Environmental, social and governance (ESG)

Over recent months, there has been much talk of the impact of Covid-19 on the environment. At the same time you may have become aware of the term ESG in the news. Here, international fund manager JP Morgan investigates the importance of ESG.

Covid-19 shows ESG matters more than ever

At the start of the year, sustainability was at the top of the political agenda, with new climate initiatives ranging from the organisation of the COP 26 UN Climate Change Conference to the launch of the Green Deal in Europe. Sustainable investing was on the trajectory to the mainstream, with asset managers prioritising the integration of material environmental, social and governance (ESG) factors into existing investment solutions, while the development of new sustainable investment solutions continued to accelerate.

However, the Covid-19 crisis unfortunately changed the priorities, with policymakers having no choice but to focus on crisis management and to redirect already scarce financial resources to support their economies.

Has the pandemic slowed down the momentum for sustainable investing? Market flows suggest otherwise. In the U.S., for example, Morningstar reported almost USD 10 billion of inflows to sustainable open-end mutual funds and exchange-traded funds in Q1 2020, already over half the total for the whole of 2019.

For investors, we believe the crisis will ultimately accelerate the ESG agenda, with wide-ranging repercussions. Environment is, of course, only one aspect of the equation. The crisis also highlights the importance of social and governance factors, with better governed companies proving to be more resilient so far.

Environment: Loss of momentum outweighs short-term benefits

The first conclusion about the environmental impact of the Covid-19 crisis is often that it is positive. Satellite images show a substantial drop in nitrogen dioxide concentrations in many countries. However, these short-term environmental benefits come with an important loss of momentum in the fight against climate change.

The Covid-19 crisis led to the cancellation of many climate demonstrations and, more importantly, to the postponement of the COP 26 Climate Conference to 2021. This is a significant setback. The US National Oceanic and Atmosphere Administration recently announced that 2020 could well become the warmest year on record. We cannot afford to lose an additional year.

The short-term reduction in greenhouse gas emissions could also be overshadowed by a rapid rise in fossil fuel consumption as economies start to reopen and recover – with low energy prices potentially exacerbating the increase. This was true for the 2008 financial crisis, when emissions initially fell from 32 gigatonnes (2008) to 31.5 (2009) before rising again to 33.2 in 2010.

However, technological advances offer some hope. The cost of producing electricity from renewable power is becoming increasingly competitive, as is the cost of battery storage, which should help to contain the rise in greenhouse gases. In addition, the volatility in oil prices adds to the pressure on oil-dependent nations to diversify their revenue sources, boding well for a greener future.

On the policy front, Europe’s green recovery plan is just one indication that climate risk mitigation policies have only been postponed, and that governments and companies will recognise the need to step up their climate adaptation measures to be better prepared for the next crisis.

Social: Covid-19 magnifies and increases inequality

Covid-19, probably more than any previous crisis, has magnified and increased inequality: between those who have access to efficient healthcare systems and those who have not, between those with the ability to work from home and those without.

This is true both within societies and across countries. Healthcare systems in many poorer countries are less equipped to deal with this crisis. However, it’s probably on the economic front that poorer countries will be hit the hardest, given their reliance on remittances from their diaspora in rich countries.

In addition, measures implemented to deal with the crisis, such as more generous unemployment benefits and furlough schemes, tend only to apply to those with an official work contract. In many emerging economies, most people don’t have contracts, but live from small jobs in the informal economy. For those people, working from home means no income.

As well as the short-term consequences, we expect the crisis to have some significant longer-term implications. One notable example is job displacement due to automation. Estimates suggest that around one third of the global workforce will have their jobs disrupted by artificial intelligence and automation over the next decade. Jobs replaced by automation during the crisis could be gone forever. Governments face the risk that resultant huge disparities among workers will lead to heightened populism. We believe companies will need to step up investment in their human capital through continuous training and health and safety improvements. While these measures will inevitably increase unit labour costs, in the long run a more skilled workforce should help companies to achieve more sustainable growth.

In summary, a wide range of “S” factors are likely to exacerbate inequalities in societies and increase unit labour costs, potentially impacting the speed of economic recovery and corporate profitability.

Governance: Covid-19 shows the value of good governance

This crisis is serving as a large-scale stress test of corporate resilience. The sudden loss of income in many sectors, together with the need to completely and rapidly reorganise value chains and methods of interacting with employees and customers, has proven disruptive for many businesses around the world.

As one would expect, companies with the best governance have fared better. Defensive capital allocation strategies have been rewarded as the level of cash on the balance sheet has suddenly become a more interesting metric for investors than the dividend yield – which in many cases will be reduced anyway due to decreasing earnings and/or regulatory pressures.

As well as navigating the crisis, boards will need to ensure they maintain a focus on long-term sustainability. Companies have good economic reason to retain a higher cash reserve by withholding dividend pay-outs and share buybacks in these unusual times, but ultimately this will hurt income-dependent shareholders. Boards and management will need to find the right balance between shareholder rights and the rights of other stakeholders, and between short- and long-term priorities.

Conclusion

The Covid-19 crisis once again highlights that ESG factors can have significant implications for the economy and for society. Embracing ESG is not a vague distant goal, but something that immediately strengthens the resilience of our societies and companies.

At a time when governments need to reorient their focus towards crisis management, it’s up to private investors to step in and fill the gap to ensure that their long-term savings help to support our long-term goals.

Stricter regulations will further encourage the shift. Indeed, as governments face more financial constraints in achieving their sustainability goals, they may well focus on the regulatory framework to encourage private investors to finance ESG initiatives.

David Kneeshaw – CEO of IFGL

Message from the CEO – September 2020

Moving forward

As you will know by now, Friends Provident International (FPI) is now part of International Financial Group Limited (IFGL). As the CEO of IFGL, I am delighted that the transaction is now complete and have the opportunity to speak to you.

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