Volatile Transitions: Navigating ESG in 2021

Anthony Campagna is Managing Director and Duncan Paterson is Associate Director at ISS ESG, the responsible investment arm of Institutional Shareholder Services. This post is based on their ISS ESG memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

Key Takeaways

  • The forecast recession and “long ascent” of global economic recovery after COVID-19 will require a strong commitment and decisive action from financial markets.
  • While the global economic downturn has been a time of significant stress for all investors, the willingness of international governments to couple stimulus programs with sustainability objectives offers a clear opportunity for responsible investors to play a leading role in the recovery.
  • Regulatory pressure will be a key driver for responsible investment practices in 2021, with significant initiatives in the European Union coming into force, and governments in Asia making strong commitments to Net Zero targets.
  • While the term ESG is broadly accepted in responsible investment markets, the range of issues that responsible investors are called upon to consider daily continues to expand. The topics covered in this paper are framed in three broad conceptual groupings: Planetary Boundaries, Inclusion and Stewardship.
  • ISS ESG has identified 10 of the key global trends that we believe responsible investors will be focusing on through 2021, both in terms of impacts on portfolio risk/returns, and in terms of time spent managing policies and stakeholder relationships.
  • This year we have also prepared a regionally-focused paper for each of the Americas, EMEA, Asia and Australia/New Zealand, highlighting risks about which the local teams in each region are speaking with their own networks.

Overview

As the world seeks to reconcile the impacts of the first, second and subsequent waves of COVID-19, investors and market participants usher in 2021 with equal measures of optimism and consternation. While working with uncertainty has been a modus operandi of the industry since its inception, 2020 tested the resolve of even the most seasoned Environmental, Social and Governance (ESG) investor: the oft-prophesied Black Swan event collided with already intensifying ecological, economic and socio-political pressures, paralyzing companies, cities and democracies across the world. In this climate, the role of the responsible investor emerges with renewed purpose.

The International Monetary Fund has outlined a “long and difficult ascent” for the global recovery, predicting the most severe recession since the Great Depression. While the recovery is projected to be “disproportionate and uneven,” the financial market is expected to play a pivotal role. For responsible investors, that role entails both damage control and an altered scope of investment opportunity concerned with restoring stability. As nations attempt to recover their economies, implementing policies to shield their borders and industries against further systemic disruptions, the need emerges for investor vigilance across industries employing vulnerable communities or operating in regions with weak employee protections.

Simultaneously, knee-jerk and protectionist reactions from governments and regulatory bodies threaten to jeopardize the significant gains of the last two decades of ESG activism and policy reform, particularly in the areas of climate change and ecological management. Compounded by civil and geopolitical tensions cultivated in the aftermath of pandemic restrictions, the investment landscape of 2021 is characterized on the one hand by fragility, and on the other by the urgent need for decisive and committed action. For asset owners and asset managers, such action includes the capacity to:

  • engage in support of labor, human rights, and health and safety protections of
    employees in global supply chains;
  • advocate against premature withdrawals from or reversal of climate change policies
    on global, regional and national levels;
  • bolster the potential of a green recovery in ailing economies; and
  • utilize active ownership strategies that hold companies to account for decisions that disrupt or exploit already volatile and biased economic and social structures.

While such levers have always been available to investment actors, they take on new meaning and uses in a world bracing for widespread recession and ongoing systemic dysfunction.

Responsible investors also have an unprecedented opportunity to call other market players to the table. The downturn initiated by COVID-19 has brought to light the potential for ESG-savvy investments to buoy economic markets in times of crisis, with ESG funds overall outperforming the S&P500 in 2020. Proof that investors globally were taking note, the U.K.’s Investment Association reported that responsible investments in 2020 enjoyed an almost four-fold increase from 2019.

Such trends are supported by the findings of the 2020 ISS Asset Owner’s Stewardship Survey, which identified an increasing focus of asset owners on stewardship activities that work to hold companies accountable for ESG risks—particularly in those sectors weakened by COVID-19. Furthermore, the ISS ESG Asset Manager’s survey conducted in Q3 of 2020 found that 62.5% of the asset managers surveyed reported an increased focus on social issues due to the pandemic, with 44% expecting future ESG ratings to increase the value attributed to issues such as workplace safety, treatment of employees, diversity and inclusion, and supply chain labor dynamics. Overall, more than a third (37.5%) of asset managers reported plans to hire more ESG-related staff to manage the expected increase in workload.

