This article is part of NordSIP Insights – ESG Integration Case Book 2020. Read or Download the entire publication here.
by Carlo M. Funk, EMEA Head ESG Investment Strategy, State Street Global Advisors
The COVID-19 pandemic is having devastating effects on almost all areas of our lives, highlighting how vulnerable and globally interconnected we are, especially in terms of commerce and trade. Where will this lead us when it comes to the value and adoption of ESG?
When looking at percentage growth rates, ESG investments are amongst the fastest growing areas in finance but in absolute terms they are still not mainstream. So, the question arises whether the current pandemic will lead to a further acceleration of this trend or slow it down.
Early results suggest that the effect on sentiment around ESG adoption will be positive with two thirds of participants in a recent study conducted by Responsible Investor saying that the coronavirus pandemic could prove a tipping point for ESG1. This could be the boost that ESG investing needs to become truly mainstream.
This paper sheds light on four important dimensions on how the COVID-19 pandemic can influence ESG adoption, namely:
- The significance of ESG criteria
- Impact on climate initiatives
- ESG performance
- Stewardship and engagement
Dimension 1: The Significance of ESG Criteria
Although maybe not obvious at first sight, the crisis uncovers the importance of key ESG performance indicators for long-term value creation.
The social part has often been perceived as rather vague and deemed insignificant by critics. This crisis proves this is mistaken. Social aspects are important in the equity space and also in fixed income, where “S” has started to manifest in the creation of various kinds of “social bonds” to combat the effects of the pandemic.
A company’s resilience and contingency planning, especially in times of crisis, are crucial for its long-term performance. Hence, investors will have a heightened focus on these governance (“G”) areas.
When considering the framework of the Sustainability Accounting Standards Board (SASB), the following material issues specific to COVID-19 can be identified:
“Access & Affordability” addresses a company’s ability to ensure broad access to its products and services, specifically relating to underserved markets and/or population groups. It includes the management of issues related to universal needs, including accessibility and affordability of health care, financial services, utilities, education, and telecommunications.
“Labour Practices” considers the company’s ability to uphold commonly accepted labour standards in the workplace, including minimum wage policies and provision of benefits, flexible working hours, working from home, and shift work.
“Employee Health & Safety” focuses on a company’s ability to create and maintain a safe and healthy workplace environment, free of injuries, fatalities, and illness (both chronic and acute). It is traditionally accomplished through implementing safety management plans, developing training requirements for employees and contractors, and conducting regular audits of their practices and those of their subcontractors. It also includes how companies ensure the physical and mental health of workforce through technology, training, corporate culture, regulatory compliance, monitoring and testing, and personal protective equipment.
“Supply Chain Management” addresses management of ESG risks within a company’s supply chain, including environmental and social externalities created by suppliers through their operational activities, environmental responsibility, human rights, labour practices, and ethics and corruption. Management may involve screening, selection, monitoring, and engagement with suppliers on their environmental and social impacts.
“Competitive Behaviour” covers social issues associated with monopolies, which may include excessive prices, poor quality of service, and inefficiencies. It addresses a company’s management of legal and social expectation around monopolistic and anticompetitive practices, including issues related to bargaining power, collusion, price fixing or manipulation, and protection of patents and intellectual property.
“Critical Incident Management” highlights the company’s use of management systems and scenario planning to identify, understand, and prevent or minimise the occurrence of low-probability, high-impact accidents and emergencies with significant potential environmental and social externalities. It relates to the culture of safety at a company, its relevant safety management systems and technological controls, the potential human, environmental, and social implications and the potential long-term effects to an organisation, its workers, and society should these events occur.
This shows the significance of financially material ESG issues for a company’s success. Hence, the added value of integrating this data in portfolio structures and investment decision making becomes evident.
To address these material issues, State Street Global Advisors developed R-FactorTM, an ESG scoring system. It leverages the SASB materiality map and measures the performance of a company’s business operations and governance regarding financially material ESG issues facing the company’s industry. We now incorporate this information in investment solutions and reporting, and our stewardship programme.
Dimension 2: Impact on Climate Initiatives
If the COVID-19 pandemic is not an environmental crisis where does this leave us? Will the ESG focus shift from climate change?
With the postponement of the 2020 United Nations Climate Change Conference in Glasgow (COP26) and other such initiatives due to the pandemic, the amendment of timelines from industry associations will likely lead to a postponement of critical decisions to fight climate change.
But will this also be reflected in a de-prioritisation in the allocation of private and public funds to the projects and R&D spending needed for the transition to a low-carbon economy? While the USA plans to spend US$2 trillion in COVID-19 stimulus that fiscal stimulus pales in comparison to the US$2.4 trillion per year need globally over the next decade to keep temperatures within 1.5°C above pre-industrial levels.
Climate change can be described as a slow-moving, or rather, “slow-burning” pandemic. The long-term impact of climate change could ultimately be even higher than that of the current pandemic.
Despite the delays, awareness of the significance of climate change should increase, which could then lend more support and funding to tackle climate change in the medium and long-term.
