Covid-19 Is Raising the ESG Stakes

For most companies around the world, including financial firms, revenues are down amid the coronavirus pandemic, leading to budget cuts and layoffs. Start-ups are finding it harder to secure funding, while some sectors of the market, such as the emerging area of alternative data, may take a hit. And environmental, social, and governance (ESG) data, which has been gaining wider recognition, may not be immune from reexamination after the crisis abates.

Much of the conversation around ESG has focused on the environmental dimension, as the impact of climate change increases and companies grapple with rising temperatures, carbon taxes, and increased catastrophic weather events that disrupt factories and break networks. But some elements of ESG—for example, board compositions, supply-chain data, and labor data such as whether employers offer paid time-off—may take on new meaning after this crisis. The issue is that there’s a lack of standards around these datasets, they can be noisy, there’s a lack of history (most of these datasets only go back 5-10 years) and these signals’ behavior can change fairly rapidly, and there are instances of greenwashing, where a company presents itself as caring about sustainability but with flimsy proof. 

As ESG is incorporated into more investment strategies as a way to hedge risk and find alpha, portfolio managers are increasingly looking to data providers to find unique insights during a period of great market volatility. As is true of most things related to the Covid-19 outbreak, it’s too early to tell if ESG will be a defining sector to help firms manage their risks, or if the pandemic will prove that ESG is still too disjointed to glean valuable insights during times of confusion. 

The data shows that ESG analysis has continued to help investors identify stronger companies that, on a relative basis at least, have performed better during this difficult time.

Jonathan Bailey, Neuberger Berman

At their best, ESG datasets reveal how well a company is prepared for transitions, says Timothy Smith, director of ESG shareowner engagement at investment manager Boston Trust Walden (formerly branded Walden Asset Management). And he doesn’t just mean climate transitions, but fundamental shifts in the markets and in economies—that part they could do better. While the three buckets try to paint pictures of that preparedness, as a data-user, he says this experience might cause ESG data and ratings providers to measure companies’ preparedness for other future, low-likelihood but high-risk scenarios.

“[Portfolio managers] are at [the data providers’] mercy, except all of us know we’re inadequately prepared [for crises] so we use these providers, but we’re not holding them to blame,” Smith says. “We’re not blaming them right now for the fact that they don’t have this down pat, but we would blame them if they didn’t even raise it as an issue and just went around like business as usual.”

Since 1975, Boston Trust Walden has followed ESG and impact-investing principles in its active ownership strategies. Smith, who joined the firm in 2000, previously sat on the sustainability advisory board for manufacturer Kimberly-Clark, which owned a factory in Thailand that was shut down by flooding in the early 2000s. The plant was out of business for a long time, Smith says. One of the board’s jobs was to develop contingency plans for events such as those, but recalls that when more extreme scenarios were brought up (beyond flooding), people shied away from spending much time on them, banking on their unlikelihood. While the idea of a global pandemic that would freeze economies across the globe could’ve been imagined, is it something that firms would’ve been likely to proactively prepare for pre-Covid-19? 

“Nobody has a crystal ball,” he says.

Material Matters

Ahead of the US coronavirus outbreak, but about a month after the number of cases in China began to spike upwards, Truvalue Labs, an ESG data and analytics provider, coined the term “Dynamic Materiality,” a patent-pending concept indicating that every company, industry, and sector has a unique materiality signature—or what is directly relevant to a business’ or sector’s operations and returns—that changes over time based on factors like emerging technologies and new regulations.

Thomas Kuh, head of index at Truvalue Labs, says that historically, ESG has gotten pushed to the side in times of financial crisis and profit loss, such as in 2008, when bankers, regulators and investors took the view that they had more “serious” issues at hand. Will it be different this time? Kuh says yes, and especially so for the social and governance disciplines.

“In terms of this crisis, what it means is these issues are really embedded in key segments of the investment world in a way that they haven’t been before. So it’s from that perspective, I would say that after the crisis, we’re not likely to see the dismissal of ESG and sustainability issues the way we have in the past,” Kuh says.

Jonathan Bailey, head of ESG investing at Neuberger Berman, says the coronavirus is prompting some to re-think their sustainability frameworks as the concept of materiality evolves.

Neuberger Berman is a New York-based investment management firm with a long-term focus and $339 billion in assets under management. The firm uses a proprietary ESG rating system, which has generated 20 basis points of alpha since the beginning of the year, on top of investment performance added last year by ESG factors, Bailey says.

“The data shows that ESG analysis has continued to help investors identify stronger companies that, on a relative basis at least, have performed better during this difficult time. Now that is obviously separate and distinct from the fact that the market is down … and almost all companies are struggling through this,” Bailey says. “So I guess the question then is, what more could have been done ahead of time to push these companies to be more resilient? And that’s not necessarily just the responsibility of ESG.”

A paper released by Morningstar on April 3 found that sustainable funds outperformed conventional ones during the first quarter. They still lost money, but they lost less. The 206 equity funds included in the study were helped by a focus on companies with strong ESG profiles and less exposure to energy.

As is true with anything, ESG needs to be used in tandem with other sources of information to yield a more complete picture. The challenge with ESG, at times, is that the information can be deceiving if taken at face value. For example, Bailey and his team have been scraping regulatory filings, and one interesting exercise has been to study the handful of companies that proactively self-identified pandemic risk as a material factor in their S-1 or 8-K forms. 

Perhaps surprisingly, the group that did this has still underperformed, Bailey says, though he did not specify what companies Neuberger Berman included in that group. Simply identifying whether something is a material risk isn’t good enough if that at-risk business doesn’t follow that up by taking appropriate steps to make itself more resilient.

Diamond in the Rough

In the end, this will strengthen arguments in favor of companies tracking internal ESG metrics and ensuring more internal risk management, says Todd Bridges, partner and global head of sustainable investing and ESG research at Arabesque Asset Management. It’s already magnifying the rate at which the “S” component is scored, and perhaps even needs to be built up at some organizations.

As an example, Amazon was named the best-managed company of 2019, according to the Wall Street Journal, despite the fact that MSCI names the retail giant an “ESG laggard” on labor management and a “leader” in corporate governance. As it stands today, the company has received a disproportionate amount of negative news attention and social media sentiment. The company went as far as to fire a worker who organized a walkout from its Staten Island-based factory over purported unsafe working conditions amid the coronavirus outbreak. Protests have also taken place at Amazon-owned Whole Foods locations for similar reasons.

When the outbreak finally ebbs, firms may be forced to acknowledge the urgency of other ESG issues—noisy and inconsistent data, loosely-defined standards, among others—and understand that progress can’t and won’t be achieved in a vacuum.

“It’s an excellent learning case whereby nation-states and inter-governmental organizations will start to say, ‘If we’re going to ever try to solve a large systemic problem like a pandemic or climate change, we are going to have to coordinate,” Bridges says. “I’m very hopeful that they’ll make this connection when things calm down later this year—this crisis has taught us that if we’re ever going to solve fundamental market problems, or inefficiencies in the markets or climate change, there are lessons to be learned.”