In light of the ongoing COVID-19 pandemic, we asked team members for their views on what COVID-19 means for ESG. Here’s what they had to say…
Is ESG a bull market phenomenon?
Ben Yeoh: No. The pandemic has shown that the resilience that comes from strong ESG practices, whether that is ascribed to the stewardship of the business model, human capital, or natural capital, will be even more important in down markets.
Neil Abbott: Not a single company I have talked to during the pandemic has suggested the need to compromise on ESG principles. The environmental benefits that have been evident due to lower levels of industrial activity have attracted the attention of some companies. We have also witnessed a remarkable acceleration of ‘social’ activities from companies, such as switching production to make PPE for healthcare workers, providing accommodation for homeless people, and extended paid vacation time for employees to cope with the stress and demands of the virus’s impact. Interestingly, governance has probably been somewhat compromised with companies needing to take quicker decisions to deal with unforeseen emergencies, but this seems to have been done in a way that most shareholders would have supported if they had been consulted.
Jeremy Richardson: There was a concern that the appetite for ESG would not stand up well under pressure from tough market conditions. However, on balance, the indications are that ESG is coming through this pretty well. For example, one popular ESG index, the MSCI ACWI ESG Universal Index, outperformed the mainstream MSCI ACWI Index by 1.6% in the first half of the year¹, and it has been reported that ESG-centric investment strategies have generally performed well. Some of this outperformance is likely attributed to being underweight fossil fuels at a time of falling energy prices. It has also been noted that ESG scoring methodologies appear to favour firms with fewer employees, which may be a systematic bias that skews results during a people-related pandemic. However, such criticisms are probably not sufficient to challenge the view that ESG has been broadly helpful to returns during the period.
How do you see the pandemic changing the focus on E, S and G considerations and will this be temporary or permanent?
Ben: Currently there is strong focus on ’S’ and we have been hearing this in our recent conversations with companies such as Amazon or UnitedHealth. But we know that these companies are not forgetting ’E’ either. For example, Amazon is still committed to its programs on Food Waste and Climate Action, although it admits that the immediate need to respond to the pandemic means that there will be delays in executing all of its plans.
Jeremy: It is clear that the need for management teams to respond to the profound operational challenges caused by the pandemic has stretched their ability to implement a number of initiatives that they had been working on and has raised new ones. A pivot to focusing on S-type issues has provided E with competition for attention, especially when slower economic activity has temporarily meant fewer emissions. It is a reminder that often those matters which are both important and urgent get seen to first; those that are seen as important but not urgent have to wait. Investors will understand some reprioritization during the teeth of the crisis but will also expect to see important climate and environmental projects picked up again at the earliest opportunity.
Habib Subjally: The pandemic has demonstrated the commercial relevance of ‘E’ and ‘S’. We have seen many examples of companies sacrificing short-term profits to respond to the pandemic and this being rewarded by an increase in the firms’ values. For example, Amazon sacrificed US$4bn of earnings to invest in its customers and employees, and was rewarded with an increase in its market cap. The same was seen at AstraZeneca when the company committed to supplying a potential vaccine on a no- profit basis. The pandemic has also shown how ‘S’ issues are getting more complex and nuanced. We have seen how social distancing in the workplace has highlighted possible sweat-shops in the clothing supply chain or how the pandemic is providing a new lens through which to see long-standing diversity issues. Such issues can lead to significant value destruction if not handled with sensitivity by companies.
Neil: The pandemic has changed the value systems for all corporates and the focus on ‘S’ may well be a permanent change in the balance of priorities.
Did ESG data help during the pandemic?
Habib: We have yet to see the data on this. Although the early indications seem to suggest they did, it is possible that the ESG scores are merely loading on other well-established factors that we know also did well into the downturn, such as quality or low- leverage. In time, a detailed risk attribution will be needed to tell us if there was any true ‘alpha’ there or if ESG was just borrowing returns from other factors.
Neil: Stock market performance is one thing, but just looking at company fundamentals we have seen that those companies that treat their employees with respect appear to have been rewarded with high degrees of engagement and flexibility during the pandemic period.
Jeremy: One of the more dramatic secondary effects of the pandemic was the fall in the price of oil as economic activity stalled. This benefitted non-fossil fuel business models, many of which have better environmental scores. It has also been noted how ESG data scores seem to tilt in favour of business models employing fewer people. This may be simply because they represent new industries, such as technology or digitally-enabled, rather than old industrial or manufacturing industries. But during a public health crisis, this unintentional bias may provide a perceived benefit in limiting a firm’s exposure to an ‘S’ issue. Of course, the pandemic isn’t over yet and so further research will be needed before we can say exactly how helpful ESG data was, but a recent paper focusing on the experience in the Chinese market supports both of these anecdotal observations. It found that strong ‘E’ and ‘G’ scores were helpful to performance, perhaps reflecting the fossil fuel effect, but that strong ‘S’ scores were unhelpful. This was perhaps because firms with a strong sense of social responsibility were less likely to aggressively cut staff costs and instead chose to accept lower profits in the short term.²
Has the pandemic changed what investors look for in terms of corporate reporting?
