A growing number of investors believe that companies with strong environmental, social and governance (ESG) policies and responsible governance are more resilient and financially successful. The COVID-19 pandemic may be a case in point.
The ESG investment approach
The ESG investment strategy can be described as “the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process (opens a new window)”. ESG investing involves a systematic consideration of specified ESG issues throughout the entire investment process in order to increase returns and reduce risk.
Boosting investment returns
Research shows that sustainable business practices do translate into higher financial performance. A meta-study by the University of Oxford (From the stockholder to the stakeholder: How sustainability can drive financial outperformance (opens a new window)), for example, analysed more than 200 academic studies, industry reports, newspaper articles and books and found “a remarkable correlation between diligent sustainability business practices and economic performance: 88% of reviewed sources find that companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into cash flows.
Better management of environmental and social factors can minimise costs as well as mitigate risks, while creating opportunities to boost income. Moving production facilities closer to suppliers, for example, can not only reduce greenhouse gas emissions associated with transport but also reduce costs, creating both environmental and financial benefits.
Investors are acting upon it. In 2019, annual European sustainable fund flows increased (opens a new window) to a record-breaking €120bn from €50bn in 2018, according to data by financial services provider Morningstar.
Individual and institutional investors alike are investing massive pools of capital in corporations that proactively govern and operate in an ethical and sustainable manner. These companies in turn benefit from higher valuations through cheaper credit conditions, for example, to expand operations.
While Morningstar noted that inflows into sustainable funds accelerated towards the end of 2019, there is evidence that the COVID-19 pandemic has, if anything, made such investments look even more attractive.
COVID-19 brings ESG to the fore
People all over the globe have noted the much improved air quality in cities due to the reduced economic activity during lockdown. Bicycle sales have boomed during the pandemic, and this may well be more than just a fad. Many cities took the opportunity that inner cities were deserted to expand bicycle paths and block streets for car traffic to increase the outside space for the population to use.
COVID-19 has also made consumers realise how close supply chains are to their own lives, making them more aware of people on the other end, the workers who got sick or who got fired from one day to the next. Gig economy businesses like Instacart, DoorDash, Uber or Lyft, for example, have introduced (opens a new window) paid sick leave for workers diagnosed with COVID-19 during the crisis.
Perhaps unsurprisingly, many financial indices tracking ESG assessed funds have performed better than the average market during the pandemic.
While the S&P 500 (opens a new window) has gained 2.74% between January 1 and September 21, 2020, the S&P 500 ESG Index (opens a new window) gained 4.43%, the iShares ESG Aware MSCI USA ETF (opens a new window) gained 5.90% and the Vanguard ESG U.S. Stock ETF (opens a new window) grew 7.67%.
There is of course, a risk that ESG will be put aside again after the crisis, but the main arguments supporting an ESG driven strategy will remain valid.
Companies that treat employees well, enhance the diversity of teams, give back to communities, and take a stand on sustainable environmental policies are strengthening their brand. Millennials are more likely to note good corporate actors and reward them with loyalty as consumers, employees or investors. Companies that deliver on strong ESG values are also more likely to attract and retain the best talent. And, governments and regulators are increasingly eager to introduce rules that promote ESG at companies.
Tougher regulation
Companies are also facing additional regulation related to ESG. The UK government is, for example, conducting a consultation (opens a new window) on a new "supply chain due diligence" law aimed at protecting global rainforests and other sensitive habitats, law firm Dentons noted in an article by partner Stephen Shergold.
In its current form, "due diligence on forest risk commodities" would introduce a duty on large businesses that use forest risk products to ensure they are not sourced from illegally cleared rainforests. Companies would be required to publish their due diligence plans, report on performance and face fines and other sanctions in case of breaches. Laws such as the UK's Modern Slavery Act or France's Devoir de Vigilance have showed the way, and active regulation of environmental and social performance in a global supply chain may be next.
Germany is also planning to introduce (opens a new window) a due diligence law for supply chains which would force companies to ensure human rights and social minimum standards are met in their supply chains if approved.
Further, investors are getting more standardised tools (opens a new window) to assess company standards and policies. The International Organisation of Securities Commissions, the global umbrella body for securities regulators, is seeking to harmonise the patchwork of rules governing how companies disclose sustainability risks. The aim is to identify “commonalities” among the vast range of sustainability disclosure standards from across the world in order to make it easier to compare information. The move could be a game-changer for the green finance sector, according to market observers.
Businesses that adhere to higher ESG standards are likely to be more resilient to future ESG-related policies, regulations, and potential reputation risk in unregulated markets. Companies that proactively address ESG issues can set the standard for their sector while minimising the risk of activist intervention.
The risk of ignoring ESG
Non-adherence to sound ESG practices can represent a considerable risk for the company and shareholders. Activists use governance weaknesses for campaigns against companies. Similarly, shareholders sue companies that don’t deliver on their ESG promises.
In a recent example, shareholders have launched a flurry of lawsuits (opens a new window) in the US against major technology firms, alleging that the companies’ boards of directors violated federal securities laws and breached fiduciary duty by making misrepresentations about their commitment to diversity and inclusion on boards and in senior ranks.
Further, more than a dozen US states, counties and cities, from fire-ravaged California to flood-prone South Carolina, are suing oil companies (opens a new window) to hold them responsible for the damage plaintiffs say the companies’ products have caused by accelerating climate change.
Such legal battles can be expensive and companies dismissing stakeholder activism risk damage to the company’s reputation and value.
Governments are also increasingly taking a tough stance against companies that pollute the environment, enacting mechanisms for controlling pollution and water resources, introducing carbon pricing and cap-and-trade schemes for sulfur dioxide emissions and carbon emissions.
Satellite and data technologies are being used for remote surveillance of companies' assets and practices, enabling governments for example to monitor illegal fishing and deforestation.
Companies that take advantage of lax regulation in developing countries and disregard human rights in their operations or sourcing practices may not only face reputational damage but also a hit to revenues if calls to boycott their products are successful. Consequences can go even further: Allegations tied to ESG events can impact a company’s creditworthiness if the potential damage and cost are widely visible and considered to be material.
Reducing the ESG risk
Lockton’s environmental practice can assist companies achieve a low-carbon future. Managing legacy issues is a component of business strategy, especially within energy, fuel storage, chemicals and pharma.
Lockton is already accredited “Carbon Zero” – meaning all of our work, anywhere in the world, adds no carbon to your supply chain footprint.
We are augmenting existing insurance coverage with gradual pollution and legacy coverage as well as helping inform the risk management process with relevant experience focussed analysis.
Lockton can help companies assess and quantify ESG related risks as well as analyse them and produce recommendations, both with respect to future risks, such as ESG, as well as on assessment and transfer of legacy operations.
For further information, please contact:
James Alexander, Environmental Practice Leader
T: +44 (0)207 933 2068 | E: James.alexander@uk.lockton.com (opens a new window)
