Environmental, Social and Governance (ESG) factors and impact investing

Read time: 10 minutes

Amongst the clouds of economic uncertainty, ESG and impact investing shine through

January seems like a lifetime ago. The UK formally cut ties with the EU, Australia continued to battle devastating bushfires, and Harry and Meghan departed for Canada. At the same time, world leaders heralded the arrival of 'stakeholder capitalism' in Davos.

"People are revolting against the economic ‘elites’ they believe have betrayed them, and our efforts to keep global warming limited to 1.5°C are falling dangerously short" said Professor Klaus Schwab, Founder and Executive Chairman at the World Economic Forum. "With the world at such critical crossroads, this year we must develop a ‘Davos Manifesto 2020’ to reimagine the purpose and scorecards for companies and governments."

2020 was declared by Sir David Attenborough as the year of action against climate change in the run up to the UN Climate Change Conference (COP26) in Glasgow this November. However, with global financial markets now in Coronavirus-induced turmoil and COP26 postponed, how will COVID-19 change the outlook for Environmental, Social and Governance (ESG) factors from an engagement and performance perspective?

ESG standardisation of classification

We should acknowledge at the outset, there is a degree of ambiguity about what constitutes 'sustainable'. Some ESG funds, for instance, work proactively toward certain ESG goals, whilst others simply exclude negative ESG behaviours.

For investors, the absence of a codified ESG structure can mean substantial variations in the performance of different benchmarks. For example, as Investors Chronicle states in its article ESG's healing power, investors can "treat the ESG scores like any other stock screen metric: as a starting point for further research."

However, the legal framework is set to become far more rigorous. The EU's draft Taxonomy Regulation will set uniform ESG benchmarks, require companies to consider sustainability risks and to disclose how ESG is integrated into their investment process.

Investor engagement

As the Wall Street Journal reported,"environmental, social and governance investing was growing in popularity before the virus began to circulate, as investors flocked to companies that have taken steps to manage nonfinancial risks related to matters such as climate change, board diversity or human rights issues in the supply chain."

We also saw from Michelmores' own recent Millennials, Money & Myths Survey that there is not only an increasing appetite, but also a sense of duty of responsibility, amongst millennials (as well as older investors) to use their money to have a positive impact on the world.

One might suspect investors would revert to more traditional forms of investment, which may be perceived as 'safer', in times of unprecedented market volatility. Only time will tell, but initial signs are positive for the growing role of ESG factors in the global economy.

With interest rates on savings at record lows (at least in the United Kingdom), the variety and scope of broader ESG, and more focused impact investment, opportunities has permitted institutions and individuals alike to marry profit with principles. This approach ensures that investors can align their portfolios with financial and non-financial targets, for instance in respect to climate change, health and education.

Indeed, incorporating ESG criteria into an investment does not have to be a trade-off with financial return. As explained in further detail below, sustainable funds outperformed more conventional funds in the first quarter of 2020, even as the Coronavirus outbreak sent markets crashing.

Acknowledging the potential for fund managers and asset owners to panic and seek to withdraw capital in light of liquidity pressures, as well as declining fee revenues, the UN Principles for Responsible Investing (PRI) urged investors to hold their nerve:

"As for the responsible investment community, it’s time for us to step up and play our role as long-term holders of capital, to call corporations to account. It’s time for asset owners sitting at the apex of the investment chain to lead the financial sector through this crisis. We need to maintain a focus on long-term horizons and support collective action while trying to understand the real issues companies are facing from COVID-19 as well as the flow on effects to our individual portfolios." Fiona Reynolds, CEO, Principles for Responsible Investment

Accordingly, for the long term, the PRI aims to ensure responsible investors are influential when the recovery process begins. In the short term, amongst seven immediate investor actions, this year’s AGM season is seen as crucial for investors to demand that companies treat their workers, suppliers and customers well through the pandemic.

It appears these demands are high on the priority list. About 66% of shareholder proposals filed for the 2020 voting season deal with environmental and social issues, as opposed to governance topics, stated Nuveen, an asset manager, in a recent proxy voting preview report, whilst 77% of the environmental proposals deal with climate change.

"During the 2020 proxy season, we expect corporations who fail to adequately address ESG issues to face additional scrutiny from stakeholders." (Nuveen)

Public engagement and scrutiny

There are not only searching questions from investors, but also wider public scrutiny. Record numbers tune in to watch the news, whilst lists of 'saints' and 'sinners' are compiled daily on social media. One research agency, Populus, reported that "the public are more responsive than ever to what businesses are or are not doing to support the country in its hour of need. The early introduction of elderly shopping hour by Sainsbury’s, for example, has helped to consolidate its position as the business perceived to be handling the crisis best (64% think it is doing well, up from 48% three weeks ago). Dyson has boosted its reputation by responding to the Government’s call to design and produce thousands of ventilators for the NHS at short notice."

