As the world adapts to the profound changes resulting from COVID-19, one may be forgiven for assuming that environmental, social and governance (ESG) considerations have taken a backseat. But amidst a global pandemic, negative oil prices and stalling climate talks, it is hard to imagine a more critical juncture for ESG than the present.
In the short-term, asset and wealth managers will need to seriously consider ESG risks and opportunities highlighted by the current crisis, particularly given the scrutiny the upcoming ESG regulation is likely to bring.
As we move towards longer term recovery, asset managers should expect the integration of these factors into their business to be of even greater importance - in the eyes of regulators and their clients.
COVID-19 has highlighted a number of important ESG issues that buy-side firms need to be alert to in the context of integrating ESG risks and opportunities into their investment decision-making and wider organisational processes.
For instance, the fragility of global supply chains is likely to prompt investors to place greater emphasis on scrutinising the robustness of governance frameworks within investee companies, and the oversight of complex third-party networks.
The current crisis has also created more interest in social factors as a key consideration in ESG integration. This is particularly true in relation to business ethics and the treatment of the labour force.
Meanwhile, a sharp downturn in demand for energy could accelerate certain commodities and stocks becoming ‘stranded assets’, which are prematurely or rapidly devalued as a result of their carbon-intensive properties. While this phenomenon has already been identified as a long-term risk in the European Green Deal, the current environment could bring about change more quickly than anticipated, with substantial implications for balance sheet risk.
Sceptics may query whether such considerations ultimately translate into returns. But the focus on non-traditional risk that defines many ESG investing strategies already seems to be bearing fruit, with the average ESG fund reporting around half the losses incurred by the wider S&P 500 benchmark during the COVID-19 pandemic, with notably less volatility. In any case, firms will also need to be thinking about the potential positive impacts of new ESG factors on investment performance, such as those stemming from companies adopting innovative technologies and business models to support the response to the crisis.
Given the current volume of regulatory activity facing asset and wealth managers geared towards integrating and disclosing climate-related and wider ESG risks, including the incoming Taxonomy Regulation and ESG Disclosure Regulation, firms can expect regulators to be paying close attention to how these types of COVID-19 ESG issues are being handled across the industry.
Asset managers should also expect greater regulatory focus on these issues when scrutinising approaches to stewardship. Only months after the revised Stewardship Code was published, and less than a year since the revised Shareholder Rights Directive took effect, investors have been presented with an opportunity to demonstrate their commitment to the stewardship of capital by prioritising sustainable returns over short-term demands. Firms should consider their engagement with investee companies on issues such as workers’ safety and the prioritisation of financial prudence over executive remuneration and shareholder payouts.
The FCA’s current focus on product governance in the sector presents a clear opportunity for the regulator to assess how firms are managing the risk of ‘greenwashing’. Under volatile market conditions, firms may be tempted to loosen their focus on ESG, but funds marketed as sustainable must be respected - not least to satisfy the regulator and clients that the fund is what it says on the tin.
When the dust settles, the renewed importance placed on sustainability is likely to influence the nature of any future economic recovery. The EU Technical Expert Group on Sustainable Finance has already stated that a number of the key regulatory initiatives established under the Sustainable Finance Action Plan will be essential in supporting sustainable economic revival. Firms can, therefore, expect the sustainable finance agenda to move even further up policymakers’ radars.
Whichever form recovery takes, it is unlikely that we will return to a business as usual landscape when it comes to ESG issues. COVID-19 has cast light on environmental and social issues that will continue to move up firms’ risk registers in future, and the more advanced firms are likely to be thinking about how to move beyond minimum regulatory compliance and embrace ESG issues in a truly transformational sense. In an uncertain market environment, one thing does appear increasingly certain - ESG will be at the forefront of investors’ minds for years to come.