The Chain: How the COVID-19 Crisis Is Affecting ESG Investing

April 27, 2020

This Chain is the first in a series on how the COVID-19 crisis is affecting agricultural markets and investor flows.

The COVID-19 pandemic has demonstrated the vulnerability of health care systems, markets, and global supply chains. The IMF has predicted the worst economic downturn since the Great Depression and UN Secretary-General Antonio Guterres considers it to be the biggest challenge the world has faced since the Second World War. The enormous impact that COVID-19 is having on human health and global economic systems may significantly reshape investor flows and help determine the future of ESG investing.

Against the backdrop of the current volatile environment, many investors are looking to build more resilient portfolios to guard against exposure to economic fallout from future crises, such as climate change. Investors and banks are likely to increasingly consider certain climate-related risks and opportunities in their investment decisions, including deforestation.

Primary Risk Factors for Future Pandemics: Deforestation and Land Use Change

The concern over climate risks among financiers increasingly involves vulnerability to reputation and financial risks from deforestation. Since the outbreak of COVID-19, deforestation has been in the spotlight for its links to infectious diseases. About 60 percent of existing infectious diseases and 75 percent of emerging infectious diseases are zoonotic, meaning that they originate from animals. Research points to land use change (31 percent), agricultural industry changes (15 percent), and international travel and commerce (13 percent) as the primary drivers of infectious disease emergence, due to close proximity of humans and animals. While the origins of COVID-19 have been linked to wet markets and wildlife trading in China, deforestation and land use change still represent the highest risk factors for future infectious diseases. By encroaching on natural ecosystems, they “heighten the risk of further pandemics by bringing humans into contact with new threats such as the coronavirus.”

Early signs of resiliency in sustainability funds

Since ESG funds aim to better capture and compensate sustainability risks, their performance during this pandemic has been closely monitored and may have long-term repercussions after COVID-19. Lower exposure to fossil fuels and high emitting industries like airlines and cruises has provided some market insulation for ESG funds, while they may be less exposed to reputational risks that arise from poor governance and stakeholder management.

A Morningstar study compared the first-quarter returns of 206 US sustainable equity open-end and exchange-traded funds against their respective peer groupings based on investment style, market cap, and region. Findings showed that in the first quarter of 2020, 44 percent of sustainable equity funds ranked in the top quartile of returns, while 70 percent ranked in the top half and only 11 percent ranked in the bottom quartile. This represents significant overperformance of sustainable funds when compared to their peer groupings.

Figure 1: Return Rankings by Quartile: Morningstar Direct

 Morningstar last week announced that it will acquire the remaining 60 percent of Sustainalytics, in addition to its current 40 percent stake. This could help standardize ESG research and scoring. Inconsistency in ESG scores has been a major criticism among investors who are looking to ratings to make informed decisions.

The early positive indicators of the ability of ESG funds to handle stress testing in a bear market may go a long way to improve investor confidence in a relatively new field. Sustainable funds have seen record-breaking inflows in recent years, including in the first quarter of 2020.  Despite the market slowdown related to COVID-19, USD 10.5 billion was invested in US open-end and exchange-traded ESG funds, equal to roughly half of the 2019 total year net flows.  Approximately 60 percent of inflows were driven by Blackrock’s 16 iShares ESG ETFs, alone, likely boosted by CEO Larry Fink’s announcement that sustainability would be integral to the Blackrock investing strategy.

Figure 2: Quarterly Flows in U.S. Sustainable Funds: Morningstar Direct

The full impact of COVID-19 is still uncertain and depends on both the containment of outbreaks around the world and the strength of government responses. However, investors are taking note of the scale of human and economic costs already incurred, highlighting the growing importance of preventative measures and risk mitigation. Furthermore, understanding the clear linkages between ecosystem destruction and infectious disease emergence may help design government recovery plans and company ESG strategies with higher resilience to pandemics in the future.

Short-term emphasis: Crisis management

While COVID-19 could prompt investors to become more resilient and increasingly factor in ESG, there is also the possibility of emphasizing short-term gains over longer-term sustainability concerns. Environmental issues may temporarily be deprioritized. Efforts to mitigate the risk of future crises are already secondary to managing imminent impacts. This has been the case for government oversight. In Brazil, for instance, the environmental agency, IBAMA is reducing monitoring and enforcement of deforestation in the Amazon rainforest, due to health concerns related to potentially exposing an aging workforce to COVID-19. After an estimated 71 percent increase in year-over-year deforestation and devastating forest fires in 2019, this has the potential to exacerbate the situation even further.

Investor engagement amid COVID-19

The overwhelming attention toward COVID-19 complicates investor engagement on ESG issues. Although climate change and infectious diseases such as COVID-19 are interconnected, investors’ main concerns since the outbreak have been paid time off policies, health care coverage, and the ability to ensure safe working conditions for employees. The relative financial materiality of risks to employee health and safety and poor labor practices has drastically increased relative to other categories of the Sustainability Accounting Standards Board (SASB). These risk areas made up a negligible percentage of company ESG risk in January but peaked at a combined 63 percent in late March. This means that climate change issues, including pressure to meet 2020 zero-deforestation commitments, may take a back seat for the time being. As a result, some companies that are scaling back on implementing ESG or taking advantage of the crisis to profit may go under the radar.

But engagement on climate change related issues, including deforestation, could pick up when the crisis ebbs. In a letter to responsible investors, the UN PRI emphasized that companies should manage for the long-term when evaluating responses to COVID-19 through prioritizing stakeholders, acting responsibly, and implementing solutions. While PRI signatories have been advised to refocus company engagement on effectively responding to COVID-19, they have also been advised to contribute to a sustainable recovery that is aligned with key priorities like biodiversity, climate change, and inequality. With total assets under management of over USD 86 trillion, PRI signatories could exert significant pressure on companies through coordination on engagement strategies.

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