As ESG investing accelerates in demand, key trends are emerging. The coronavirus pandemic, in particular, has intensified discussions about the interconnectedness of sustainability and the financial system.
The COVID-19 Pandemic as a Sustainability Catalyst
The pandemic has focused investors on the vulnerability and resilience of the financial system, and intensified discussions around sustainability. For years, sustainable investing was considered “a slow-moving but unstoppable train” that had started to pick up pace. It appears that COVID-19 has accelerated it further, but the challenge of balancing short-term and long-term needs has never been more stark.
There is concern that as the pandemic subsides and the world begins its economic recovery, attempts to return to higher growth levels could have negative consequences for the climate. For businesses that have suffered financial losses, more sustainable approaches may be seen as an unnecessary luxury.
Others argue that the pandemic has revealed the need for systemic thinking and shown the personal consequences of our interconnectedness: Our lives rely on economic, environmental, and social systems more than we realized. In our discussions with ESG-aware investment professionals, a majority said that a legacy of the pandemic will be the acceleration of the positive growth trends in sustainability.
The COVID-19 pandemic has also encouraged a more holistic view of ESG versus the individual elements of E, S, and G. Historically, investment professionals have focused most on governance, but the gap has narrowed significantly in the last few years, especially as environmental issues became more prominent. The challenges and unexpected benefits that the pandemic uncovered are changing the way investors and investment professionals view sustainable investing.
The early performance experience from the pandemic was that well-rated ESG companies performed better and were more resilient, indicating that the higher quality embedded in many highly rated companies had paid off. For example, the outperformance of four MSCI ESG indexes in global markets during the crisis was attributable mainly to equity style tilts of which ESG factors were the strongest contributor.
Although it has been a very short time period for consideration, the pandemic has demonstrated that awareness, management, and preparation of sustainability risks should be at the center of sensible risk management and a company’s business planning.
Purposeful Capitalism at an Inflection Point
The purposeful capitalism scenario envisions an investment industry with a greater focus on ethics, professionalism, and serving the interests of clients and society. In this narrative, if greater benefits accrue to society through this mindset change, it will strengthen the investment management industry’s license to operate granted by investors and society at large. Stronger application of ESG principles is central to this narrative.
This requires the industry to give greater attention to long-term systemic challenges, as well as balancing multiple stakeholder interests. When we look only at near-term impacts, we reduce our options for positive long-term outcomes.
In the United States, the politicization of sustainability has been a significant impediment to sustainable investing. The US Department of Labor proposed a new investment duties rule in June 2020 to limit ESG investments in retirement accounts governed by ERISA that was met with significant industry opposition.
In many other countries, however, particularly in Europe, there is typically support for sustainable investing across the political spectrum. The European Union’s Sustainable Finance Disclosure Regulation (SFDR), which comes into effect in March 2021, will require new transparency obligations and reporting requirements on investment management firms concerning ESG products. At the same time, the EU taxonomy on sustainable activities creates criteria to determine whether an economic activity is considered sustainable and is aimed at contributing to the transition to an economy with a lower carbon footprint.
While investors and investment professionals will have to respond to regulation, they also have considerable agency in shaping the future.
Organizational Motivations for Considering ESG Factors
The top two motivations for organizations in considering ESG factors are to manage investment risks and respond to client demand.
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