Author: Maha Khan Phillips
What impact has the Covid-19 pandemic had on environmental, social, and governance (ESG) investing? Alessia Falsarone highlights five main takeaways from the crisis and their potential longer-term implications for investors
1. Acceleration and expansion of several long-standing ESG trends
There is little doubt that the Covid-19 pandemic has increased investor focus on ESG principles, shining a spotlight on critical areas such as operational resiliency, employee safety, job security, and responsible corporate governance. Indeed, the crisis appears to have accelerated the move away from labelling these investment criteria as ESG, with more investors instead simply addressing sustainability risks across all portfolio allocations.
Other potentially transformative trends have also emerged. In the private sector, there is even greater emphasis on supply chain stability and enhanced transparency about employee benefits and compensation structures in events of 'force majeure'. Companies now also face a need to operate in jurisdictions prepared to address any future pandemic, where minimizing harm to people and processes is a high shared priority for lawmakers and investors. A sustainable-return mindset also has begun to emerge, with sustainable business activity performance more clearly reflected in enterprise value. Scrutiny of any discretionary capital distributions (e.g., executive compensation, dividends, stock buybacks) is also likely to continue post-crisis.
In the public sector, expect more active engagement between policy officials, investors, and other stakeholders. Local governments’ increased role in pushing for health and safety actions may also continue post-pandemic. This may include heightened organisational preparedness standards around human rights and appropriate healthcare system and mapping measures. Governments have also learned lessons from their successes and failures in 'flattening the curve' that can be applied to potential future social crises.
Additionally, the pandemic has shown the need to integrate ESG evaluation into economic output (GDP) studies and forecasts, from the perspective of both competitive market behavior and shared economic and human well-being. These are goals worth investing toward, and often only concerted efforts on a global scale can make it happen.
2. Growing importance of business continuity and ESG-supportive behaviors
The crisis has offered clear insights into ESG behaviors based on how companies have responded to their customers and employees and through their product offerings. It also has provided a real-life test of organisational readiness and the ability to think and act quickly. These actions all may have a significant impact on future brand value and profitability.
One critical area has been business continuity planning (BCP). Investing in BCP has traditionally meant maintaining adaptable business operations powered by distributed technology networks. The crisis has shown that access to up-to-date employee health and safety information and supply chain reliability are also crucial inputs, requiring predictive metrics that go beyond after-the-fact incident rates. If these factors have not been consistent elements of investors’ due diligence before the crisis, they certainly will be now.
The crisis has prompted businesses to incorporate ESG-supportive behaviors in numerous other ways. Notably, technology companies have taken the lead in deploying their systems and talent to tackle the health information void during the crisis – including some of the same companies that have come under severe scrutiny over the past few years for ethics, privacy, or data-protection issues. For instance, some have committed cash and advertising credits to help small businesses, produced and donated personal protective equipment for front-line workers, and offered to deliver and pick up at-home test kits. Some are even working with competitors in these efforts, including one partnership to create a coronavirus contact-tracing app. These are just a few examples of leaders pivoting their businesses to address immediate societal needs and highlight how these same leaders could act swiftly and effectively to address other aspects of governance.
3. A focus on transparency and consistency in ESG implementation
While the crisis has generated a renewed emphasis on ESG practices, a lack of transparency and consistency in ESG metric reporting and scoring can add to research challenges for sustainable investors. Moreover, traditional ESG reporting frameworks were largely developed from an accounting-metrics perspective, rather than for specific investment management applications. Consequently, understanding how different portfolios and investment managers apply ESG principles can be crucial in effectively evaluating their strategies.
One way we can address this challenge in developed market fixed income portfolios is by introducing a proprietary set of ESG Key Risk Indicators (KRIs). These investment applications align with Sustainability Accounting Standards Board (SASB) reporting guidance while providing actionable investment metrics that are practical, transparent, and quantifiable. This can help translate ESG-focused measures into aggregate portfolio views of ESG risk exposures and potential sustainable alpha enhancers. Focusing on a transparent, measurable investment framework can also help to avoid potential 'ESG-washing' in individual issuers, as well as provide greater clarity around whether an ESG portfolio management approach is fit to address 21st-century investors’ needs.
4. The unfolding of greater industry collaboration
Interestingly, the outbreak has prompted some notable changes across the broader investment industry surrounding sustainability – specifically, an increase in collaborative engagement among asset owners and investment managers, particularly Principles for Responsible Investment (PRI) signatories. This represents a marked change for an industry that has historically held its research and investment applications closer to the vest, reflecting in part the realization that organisational alpha may be enhanced by dialogue and cooperation. An example of this new sense of partnership is the launch of the PRI collaboration platform on Covid-19 responses, covering everything from immediate health concerns to longer-term investor focus on a sustainable, inclusive recovery.
5. Enhanced ESG investment risk profiles and performance potential
ESG-themed funds, on average, have outperformed during the current crisis. According to Lipper/Refinitiv, in the first quarter of 2020, across the entire funds market (roughly 34,000 funds), approximately 45% outperformed the MSCI Global Index, while 55% underperformed. In contrast, nearly 54% of the roughly 2,700 ESG themed funds outperformed the MSCI Global, whilst 46% underperformed.
This performance highlights the expected risk-adjusted return resilience of many ESG offerings due to generally lower volatility profiles and a structural underweight in oil sectors (though we note that continued variances in ESG implementation and the short horizon can challenge ESG/non-ESG comparisons and substantive longer-term conclusions).
For example, the pandemic resulted in an uptick in negative credit rating actions for many developed market fixed income issuers, but issuers with leading ESG practices in their respective sectors seem to have largely avoided downgrades (according to PineBridge Investment’s review of ESG-driven rating actions taken by S&P Global Ratings since 30 March 2020, and as of 10 June 2020).
ESG-themed funds have also experienced record net inflows throughout the crisis, as more investors seek out sustainable investments (Morningstar as of 12 May 2020).
We expect this trend to continue, with marketplace demand remaining high as the post-Covid-19 world is tasked with committing to the imperatives of environmental protection and social inclusion, while adopting a sound roadmap to sustainable financial outcomes.
Alessia Falsarone is Head of Sustainable Investing and Senior Portfolio and Risk Strategist for Developed Markets Fxed Income at PineBridge Investments