COVID-19: Sharpening the Focus on ESG
How does the COVID-19 pandemic impact the growing investor focus on ESG? Is COVID-19 going to enhance the importance of ESG or diminish it? How should companies be thinking about ESG during this global crisis?
Looking at COVID-19 Through an ESG Lens
Over the past three decades, there has been a drastic shift from tangibles to intangibles as value drivers for the world’s largest companies. In 1975, 83% of S&P 500 company assets were tangible. In contrast, by 2015, 84% of assets of the same group were intangible. The global capital markets’ focus on ESG factors has highlighted the financial materiality of intangible risks and opportunities to companies – the COVID-19 pandemic is likely to sharpen this focus.
This pandemic has demonstrated the interconnectivity of ESG risks and opportunities. COVID-19 is inherently a social or “S” issue. Companies are grappling with an enormous range of short- and longer-term issues relating to their employees. Short-term issues include how to keep their employees safe, how to accommodate illness and caregiving responsibilities, how to keep employees engaged and productive when working remotely, while also supporting their mental health in a time of crisis and significant uncertainty. Longer-term issues include the potential impact on employees of more widespread virtual work, a potentially reduced workforce and the real or perceived additional health risk of business meetings and travel. How well (or poorly) a company deals with its workforce during this crisis will also likely have lasting brand and reputational impacts.
COVID-19 has also shone a light on the need for robust and effective corporate governance practices. To make it through this crisis, companies will need to demonstrate that they have robust risk management processes that can be mobilized quickly and effectively to protect facilities and (if possible) maintain critical operations. Over time, investors will also be scrutinizing how companies treat their employees and broader stakeholders during this time, including their suppliers, their customers and the communities in which they operate. The governance oversight of key decisions like capital allocation and share buy-backs will likely face renewed scrutiny. Executive compensation decisions that effectively connect pay with corporate performance and shareholder returns during the economic downturn, while also recognizing the extraordinary challenges faced by management during the crisis, will be particularly important.
This pandemic also has clear links to an environmental or “E” issue – climate change – which represents another systemic risk to the global economy and human health. The World Health Organization estimates that climate change will result in over 250,000 additional deaths per year between 2030 and 2050, resulting from increased malnutrition, malaria, diarrhea and heat stress alone. Further complicating the issue, the increasing frequency and severity of extreme weather events, particularly flooding, strongly affects water-borne diseases and diseases transmitted through insects and other cold-blooded animals. Changes in our climate are likely to lengthen the transmission seasons of vector-borne diseases and to alter their geographic range. As a result, dealing with the health effects of new diseases in new regions might become more common.
COVID-19 has shown how interconnected our health, the environment and the economy are to one another. The global response to this pandemic is having significant and profound social and economic implications. While many have warned of the risk of a global pandemic, that systemic risk was difficult to quantify and predict and it is fair to say that it was not at the forefront in the risk management processes of most companies or investors. Yet this largely unforeseen event has triggered a major collapse of the global economy. It is impacting every sector and every country. Even if prescient investors had tried to factor in the risk of a pandemic, there would have been no way to diversify away from its impacts.
Investors are Renewing Their Focus on ESG
Investor sentiment is that the importance of ESG isn’t diminishing, rather it is the opposite – the importance of ESG is being further enhanced and amplified in the current circumstances. Investors continue to focus on ESG factors through the COVID-19 lens, resulting in renewed attention to social factors, including human capital management, employee health and safety, and corporate culture.
The Principles for Responsible Investment (PRI) has issued guidance for its 2,250+ signatories on COVID-19 that calls on investors to undertake specific stewardship activities to promote long-term economic strength. In addition, the PRI has established two signatory participation groups to coordinate and develop investor responses, focusing on: 1) short-term responses, and ensuring responsible ESG approaches remain at the forefront of investor activities and 2) a future economic recovery phase, considering the how the financial system should function to ensure sustainable outcomes. These groups will encourage discussion and then support action on the highest priority areas for investors, companies and governments.
In addition, a coalition of institutional investors representing $6.4 trillion in assets under management have signed the Investor Statement on the Coronavirus Response, which calls on companies to take specific steps related to employee health and safety, human capital management, companies’ relationships with customers and suppliers, and their approach to executive compensation.
