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If there’s anything the novel coronavirus pandemic has shown us, it’s how deeply interconnected so many of our basic survival systems are. This comes as no surprise to investors who incorporate environmental, social and governance (ESG) analysis into their strategies. In expert hands, an ESG investment lens teases out all sorts of risks that aren’t necessarily apparent in conventional financial analysis.
It’s not just theoretical: Amid plunging stock markets, ESG investments have fared better than the overall market. During March, 62 percent of ESG-focused large-cap equity funds outperformed that index, according to Morningstar.
So far this year, 59 percent of U.S. exchange-traded funds focused on ESG performance are beating the S&P 500 Index, according to Bloomberg Intelligence. That outperformance could spur further demand for ESG funds — an area already attracting growing investment before the pandemic hit.
What might be behind this? One of the fundamental aspects of fully integrated ESG analysis is a recognition that most issues that affect the business world (and the world in general) are interrelated and cannot be evaluated in isolation. This truth rises in stark relief as infections spread exponentially across the globe and basic economic systems falter under increasingly stringent containment measures.
Supply chain clarity
Global supply chains present an excellent example. ESG investors regularly focus on supply-chain transparency as they consider how companies manage human rights abuses in commodity mining and environmental damage associated with deforestation and overfishing, among other concerns. These challenges often occur many steps up a supply chain, and when companies struggle to address them, it’s often because they simply don’t know much about where their raw materials really come from and who provided them.
In a similar vein, as this pandemic started to disrupt supply lines from China as its authorities began to shut down economic activity, many companies were caught by surprise when their own products or services were affected.
According to Jennifer Bisceglie, CEO of risk management platform Interos, most companies never really have thought about their supply-chain risk, and even those that do often go only as far as their direct suppliers. Few understand or consider the complex web of interactions that must occur in order for those direct suppliers to fulfill their commitments.
Harvard Business Review (HBR) recently echoed this sentiment, noting how critical it is for companies to know their suppliers. While the scale of this pandemic is unprecedented, it is far from the first occurrence of supply-chain shocks. The HBR reminds us, “After the 2011 Sendai earthquake in Japan, it took weeks for many companies to understand their exposure to the disaster because they were unfamiliar with upstream suppliers. At that point, any available capacity was gone.”
ESG questions, data-driven answers
Jeff Meli, global head of research at Barclays, said companies should expect more questions from investors about their resilience and contingency planning, according to a recent Wall Street Journal article. For example, investors necessarily will want to know more about employee sick leave policies, disaster preparedness and the like.
Such questions come at a time when innovations in artificial intelligence (AI) and machine learning allow third parties to provide data-driven intelligence on companies that well could contradict their public reporting.
For instance, AI-powered data providers are capable of scouring social media posts around the world to see how companies’ employees are talking about their company’s response to the pandemic, allowing investors to determine how well the results stack up against company disclosures. As one financial analyst (who asked that their name be withheld) told GreenBiz: “The data will pick up the hypocrisy.”
Truvalue Labs, which uses AI to uncover timely ESG data on a variety of asset classes, already has identified the emergence of material issues that are specific to COVID-19, including employee health and safety, labor practices and supply-chain management.
Outperformance factors
Many observers believe that strong ESG performance indicates better management, which translates into stronger long-term returns. The idea is that management teams that do a good job of minimizing their environmental footprint, promoting good employee relations and creating resilient governance structures are more likely to be adept at running all other aspects of a company’s business.
“ESG funds tend to be biased towards higher-quality companies with a stronger balance sheet, companies that are run better and operate more efficiently,” Hortense Bioy, director of passive strategies and sustainability research at Morningstar, told the Financial Times.
An additional, complementary explanation has emerged recently. Adrian Lowcock, head of personal investing at Willis Owen, explained that funds with strict ESG selection criteria are the ones that have held up the best because they tend either to be under-invested in oil and gas or to exclude the sector entirely.
Indeed, sustainable investors have long been concerned about climate change and the prospect that fossil-fuel companies will lose value as the world eventually makes a concerted effort to address it. Oil and gas companies have been among the worst hit in the current downturn for a variety of reasons, not least because many of them are overleveraged and drowning in debt. But that, too, is connected to sustainability and climate considerations, and the whole point of deep ESG analysis is to understand the complex ecosystems within which companies operate.
Many investors have questioned how much climate change truly will present a material investment consideration anytime soon, given many world leaders’ reluctance to tackle the risk at a regulatory level. Here too, the current pandemic ultimately may prove to be a game-changer. Mark McDivitt, global head of ESG at State Street, told GreenBiz:
The United States plan to spend $2 trillion, or 10 percent of GDP, for economic stimulus has been critical to addressing this acute Black Swan event as it relates to the negative impact on our economy. What’s equally imperative but less obvious is the need to spend $2.4 trillion per year globally over the next decade to keep temperatures from rising 1.5 degrees C above pre-industrial levels — also a Black Swan event but on a “slow burn,” and with a demonstrably greater adverse impact than the fallout from COVID-19.
Science — which does not concern itself with political expediency — points to an ever-growing risk that climate change fallout will be at least as disruptive to society as the current pandemic, the more so the longer the world drags its feet on the sort of massive structural adjustment the Intergovernmental Panel on Climate Change says we need to make.
Some traditional investors have framed their resistance to ESG investing in terms of fiduciary duty, arguing that they are charged strictly with maximizing returns, not with pursuing environmental and social aims. Perhaps this pandemic will highlight the fact that ESG analysis, as McDivitt noted, is really just about evaluating 21st-century risks and opportunities.
If this pandemic demonstrates anything, it’s the need to pivot and begin addressing these long-term sustainability factors. Investment strategies that fully integrate ESG analysis surely will benefit.