As investors seek to increase the sustainability and resilience of portfolios and financial institutions expand the selection of sustainable funds globally (3,432 as of 2Q 2020), there is growing interest in mitigating Environmental, Social, Governance (ESG) risk in equity portfolios. Already, signatories to the Principles for Responsible Investment (PRI) have increased by 28 percent in 2020, the highest annual growth in a decade, and assets in sustainable equity funds have surpassed 1.1 trillion. As inflows into ESG equity funds break records in 2020, the COVID-19 pandemic highlights the material financial implications of high impact and low probability risks and underlines the potential macroeconomic impacts of unmitigated ESG risks. In a JPMorgan poll of 50 global institutions with USD 12.9 trillion in assets under management, 70 percent considered it likely that the pandemic will raise awareness and incentivize mitigation efforts for known high impact and high probability risks like biodiversity loss and climate change. Increasing awareness of exposure to ESG-related financial risks, along with the risk of divestment, is materializing among Brazilian soy and cattle investors amid soaring deforestation rates, the worst fire season in a decade in Brazil, and opaque supply chains.
Financial materiality: ESG prioritization during COVID-19
In the early stages of the pandemic, companies were in the spotlight for performance on social issues related to employee health and safety and labor practices. Companies prioritized immediate reputational risk factors in safely and effectively retaining employees and designing human resource policies to protect stakeholders during COVID-19. According to Truvalue Labs, analysis of company communications show a relative rebalancing of the environmental (31 percent), social (42 percent), and governance (27 percent) components of ESG in August as conversations around sustainable, inclusive, and equitable recovery plans drive a wholistic discussion of ESG risks.
Figure 1: Sustainability Accounting Standards Board (SASB) Volume mix by ESG category
Source: Truvalue Labs
A central component of the discussion revolves around preventing future pandemics. Deforestation is a key risk factor for zoonotic diseases because habitat destruction increases interactions between humans and wildlife. A study of 7,000 wildlife communities found that as land-use change eliminated larger predators, smaller species proliferated and the proportion of the population carrying pathogens increased by 70 percent. In fact, between 60 and 70 percent of human infectious diseases since 1990 are linked to wildlife. Deforestation also plays a major role in climate change, releasing about 13 percent of greenhouse gas emissions globally. When combined with the roughly 10 – 15 billion tons of carbon sequestered annually, it is estimated that combatting deforestation could make up 23 percent of climate change mitigation by 2030. Cattle, soy, palm oil, and timber companies are likely to be the most impacted by international climate change mitigation policies as they account for at least two-thirds of tropical deforestation globally.
Even as deforestation and fires have soared amid reduced enforcement during COVID-19, the financial risks of being linked to deforestation are materializing. Investors with USD 3.7 in assets under management wrote to the Brazilian government in June to urge immediate action to curb deforestation, citing a fiduciary duty to act in the long term interest of beneficiaries. One investor, Nordea Asset Management, followed through with a EUR 40 million divestment from JBS SA, Brazil’s largest meatpacker. Market access risk is another material concern for agribusinesses in the Amazon as deforestation-linked products threaten to derail the EU- Mercosur trade deal and countries like Germany and the UK consider passing legislation to reduce deforestation in supply chains. Figure 2 outlines the primary financial risk factors for upstream and midstream agribusinesses involved in deforestation, although ESG risks related to deforestation reverberate along supply chains and financial flows.
Figure 2: Summary of financial risks associated with company involvement in deforestation
Source: Chain Reaction Research
Sustainable fund investments: Record-breaking inflows and outperformance
Research during COVID-19 supplemented previous findings during the late-2018 stock market decline that showed ESG funds may be more resilient and less volatile than comparable funds. While ESG fund outperformance during COVID-19 was partially attributed to lower fossil fuel exposure and higher technology weightings, “perhaps the biggest reason for their outperformance is that sustainable funds appear to have benefited from selecting stocks with better ESG credentials.” The role of ESG stock selection compared to energy and technology weightings in overperformance varied by region, as shown in Figure 3.
Figure 3: Outperformance attributable to energy and technology versus ESG stock selection
Source: Chain Reaction Research visual based on Morningstar Direct data
As the stock market rebounded in the second quarter of 2020, global inflows into sustainable ESG funds rose by 72 percent to USD 71.1 billion. Meanwhile, assets in sustainable funds grew by 23 percent to a record USD 1.1 trillion at the end of June. Regionally, Europe is still the leader in ESG investments with 86 percent of 2Q inflows, followed by the US at 14.6 percent. In the United States, USD 9.3 billion of ESG stock fund inflows contrasted with an estimated USD 137 billion of outflows from overall stock funds. However, despite growing evidence that ESG risk mitigation does not come at the expense of bottom-line performance, the Trump administration has proposed an update to the Employee Retirement Income Security Act of 1974 (ERISA) that would drastically increase the paperwork needed for pension plans to prove that economic interests are prioritized ahead of “non-pecuniary” goals. If this proposal moves ahead, it may reduce investments from key stakeholders of ESG funds with a shared interest in aligning long term-risk with long-term returns to maximize investor returns.
Figure 4: Quarterly flows into sustainable funds (USD Billion)
Source: Morningstar Direct, Manager Research