Sustainable finance is performing well in the pandemic -- but why?

Sustainable finance is not new. Early calls for economic transactions to incorporate environmental, social, or governance (ESG) issues can be traced back as far as the Holy Books. But it would have been difficult to divine the uptake of sustainable finance in recent times, largely achieved in the wake of the 2008 financial crisis and amid the Covid-19 pandemic.

Mathematical consensus is building up around the idea that ESG issues have a financially material impact on equities and other asset classes and, as a result, financial assets managed through ESG lenses have been steadily growing nearly 20% a year, and presently account for over one-third of the global financial market.

In 2018, Deutsche Bank forecasted that the practice of responsible investing, which calls for financial transactions to incorporate ESG issues, “will spread to cover all managed assets globally in the next 10-15 years.” But in the wake of Covid-19, that timeframe is likely to be shortened up.

Stock indices could be foretellers of the world to come. ESG indices—whether constructed around exclusions of controversial sectors or stocks, or designed to highlight companies that better manage ESG-related opportunities or risks—keep outperforming traditional indices even during the current crisis. The MSCI KLD 400 Social Index, the MSCI World ESG Leaders Index, and Refinitiv Eurozone ESG Select Index were up by 200 to 320 basis points relative to their non-ESG counterparts in the 12 months ended April 30th. Morningstar has shown that in a comparison of 26 sustainable index funds with conventional index funds, 24 of them outperformed the comparable conventional index fund in the first quarter of 2020.

So, this bears the question: Are companies with superior ESG performance better prepared to operate in a post Covid-19 world? And linked to this is another question: Why is sustainable finance outperforming traditional finance during the coronavirus crisis?

11 reasons

There is no single explanation. Rather, there are multiple factors, which taken together suggest that ESG is primed for an era in which analysts will want to be as familiar with virus lab names as they are with discounted cash flow models.

Here are just a few reasons why ESG is suddenly looking like more of a standout:

1. Portfolio construction shaped by ESG data has traditionally showed limited exposure to heavy-polluting companies such as transportation and cruise-line operators, two of the sectors most affected by the Covid-19 upheaval. Most ESG indices such as iSTOXX Global ESG Select 100 Index, which singles out global sustainability companies, include no airline companies or cruise-line operators in their holdings, and American Airlines was considered ineligible for the S&P 500 ESG Index due to its poor ESG score.

2. ESG portfolios steered by negative screening strategies also shy away from holding stocks in oil companies, all of which are umbilically connected to global oil prices, which in turn are negatively impacted by disturbances in global transportation and mobility. ESG investors have historically stayed away from producers such as Exxon Mobil or Royal Dutch Shell. According to Morningstar, in the first quarter of 2020, the average energy exposure of 12 well-known US sustainable index funds was 1.9% compared with 2.6% for the S&P tracker IVV.

3. ESG portfolios are often heavily exposed to tech companies, several of which—Zoom Video Netflix, Teladoc Health, and RingCentral among them—showed superior performance due to the high domestic consumption of IT products and services during the pandemic. While the S&P 500 plunged 13% over the last three months, the Nasdaq was down by approximately 6%. And notably, 26% of all assets that make up the ESG MSCI USA Leaders Index are tech corporations.

4. There’s a similar dynamic at work for healthcare, consumer staples, and select retail companies. As they produce or distribute products in extreme demand in the pandemic, their market values have been relatively resilient. After information technology, healthcare is the most represented sector in S&P 500 ESG Index. Notably, companies in these sectors have gone a long way in recent years to embrace ESG standards and, consequently have entered the radar of sustainable investors. Consumer products giant Colgate-Palmolive and CP ALL, which operates convenience stores in Thailand, were among the top-performing companies in the 2019 Dow Jones Sustainability Index.

5. ESG companies are, boldly put, better-managed companies. They are often directed and controlled to strive in fast-changing political, social, and environmental situations. They tend to have stronger competitive advantages and healthier balance sheets than their non-ESG equivalents. The fund that tracks the Good Governance US equity long/short index—which assesses the overall quality of a company’s governance (the G as in ESG) by using a stewardship model that includes financial prudence, proactive risk management approaches, and multiple stakeholders—outperformed the S&P 500 (TRI) by 0.66% in April 2020 and by 10.17% year-to-date.

6. In critical periods, to be agile is a matter of survival. Over the years, ESG companies have gone through structural and back-breaking changes to cut down costs related to their operations—energy saving, better water management, less raw materials used. Environmental stewardship is not just about being good to the planet; it is about controlling costs, maintaining margins, and preparing companies for slumps in revenue. The lack of corporate fat and their experience with internal change will help cushion ESG companies now and in the future.

7. Persevering through the current crisis also has a lot to do with adjusting to flexible working conditions. Overnight, millions of employees were ordered to work remotely, putting a dramatic strain on logistics and work dynamics. Less flexible companies will pay a toll. ESG companies generally outperform their counterparts in this regard too, as their HR policies and practices often cater to the different needs of employees and encourage a healthy work-life balance by offering flexible working models, such as remote working and parental leave.

8. Current and future crises will tell leaders and laggards apart, and this will have a lot to do with innovation. Plainly, the most innovative companies will be better equipped to survive. The junction between sustainability and innovation has been the subject of a swelling body of literature. A 2009 study showed that sustainability “is a mother lode of organizational and technological innovations that yield both bottom-line and top-line returns.” Another study by Harvard professors underscored that companies that regard corporate responsibility not as a box-ticking exercise but as an opportunity to create shared value and social innovation can deliver superior shareholder returns.

9. Also, ESG investors are more inclined toward long-term investing than to short-termism, favoring strategy, fundamentals and long-term value creation over beating next quarter’s earnings estimates. As a result, they pick assets that tend to show less volatility and are typically less exposed to tail risks such as punishment from regulators or environmental accidents. Though short-term gains might get sacrificed, longer-term investing carries the potential for outperformance in roller-coaster contexts.

10. Although global companies will remain global, working patterns and civic life will take on a more isolationist and localized nature in the wake of Covid-19. We will keep engaging and delivering borderlessly by maximizing the power of remote communication technologies, but our physical horizons will shorten up—and companies will need to adjust. Those that boast a solid track record in community dialogue and citizen engagement and have a solid local anchor, like ESG companies often do, will get a head start.

11. We should expect that at least some portion of the crisis-prompted stimulus plans and incentives rolled out by global organizations such as the IMF could serve as opportunities to steer the economy toward lower carbon emissions. While many of the measures taken to date have been focused on containing the economic damage, the implementation of new instruments is likely to be aligned with previous commitments such the €1 trillion European Green Deal. At the national level, Portugal set this example with its announcement of a €5 billion ($5.4 billion) green hydrogen. “The economy cannot grow along the lines of the past and our post-coronavirus vision is to create wealth from projects that reduce carbon emissions and promote energy transition and sustainable mobility,” environment minister Joao Matos Fernandes told Reuters.

A significant level of protection

It is fair to say that ESG outperformance is partially due to fortune. Had the corona virus badly hit the tech sector and not the mobility or energy industries, we would be writing about an ESG crisis. But it is equally fair to say that integrating an ESG lens on an equities portfolio added a significant level of protection during the first quarter of the year.

A financial market is a mathematical and trading reflection of our society. And, as such, just as with systemic risk, looking at balance sheets without accounting for ESG considerations is faulty financial practice. The Covid-19 crisis helps to show why, and suggests that in the 21st century, ESG companies will likely keep showing more resilience than their lower-quality counterparts.

 

Published originally by Quartz. Available here.