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Sustainable Finance

Is ESG a luxury or a necessity?

October 16, 2020

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By Patrick Bryden, Head of Environmental, Social and Governance Research, Global Banking and Markets, Scotiabank.

 

Although it might seem like a distant memory, one of the interesting developments in the pre-pandemic capital markets was rising demand for ESG-oriented (Environmental, Social and Governance) investments.

 

While critics might have called principles of sustainable finance and associated securities a “luxury” in a flourishing market, today’s continued interest in responsible investment solutions demonstrates that consideration of ESG factors continues to make sense, in the context of performance and preference among investors and issuers alike. You could say that COVID-19 has “stress-tested” ESG investment strategies and proved they have moved from being a luxury to a necessity.

 

The rising profile of ESG

 

It’s worth noting that the community of ESG “believers” was growing long before the pandemic. In fact, a meaningful swath of the investment sector was adopting ESG principles due to the body of evidence that sustainability minded companies often outperform competitors that do not embed these considerations into their strategies. In recent years, academic research has borne this thesis out, most notably a watershed study by Robert G. Eccles and George Serafeim at the Harvard Business School and Ioannis Ioannou at the London Business School entitled, “The Impact of Corporate Sustainability on Organizational Processes and Performance”1

 

Such performance histories complement a steadily rising desire in societal, political and business circles to respond to the impacts of climate change on our planet. In fact, early in 2020, many high-profile global companies announced their commitment to become carbon neutral; Larry Fink, head of one of the world’s largest investment managers, pointed out to investors: “I believe we are on the edge of a fundamental reshaping of finance.”2

 

Such pronouncements reflect the recent groundswell of support for the United Nations’ Principles for Responsible Investment (UNPRI). Over time, much of the world’s institutional money signed onto the UNPRI guidelines. While some investors joined the party to “tick the box” and invest with reputational peace of mind, most others were pursuing responsible investments authentically because of investor demand and the documented performance achieved by ESG portfolios.

 

Pandemic proves the resilience of ESG

 

Despite the many pro-ESG arguments, some observers called the sustainability trend a “luxury”, meaning it could occur only in the heights of the bull market when companies have the gifts of time and resources and when investors enjoy comfortable returns.

 

COVID-19 silenced many of these doubters when this unprecedented pandemic revealed how important it is for companies to build resiliency against economic shocks. Indeed, we have seen how companies with strong ESG values managed well during the market volatility. Those companies with enlightened risk management, resource stewardship and ethical practices were more prepared to deal with the setbacks. This real-time case study has only intensified the ESG conversation in boardrooms and helped accelerate companies’ plans to strengthen sustainability activities.

 

The pandemic also shifted the focus from the obvious sustainability staples of governance and environmental practices, to the “social” side of the ESG triangle. For instance, diversity and inclusion concerns have risen in importance as the Black Lives Matter movement has intensified. Also, big-picture issues of income distribution, worker rights and safety, and our health and social safety nets have gained prominence.

 

Many companies are now examining the management of their workforces and supply chains. Others are taking a closer look at the links between companies with strong people and diversity cultures and financial performance.

 

Panning for ESG gold

 

If the previous challenge was convincing skeptics of ESG’s value in the investment process, the next feat involves helping enthusiastic market participants access the right sustainable opportunities. This is an evolving task since ESG combines quantitative and qualitative factors that are largely under-researched. While the quantity and quality of data are improving, particularly as the buyside pushes for increased corporate disclosure, the data can be quite nebulous at times. For instance, on social issues, it can be difficult to connect key performance indicators such as worker turnover and worker safety to the profit and loss statement, but over time we believe the importance of such connections will be self-evident to all investors through improved disclosures.

 

That said, it is our job as analysts to determine what data are relevant and meaningful as part of our investment research process. Working together, securities analysts, corporate strategists and sustainability professionals are trying to understand these factors and integrate ESG into our thought and decision-making methodologies.

 

It’s exciting that, as the marketplace shares more information, we are refining the way we use these data to ask different questions. ESG reporting is the starting point, not the finish line. It helps us have better conversations with companies and get to the bottom of what they are doing and how that translates into operational and financial performance, and extends to shareholder stewardship and stakeholder engagement. This allows us to identify best-in-class companies and laggards, plus it also helps us find the ones that have strong potential to outperform in the future, based on trends of ESG improvement over time.

 

With ESG becoming a necessity in a post-pandemic world, companies appreciate how the market will recognize those that are doing it right versus those that are just playing along or trying to put a “green bow” on their products. While the challenge of measuring ESG is currently great, the rewards of getting it right are high. As our processes mature, we can discover real numbers, real stories and real strategies that show which companies are doing a better job. This is becoming a necessity for both investors and for companies that understand how capital will follow those that demonstrate forward-thinking.

 

1 Robert G. Eccles, Ioannis Ioannou, and George Serafeim, “The Impact of Corporate Sustainability on Organizational Processes and Performance,” Management Science 60, no. 11 (November 2014): 2835–2857.

 

2 Blackrock Investor Relations

 

View Reg AC Certification and Disclosures

 

For more information about Scotiabank’s ESG research, please contact:

 

Patrick Bryden
Head of Environmental, Social and Governance Research
403-213-7750
patrick.bryden@scotiabank.com

 

Learn more about our Sustainable Finance Group

 

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