Regional Developments

Regional trends in ESG risks emerge as a confluence of several macro trends endured through 2020. Stoppages in the manufacturing of consumer staples and consumer discretionary goods exacerbated labor and human rights, modern slavery and occupational health and safety in key supplier countries. The global surge in demand for health care and personal protective equipment highlighted frictions in wealth disparity and social inequality on the one hand, and weaknesses in waste disposal processes and plastic pollution risks on the other. As these risks unfolded alongside increasing rates of climate change and refugee migration, civil society in several regions grew increasingly unstable, bringing concerns around governance, accountability, and the urgency for climate change action into sharp focus.

Americas

Following the widespread Black Lives Matter protests that gripped the country and ripped across global headlines, the election of Joe Biden in the U.S. has been seen as an encouraging sign of progress towards the restoration of economic and social stability in the United States. Biden’s hallmark $1.7 trillion plan to fuel a “green recovery” from COVID-19 suggests enhanced potential for the nation to achieve the goals of the Paris Agreement. Other ESG-related by the Trump presidency are also expected to be revised.

Meanwhile in the region’s south, the Amazon rainforest fires and enhanced measures to protect biodiversity in Brazil remain high on the ESG radar. The Bolsonaro government faces a threat of divestment by major European investors—including divestment from government bonds—if ESG risks facing the Amazon rainforest regarding deforestation, mining and beef production are not addressed.

Such actions are consistent with a greater demand for ESG-aligned investments across the Latin American region, where demand for ESG-investment has tended to outstrip supply. Encouraging developments include Mexico’s issuance of the country’s first ESG-themed ETF, which drew over $450 million within two months of issue, as well as the new entry of two of the country’s largest pension funds to PRI membership. Where this momentum can stimulate genuine action, the Latin American region is considered to have strong gains to observe from implementing a “green recovery” from COVID-19, with Chile already leading the way in the development of significant renewable energy capacity.

In our regional ESG Themes and Trends 2021 paper for the Americas, we drill down into four key ESG topics:

  • Topic 1: ESG’s Hidden Asset—All That Cash
  • Topic 2: Climate Change—The Other Global Pandemic
  • Topic 3: Biodiversity Developments in 2021
  • Topic 4: Diversity & Inclusion—One Step Forward, Two Steps… Forward

Asia

ESG developments in the Asia Pacific region have largely been characterized by a surge in green finance and increased regulatory commitments regarding ESG issues. Some notable developments include commitments by the Japanese government to become carbon neutral by 2050 and bolster $2 trillion in green business and investment, and the Indian Government’s introduction of a landmark Stewardship Code outlining six principles that include the mandatory requirement to monitor and engage with investee companies on ESG risks. China will also implement mandatory environmental reporting by companies in 2021—delayed from 2020 due to the pandemic, while the Hong Kong Stock Exchange implemented mandatory ESG disclosure rules regarding board disclosure, climate change and ESG reporting.

Despite these significant moves by several governments within the region, the short- to medium-term impacts of COVID-19 on supply chain production across several countries in the region have highlighted concerns regarding employee welfare. An ILO policy brief released in June 2020 found that employees in Asia and the Pacific represented those at highest risk of losing their job. While the ILO urges large-scale support for enterprises and enterprise workers, ISS ESG research has highlighted emerging risks of violation and abuse of modern slavery regulations, coupled with weak enforcement, across the region.

Increased attention flowing to the “S” aspect of ESG as a result of the COVID-19 pandemic is also likely to lead to scrutiny of the traditionally low levels of diversity observed within Asian companies. International and regional investors are likely to be taking a more proactive approach in their engagement strategies in the coming year.

These and other issues are examined in more detail in our dedicated Asian edition of the ESG Themes and Trends 2021 research series Specific topics covered include:

  • Topic 1: The Shift Towards a Mandatory Climate Risk Disclosure Regime in Asia—Will
    There Be a Resulting ESG Data Boom?
  • Topic 2: China—Climate and the Five-Year Plan
  • Topic 3: Supply Chains in Crisis—Why Transparency Is Vital to “Build Back Better”
  • Topic 4: Japan—Diversity Beyond the Boardroom

Australia & New Zealand

Investors in Australia and New Zealand continue to lead in their integration of ESG, with the Responsible Investment Association Australasia reporting responsibly managed assets under management growing by 17% year on year, and now representing 37% of total managed assets.

