An ESG Reflection: Three Mid-2020 Takeaways for Investors

Over three months ago, the COVID-19 outbreak was named a pandemic, bringing health care infrastructure to its knees and rocking global markets. In this time, discussions of the pandemic’s ripple effect have extended to company policies and responses, such as continuity planning, business resiliency, and treatment of employees. Doing so raises the question: How do the coronavirus pandemic and its downstream effects intersect with environmental, social, and governance (ESG) investing?

Introduction

According to the Financial Times, ESG-focused and sustainable equity funds fared well during the global economic downturn in February and March of 2020. 62% of ESG-focused large-cap equity funds outperformed the MSCI World Index in March, as markets saw further downturns coinciding with the implementation of lockdown measures globally. In many cases, this can be attributed to underexposure to oil and energy sectors that have been hit particularly hard; it can also be credited to favoring efficiently run and high-quality companies with strong balance sheets.

Corporate responses to pandemic lockdown measures, including transitioning to remote work, maintaining business operations, and offering paid sick leave benefits, have drawn increased attention to the social pillar of ESG. While it may be too soon to determine how ESG strategies and the weight placed on social factors will shift going forward, we can take this opportunity to take stock of ESG trends seen so far this year and consider how they may intersect with corporate shifts in response to the major events of the last few months.

We will summarize three trends that have come to the forefront in 2020: demand for raw data, corporate engagement strategies, and regional differences in weighing ESG pillars.

1. Demand for Raw ESG Information

One of the most commonly referenced challenges associated with adopting ESG investment strategies is the lack of consistent data on ESG issues. To date, companies have differed widely on the types of information they disclose and how they report it. In response, numerous organizations and initiatives, such as the Global Reporting Initiative (GRI) and Sustainable Accounting Standards Board (SASB), have released voluntary reporting frameworks over the last three decades that offer competing criteria for what constitutes material ESG information. ESG data vendors have also addressed the challenge of inconsistent company disclosures by collecting information from diverse sources (e.g., companies, NGOs, government bodies, and external media) and applying their expertise, research, and proprietary aggregation methodology to produce comparable metrics and scores.

However, as investors adopt more sophisticated ESG strategies, we have seen an increased appetite for sources of raw ESG information that offer more transparency into company policies and behavior. When our clients refer to raw ESG information, they are predominately referring to ESG information reported directly from a company or regulatory body that has not been aggregated or transformed.

Many firms are looking to build custom ESG metrics in-house, a decision that is driven by a desire for customization and transparency as well as the ability to commit extensive resources to the project that includes budget and ESG expertise. In doing so, firms have the flexibility to adjust the weight placed on specific ESG factors in response to the evolving market, geopolitical, and societal context. The agility offered by in-house ESG analysis is often hard to replicate with vendor-provided top-level scores.

In other cases, firms that are looking to add another dimension to their analysis by layering more granular information for specific ESG issues on top of vendor-provided ESG scores.

Below are a few examples of raw ESG information that can be incorporated into existing strategies or used as an input for custom scores.

• Descriptions of corporate policies (e.g., corporate governance, health, or safety practices) and diversity metrics (e.g., number of women and people of color on the board and in the C-suite)
• Environmental impact metrics (e.g., carbon emissions, water consumption, or energy consumption)
• Regulatory violations, fines, and lawsuits (e.g., OSHA violations and SEC, EPA, or environmental fines)
• Detailed revenue exposure by geography and industry (e.g., fossil fuels, drug manufacturing, or tobacco sales)

The demand we have seen thus far has been for vendors that collect this data and deliver it in standardized formats so that firms can avoid collecting the underlying data themselves. The key advantage of these datasets is the depth of detail and transparency they provide, allowing for customization in the application and ability to tweak aggregation methodology in alignment with investors’ values.

2. Direct Engagement to Drive Change

Over time, we’ve seen the focus of ESG investing move from screening out exposure to “sin” stocks, such as those in tobacco, defense, and weapons industries, to investing in companies with a positive footprint, including green technology and climate-focused funds. Investors are now identifying ESG-laggards and engaging directly with the companies to advance their ESG agenda.

