ESG Focus | Nov 05 2020
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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
–Institutions mobilise for social investment as governments "lean in"
–Social and green investments to benefit from structural tailwinds of 4IR
–Covid ushers in governance changes for boards
-Geopolitical implications are profound
ESG Focus: Covid, The Aftermath – Part 3
By Sarah Mills
In Part 1 and Part 2 of the Covid series, we discussed the mooted “green” recovery, the anticipated rise of the social enterprise, and explored the macro-economic backdrop and stimulus funding for these two massive shifts.
In this article, we discuss the affects of covid on the broader investment market and drill down into the implications for green investing, social investing, and corporate governance. We finish with the winners and losers.
A quick recap
The world is facing two scenarios: a vaccine is discovered and the world emerges from lockdown with a safety net; or no vaccine and the world emerges from lockdown regardless. In either scenario, the economic fallout is likely to be only a matter of degree.
The International Monetary Fund expects the global economy will shrink -4.4% this year, throwing billions into poverty.
Modern monetary theory has gained ascendancy, as governments commit to print money to repump the economy on the premise that, as long as supply outstrips demand, inflation will be kept in check.
The agenda is to issue free money to institutions and governments which then on-lend it. The wildcards are historic debt levels and economic drag from zombie corporations.
Much of this stimulus is expected to be channelled via central banks and governments to countries and companies that demonstrate commitments to decarbonisation, a circular economy, social enterprise (including health) and 4IR technologies.
The OECD argues the faster these shifts occur, the better the prognosis for markets, and believes the resource efficiencies alone will pay for the transition to a circular economy.
Others suggest these gains will be further leveraged through structural tailwinds of 4IR, renewable technology, internet of things, 5G and quantum technology. It is estimated the innovators of the past decade are likely to be the ones that pay-out this decade, given the time-to-market for new technology.
The stimulus is expected to be filtered through ESG disclosure nets; and governed and policed through ESG ratings, regulation and taxes to manage public debt-to-GDP ratios (which may well hit the fossil fuel industry hardest – along with a possible reduction in subsidies).
Institutions managing trillions of dollars, believe covid is a turning point for ESG. ESG has outperformed the market during covid and proved more resilient to demand shock and has established a reputation as the new safe haven.
In summary, covid is expected to accelerate any ESG themes that were in play prior to lockdowns: clean aid, dirty aid, social aid – and investors need to avoid the, ahem, lemon-aid.
We will start with the social theme as it is the most complex and is more specifically related to covid. Then we will check out the green theme followed by direct covid themes such as “persistent fear of infection” (PFI), and the junction of generic themes such as 4IR and technology with social, green and covid themes.
Generally, the winners across all categories are themes that coincidentally dovetail with the UN’s sustainable development goals (SDGs).
Stimulus draws focus to the social theme
By the time the pandemic is over, half the world’s population may be living in poverty. Covid is expected to exacerbate global inequality and policymakers intend to address this through social enterprise.
Trillions of dollars have already been allocated in a largely ad-hoc fashion to alleviating the social impact of covid. As the dust settles, social stimulus is likely to continue in tandem to clean aid and dirty aid.
When it comes to investment, the environment is a relatively easy and simple challenge. Not so social investing, which covers thorny challenges such as human rights, gender issues, military investments, and health, not to mention “patient capital”.
Since covid hit, CSRWire points to a 10-fold increase in impact investing and a 400% increase in grants, much of which was specifically related to the effects of covid.
For example, of the total $252m placed with fund manager ImpactAssets, donors invested and granted $213m in three covid-related critical needs areas:
-stopping the spread through testing, treatments, vaccinations, PPE, front-line workers and health-care delivery;
-supporting social entrepreneurs whose loss in a recession would result in a major regression in equality; and
-building community resilience for low-income communities.
“Preserving progress” in green entrepreneurship during recession has also featured during covid.
The above covid themes are transitory but for the long-term social investors, modern slavery, employment conditions and pay, remain the key themes.
The social market is divided into two main sectors: large existing organisations aiming for best-in-class ESG status and social impact start-ups and investments.
The former will initially be addressing issues of modern slavery in supply chains and human capital management.
To attract ESG equity capital, companies will have to demonstrate clear progress on these fronts. Capital is likely to be diverted away from laggards. Some may choose to issue social bonds linked to these improvements.
Fund managers will soon be reviewing and assessing all investments in corporations within a social context; including their baseline performance on indicators of racial, gender and socioeconomic equity.
Some indicators are easily drawn from annual reports: such as gender make-up of boards and increasingly, modern slavery registers.
The latter (social impact start-ups and investments) that aim to promote social good or prevent social ills will be elevated onto the ESG radar. Social impact investments sharply outperformed during the coronavirus, causing some investors to reconsider their weightings.
