ESG Trends in the Small-Cap Market; What to Expect in 2024
2023 was a seminal year for Addidat, we launched our first products and developed our network across the UK small-cap and AIM communities. As we have been preparing ourselves for the year ahead, we have been interrogating our data for trends and reflecting on our conversations and experiences with both investors and investee firms.
We have summarised our key thoughts on lessons learned in 2023 and how we anticipate 2024 to play out when it comes to ESG and sustainability in the UK small-cap market.
The macro picture; the UK equity market
The sluggish rate of IPOs and pace of companies leaving the market throughout 2023 has been alarming but there is, perhaps, cause for optimism in 2024. We are heartened that both the incumbent government and the opposition are showing signs of creating policy to address contracting markets and we, like many others, will be looking for what’s next for the Mansion House Reforms, the recommendations in Rachel Kent’s UK Investment Research Review and the shadow chancellor’s proposed pension reforms.
We believe in the importance of functioning equity markets to drive growth in the UK and as increasing evidence mounts, sustainable business practices and positive ESG performance contributes to long term success of businesses. As a result, and alongside mounting pressures driven by societal shift and market instability that result from negative ESG megatrends, positive ESG performance continues to rise up the priority list for the whole UK equity market.
Investors; a small-cap awakening to ESG
Whilst ESG has been of increasing importance in the large cap market in the UK, the approach adopted by small- and micro-cap investors has largely been light-touch with a focus on governance. However in 2023, interest has started to pique more widely.
What is driving this? Firstly, an increased focus on ESG performance by Asset Owners on their full portfolio including small-cap investments, is necessitating Asset Managers to push ESG up their priority list.
Additionally, the rise of ESG performance reported by investee companies across the small-cap market, is creating a real opportunity for managers to start grasping the potential of alpha generation using ESG indicators in their portfolios. However, investors are currently constrained by the lack of good and reliable data on small-cap ESG performance. It is perhaps therefore no surprise in the level of interest we have received by the investment community in accessing our proprietary data-set, which covers performance of all AIM participants across the ESG spectrum. A key objective for Addidat in 2024 is to facilitate the UK small-cap investors and therefore wider market, with meaningful access to our data.
Looking ahead to the summer we will see the implementation of the UK’s Sustainability Disclosure Requirements (SDR), which requires investors managing portfolios with a sustainable lens, to align their funds and report on a set of criteria. We’re keen to see how the UK small-cap market will respond, as this could present investment opportunities to investee firms who have developed ESG products, as well as those demonstrating improvements in their own ESG performance.
The regulatory horizon; the pressure continues to rise for firms
One of the key challenges we hear from companies is the ability to keep up with ESG regulation. For firms crossing multiple jurisdictions, and especially for those with significant EU presence, this is a particular pain point with new regulations seemingly being released on a monthly basis. Company’s manufacturing products for end-consumers, rather than businesses, are also at risk of increased scrutiny with the increase in regulation and lawsuits associated with combatting greenwashing.
Key areas of focus this year include:
Climate-related disclosures, ongoing; we are currently just over half way through the first year of mandated disclosures on the TCFD aligned reporting for UK small-cap firms with more than 500 employees or £5bn AUM and, as discussed further in our recent article, we expect 25% of the AIM market to be reporting in line with the recommendations by the end of 2024, nearly double current levels.
Updated QCA code, from 1st April; the updated QCA code released in Q4 2023 will impact the vast majority of the UK small-cap industry this year as firms implement changes required to meet the enhanced code. Changes include an increased focus on social and environmental factors, employee stakeholder considerations, board diversity and independence, as well as heightened risk management frameworks.
Energy Savings Opportunities Scheme, 5th June deadline; ESOS requires UK firms with over 250 employees and exceed financial thresholds to conduct an audit on their energy efficiency of buildings, industrial processes and transport to identify cost effective energy saving measures. Details can be found on the government website.
UK Government an FCA’s endorsement of the IFRS sustainability disclosures, H2 2024; the UK Government department for Business and Trade has announced it will be creating UK Sustainability Disclosure Standards based on the IFRS’s sustainability standards (produced by the International Sustainability Standards Board, ISSB) released last summer; an update is expected in July. The FCA is also intending to update the Listing Rules for main market participants. Read more about the ISSB and the standards here.
AIM firms are increasing investment in ESG
We have heard many companies this year stating they have been advised they are “behind peers”, but this is often based on poor data which can lead to over investment. For example, views are based on comparisons against much larger organisations, who have teams of ESG focused staff and tighter regulation driving performance. Or result from the echo-chamber of ESG which can easily lead to the feeling of underperformance.
Our proprietary data provides valuable insights to the status of ESG performance in the UK small-cap market and progress being disclosed by firms. Insights we have derived from looking at the whole AIM market include:
A continued investment in Net Zero strategies. Perhaps no surprise that Net Zero strategies remain a focus for firms due to regulatory and societal focus, however 1 in 5 AIM firms reported for the first time on their Net Zero journey in 2023, bringing the total of all firms at least reporting greenhouse gas emissions or taking steps to reduce their footprint to over 60% of the market.
Firms are increasing Board accountability for ESG. 5% of AIM firms established a Board level ESG committee in 2023, bringing the total of firms across all AIM participants to 12.5%. Additionally, 10% of AIM firms are including ESG performance in Executive remuneration criteria.
Enhancing strategies with data. In the wake of the growing threat of greenwashing, firms are establishing metrics and targets to underpin their commitments and build internal and external confidence in their ESG strategies. As an example, 10% of firms have already developed and disclosed targets for their diversity, equity and inclusion strategies.
What should firms be focusing on in 2024?
We have spoken to several companies over the last year and there are some key themes in the challenges at play. The most consistent message is the lack of budget to address ESG pain. One of the most stressful things for a Board and Executive team is taking decisions on unplanned expenditure, burning effort and goodwill in the process. ESG, in the medium term at least, is not going away and strategies will not be successful without investment. If you’ve not yet established an ongoing ESG budget, make this a priority for 2024.
How companies spend that budget is the next critical decision, and this will ultimately come down to each firm's unique position, considering several factors including the wider business strategy, peer performance, and current ESG maturity. We’ve identified that many firms are not focusing their ESG effort in the areas that will deliver the biggest financial results. And even more common, we find that firms are not aware of, and therefore not communicating and getting credit for, all their ESG strengths. Our advisory and outsourced ESG Manager services, which are underpinned by our proprietary data and experienced team, enables our clients to fast-track the development of right-sized ESG strategies, building on existing strengths, and avoiding overinvestment.
Conclusion
ESG is only increasing in importance in the UK small-cap market and the pace of change is speeding-up. More peers are investing, regulation is tightening, and investors are increasingly looking at ESG performance in their decision process.
Small-cap companies have an optimal ESG opportunity. Implementing the right ESG strategies before significant growth, and resulting operational complexity, will support growth ambitions and reduce total investment on ESG in the long run.
As the pace of ESG adoption and evolution picks up in 2024, we will continue to advocate for right-sizing ESG strategies in the small-cap markets, and are excited about the role we can play in helping both companies and investors achieve success in ESG in a sustainable way.
For small-cap firms, doing it all, now, is not the right answer. But neither is putting it off.
To discuss further, please get in touch with the team.
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