Jeremy: It has been noticeable that during the height of the pandemic investors were focusing on the important issues and de-prioritized others. So reassurance around liquidity and access to cash was considered essential given that lockdowns had stopped many companies from trading. Investors also appreciated knowing what companies were doing in order to ensure their own continuity after the pandemic – how were they looking after customers, employees and supply chains, for example? In contrast, investors largely accepted that there were some profound practical challenges in reporting the full suite of traditional data to the same timelines. I think this showed that the materiality of certain types of information was changed by the pandemic and I am encouraged that greater value was put on information relating to the stewardship of extra- financial capital, such as customer relationships and human capital. Hopefully this doesn’t prove to be temporary.
Habib: Like management teams, investors are suddenly realizing that ‘E’ and ‘S’ performance is more closely linked to changes in the value of a company. I expect more investors will be asking companies about the health of their environmental and social capital, leading to greater demand for alternative forms of reporting that doesn’t just focus on the financial numbers.
Neil: It is too early to say how corporate reporting may evolve but I suspect the role of corporates in supporting the wider community during the pandemic will be scrutinized. Corporates have an opportunity to use this episode in their communications with society to explain what worked, what didn’t and what lessons have been learnt.
Will the pandemic cause shareholder engagements to change?
Habib: Hopefully. I sincerely hope shareholders will encourage management to do the right thing to create value. Some are already doing it; several senior managers have said to us that they think the pandemic is a great opportunity to take market share over the long term by demonstrating their business values to clients and employees. Profits aren’t so important right now; what matters is how you stood by your employees and customers and did not extort them.
Neil: It’s too early to say, but again shareholders will be seeing good companies sacrificing short-term earnings to protect the longer-term wellbeing of their assets (people, brands, commercial relationships etc). This will need to be fully understood. Further, the approach to liquidity (which I would incorporate under Governance) has also been radically different during the pandemic, and this is something shareholders will need to engage on. It is quite possible that we will see corporates wanting to adopt much more conservative balance sheet structures in future, given the lessons from this pandemic.
Jeremy: We are seeing some very powerful secondary effects from the pandemic given how it appears to amplify some of the pre-existing inequalities within society. This is creating challenges for businesses who find themselves on either side of the debate, or even those like social media platforms that try to remain neutral and impartial. We are currently still seeing a lot of focus on climate-related proxy proposals but expect to see more social and diversity-related proposals surface in due course. We have been hearing in our conversations how culture, even within a single international business, can vary from office to office, so responding to these issues is unlikely to be simple and will require sensitivity from all parties.
Do you see governance structures changing as a result of the pandemic?
Neil: Not really, although it is clear that some companies have been able to cope better with the pandemic than others. Boards should be reflecting on this and, if not already present, adding pandemic- resilience planning to their strategy documents.
Jeremy: The pandemic has the potential to fundamentally change some of the assumptions of how companies should fund themselves. What we consider to be an ‘efficient’ balance sheet may change, for example, given the fragility caused by excessive debt and an over-distribution of profits. How companies are holding their AGMs is also changing out of necessity. Digital-only events may be a practical alternative for now, but we need to be mindful of the need to return to physical meetings as soon as we are able. They are an important part of maintaining management accountability, especially for smaller shareholders.
Luis: A lot of our companies mentioned their goals in figuring out the right thing to do. Some of these measures are a reflection of ongoing good governance and reinforce the mission. For example, Microsoft’s bold intention to become carbon negative has been supplemented by commitments on addressing racial injustice and also for re-training 25 million people for the digital jobs of the future. It is increasingly clear that governance is not just about risk management, because the pandemic has shown that when combined with a clear purpose that is shared across an organization, it can empower individuals to take the right decisions on a timely basis and creates a resilient and more sustainable business.
What has surprised you most?
Ben: I have been positively surprised by the strength of connection between a business’ extra-financial performance and its market valuation. It really does feel as if the pandemic has shone a light on the role of the ‘contingent assets’ we often talk about.
Habib: I have been struck by the lack of valuation support we have witnessed in parts of the market. In past recessions we have seen a sharp rotation away from momentum-winners into value names where there is support from dividend or book value. This time around value factors have been very poor. I would argue that this is because the market is more focused on extra-financial assets and liabilities, which are often referred to as ‘intangibles’. It seems these factors have been an important driver of performance, not traditional financial definitions of ‘value’.
Neil: The change in the risk profile of many businesses. For example, pub retailing, restaurants and hotels would traditionally be low-risk businesses with some predictable cyclicality, but COVID-19 has created a totally new demand environment, the like of which we haven’t seen before. In addition, the support for corporates from governments has been dramatic across many jurisdictions. It is not clear whether there will be long-term costs for corporates and their shareholders for relying on this support. Finally, the speed and magnitude of the change in the economic environment around the world has been unprecedented and this will most likely impact investor appetite for risk in the future.
Jeremy: I have been most surprised by how the pandemic has encouraged us to challenge many previous assumptions about how and where we work. The notion of travelling long distances to meet people in offices no longer seems quite so normal or obvious. This could have long-lasting effects on work patterns and how society allocates resources, including property, access to the internet and time. One of the big challenges to de-carbonizing the economy was the inertia of convention. But the pandemic represents a discontinuity and consequently has hopefully created an opportunity to consider new approaches.