May 6, 2020
How a business manages financial and nonfinancial risks has become an increasingly important factor in the decisions made by institutional investors, and an organization’s environmental, social and governance (ESG) practices provide a vital metric for investment dollars.
Over the 12 months through January 2020, ESG equity funds took in $70 billion in assets, while traditional equity funds experienced nearly $200 billion in outflows, industry analysis has found. Meanwhile, as the first three months of 2020 handed Wall Street its worst quarter since 2008, ESG funds bucked this trend: 44 percent of “sustainable” mutual funds posted top-quartile returns while only 11 percent landed in the bottom quartile of their peers. This may indicate that investing in companies with a strong ESG framework isn’t just a feel-good measure: they may perform better.
“There are more than 2,000 studies that show that companies with strong ESG practices – meaning that companies identify, address and mitigate these risks successfully – produce better corporate financial performance,” says Meredith Jones, partner and global ESG practice lead at Aon. “Looking at historic bankruptcy and stock volatility data, there is also strong evidence that those firms may also be more resilient.”
As a result, the global outbreak of the novel coronavirus (COVID-19) isn’t likely to decrease investors’ focus on ESG practices and outcomes. If anything, Jones adds, ESG issues that leapt to the fore during the pandemic may heighten investor scrutiny.
“A resilient business understands that ESG issues and the operating environment are dynamic and changing: it watches and adapts accordingly,” observes Greg Lowe, global head of sustainability and resilience at Aon. “COVID-19 is teaching us that no matter how foreseeable a risk may be, the impact an event has on society and business hinges on our ability to plan for significant disruption and changes in the operating environment.”
ESG investing involves looking at nonfinancial information associated with an investment to identify potential risks and rewards associated with how the company deals with environmental, social, and governance issues.
“ESG began as a way of accounting for risks that were not typically measured or disclosed, but has emerged more as ‘pre-financial’ risks in the operating environment,” says Lowe.
As interest in ESG grows, many misperceptions remain.
Myth #1: There's One Tried and True "Recipe" for ESG
Counter to this misperception; an ESG strategy isn’t something that can be replicated from peers.
“I think that’s a significant struggle for companies of all sizes,” notes Laura Wanlass, partner and global head of corporate governance at Aon.“They’re having a hard time figuring out what ESG means, and they want a simple checklist to follow. But it’s about determining what issues are material for your own company and industry, and that can look very different from company to company.”
Some companies – especially small to mid-level enterprises that may not have dedicated investor relations teams may take a piecemeal approach, relying on templates such as sample disclosures for proxy filings. “We’re at a tipping point where ESG is becoming more mainstream,” says Jones. “But there’s still a knowledge gap. Board members and executives are learning as they go along. The lack of standardization among investors and data providers in this still-growing area doesn’t help. Many firms are just now starting to embrace the value of setting a strategy.”
Myth #2: In Times of Crisis, ESG Should Take a Back Seat to Profitability
According to this school of thought, when the financial chips are down, companies and shareholders care only about profitability. “I think that’s an unlikely scenario,” says Jones. “Crises like COVID-19 highlight where these nonfinancial risks exist within companies and how damaging they can be to the bottom line.”
Public companies may find that their human-capital decisions in response to COVID-19 have an impact on the way shareholders vote and engage. “In the last economic downturn, shareholder activists used compensation, governance, and human-capital decisions as ways to win board seats or bring about corporate change,” notes Wanlass. “So, ESG becomes increasingly important in any type of downturn.”
Myth #3: ESG is Really About the "E".
Companies have gotten comfortable with governance – the “G” – says Wanlass. Increasingly, the environmental “E” in ESG is what gets a lot of press and shareholder attention – particularly in the face of growing concern about climate change. Larry Fink, CEO of investment giant BlackRock, this year indicated that the firm has put sustainability and climate change at the heart of its investment activities.
As companies deal with COVID-19, however, the social considerations of ESG – the “S” – come to the fore.
How companies deal with employees, engage with customers, and manage supply chains are all areas that fall under ESG, according to Jones. For example, the COVID-19 outbreak underscored the value of having a robust remote-working infrastructure, including strong networks and cybersecurity practices, in place when the crisis hit. For companies that had to develop those capabilities on the fly, this lack of ESG planning proved problematic.
In addition, companies with sound employee sick-leave policies were better positioned to deal with COVID-19 than companies that scrambled to develop policies to respond to the pandemic. And nonessential businesses that refused to close or stagger shifts to reduce employee exposure, or failed to provide additional cleaning or protective equipment, all fell short of the mark on social issues, Jones points out. “From a deliverable standpoint, not to mention negative PR, that can cause a lot of revenue pain.”
Myth #4: ESG is About Being a "Nice Company"
“It’s important to distinguish between the things that can have a real positive – or negative – impact on your business and the things that just make you look like a ‘nice’ corporation,” says Jones.
As important as charitable activity and volunteerism might be, that work isn’t necessarily focused on mitigating business risks, she says. For example, employees reading to disadvantaged students to increase literacy is a worthy cause. But for a company facing challenges with diversity in its workforce, ESG activities with a potentially greater impact might include building recruitment relationships with women and minority students in high schools and colleges, establishing a ”Rooney Rule” for hiring and promotions or building a more inclusive corporate culture.
Myth #5: ESG Brings Value Only to Shareholders
ESG practices can yield stronger company performance. But shareholders aren’t the only benefactors.
“There are many reasons to focus on ESG that go beyond shareholders,” posits Jones. “It’s about creating a sustainable and resilient business over time that takes into consideration risks not easily identified in a spreadsheet, so employees have jobs and customers get products and services. Done well, ESG creates a virtuous cycle for all stakeholders of a firm.”
What’s more, sustainable companies are where people want to work.
“The market for top talent will always be competitive, perhaps even more so now as companies look to create their workforce of the future,” says Jim Hoff, senior partner, strategic communication advisory at Aon. “Effective and visible ESG practices are increasingly important to an employer’s brand. The best people seek out employers with demonstrated resilience and sustainability as key components of the employment value proposition.”
“Studies have shown that companies with strong ESG practices can minimize employee turnover and maximize productivity,” adds Wanlass.
COVID-19 Will Underscore ESG's Value
The COVID-19 pandemic has cast ESG practices into the spotlight. Companies will be able to examine how the crisis affected them, see where they responded well and where they fell short, and identify opportunities to enhance ESG practices going forward.
“People will pay attention to how businesses manage risks associated with human capital, communities, and the environment because ESG isn’t just a three-letter buzzword: it’s about resilience and sustainability,” says Jones. “So companies should be prepared for investors to encourage ESG best practice with their dollars and their feet, as well as with the proxy votes going forward.”
“Risks can be very abrupt, like the COVID-19 pandemic,” Jones continues, “or they can be longer-term, like the potential for climate change to disrupt business. Either way, the most resilient and sustainable businesses think about those risks and manage them before they cause revenue or reputational losses.”
The post Why ESG Is Even More Important In A Crisis Like COVID-19 appeared first on The One Brief.
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