ESG Trends to Watch: Stax’s Top 10 for 2024

It is admittedly a confusing time for ESG—most proponents and critics alike are aghast at what has developed into the mainstream narrative around what ESG is and isn’t. The good news, however, is more clarity is coming that might help alleviate the concerns on both sides. The backlash against ESG (by critics) has led to a renewed focus (by proponents) on doing the actual job of tying ESG to demonstrable financial performance. As Megan Starr, Global Head of Impact at Carlyle, noted in their 2023 ESG report The EBITDA of ESG “it is critical to work to build connections between the often-nebulous concept of ESG and traditional financial line items.” As GPs further develop these approaches and demonstrate the connections to LPs through expanded reporting, expect further clarity and a new benchmark on ESG to emerge.

Impact investors have been a clear beneficiary of the ESG confusion. Many have been able to distinguish their investment theses and showcase their impact integration and performance relative to ESG-integrated investment approaches, and they have attracted more investment inflows as a result. KKR recently raised $2.9B for its second global impact fund—more than double the $1.3B raised for its first impact fund in 2020; and in October 2023 BlackRock launched a new climate transition-oriented private debt fund that received a $1B commitment from the UAE’s ALTÉRRA investment vehicle. 

Benefits are also accruing to more of the mid-market impact funds: Apax closed last month on a $900 million raise for its impact fund, Two Sigma Impact raised $677 million last year for its inaugural impact fund, and LeapFrog is targeting a $1B raise for its flagship consumer fund, which is expected to close next month. 

Even with further clarity around ESG-integrated investment approaches, impact investment funds will continue to attract more attention from investors that intentionally seek positive social or environmental impact. What will this be contingent upon? Demonstrating (1) optimized operational models that allow for scale and (2) valuation premiums for impactful businesses.

In July 2023, the European Commission adopted the European Sustainability Reporting Standards (ESRS), which provided guidance on what metrics companies need to report and how to report them to satisfy Corporate Sustainability Reporting Directive (CSRD) requirements. There are over 1,178 metrics of which only 174 are voluntary, and many of the required disclosures take the form of narrative or semi-narrative descriptions (i.e., get ready for a deluge of confusing ESG data). As the CSRD requirements surpass the level of detail outlined in the Non-Financial Reporting Directive (NFRD) it replaces, and with CSRD expanding the non-financial reporting scope to over 50,000 entities, there exists an incumbency bias that favors firms already equipped with resources in place (including the ability to pay for third-party experts, reporting tools, and assurance to manage these efforts) to satisfy CSRD requirements.

Recognizing their inherent disadvantages (e.g., California passed two climate-related disclosure bills in October 2023 that go beyond the requirements of the SEC’s proposed climate-related disclosure rules), smaller companies will make progress advocating for a much more limited, yet practical set of standardized disclosures in markets that are considering mandatory sustainability reporting requirements. 

The future of publicly available corporate carbon footprint assessments, including scope 1, 2, and 3 emissions, is complex and multifaceted, but there are growing trends (including regulatory pressure (e.g., CSRD), investor demand, and consumer awareness) pushing the marketplace forward towards increased transparency and availability. For example, carbon footprinting tools that incorporate global regulatory requirements and guide the corresponding data collection process have materialized, with the total global carbon accounting software market projected to grow to $64.4B by 2030. 

With companies responsible for all the data inputs, and the tools subsequently yielding standard regulatory-aligned disclosures, there is limited differentiation between carbon assessment tools other than their fees. As the footprinting exercises become commoditized, momentum begins to shift towards analyzing a company’s decarbonization roadmap (i.e., the strategy and progress towards reducing actual carbon emissions and not simply the reporting of a company’s carbon footprint)—and isn’t that where the focus should be anyway?

