Has ESG Passed the COVID-19 Challenge?

Catherine Ann Marshall, principal consultant at RealAlts, recently wrote a comment for the Canadian Investment Review on the slow burn of climate change in heat of pandemic:
Meeting a deadline in the midst of a pandemic seems like a good test of corporate resiliency and, according to a recent survey of Canadian Principles for Responsible Investment signatories that I conducted on behalf of my consulting firm Real Alts, the majority of respondents likely passed.

The survey found that almost 80 per cent of respondents met the annual PRI reporting deadline on March 31, 2020, just two weeks after the country entered lockdowns. In addition, only eight per cent of respondents reported having trouble meeting the deadline due to the novel coronavirus.

The fact that most respondents were able to report on time in the midst of significant business disruptions in late March is consistent with other data on bankruptcy and stock volatility that suggests strong environmental, social and governance practices may be associated with corporate resiliency.

However, before I give respondents a gold star for resiliency, I have to report a perplexing issue with the survey results. It found that all respondents said that new mandatory climate change questions included in this year’s PRI reporting requirements did not create a problem with submitting on time. However, further analysis of the survey shows that many respondents submitted their PRI report without completing the Task Force on Climate-related Financial Disclosures self-evaluation process, which five of the PRI report’s climate change questions were based on.

Specifically, when asked whether their organization had used the relatively new form of resiliency testing called scenario analysis to plan how to manage stress on these climate-related risks and opportunities, just 24 per cent of respondents had done so.

The respondents’ experiences seem to follow a pattern reported by TCFD last year. Of the 11 disclosures recommended by TCFD, the one with the biggest reporting increase was identifying climate-related risks and opportunities on business strategy. This suggests firms are finding it easier to do this work. However, there was only a marginal increase in reporting on scenario analysis over the last three years. The TCFD viewed the low increase in scenario reporting as significant and attributed it to “. . . the early stage of the learning curve for these analyses.”

The time and effort required to undertake scenario analysis may be at the heart of the difficulty in completing the TCFD questions in the PRI report. The survey showed that, on average, signatories had to put in a medium amount of time and effort into climate-change reporting they undertook. The time and effort to complete the scenario analysis section in the midst of a pandemic may have been too large a burden for these organizations.

Despite the heat of a global pandemic, the fact that PRI signatories surveyed were able to adapt quickly and report on time, is promising. But making a firm or investment strategy resilient is a journey, not a destination. Now is the time to build resiliency to climate change through scenario analysis, before a climate change-related disaster takes us by surprise.
I thank Cath for sharing this with me and have been meaning to post it on my blog as it is interesting how PRI signatories surveyed were able to adapt quickly and report on time.

Still, as she notes, there's more work that needs to get done and "now is the time to build resiliency to climate change through scenario analysis, before a climate change-related disaster takes us by surprise."

The global pandemic caught us by surprise (it shouldn't have) and something tells me if we don't properly prepare for the looming climate-change disaster, it too will catch the world by surprise (again, it shouldn't, it's coming and we'd better be prepared).

One thing is for sure, global investors are taking ESG extremely seriously across public and private markets.

In fact, last month, Attracta Mooney of the Financial Times reported that ESG has passed the Covid challenge:
When BlackRock boss Larry Fink announced plans in January to put sustainability at the heart of the world’s biggest asset manager’s investment strategy, there was no mention of the newly-emerging coronavirus in China.

In his annual missive to chief executives around the world, Mr Fink said the $6.47tn asset manager’s “conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors” as he outlined a radical shake-up of BlackRock’s investment approach.

The move came amid mounting hype about sustainable investing, which has jumped in popularity as investors have increasingly turned their attention to the impact that environmental, social and governance factors have on returns.

But the rapid growth — which came at a time of record highs in stock markets — was also met with large amounts of cynicism, with many sceptics arguing that asset and wealth managers and their clients would rapidly dump ESG investing once markets became volatile again and making profits became harder.

The emergence of coronavirus and its catastrophic impact on economies marks the first real test of just how dedicated investors are to sustainability, or whether ESG is a case of greenwashing, or PR spin.

So far, the cynics have been proved wrong: it is early days, but ESG seems to have met the Covid-19 challenge with flying colours.

