If 2020 was the year where the pandemic exposed the gaps of our social fabric and financial systems, then 2021 must be the year where we mend these gaps for the better. Covid-19 has had uneven repercussions within countries and across continents, and a key factor determining how well an entity is coping is its level of resilience. Building resilience can be achieved through embedding sustainable practices throughout a business, but this does not happen overnight – it critically relies on committing to a long-term view and an emphasis on values.
Mainstream investors who expect to beat market returns in the long run should consider how to build resilience into their portfolios for both potential and existing investments. To do this, they can follow a three-step process: First, educate themselves on the sustainable elements relevant to the investment world and implement the ones important to them; second, communicate the process to their key stakeholders; and lastly, identify key investment opportunities using their enhanced lens.
EDUCATION IN SUSTAINABILITY
Meta studies have shown that the performance of non-financial factors can in turn affect the financial performance of a company, and hence an investor’s portfolio, especially in the long run. It is therefore crucial for an investor to firstly be able to assess a company’s non-financial performance – commonly covered under corporate sustainability performance – and secondly, know how to incorporate the evaluation of a company’s sustainability credentials into the investment decision-making process.
The key to assessing sustainability performance is understanding the pertinent environmental, social and governance (ESG) issues to the target company’s subsector – also known as material ESG issues – because they can vary greatly across industries, mainly depending on the company’s value chain. For instance, ESG issues for an industrial manufacturer will typically include carbon footprint (environmental) and worker safety (social), while matters such as data privacy and product governance (both governance) are of more consequence to a financial institution. These aspects are typically non-financial in nature, yet a comprehensive evaluation of their performance can be a proxy for how well the company’s management is operating holistically, which is an important consideration in times of crisis.
The Sustainability Accounting Standards Board (“SASB”) is a great starting point to access recommended ESG issues for disclosure according to sector and subsectors. Another option is the Global Reporting Initiative (“GRI”) which is less prescriptive; it not only provides a universe of ESG issues but also the process to conduct materiality assessments, helping to determine the issues that should be prioritised.
Incorporating the evaluation of sustainability performance into the investment process, on the other hand, is more art than exact science. Instead of reinventing the wheel, an investor can start by exploring the common investment methods which incorporate ESG considerations such as negative screening, positive screening (or thematic investing) and ESG-integration. Negative screening avoids investing in certain sectors due to their ESG impacts (such as alcohol or coal), while thematic investing is to specifically invest with environmental and/or social outcomes in mind (for instance, in clean technology or women-led startups). Both screening methods tend to be static while the ESG-integration method is more dynamic. The latter can include factors such as ESG risk scores as well as tracking the occurrence or management handling of ESG controversies which can change anytime and must be constantly evaluated.
COMMUNICATING THE NEED FOR RESILIENCE
Each player in the financial system must demand a more responsible investment decision-making process to build a more resilient world. We all have a role to play, whether as a client of a bank, an external fund, or as a potential or existing investor in a company – if no one is responsible, then it means everyone is responsible.
From the investors’ perspective, demanding companies track and disclose their data is a good place to start. Decent quality data is needed for sustainability assessment across the various investment methods which can be used to consider sustainability issues. The key feedback from companies which do not disclose data is simply that their investors are not asking for it. Therefore, as investors, we should communicate our demands for sustainability data clearly, bearing in mind that non-financial performance of a company can have material financial consequences, in turn affecting our portfolios.
Generally, there are two ways investors can effectively communicate this request. The first is through direct engagement with the company; in this case, it is usually effective to explain the benefits of thorough sustainability performance management and reporting, which includes building resilience. The second method is through the investor’s own annual disclosures, such as a sustainability report – in this instance, investors are advocating that such practices should be made mainstream. One of the reasons commonly cited by investors who have not yet considered ESG issues in their investment decisions is the lack of good quality data – all the more reason for investors to be demanding this of companies.
Regulators are catching up with disclosure requirements for investors, especially in terms of climate change risks which they see as a very real, quantifiable threat. Despite climate risk quantification exercises having been criticised as not exact science because of the lack of data and varying assumptions in scenario analysis, climate change risks remain. In fact, the longer we take to address the situation, the sooner we will be faced with the negative impacts on our businesses and portfolios. The EU, New Zealand and Singapore have all issued varying levels of environmental risk management reporting requirements for financial institutions, while Hong Kong recently closed its consultation paper on disclosure of climate-related risks by fund managers.
IDENTIFYING OPPORTUNITIES WITH AN ESG LENS
Out of the E, S, and G issues, the environmental ones tend to be most quantifiable as compared to social or governance issues which are more qualitative in nature, and there is still plenty of debate on whether the S and G proxy quantitative indicators are indeed good benchmarks of such qualitative aspects. Combining this with secular trends observed in the media and the swell of countries committing to the net-zero target in the past year, the investment theme of decarbonising the economy will remain high on the agenda in 2021.
In order to achieve carbon neutrality by their respective target dates, estimates put the Chinese bill at $15trn over the next 40 years and the EU bill at S$2.8trn by 2027, while Biden has campaigned for access to $2trn spending on climate change during his presidency. The EU, China and the US contribute to 50% of annual global carbon dioxide emissions and amongst them will need to spend at least US$1 trillion every year to hit their carbon-neutral goal. Energy production for industry, transportation and use in buildings accounts for almost 75% of global emissions, meaning three key areas of growth in decarbonising the economy will be energy production and storage, transportation, as well as other infrastructure and buildings.
With the pandemic far from over, social bonds issuance will not be abated as efforts continue to try and tackle the underinvestment in sectors such as healthcare and programmes to generate sustainable employment or promote socioeconomic advancement. Social bonds issuance grew eight times from $17.8bn to $149.1bn between 2019 and 2020 with the EU contributing 43% of the total and supranationals, such as the Asian Development Bank (“ADB”), contributing 37%. Of the €100bn ($121.3bn) social bonds pledged by the EU, 60% was issued in 2020, leaving the remainder for 2021. While not the only avenue, social bonds are now a popular way of funding projects needed to build resilience, especially in Europe where the bond markets are much better developed and access to private capital is readily available – hopefully they are here to stay.
Everyone has a part to play in cultivating the fabric of resilience; though everyone might be at different points of the journey, we must all start somewhere. Doing good without compromising returns is more than possible, and future-proofing our value chains in the long run helps achieve this goal. While we have embarked on the journey to build back better at Maitri Asset Management, we recognise that we will always have more to do as investors and there is a long path ahead. The best time to start was yesterday, but there is no better time to start than today.