How will AI transform sustainability? Let’s go straight to the source – from Bard AI (edited for clarity):

Generative AI has the potential to transform sustainability in numerous ways, across diverse sectors and aspects. Here are some key areas where we can make a significant impact:

• Optimizing resource utilization: We can analyze data to identify inefficiencies in energy, water, and material consumption across industries
• Accelerating clean energy solutions: Generative AI can be used to design more efficient solar panels, wind turbines, and other renewable energy technologies
• Combating climate change: We can analyze vast amounts of climate data to forecast extreme weather events, inform disaster preparedness, and identify areas most vulnerable to climate change impacts
• Preserving biodiversity: AI can analyze ecological data to understand and predict species interactions, habitat changes, and potential threats to biodiversity

• Empowering sustainable communities: We can be used to design and manage smart cities, optimize transportation systems, waste management, and resource allocation
• Supporting sustainable agriculture: AI can analyze soil conditions, weather patterns, and crop data to optimize farming practices
• Promoting circular economy models: We can design waste management systems that utilize AI to identify recyclable materials, optimize collection routes, and develop innovative recycling technologies
• Enabling equitable access to sustainability: AI can be used to develop educational materials, translate information into different languages, and connect communities most impacted by environmental issues

Even with AI’s prolific expertise, it’s going to need many human partners on the ground to implement all the above into the non-virtual world.

By all indications, private market deal activity is expected to pick up in 2024 after a relatively slow year in 2023 compared to both 2021 and 2022. Stax’s clients across private equity and investment banking experienced increases in deal volumes in Q4 2023 and are signaling a more positive outlook for H1 2024. 

However, they have also cautioned that bid/ask spreads remain high with buyers paying less than what sellers want, which is making it hard to close. With this backdrop, there are multiple implications for ESG. On the buy side, it is essential to conduct a more robust ESG due diligence (i.e., not just a check-the-box diligence that previously satisfied many LPs) to uncover specific ESG factors that can lead to value generation (reference: 1. A New ESG Standard) during the hold period. On the sell side, it is important to demonstrate a firm’s ESG strategy and performance to attract buyers that are looking at more than just financial metrics (i.e., widen the pool of potential buyers to create more demand). 

Overall, the current market presents both challenges and opportunities, but prioritizing the integration of material ESG factors across the investment lifecycle is rapidly emerging as a crucial differentiator and source of competitive advantage.

ESG and sustainability are here to stay and are becoming core competencies for graduates. Universities are embracing cross-disciplinary approaches to ESG and sustainability education, blending science, economics, policy, and business in innovative, fundamental programs and courses. These students enter the workforce equipped with knowledge that encompasses social and governance pillars, incorporating technology and data analysis and fostering global perspectives. In finance, investment firms are hiring roles that require knowledge of and expertise in biodiversity, climate, and/or natural capital to support dedicated investment themes. Collectively, the individuals that view business through both entrepreneurial and policy-focused lenses and possess multi-disciplinary skills are poised to become tomorrow’s changemakers.

Circular practices unlock environmental benefits, foster innovation, and create new jobs by reducing resource extraction (as measured by new initiatives like The Taskforce on Nature-related Financial Disclosures guiding impact reporting to nature), minimizing waste generation, and lowering emissions. These outcomes align perfectly with ESG pillars, attracting investors and boosting a company's overall sustainability performance. With technological advancements paving the way for more efficient resource loops, businesses across industries will embrace circularity as a key driver of long-term economic success through cost savings, new revenue streams, enhanced reputation, and positive social and environmental outcomes.

The once separate “add-on” view of ESG as a distinct realm is beginning to dissolve and is becoming seamlessly woven into the fabric of businesses. Companies aren’t viewing it as a check-the-box exercise anymore, but as a lens through which to optimize and refine existing processes. 

In addition, new regulations like CSRD, which require double materiality assessments, are leading to a deeper integration of sustainability into core business strategy. For example, Finance, Legal, and Sustainability teams now are typically working together to fulfill mandatory ESG reporting requirements. From product design to talent management, sustainability principles are guiding decisions, creating efficiencies, and mitigating risks. This "ESG within" approach unlocks cost savings, strengthens brand loyalty, and prepares companies for a future where responsible practices are de rigueur. 

By embracing this integrated mindset, businesses unlock compliance, long-term value creation and a competitive edge in a world increasingly focused on building a sustainable future.

While "ESG" has become the go-to term for sustainable business practices, its complexity and susceptibility to greenwashing has raised concerns about effectiveness. As the focus shifts from mere reporting to tangible impact, a term like "responsible business" could gain more traction. It offers greater clarity, emphasizes action over metrics, and aligns with the understanding that sustainability directly drives long-term value. Ultimately, replacing "ESG" entirely might not be necessary, but evolving the concept towards action-oriented, outcome-driven "responsible business" practices will significantly advance the journey towards a more sustainable future.