Comment: Covid-19 has brought the 'S' in ESG back into focus

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While the covid-19 crisis has no doubt emphasised how critical balance sheet resilience is now for companies and their longer-term viability, it has also accelerated a number of environmental, social and governance (ESG) themes, which existed before the crisis. Many investors and executives argue that now is the time to "build back better" and create a more sustainable corporate world, as Julie Moret reports.

We're still in the early stages of understanding the longer-term impact the covid-19 pandemic will have on the real economy. That said, the immediate impact on people's lives and the dislocation of markets is evident.

The crisis has both intensified and highlighted a range of societal issues, such as growing inequality and the fragility of customers and employees, especially in certain segments of the economy, which have been left with little protection. It has also underscored the interconnectedness of people, the planet and profit.

What we're advocating are the ingredients that go into capturing quality and incorporate wider attributes."

These drivers will increasingly require us to reframe what a well-managed business looks like. It reflects the increased pressure all companies face to manage a wider group of stakeholders beyond just shareholders.

What we're advocating are the ingredients that go into capturing quality and incorporate wider attributes. The crisis shines a light on the growing relevancy to corporates of wider stakeholder-oriented models, which provide equitable returns not just to shareholders but to employees, customers and suppliers, as well as the effective management of environmental externalities. All these considerations ultimately earn a company's social license.

This infers a focus on stewardship and active engagement by investors. As investors, we are responsible stewards of our clients' capital, which is to say we look after the assets our clients have entrusted us, with a view of returning them in a better condition than which we acquired them in the first place.

ESG information provides an assessment on how companies are managing these issues. As such, it becomes a tool not only to further differentiate between well-run businesses versus the laggards, but also identify companies that are making a positive societal impact.

We've been advocating this for quite some time—companies need to consider wider stakeholder models in a changing world. We are mindful that businesses today are facing significant cost pressures in regard to allocating capital towards the welfare of staff, customers and suppliers.

The conversations we've had with companies during this uncertain period have revolved around the strength of balance sheets, cash flow sufficiency and liquidity—all of which we use to assess whether a business can continue to operate over the long term.

Our messaging has focused on exercising prudence and caution with a view that management should review the appropriateness of dividend and buyback programs, examining whether these policies could weaken the operational viability of the business in the face of the near-term pressures we outline above.

Bailout conditions impact dividends
In this current crisis, some of the first companies to cut dividends have been consumer-facing, including retail, entertainment venues, travel and leisure—areas where coronavirus-induced lockdowns brought business to a near halt. This dividend-cutting trend is likely to be sustained if measures to contain the pandemic negatively impact other parts of an economy.

In the United Kingdom, for example, as part of the government's covid-19 bailout program, companies that place employees in the furlough scheme—which provides income for unemployed workers—have been banned from paying dividends. The program, now extended until the end of October 2020, grants employers that use temporary furloughs (instead of permanent layoffs) 80% of their workers' monthly wages, up to £2,500 per month.

Additionally, UK officials have told banks not to use any emergency funding for dividend payouts, as the bailout scheme is centered around helping businesses survive, not rewarding executives or shareholders.

Human capital matters
The coronavirus pandemic has put human capital under the spotlight—issues such as employee contracts and rights have come to the forefront as investors and civil society scrutinise how businesses act during the crisis, including the way they treat their workers.

The crisis has exposed the fragility of independent contractors within the gig economy and those on zero-hour contracts in sectors heavily affected by the crisis, such as entertainment and leisure.

Many of these workers have been left with little protection, both financial and health-wise. Post-covid-19, it is reasonable to expect sustained pressure on companies to improve labour rights and pay, which represents higher costs for companies and implies the levels of free cash flow distribution back to shareholders are unlikely to revert back to pre-covid-19 levels, at least in the near term.

An increasing number of companies have adapted to meet wider stakeholder models by re-thinking the "S".

Some businesses, such as global cosmetics giant L'Oreal, promised to pay its small- and medium-sized suppliers on the first available day, rather than delaying.

Others, such as Japanese internet company GMO Internet, prioritised employee wellbeing and instructed all 4,500 employees to stay home and work remotely, two months ahead of Japanese government advice. In the United Kingdom, Bet365 said it would guarantee earnings for five months and jobs until at least the end of August 2020.

Corporate culture has also reached a turning point. We sense a shift in perception where virtual meetings and flexible working hours become more acceptable as business leaders consider how to create an environment conducive to employee needs. We've observed creative solutions some companies have made during the current crisis, including use of new technologies, including telecommunications.

'S' won't eclipse 'E'
Sustained growth in client demand for environmentally focused capabilities, along with political and regulatory momentum in a number of countries, will likely ensure environmental matters aren't eclipsed by the near-team focus on the societal issues.

In fact, a study we sponsored earlier this year revealed that environmental issues remain top of mind for investors. When asked to rank ESG factors, nearly half of the respondents in the survey (46%) said they believe environmental factors are the most important, with just 34% citing governance, and the remaining 20% for social issues.

The growing relevancy of environmental issues linked to climate change, natural resource scarcity and efficiency is undoubtedly driving greater interest in ESG products and solutions. Regulatory pressures are also accelerating these themes. Encouragingly, the study's findings show that advisers are responding to the increased demand for ESG-focused strategies from clients, which should help deepen the industry's knowledge and innovation in this space.

The crisis has underscored our conviction that companies, which take environmental and social issues into consideration, and have good standards of corporate governance, will likely be more resilient businesses and better at navigating periods of shocks. We remain convinced that the time invested in understanding and integrating ESG issues into the investment process, in addition to our corporate engagement, makes us better-informed investors.

Julie Moret is global head of ESG at Franklin Templeton.

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