“I don’t believe that the Covid pandemic will do any significant or lasting damage to investors’ commitment to socially responsible and environmental investing,” says Mona Shah, director of Stonehage Fleming Investment Management. “Most investors recognise that ESG and maximising profits are not mutually exclusive.”

Amin Rajan, chief executive of Create Research, a consultancy, believes the recent growth of ESG investing is likely to continue, even in a prolonged period of economic uncertainty that potentially offers lower returns. “If anything, it is likely to enhance the appeal of ESG investing once the dust has settled,” he says.

It is a view echoed by wealth managers across the UK, according to a survey carried out by the FT and Savanta, the market research company. Almost nine in 10 wealth managers polled believed that the Covid-19 pandemic would result in increased investor interest in ESG investing. Wealth managers such as Rathbone Brothers, Canaccord Genuity Wealth Management and James Hambro & Partners were among the 35 per cent that expected significant increases, while 52 per cent expected a slight increase.

Only 3 per cent of those polled said they believed interest in ESG would slightly decrease, while 10 per cent expected no change.

‘Part of something much bigger’

A key reason for the expected further rise in interest in ESG investing is that the crisis has shone a spotlight on the role good businesses play in society, says Rob Morgan, pensions & investments analyst at Charles Stanley, the wealth manager.

The pandemic has acted as a “reminder that we are all part of something much bigger and we have to think of others, not just ourselves”, he adds. “That feeling can also be reflected in our investments through socially responsible investing, so there is a direct link.”

Mr Morgan says there has been much discussion about how companies are reacting to the crisis. “There are examples of good and bad practices — and that has served to highlight that companies are part of the fabric of society,” he says.

Companies which have run into criticism include Mike Ashley’s Frasers Group, which briefly tried to keep open its Sports Direct chain of shops, despite a government ban on non-essential retail early in the crisis.

Other businesses have been praised for how they treated staff, or have slashed executive pay to share the burden of the crisis. “Companies are increasingly expected to do good as well as make money. Investors need to be aware of that,” says Mr Morgan.

Even now, the ESG agenda is not without its critics. They say that ESG has significant blind spots and distortions. For example, Vincent Deluard, global macro strategist at INTL FCStone, the financial services company, found that funds with an ESG focus are overweight in companies with few workers. “Despite its noble goal, ESG investing unintendedly spreads the greatest illnesses of post-industrial societies: winner-takes-all capitalism, monopolistic concentration, and the disappearance of jobs for normal people,” he said in a recent report.

But such voices are becoming rarer. Before the crisis, wealthy private investors were already more likely to invest in companies with high sustainability ratings, according to research from associate professor Amir Amel-Zadeh at Saïd Business School at the University of Oxford and professors Mary Pieterse-Bloem and Rik Lustermans at the Erasmus School of Economics, in Rotterdam.

Their study found that companies with a good sustainability rating received 15 per cent per cent more investment from wealthy investors every month over the years 2016-19, compared to those with a low rating. “Sustainability matters to investors,” says Mr Amel-Zadeh.

Andrew Lee, UBS Global Wealth Management’s head of sustainable and impact investing, says the coronavirus crisis accelerates sustainable investing’s importance. “The health crisis highlights the linkages between sustainability issues, the economy and corporate financial performance and thus heightens investor focus on these issues.”

In a poll of UK independent financial advisers (IFAs) by asset manager Federated Hermes, more than three-quarters of respondents believed investors would be motivated to divest from companies that have failed to support their employees or wider society through the crisis.

The Federated Hermes survey also found that 85 per cent of UK IFAs had seen a rise in client requests to allocate capital to ESG-integrated funds since the start of the Covid-19 outbreak.

While investors fled many mainstream investment funds during the March sell-off, ESG funds based in the UK had overall inflows, according to Morningstar, the data provider. Investors piled a net £2.9bn into ESG investment funds in the first three months of 2020, making it the second-best quarter for such funds.

Sustainable returns

The data also show that while net inflows slipped to £348m during March, they recovered fast to £1.05bn in April, a similar level to February.

Across Europe, sustainable funds pulled in €30bn in the first three months of 2020, compared with outflows of €148bn across European-based funds overall. Redemptions of €3.9bn from ESG funds in March turned into inflows of almost €12bn in April, the data show.