Investors are taking shareholder action to guide changes in company policies and performance on ESG issues through proxy proposals and private discussions with executive leadership to set targets and hold them accountable. Through proactive action, investors can ensure company policies align with their ESG values.

Within the first two quarters of 2020 alone, 71 environmental, social, or governance-related proxy proposals have been brought to U.S. company meetings by hedge funds, investment advisors, mutual fund managers, and public pension funds according to FactSet. This accounts for 74% of all proxy proposals brought to company meetings in this period and a 6% increase in environmental, social, or governance proxy proposals from the first two quarters of 2019, despite the market downturn. While this is promising, it likely does not offer a full picture of ongoing shareholder engagement as many investors opt for private discussions with company leadership. 

Hedge funds are especially well positioned to target companies that underperform on sustainability issues through shareholder action. In fact, KPMG’s 2020 survey of global hedge fund managers on their approach to ESG found that 75% already rely on shareholder engagement to advance their agenda and 31% indicated that shareholder engagement is their primary approach to ESG.

3. Regional Differences in Weighing ESG Issues

As ESG strategies and the data landscape evolve, one constant remains: there is no one-size-fits-all approach to ESG investing. This holds true on a regional scale. Where firms invest shapes how they prioritize the environmental, social, and governance elements of ESG.

The EU, which has the most advanced and abundant suite of ESG regulatory measures of any region globally, has crystallized the relationship between ESG and investing and made ESG an inescapable aspect of how businesses are managed and report. Within the EU regulatory regime, the environmental pillar is at the forefront.

Very briefly put, one of the primary purposes of the EU ESG regulation is to channel investment into genuinely sustainable economic activities, with the ultimate goal of honoring the EU’s UN Sustainable Development Goals (SDGs) and Paris Agreement commitments. The UN Paris Agreement is an international agreement to combat climate change and limit global warming to 1.5-2 degrees C above pre-industrial levels and many of the UN SDGs are directed towards the environmental issues within the umbrella of ESG, including climate action, access to clean water, affordable clean energy, responsible consumption and protecting the environment on land and in the oceans.

The second objective of the EU regulatory regime is to ensure financial stability in the face of climate change, along with other ESG-related risks. The regulation pursues these objectives by setting out exacting requirements for how companies report on ESG information, how it is incorporated into investment processes, and how financial firms classify ESG investments.

From the 100-foot view, this regulation places an emphasis on climate and environmental risks and has significant implications for how ESG criteria are evaluated by EU investors, which is likely to also impact investors globally in the future. For a full breakdown of the EU ESG regulations and proposals, download FactSet’s E.U. ESG Regulations Guide.

By stark contrast, investors in the Chinese market put a heavier emphasis on the governance pillar of ESG. A 2020 survey of global asset owners by Greenwich Associates found that ESG issues have a significant impact on whether institutions invest in China. For those considering investments in China, 51% of respondents noted that governance was the most important ESG factor. The emphasis on governance is tied to the perceived subpar corporate governance standards, which is not helped by China’s opaque standards that make it difficult to access critical ESG metrics.

Conclusion

In the last six months, we have seen firms become more hands-on with ESG. They are looking to gather more detailed insight into company policies and performance through raw data. We have also seen investors focus on turning laggards into leaders through active shareholder engagement that drives their ESG agenda forward. Both of these trends allow investors to be nimble and adjust their approach based on the evolving market, geopolitical, and societal context.

Within the last month, we have seen the national mobilization of Black Lives Matter protesters and activists in the U.S. calling attention to systemic racism and racial injustice. This topic is also being addressed through corporate statements, product changes, donations, and new policies highlighting how employers support their communities and employees and foster diversity and inclusion.

Going forward, we may see investors respond to the Black Lives Matter protests and coronavirus pandemic by expanding their ESG goals, demanding more transparency into companies’ diversity and inclusion, continuity planning, business resiliency, and pushing for more ambitious action to guard against future market shocks and better serve their employees.

For more information on FactSet’s ESG offerings, visit the ESG Investing Solutions webpage and the ESG category in the Open:FactSet Marketplace.