There's no doubt covid-19 is altering global societies and economies. Yet the virus is affecting investment theory, too. There is a growing consensus among many investors that the so-called neoclassical economic theory must evolve past the sole focus of maximizing firm profits. By Guillaume Mascotto
These investors assume what is good for the long-term viability of our economic system and society will also lead to good stocks and good companies. As a result, investors are increasingly measuring company performance by more than just financial profit and loss. While key trends were already altering the investment management landscape before the covid-19 outbreak, we believe the virus' escalation to a global pandemic will hasten the shift in mindset toward sustainable investing. This shift does not seek to splinter socio-economic development. Instead, it seeks to achieve a balance between environmental, social and economic considerations.
Systemic risk v idiosyncratic risk
Public health is a key ESG issue, but it's important to distinguish between systemic risk and idiosyncratic risk. Negative public health externalities are only the results of idiosyncratic risk if company misconduct or process quality/asset integrity failures trigger the issue.
Integrating material ESG factors within fundamental research can help minimize downside risk or capture upside potential not otherwise captured by traditional financial analysis."
In the case of covid-19, there's currently no evidence establishing a direct link between the pandemic's cause and companies' ESG risk management practices. Nevertheless, the pandemic's reverberations will undoubtedly impact those risk management fundamentals in the future.
Three major ESG implications of covid-19
Against this backdrop, we have identified three major ESG implications of covid-19:
1. The "S" pillar of ESG will gain traction.
We believe the pandemic's tangible consequences will result in growing investor focus on companies' social performance. We expect investors to consider more qualitative indicators as a gauge of long-term competitiveness (human capital) and operational integrity (business continuity). These indicators include:
- emergency response mechanisms (e.g., telecommuting, distributed management)
- supply chain controls (e.g., quality and safety management, local v global dependence)
- employee benefits (e.g., paid sick leave, health and well-being programs, short-time work, telemedicine)
As companies adapt to the "work-from-home era," they also face heightened data privacy and security risks. This makes managing cybersecurity risk incredibly important. Best practice cybersecurity programs include:
- General Data Protection Regulation (EU GDPR) compliance
- best-in-class certifications (e.g., ISO 27001-2, ISO 27018, SOC, PCI, FISMA)
- dedicated, quarantined IT security staff
2. Investors will increasingly seek active ESG solutions.
We believe integrating material ESG factors within fundamental research can help minimize downside risk or capture upside potential not otherwise captured by traditional financial analysis. The pandemic-led volatility underscores the importance of active ESG solutions when navigating market cycles.
Our underlying investment philosophy assumes high-quality issuers with strong fundamentals will outperform over time if they also have:
- long-term competitive advantages
- strong ESG risk management practices
- solid margins of safety against short-term adverse systemic forces—including rising costs related to COVID-19
We dub this an ESG Active Barbell approach.
3. Nature, health and finance will become intertwined.
Some observers think the covid-19 pandemic detracts from the fight against climate change. They fear public and private investment in renewable energy will decline due to lower near-term profits and potential capital reallocation toward social-related risk management priorities.
In reality, the drastic mitigation measures put in place to fight the virus may be helping clear the air, too. Geospatial data from the European Space Agency's Sentinel-5P satellite and NASA show a 40% reduction in nitrogen dioxide levels over Italy. Similarly, nitrogen levels over eastern and central China have fallen 10%-30%.
Just as mitigation measures are likely to remain in place in the near term, their positive effects on the environment and public health are also likely to persist.
While weather conditions could skew data of satellite observations, asset owners focused on decarbonizing their portfolios may take the opportunity to redouble their efforts—arguing that urgently transitioning toward a lower-carbon economy is, in fact, doable.
The association between particulate matter ambient air pollution and serious health implications is well documented. A 2019 study in the New England Journal of Medicine, for example, concluded that short-term exposure to certain types of particulate matter in 652 cities worldwide was independently associated with daily all-cause, cardiovascular and respiratory mortality.
It is possible the drop in air pollution may be offset as global industries ramp up again to make up for economic losses once the virus is contained. In this context, investors are likely to favour companies that go beyond regulatory compliance and embrace the right long-term strategic direction. In addition to strong social-related risk management programs, this strategic direction could include investment in renewable energy or negative emissions technologies, board-level oversight on environmental performance and executive long-term incentive targets aligned with the International Energy Agency's 1.5°C Sustainable Development Scenario.
Moving toward a circular economy mindset
The covid-19 pandemic and its material human, economic and financial costs could very well support the notion that the environment, public health and the global economy intertwine. As such, we believe investors are likely to look for ways to align their investments with the long-term safeguarding of the planet and people's lives without sacrificing returns.
Guillaume Mascotto is head of ESG and investment stewardship for American Century Investments