Source: Populus (fieldwork carried out between 3-5 April, among 2,093 members of the public. Showing selected organisations from a wider list)

On the other hand, organisations perceived to be taking advantage of workers, customers or public finances (such as certain other large retailers and football clubs) are in the crosshairs.

Viewpoints on the anticipated adoption of ESG factors

Meanwhile, Barclays makes the following observations in their new ESG research publication:

"Prior to the outbreak of COVID-19, finance was already at a tipping point, where the integration of sustainability concerns was becoming the norm…COVID-19 will accelerate this trend [towards ESG] even further — creating a greater sense of urgency and responsibility toward everything from consumer behaviour 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." Jeff Meli, Global Head of Research at Barclays

Aberdeen Standard Investment's 2020 survey supports this view. Merrick McKay, the firm's head of European private equity commented: "The general trend suggests that private equity firms are regarding ESG as increasingly important, with firms based in Europe leading the way. There's still scope for improvement in terms of their ability to measure and monitor against key ESG-related metrics [particularly the UN Sustainable Development Goals] and this is something that we will be encouraging during our discussions with GPs."

It is clear that the conversation is changing, and even more so during this pandemic. The Aberdeen report shows that ESG awareness is increasing across the private equity world and the PRI points towards high growth in the number of its signatories, particularly from the United States.

We have also seen a social shift in the bond market, through the growing issuance of green, social and sustainability bonds:

"The Coronavirus is a social issue that has brought unprecedented disruption to societies and is impacting the wellbeing of the world’s population. Capital markets are responding to this challenge with more than $9 billion of social bonds issued in the past three weeks, all from supranational entities. However, more can be done, and this presents a great opportunity for governments to follow suit." Simon Bond, Director of Responsible Investment Portfolio Management, Columbia Threadneedle Investments

Performance

Our Millennials, Money & Myths Survey showed that, whilst affluent millennials feel a responsibility to use their money to have a positive impact on the world, there is a perception that impact investment is less profitable than other types of investment (as shown below).

Indeed, Forbes recently published the first in a series of articles titled Does Impact Investing Always Come At A Price? As you might expect, the answer is complex. According to impact investment researcher and advisor, Rachael Browning, "It is stuck in both the old way of perceiving 'returns' and the hope for doing things better in future, in a world that desperately needs ambitious impact-driven capital."

Although the market is in its infancy, the initial data on returns is positive and counters the pessimistic perception. Pre-Coronavirus, numerous reports showed better or comparable returns for impact investments. Under Coronavirus conditions, investment research firm Morningstar reported that, for the first quarter of 2020, 70% of sustainable equity funds recorded returns in the top halves of their broad-based peer group. Of those, 44% scored within the top quartile. When the full extent of the pandemic became clear in early March, ESG-aware companies outperformed other global stocks by about 7%, HSBC found.

In Europe, a Bank of America study found that the 50 shares held by ESG funds in the most overweight proportion, compared with their size in benchmark indices, beat the most underweighted shares by 10%. Investors Chronicle observes that ESG is not a bull market luxury but, instead, adds resilience to portfolios.

Granted, sustainable funds still suffered heavy losses amid last month's downturn. However, it is encouraging to see that losses in 'sustainable' funds were notably lower compared to traditional funds. Morningstar's head of sustainability research, Jon Hale, explained that companies that attend to their environmental challenges, treat their stakeholders well, and govern themselves in an ethical way are proving to be more resilient during this crisis.

Charles Stanley, one of the leading investment management companies in the UK, backs up this view in its Investing with Conscience guide:

"There is evidence that some responsible investing approaches can lead to higher shareholder returns. Businesses that address short-term risks whilst adapting to longer-term structural trends should have more chance of success than ones that don’t. Poor environmental, social and governance practices, meanwhile, ultimately might be harmful to a business. Responsible investing means favouring companies that value long-term sustainability, not just short-term profitability, and in the long run that can lead to better long-term returns for shareholders." Investing with Conscience, Charles Stanley Direct

The future

As Investors Chronicle recognises, before the global pandemic arrived, ESG was the "hot investment topic". However, we have seen that asset owners such as sovereign wealth funds, large pension funds and endowment funds, have continued to demand that their money is, at the very least, invested in a way that does not exacerbate problems such as climate change – and, hopefully, in a way that helps to solve them.

ESG-conscious millennials, who will soon benefit from one of the biggest generational wealth transfers from their Baby Boomer parents, are looking to invest conscientiously and are looking to the right type of products to facilitate this.

BlackRock, the world’s largest asset manager, says that because flows into ESG investment have so far been in their early stages, "full consequences of a shift to sustainable investing are not yet in market prices – and a return advantage can be gained during this transition."

The responsible investor may indeed be a financially wise one.

For further information on Michelmores' Impact Investing practice, please contact Joe Whitfield or James Whistler.

This article is for information purposes only and is not a substitute for legal advice and should not be relied upon as such. Please contact our specialist lawyers to discuss any issues you are facing.