Comment: The long and the short of ESG in the covid-19 crisis

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There has been a view that environmental, social and governance (ESG) investing was just a fad, which would go away at the end of the bull market because it was expensive and just something nice to have while the going is good. It's time to reset priorities, argues Camilla Ritchie.

The covid-19 crisis is therefore a good test of ESG, with many wondering how would it perform in these exceptional market conditions.

It's still too early to say anything much about how financial markets are going to turn out once this pandemic passes, but ESG has been a bit of a bear market phenomenon, with strong flows of money into ESG ETF funds during the first few weeks of the crisis, while other funds saw outflows.

ESG stocks have shown their worth in the immediate shock of the crisis, both in terms of resilience and diversification benefits, and are likely to be a strong position when markets return to a growth trajectory."

Why is that? It could be due to a number of things. Perhaps people have been buying companies that score higher in terms of ESG because they have appreciated how much less pollution there has been, or how much society has come together to beat the virus by locking down and keeping safe.

Maybe it's been felt that ESG investing was a way to change company behaviours by giving the nudge to good ESG companies and avoiding others.

Additionally, it appears that ESG indices have been showing better performance too.

This last point could be connected to the fact that ESG indices are typically made up of fewer companies that are dependent on market cycles or companies that look cheap but don't offer very good growth prospects.

The ESG indices also tend to have more companies that are so called "quality" or "growth" orientated, which have delivered relative outperformance compared with cheap value and cyclical stocks during the crisis.

Finally, ESG has in the past been a good indicator of company resilience, with ESG companies less likely to fail than those that score badly in ESG terms.

In bull markets some companies borrow heavily against their balance sheet, but find when cash flow dries up they struggle to survive.

When properly assessing the E, S and G factors, however, a high level of borrowing would raise warning signals over governance.

In a crisis like this there has been a flight from more risky companies such as these to those which are seen to be more resilient.

For all of these reasons, ESG stocks have shown their worth in the immediate shock of the crisis, both in terms of resilience and diversification benefits, and are likely to be a strong position when markets return to a growth trajectory.

But what are the longer-term prospects for ESG?

Resetting priorities after covid-19
In the future, we need to make sure that this change sticks.

In the immediate aftermath of the Global Financial Crisis, pollution levels were far lower due to much lower economic activity, but then when this picked up pollution levels went right back up again.

It needs to be different this time if we are going to achieve carbon reduction targets set by the 2015 Paris Agreement on Climate Change, with the goal of limiting global warming to between 1.5% and 2% by 2050.

The consultancy McKinsey has suggested that a low carbon recovery is a distinct possibility. They surveyed both developed and emerging countries for their views, with nearly two-thirds of survey respondents saying governments' economic-recovery efforts after Covid-19 should prioritise climate change.

Taking a European country as an example, if this was provided with up to €150bn of capital for climate related projects, they calculated it would yield over twice that in gross value added, with three million new jobs created either directly or indirectly.

This would enable carbon emissions reductions of the order of 15%-30% by 2030.

In addition, they pointed to an academic paper which showed that for every $10m invested in renewable energy and energy efficiency projects, there would be 152 direct or indirect jobs created against only 25 jobs in the oil industry.

So, from an employment and ESG point of view, this investment should be directed to green projects rather than non-ESG ones in the fossil fuel industry.

Maybe the European Commission has read the McKinsey report because it has just announced that it wants to make €750bn available in the form of grants and loans to put into green projects to help the economy after that Covid-19 crisis.

The money will only be available to those projects that are green and in line with the Green Deal.

This is the EU's roadmap for making the EU's economy sustainable, turning climate and environmental challenges into opportunities across all policy areas and making the transition just and inclusive for all.

This could include projects aimed at transitioning a company from being high carbon to low carbon, not just for companies on the right side of the energy transition today.

Should governments around the world adopt these or similar measures then we could be well on the way to reaching the targets of the Paris Agreement.

This would be good news for companies involved in businesses that help to reduce carbon emissions, such as renewable energy generation companies and high tech companies operating with a low carbon footprint.

High carbon emitters, such as those companies in the fossil fuel industry would be challenged, as would a large part of the traditional manufacturing industry relying on high energy inputs and carbon intensive transportation.

In such an environment, it looks like ESG investing could be a winning formula in the long term too.

Camilla Ritchie is senior investment manager at Seven Investment Management.

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