Harriet Steel, head of business development for the international business of Federated Hermes, says investors once backed ESG funds because they echoed their moral views, but there is now an increasing awareness that such funds often perform better too. “The crisis has brought into sharp focus that these [ESG risks] are not non-financial issues, they are financial risks,” she adds.

According to research from Charles Stanley, sustainable funds are far more likely to outperform the market than standard funds, whether over one, three, five or 10 years. For example, UK sustainable funds returned 9.1 per cent over the past five years, compared with a loss of -0.1 per cent for funds investing broadly across British stocks, the research finds.

A similar story has played out globally this year, according to research from BlackRock in May. It says sustainable strategies have outperformed during this period of intense volatility, with 94 per cent of a globally representative selection of widely-analysed sustainable indices outperforming their parent benchmarks in the first quarter.

BlackRock itself has shown no sign of backtracking on sustainability. It said in a staunch defence of ESG in May: “During the past few months, we have seen that regardless of industry, strong sustainability characteristics have been essential to helping companies weather the crisis, and investors have increasingly sought out sustainable investment strategies.”

In other words, the pandemic has only enhanced ESG’s investment appeal.
There's no doubt the pandemic has enhanced ESG's investment appeal and there are legitimate reasons to believe ESG investing is more robust and offers better returns over the long run.

The problem I have is when ESG hype overtakes reality and when investors start jumping on the ESG bandwagon without fully understanding the risks.

Look, of course BlackRock is praising ESG investing, it's in the business of asset gathering and charges fees for its ESG funds.

But when I see the insanity going on in the markets today, I can't help thinking that COVID-19 and the policy response is fueling an ESG bubble.

In particular, ESG investing is adding fuel to the Fed-induced tech bubble and you see it in these two stocks: Amazon (AMZN) and Tesla (TSLA):

When people ask me if I'd buy the breakout on Amazon, Tesla, NVIDIA, Apple, Netflix, Google or whichever tech stock has melted up, I reply: "No, in fact, I'd start shorting all of them here."

"Yeah but they're ripping higher and are ESG compliant".

My reply: "I couldn't care less if they are or aren't ESG compliant, I wouldn't touch any of them here. Period."

Meanwhile, oil companies like Exxon Mobil (XOM) keep getting trashed by investors as if the world doesn't need oil any longer:

Ridiculous, even with an 8% yield, the stock keeps getting pounded into oblivion and will likely retest March lows the way it's trading. This is the flip side of the ESG bubble.

Anyway, all this to say, while I'm all for ESG, I take all this talk of "ESG investing" with a healthy dose of skepticism, especially in public markets where ESG is exacerbating the tech bubble, heightening, not lowering risks.

So, be careful reading too much into the outperformance of sustainable funds, it's way too soon to make any robust observations, especially in public markets.

Yes, ESG investing appeals to those of us who want a fair, just and sustainable world but just be careful not to fall victim to ESG marketing ploys and realize that ESG investing might be exacerbating a tech bubble and putting your hard earned money at risk.

Just remember my rule of thumb on investing: when everyone is jumping on the bandwagon, that's when the risks are highest and you probably want to walk away.

That goes for tech, emerging markets, commodities, private equity, private debt and ESG investing.

So, while ESG has seemingly passed the COVID-19 challenge with flying colors, count me as a cautious skeptic who would rather see a much longer investment period to really gauge its long-term success.

It doesn't mean I am against sustainable investing -- far from it -- but I'm less enamored by the latest trends in investing than others and always remain very skeptical and analytical in my approach.

A lot of public and private market funds have jumped on the ESG bandwagon because that's where the money is heading but I think we need to all cool it before making huge proclamations on ESG investing, it's still early in the long game and there's a tech bubble which is inflating ESG's relative returns.

Below, ESG is the hottest theme in world finance right now but what exactly does it mean? Here is a very simple explanation from Refinitiv - the company at the leading edge of measuring ESG performance.

Also, ESG is a catch-all term for investing strategies that consider a company’s environmental, social and governance factors. ESG investing is predicted to surge following the coronavirus pandemic and demonstrations over racial justice. Consumers and Wall Street investors alike are increasingly holding companies accountable for their performance on environmental, social and governance benchmarks—or ESG, for short. Here's how ESG investing could transform the financial and business industry.

Lastly, ESG funds have seen massive flows incoming in recent years. Do they really do what they are intended? Watch this clip to see a more skeptical view.