The acute financial impact of COVID-19 has raised fears of a slowdown in the pace of the movement to persuade companies to consider environmental, social and governance (ESG) factors in their operations, investments and policies. As businesses retreat to focus on financial survival, many commentators are concerned that the crisis will push aside the commitments some industries have made — for instance, energy, airlines and fashion — to environmental sustainability.
But, contrary to these fears, it seems that this pandemic will hasten the reshaping of the broader investment landscape to yield a more sustainable future. This crisis has illuminated our fragile relationship with nature, and investors are treating it as a stress test for future environmental calamities. As they analyze the resiliency of their investments in the face of the steep economic shocks of COVID-19, they see better risk management in ESG investments. We are now starting to get a clearer understanding of a new phase of ESG investing in the post-COVID-19 world.
ESG investments look good
The perennial question around ESG investing has been whether it carries a “cost premium”: that is, do investors settle for lower financial returns in exchange for having their investments address social considerations? It seems that they do not have to compromise. Initial data indicate that ESG-focused funds have actually fared better than their traditional peers during this period of market volatility.
For instance, S&P Global Market Intelligence analyzed the performance of 17 exchange-traded and mutual funds for the year until May 15, 2020. Each has more than US$250 million in assets under management and makes investments based on criteria that include ESG factors. Of the sample, 14 lost less value than the S&P 500. Nuveen Winslow Large-Cap Growth ESG Fund, the top performer, gained 3.4 percent, compared with the 11.4 percent decline in the S&P 500. A similar study from HSBC found that climate-focused shares outperformed others by 7.6 percent from December 10, 2019, to March 23, 2020. Another analysis, by Morningstar, indicates that from March 1 to 20 this year, large-cap ESG equity indices outperformed their conventional peers.
Several explanations have been suggested. ESG funds tend to have outsized holdings in technology-focused firms that have done well in this crisis, and they have fewer investments than other funds do in fossil fuel companies, which have suffered steep declines in the value of their assets. But it could also be that ESG-focused companies have a more holistic approach to risk management. A lower cost of capital, experience in thoughtful engagement with suppliers and strong relationships with external stakeholders all contribute to reduced risks from extreme events and economic shocks like the one brought on by COVID-19.
For institutional investors with a long-term horizon, such as pension funds and wealth managers, ESG investing may emerge as an enduring risk management strategy. In an April survey by the financial consulting firm Millani of 23 Canadian institutional investors, representing C$2.3 trillion in assets under management, 74 percent said they believe the pandemic will have a positive impact on ESG investing.
Another indicator of the considerable institutional appetite for ESG funds is the integration of ESG principles into existing non-ESG funds. In April and May, T. Rowe Price, BlackRock and Union Bancaire Privée amended their traditional portfolio funds to incorporate ESG criteria.
The strength of a company’s relationships with its workforce, suppliers and environment, as reported in a company’s ESG disclosures, shapes investors’ decisions about which stocks to buy. Given the light this crisis has shed on ESG risk management, firms with inadequate risk disclosure are being shunned by investors. For example, when many companies held their annual meetings this spring, BlackRock withheld votes for certain senior board members of companies that it deemed to have provided inadequate ESG disclosure.
The growing demand for ESG disclosures is also being increasingly driven by public authorities who are requiring disclosure of major companies’ approaches to sustainability. In Canada, the federal government’s Large Employer Emergency Financing Facility, which provides bridge financing to Canada’s large companies affected by COVID-19, requires recipients to publish annual climate-risk disclosures. The disclosures must be consistent with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), an international body established by G20 leaders to improve the efficiency of these disclosures.
In the United States, the Investor Advisory Committee of the Securities and Exchange Commission issued a strongly worded recommendation relating to ESG disclosure and urged the commission to include reporting of “material, decision-useful, ESG factors” in companies’ public filings (such as annual reports). In the United Kingdom, the Financial Conduct Authority has published a consultation paper proposing that all issuers with a premium listing (mostly companies on the main board of the London Stock Exchange) make climate-risk disclosures consistent with TCFD recommendations or explain why they have not.
A second-order effect of the move toward enhanced sustainability disclosure is that market participants, stakeholders and regulators will push for standardized reporting that enables investors to more easily identify companies that perform better on ESG issues. Currently, a proliferation of overlapping, and sometimes conflicting, reporting frameworks has created confusion for investors and “reporting fatigue” for companies.
This year, influential asset managers like BlackRock and State Street have made the case for the TCFD and the Sustainability Accounting Standards Board, a US-based nonprofit that develops such standards for publicly listed corporations, to integrate their climate-risk disclosure standards. The combination of two key global reporting regimes should reduce reporting fatigue and provide more comparable ESG data.
Another step in this direction is the publication of the European Union’s report on a sustainable finance “taxonomy.” The EU’s technical expert group considers the taxonomy tool to be “one of the most significant developments in sustainable finance.” From a practical perspective, the report provides general-use definitions for sustainable investment and details industry-specific metrics for companies to achieve targets of the Paris Agreement.
The “S” in ESG
The “S” in ESG, the social factor, is normally associated with how a company manages its relationships with employees, suppliers and the communities where it operates. In the pandemic, it has become more prominent. Case in point: over 300 institutional investors, managing more than US$8 trillion in assets, issued a public statement urging businesses to provide paid leave, prioritize the health and safety of their employees, retain workers and maintain supplier relationships.
Large corporations are paying attention to social concerns too. Unilever offered early payment to its small and medium-sized suppliers to ease their liquidity concerns. Canadian miner Barrick Gold purchased more than 800,000 finger-prick antibody testing kits for its workers and communities living close to its mines. Facebook extended a month of paid leave to its employees to care for sick family members.
The COVID-19 crisis has forced public, private and other organizations to tap liquidity from all available sources, and many have turned to bonds to finance social projects. “Social bonds” are debt instruments that raise capital for social projects, including affordable housing, health and education. This year these social-finance instruments came out of the shadows.
According to the International Capital Market Association, social bond issuance for 2020 totalled US$11.58 billion as of May 15, compared with just US$6.24 billion during the corresponding period last year. Issuers have included the World Bank, the Nordic Investment Bank and cities, including Toronto. Announcing the program in May, Toronto’s mayor, John Tory, said that the city planned to issue up to C$100 million in social bonds in 2020 to fund capital projects for various social initiatives, including drinking water access, sanitation systems and transit.
This pandemic has laid bare the damaging consequences of neglecting warning signs of our strained relationship with natural forces. We can take some solace from the growing signs that this challenging moment will be a catalyst for the wider adoption of ESG strategies, frameworks and systems that can help our societies withstand inevitable future shocks.
This article is part of the The Coronavirus Pandemic: Canada’s Response special feature.