Dimension 3: ESG Performance
Many investors view the incorporation of ESG data, especially in the “best-in-class” space (where companies with better ESG ratings are systematically overweighted), as having a negative effect on portfolio risk return profiles. Some investors still view the integration of ESG parameters as a constraint with negative effects.
A recent study by Morningstar2 concludes that there is “no evidence that investors need to sacrifice returns when they invest in good ESG companies globally compared with bad ESG stocks.”
Several studies have identified a positive link between ESG integration and various measures of corporate performance. In a well-known meta-study3 of over 2,000 academic studies, 90% showed a non-negative relationship between incorporation of ESG criteria and corporate financial performance, and 63% identified a positive link.
Harvard University4 has found that firms with good performance on SASB-defined material sustainability issues significantly outperformed laggards.
But how do ESG funds perform compared to traditional funds during market sell-offs? There have been few opportunities to test this given that ESG investing has mainly occurred during relatively benign conditions. ESG integration should help reduce portfolio risk by investing in higher-quality issuers with stronger balance sheets, governance and risk management practices and labour standards. Does the data on the current downturn support this?
HSBC5 measured the performance of shares in 613 public companies globally valued at more than $500 million, where climate solutions generate at least 10% of revenues. HSBC also looked at the 140 shares with the highest ESG scores and values above the global average. The study ran from 10 December 2019 to 23 March 2020, and from 24 February 2020 to 23 March 2020, the latter period being when market volatility spiked. The climate-focused stocks outperformed others by 7.6% from December and by 3% from February. The high ESG-scoring shares beat others by about 7% for both periods.
In another study, Morningstar6 found that sustainable and ESG equity indices outperformed conventional indices in the Global, Europe and US Large-Cap categories in the month to 20 March 2020. These studies suggest that portfolios with ESG integration provide good downside protection when markets are struggling.
In the fixed income space, specifically in emerging market debt, the ESG equivalents of the broad market indices outperformed during March 20207.
Additionally, the flows of ESG funds that provide broad market exposure are much more robust vis à vis conventional counterparts.
However, it’s important to emphasise that we are still in the early stages of the COVID-19 pandemic and given the limited data these findings should be treated with caution.
Dimension 4: Stewardship and Engagement
In a crisis, engagement with companies will shift to more immediate issues such as employee health, serving and protecting customers, ensuring the overall safety of supply chains and short-term financial resiliency. Many companies are considering reducing their capital spending, share buybacks, dividend payments and expenses.
Companies will need to balance the (sometimes competing) needs of employees, customers, shareholders, regulators and the broader community, which will differ by company, industry, and region. Engagement practices must be mindful of these developments.
With this in mind, shareholders should encourage companies to:
- Refrain from undertaking undue risks that are beneficial in the short-term but harm longer-term financial stability and the sustainability of the business model.
- Communicate to investors COVID-19’s short- and medium-term potential impact to the business, overall operations and supply chains, including management preparedness and scenario-planning and analysis.
- Articulate how COVID-19 might impact or influence their approach to material ESG issues as part of their long-term business strategy.
As the pandemic hinders companies’ ability to hold in-person annual general shareholder meetings (AGMs) companies will have to shift to a virtual model that preserves all the rights and opportunities of shareholders.
Shareholders should also be able to have active and robust interactions with management and the board at appropriate times. Finally, the focus on financially material ESG issues, and how these issues can be adopted in engagement activities should increase.
Conclusion
Although some climate-related initiatives will likely be postponed due to COVID-19, the short-term lack of progress will be more than counteracted by the realisation that climate change is comparable to a slow-moving pandemic with equal, if not worse, effects in the medium and long-term.
The crisis could well heighten interest and adoption in ESG investing. There is growing evidence of the positive performance effects of ESG integration during market sell-offs. Prudent engagement and stewardship practices are particularly crucial in these challenging times. The focus on material ESG issues as part of company engagement strategies should not be forgotten.
Visit our website to discover more on our approach to ESG Investing.
Notes:
1. ‘RI Survey: Pandemic could be tipping point for ESG’ (2020).
2. ‘Better Minus Worse: Evaluating ESG Effects on Risk and Return’, Patrick Wang and Madison Sargis (2020).
3. ‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’, Gunnar Friede, Timo Busch & Alexander Bassen (2015).
4. ‘Corporate Sustainability: First Evidence on Materiality’, Mozaffar Khan, George Serafeim, and Aaron Yoon, Harvard University (2015).
5. ‘ESG stocks did best in COVID-19 slump’, Ashim Paun (2020).
6. ‘How ESG ETFs Have Performed in the Sell-Off’, Briegel Leitao (2020).
7. State Street Global Advisors, Bloomberg (2020).
Marketing Communication
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent. The returns on a portfolio of securities which exclude companies that do not meet the portfolio’s specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio’s ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole. Responsible-Factor (R Factor) scoring is designed by State Street to reflect certain ESG characteristics and does not represent investment performance. Results generated out of the scoring model is based on sustainability and corporate governance dimensions of a scored entity.
The views expressed in this material are the views of the ESG Investment Strategy team through the period ended April 7, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forwardlooking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal.
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Exp. Date: 04/30/2021
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