Pandemic proves catalyst in ESG uptake

Today, there is growing consensus that environmental, social and governance (ESG) is no longer a fad. According to one recent account, global assets incorporating ESG factors to support investment decisions have almost doubled over four years, and more than tripled over eight years, reaching approximately US$41 trillion ($57.6 trillion) in 2020.

Moreover, while the focus has been mainly on ESG-specific products, institutional investors are now beginning to think of ESG as integral to meeting their fiduciary responsibilities. The logic is that if ESG factors can be financially material then wouldn’t it make sense to systematically incorporate these factors across the investment complex, rather than just in select ESG products? 

While such trends were already altering the investment management landscape prior to COVID-19, the virus’ escalation to a global pandemic has hastened the shift in mindset toward sustainable investing. The pandemic and related economic fallout have also supported the notion that investors do not need to make a binary distinction between ESG and returns, especially during periods of market volatility. Indeed, a recent study found that, in Q1 2020, over 90% of sustainable indices outperformed their parent benchmarks.

There is also a consensus building within the investment community that the ‘theory of the firm’ needs to evolve within an ESG framework. Investors increasingly believe companies should focus on the overall positive effects of their businesses on society and not simply on maximising shareholder value. 

Traditionally, such a view would have been counterintuitive to many analysts and investors, and it sparks a debate about the definition and scope of fiduciary responsibility.

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It’s an important issue that rose steadily on the ESG agenda pre-pandemic and one that is sure to continue in the coming months and years.

RESURGENCE OF ‘S’ PILLAR 

While social issues have always been central to ESG analysis, especially for exposed sectors such as healthcare, technology and consumer, one of the pandemic’s tangible consequences is the social dimension of ESG is now coming into greater focus.

While public health is a key social issue within the ESG pillar trilogy, it is important for investors to distinguish between systemic-driven risk (exogenous) and ESG idiosyncratic risk (endogenous). For public health negative externalities to be considered idiosyncratic-driven, investors would need to evaluate whether the issue is triggered by companies’ misconduct or process quality/asset integrity failures. In the case of COVID-19, available evidence does not establish a link between the cause of the pandemic and companies’ ESG risk management practices (like it did with the 2008 financial crisis). 

But the pandemic’s societal reverberations will no doubt have an impact on these very ESG fundamentals going forward; more precisely, under the social pillar. Institutional investors are likely to increase focus on companies’ emergency response mechanisms (e.g. telecommuting, distributed management) and employee benefits (e.g. paid sick leave, telemedicine) as a gauge of long-term competitiveness (human capital) and operational integrity (business continuity). While companies could adapt to the ‘working from home-era’, they will also likely face heightened data privacy and security risk.

Pre-pandemic, these factors were difficult to quantify but investors now understand they can have material implications for the companies being invested in and therefore need to be quantified and accounted for. Subsequently, and considering the growing issue of ‘green washing’, the post-COVID-19 investment space is likely to result in increased investor ESG due diligence. It is expected that investors will ask for verifiable evidence that ESG considerations, including those flowing from COVID-19, are formally integrated into a manager’s investment process and for support of such claims by stock selection, reporting and portfolio construction.

RECONCILIATION OF NATURE AND SOCIETY

In addition to a growing focus on social issues, the pandemic has shown the intrinsic intertwining of nature, health and finance which, while previously accepted, has since become very apparent. 

Some observers think the COVID-19 pandemic detracts from the fight against climate change. They fear public and private investment in renewable energy will decline due to lower near-term profits and potential capital reallocation toward social-related risk management priorities.

In reality, the drastic mitigation measures put in place to fight the virus may be helping clear the air, too. Just as COVID-19 mitigation measures are likely to remain in place in the near term, their positive effects on the environment and public health may also persist. As a result, investors focused on decarbonising their portfolios may take the opportunity to redouble their efforts, arguing that urgently transitioning toward a lower-carbon economy is, in fact, doable. 

It is possible the drop in air pollution may be offset as global industries ramp up again to make up for economic losses once the virus is contained. In this context, investors are likely to favour companies that go beyond regulatory compliance and embrace the right long-term strategic direction. In addition to strong social-related risk management programs, this strategic direction could include investment in renewable energy or negative emissions technologies, board-level oversight on environmental performance and executive long-term incentive targets aligned with the International Energy Agency’s 1.5°C Sustainable Development Scenario.

TAKING AN ESG ACTIVE ‘BARBELL’ STRATEGY 

Commitment to ESG and impact-themed investing has evolved from a question about why it’s important, to how it can be most efficiently implemented. Despite these gains in sophistication and demand, investors still have questions about ESG investing. 

First, they question the amount and complexity of ESG data and methodologies. Multiple data service providers employ a variety of evaluation criteria and reporting methods, so there is still no one size fits all solution. 

Asset managers and asset owners are left reviewing and evaluating companies and securities according to various methodologies. And many times, they add customised reviews to determine a reliable ESG scenario for an investment.

Artificial intelligence (AI) and machine learning offer possible ways to deal with this overload of information. The ability to analyse and process exponentially more information than a human at vastly faster speeds, is AI’s core benefit. But investors remain concerned about relying on already confusing and possibly conflicting data, fearing that inserting a machine into a constantly evolving system could exaggerate inherent data ‘spottiness’. 

Another investor question focuses on whether ESG investing is a reliable source of alpha. There continues to be no consensus on this issue. While some asset managers are working to reduce the risks of ESG exposure, others are aiming to deliver outperformance through investments in companies sporting high third-party ESG ratings. 

Amid the variety of approaches to ESG investing and associated challenges to implementation, the COVID-led volatility underscores the importance of active investment solutions to fill in these gaps and to navigate through market cycles. 

One way to bridge the gap is the adoption of barbell-like strategy centered on delivering alpha through investments in high-quality and attractively valued companies with improving business fundamentals and solid ESG risk management practices. In addition, this approach focuses on issuers which possess long-term competitive advantages as well as solid margins of safety against short-term adverse systemic forces—including rising costs related to COVID-19. 

Where possible, this approach also tilts toward companies that demonstrate acceleration in ESG growth trends such as clean technology, cybersecurity, global data connectivity, demographic changes and, arguably of greatest importance, healthcare innovation and accessibility. 

In a post-COVID environment, investors are likely to look for ways to align their investments with the long-term safeguarding of the planet and people’s lives without sacrificing returns. This is where an ESG active ‘barbell’ approach which protects investors against short-term systemic downside ESG risk and capture long-term ESG upside potential can prove effective.   

Guillaume Mascotto is head of ESG and investment stewardship at American Century Investments.