Several large institutional investors have issued public statements on the COVID-19 crisis, reinforcing their commitments to ESG integration and stewardship, including:
State Street Global Advisors’ Stewardship Engagement Guidance to Companies in Response to COVID-19: “We recognize that our engagement conversations will shift to more immediate ESG issues such as employee health, serving and protecting customers and ensuring the overall safety of supply chains in the context of the current crisis – the scope and duration of which none of us can predict… We continue to believe that material ESG issues must be part of the bigger picture and clearly articulated as part of your company’s overall business strategy.”
Andrew Howard, Head of Sustainable Research at asset manager Schroders PLC said: “We have long argued that companies don’t operate in a vacuum. Their success reflects their ability to adapt to challenges and trends in the societies to which they belong. That is more true now than ever; social and environmental challenges, and investment drivers, are increasingly overlapping.”
Interestingly, early performance data during the market downturn has suggested that strong ESG performance leads to stronger risk mitigation, lower downside and more business resilience in the face of economic shocks. Bloomberg research found that the top 20% of ESG-ranked stocks outperformed the US market by over five percentage points during the recent sell-off. Research from Morningstar found that 7 out of 10 sustainable equity funds finished in the top halves of their Morningstar Categories and 24 of 26 ESG-focused index funds outperformed their conventional counterparts.
How Should Companies Respond?
Given the pervasive impacts of the pandemic, almost every business has been impacted directly or indirectly. Good governance practices are a critical foundation for companies to respond to this changing economic landscape with a focus on emergency management, business continuity planning, supply chain resilience, and maintaining strong corporate culture during an unprecedented shift to remote working arrangements.
Companies must be mindful of investor expectations on ESG and how these expectations are evolving to focus on a company’s response to COVID-19. Companies should be prepared to answer questions from investors on ESG topics such as human capital management, corporate culture, business resilience, executive compensation and how COVID-19 impacts other material ESG factors. Additionally, how businesses react to COVID-19 sends a signal to investors and other stakeholders (including employees and customers) on how the company is likely to respond to systemic ESG issues in the future.
The role of business in society continues to evolve and proactive companies are using this as an opportunity to highlight their commitment to their employees and other stakeholders, as well as the communities in which they operate. Companies that do this well are likely to engender significant loyalty and goodwill with their employees and other stakeholders, with positive impacts to their brand and reputation likely resulting. In contrast, companies that do it poorly are likely to lose goodwill and brand value, while also becoming likely targets for shareholder engagement.
In fact, Citigroup Inc. has already revealed that investors are asking more questions about ESG issues, such as employee benefits and mortgage relief, to understand corporate strategies to limit the economic damage from the pandemic while preserving important business relationships. The bank said it expects the pandemic to affect its relative priorities in ESG, including, for example, a renewed focus on the pros and cons of having temporary workers and the use of stock buy-backs.
Jeff Meli, Global Head of Research at Barclays PLC stated: “Prior to the outbreak of COVID-19, finance was already at a tipping point, where the integration of sustainability concerns was becoming the norm. Today’s launch of Barclays’ Fundamental ESG Research is an opportunity to reflect on whether COVID-19 will accelerate this trend even further – creating a greater sense of urgency and responsibility toward everything from consumer behavior to climate change, supply-chain practices and the future of work and mobility – and potentially alter the nature of the investment process as a result.”
Strong ESG practices have never been more important than they are today. Business leaders are facing unprecedented challenges to their operations, supply chains and workforce as a result of this pandemic. The need for an urgent and widespread response to the broad issues and risks created by COVID-19 demonstrates why it is important for companies to establish a strong ESG strategy to ensure that they can quickly and effectively respond to other ESG issues that may occur in the future, such as physical climate impacts to supply chains and operations. Strategic plans need to reflect a resilience mindset to ensure they can adapt to rapidly changing circumstances and societal expectations.
Despite the global turmoil that is underway, many annual general meetings are continuing, albeit virtually in most cases. As detailed above, companies are likely going to face increased scrutiny on how they are managing ESG issues related to the pandemic and the economic downturn. This pandemic also has immediate impacts for companies’ annual reporting, including regulatory filings (e.g. MD&A and AIF) and voluntary ESG and sustainability reports. Companies need to ensure their risk disclosures adequately reflect the current circumstances and provide an appropriate level of detail about how they are responding to COVID-19 now and across different time horizons, given the uncertainty about how long the pandemic will continue.
Now is the time to double down on ESG programs and performance based on principles of adaptability, innovation and resilience, while respecting employees and broader stakeholders. Proactive businesses will use this opportunity to strengthen their corporate culture, brand and reputation to ensure they can adapt to future ESG-related challenges.
This document is for general information purposes only and is not intended to provide legal, accounting, investment, financial or other advice.