Let's talk about headwinds, and one of those is the fact that we're seeing green agendas being scaled back, particularly in developed markets. That surely is a major concern. What is the risk here?

What should investors be mindful of? Yeah, I think you're absolutely right. It's quite eye-opening, revealing, staggering, perhaps, the change in mood towards regulation coming from developed markets, not least as a result of the Ukraine-Russia crisis and the impact that had on cost of living, inflation, energy costs, but also food-related expenses.

That really has put pressure on politicians to dial down their willingness to push forward with the climate agenda, and I think certainly in Europe, we're seeing various countries where now on the ground locally, there is greater pushback against what Brussels is suggesting, and so what I think the key challenge will be for investors is to identify whether this is a structural story, because if it isn't, of course, well, then one can almost discount that somewhat when making investment decisions, but if it isn't temporary, if it is structural, then the key issue will be which areas can I focus on that do not require government intervention, and that's when we come back to technology, because I do strongly believe that in a world of sustainability, there are three actors. There is the government, there are corporates, and consumers, and I think that of the three, the greatest level of support for sustainability is likely to come through technological innovation and corporates, providing products and services that are more sustainable at cheaper prices. That's the area for investors to focus on if they believe that the pushback against sustainability and ESG becomes more structural.

And then what about emerging markets? What is the policy agenda looking like there, and how does it diverge from developed markets? The challenge for emerging markets is a little different, and I do have sympathy with a number of emerging markets who are basically advocating that the challenges that the world is facing have actually been brought about by developed markets.

The challenge that the emerging markets face is therefore one of trying to balance their own developments, economic growth, social development, social growth, with meeting sustainability targets, and I think that there needs to be a fairer sharing of the sustainable burden between developed markets and emerging markets, and that is something which has proven to be quite challenging, but that is the key aspect for emerging markets. If one thinks about, for example, a region such as Africa, Africa has conditions to completely move beyond the world that we've known in terms of energy production, and they can adopt solar and wind much more quickly without legacy assets than we've ever been able to do in the developed world, and particularly given the trajectory of costs of producing solar and wind power continues to come down quite significantly, that will make it a lot easier to adopt renewable technologies and actually still do their bit for sustainability, not at the expense of their own economic development. So I think the challenge is different for the EM space.

It does require funding from developed markets, greater support from developed markets, but I do think that on a relative basis there are certain areas within emerging markets that actually can achieve a lot, even if that support isn't as significant as we'd like it to be. Well, you've certainly fuelled my optimism on emerging markets. What should investors do, and how should they be positioned, given some of the matters that we've discussed today?

What are the key markers, would you say, when it comes to ESG investment? When you think about sort of asset classes, we believe that the risk-return characteristics of sustainable debt is a more promising one in the current environment than sustainable equities. We would prefer the green bond space relative to the sort of sustainable equity space.

That's one. The other that I would say is within the debt space, given where we are today and using a 12-month investment horizon, we believe that investors should slowly start to increase exposure to longer-duration sustainable debt at the expense of shorter-duration debt. Then finally, when thinking about the credit quality of that debt, we've also seen in our performance, interestingly enough, of lower-rated sustainable debt relative to higher-rated sustainable debt.

Again, from a risk-return perspective, balancing your portfolio a little towards longer-duration and or higher-rated debt, where we are in the cycle, makes sense to us at the expense of shorter-duration, lower-quality debt. Jutine Clare, thank you so much for joining me. That is it from us for now.

From me, Manisha Tank, and the whole production team, bye-bye.