Incidents like the destruction of the 46,000-year-old Juukan Gorge caves in Western Australia by mining giant Rio Tinto have raised investor doubts about the practices of the important resources industry, however. The region has also made headlines for Australia’s lagging legislative action on climate change and emissions reductions, which are seen as particularly tone deaf given the widespread acknowledgement that the devastation of the 2019 bushfires was worsened due to climate change. Nevertheless, members of the Australian Sustainable Finance Initiative have forged ahead with a series of ambitious recommendations that seek to align financial market practices with the targets of the Paris Agreement and other global initiatives.

As noted above, some of the largest Asian markets for Australian resources are committing to Net Zero targets—given national policy support for the export of fossil fuelintensive commodities, how well prepared is the Australian economy for some of these key markets drying up?

The New Zealand Government, following its Zero Carbon Act of 2019, declared a climate emergency in December 2020, and has proceeded with strategies that aim to achieve climate neutrality by 2050. Most notably, in September 2020 the New Zealand Government mandated climate-related financial disclosures for all publicly listed companies, large insurers, banks and investment managers—a move that demarcated the island nation as the first jurisdiction in the world to require compulsory climate change reporting.

The local ISS ESG research team has prepared a regionally focused ESG Themes and Trends 2021 paper. Topics covered in this analysis include:

  • Topic 1: Bang! And the Reputation Is Gone—Indigenous Inclusion in the “Never Again”
    Era
  • Topic 2: Portfolio Disclosure—This Time for Sure!
  • Topic 3: Water Stress—Still a Big Deal in 2021
  • Topic 4: Buy Now, Pay Later—Investor Dilemmas Around Consumer Credit

Europe, Middle East & Africa

In the European Union, the EU Green Deal has put forward plans to cut a further 55% of emissions by 2030, with an aim to achieve climate neutrality by 2050, and further measures expected to be announced in June 2021. Several pieces of sustainable finance legislation are being fine-tuned or are coming into force. The EU Taxonomy Regulation for example, is intended to ensure that designated environmentally sustainable economic activities genuinely contribute to climate change mitigation and adaptation and thus to the transition to a low-carbon economy.

In the Middle East, issuance of green and sustainable bonds increased by 50% during 2020 correlating with increasing legislative actions in the region aimed towards a green recovery. The 2019 INVESCO Global Sovereign Asset Management survey also found almost 60% of 139 sovereign investors and central bank reserve managers in the region reported incorporation of a top-down ESG strategy—an encouraging sign for a region often lagging in performance against traditional ESG benchmarks.

With an eye firmly focused on the “S” of ESG, the African Development Bank won accolades after its issuance of a $3 billion “Fight COVID-19″ bond, which aims at remedying the social impacts of the pandemic. Social bonds and green bonds are a key means through which a “green recovery” is anticipated for African nations, as evidenced by ongoing growth in the issuance of sustainable bonds and social bonds since 2019. Companies and investors working in African countries will also be increasingly impacted by the changes to the Equator Principles which came into effect July 2020 and dictate greater alignment with the UN Guiding Principles on Business and Human Rights, the Recommendations of the Task Force on Climate-related Financial Disclosures, and adherence to the International Finance Corporation’s standards regarding Free, Prior and Informed Consent.

ISS ESG’s team in EMEA has pulled together their top three ESG Themes and Trends for 2021. The topics covered are:

  • Topic 1: The EU Sustainable Finance Disclosure Regulation
  • Topic 2: Mandatory EU Human Rights Due Diligence—A Game Changer for the
    European Market
  • Topic 3: Biodiversity—A Major Linchpin for Investors in 2021

Summary

The issues and developments highlighted above are but small parts of the increasingly complex and diverse global ESG landscape that greets investors in 2021. With the impacts of the pandemic still looming over most economies in the world, responsible investors face a balancing act of maintaining momentum on climate change action, while becoming instrumental actors in the recovery and redevelopment of localized economies.

In the process, a sea of “red flag” issues across labor and human rights; biodiversity and resource scarcity; wealth disparity and income inequality; and governance and accountability, demand immediate attention and investor mobilization. Fortunately, ESG investors are now seen to be ahead of the pack, and in prime position to utilize their reputations to garner greater mainstream buy-in towards sustainable business practice. As such, 2021 offers responsible investors an opportunity to truly live up to their potential, aiding in the delivery of a socially and environmentally sustainable global recovery.

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