In May, the Global Impact Investment Network (GIIN) launched the Response, Recovery and Resilience Investment Coalition (R3 Coalition) – an alliance of investors, policymakers and philanthropists who aim to catalyse strategic flows of impact-investment capital after covid-19.
R3 Coalition’s main focus is to strengthen both market and societal resilience to future crises and to address systemic inequality linked to poverty, gender, race and ethnicity.
Companies that address imbalances either within their own organisations, or as an impact start-up mission would be candidates for funds.
The most likely recipient of 3R funds will be into health interventions and corporations that improve access to capital in a manner that fills covid-induced gaps.
This appears to be playing out in the fixed-income impact investment market as investors seek ESG support. Artesian for example, recently launched the Women’s Economic Empowerment Bond in partnership with the United Nations Capital Development fund.
The way many of these bonds work is that they screen for a particular impact such as gender, and reward like-minded companies with access to debt. In the case of gender, screens might include women in management, financial empowerment of women, etc.
Government and corporations lean-in on social issues
As mentioned in Part 2 of the covid series, distribution of social stimulus is likely to be ideologically driven.
Governments are less likely to be considered the default provider of social services under the new regime.
Rather, they are expected to act largely as intermediaries for channelling stimulus funds to the private and not-for-profit sectors.
Government grants are expected to be issued to organisations that address key gaps in social inequality, harnessing and focusing capital in a manner that could revolutionise health and other areas, and driving a rapid period of innovation in these sectors. At least that’s the theory.
“Lean” technology development principles are expected to be applied to social issues.
Governments and companies are expected to adopt an “outcomes-based” approach to social investing similar to the “seed capital” approach that has already been modelled between governments and not-for-profits.
It has been suggested that governments could share in profits from this seed capital; and that government and not-for-profit partnerships might also leverage additional private capital.
Community Development Financial Institutions are expected to proliferate and on-lend at low rates. Some are expected to adopt blended finance mechanisms such as credit enhancement or guarantees to de-risk opportunities.
From start-ups to big-business
A plethora of start-ups have hit the ground running in areas as diverse as mental health to social finance. Biotechs are already basking in the sun.
Then there are the larger capital projects that are likely to hit the radar, as the private sector moves into roles once occupied by governments such as public housing. This model has been aired for the past few decades and it appears its day has come.
For example, Italian asset manager Azimut announced in May plans to raise EUR1bn for a social infrastructure fund, citing plans to invest in aged-care homes, schools and student housing. Interestingly, these are assets that took a pounding during covid-19 and enjoy good prospects for recovery.
Big question marks
It is arguable as to whether corporations can ever replace governments in the social welfare arena.
Certainly, the US situation has proven the privatisation of health a failure, delivering poor relative outcomes compared with other western health systems. But investors have benefited and the policy is to continue to divert massive stimulus to these areas.
Nor are the measurement and policing for “outcomes” in place yet. It may be that the funds will be used in the short term simply to buy out smaller operators, raising the prospect of merger and acquisition activity in the social sectors.
Not to mention corruption, a trait shared by both corporations and government.
In Australia alone, journalist Michael Pascoe wrote that he stopped counting politically rorted federal grant programs when he got to $1.1bn.
“I should have kept going to reach $8.1bn,” he writes in NewDaily. “That’s the total for 11 federal programs that have serious question marks – or worse – over their ethics, probity and basic governance.”
When it comes to corporations using government-grant-status for credentials, investors will need to be wary.
Junction investing: where the E, S and G meet
Individual ESG plays are gaining much attention, particularly in the impact market, but corporations and countries that demonstrate commitments to all three: the E, the S and the G, are likely to attract the interest of large investment funds seeking best-in-class opportunities.
There is often a strong overlap between green and social themes, particularly in areas such as onshoring, work-from-home, telehealth, supply chain efficiency, water sustainability and decarbonisation both in impact and best-in-class markets.
Many social impact investors naturally target local investments that have less environmental impact.
The argument goes that the more social issues that are solved, the lower the toll these issues will exact on society and productivity.
Governance will be a critical screen for both green and social investments. Board diversity and director track records, for example will be among the key screens for fund managers.
Structural tail winds
Many speculate that the efficiencies to be gained from a sustainable and circular focus will pay for the cost of investment.
They also expect the fourth industrial revolution will drive massive employment, and policymakers are hoping it will lever the global economy out of recession.
As such, these areas may also qualify for social funding and green funding.Technologies include 5G, self-driving cars, machine learning, Internet of things, mobile phones and quantum technology.
Some estimate these tailwinds will add trillions to GDP and generate millions of jobs to industries such as manufacturing, construction, transport, finance, insurance and agriculture.
Social theme: winners and losers
Bioetech has been the first cab off the rank as a covid-related social impact investment.
Investors are also focusing on a broad range of sectors where technology or processes could advance social equity by democratising access to key products and services or reducing income inequality.
These include energy, housing, healthcare, and expanded services for low-income and under-served markets.
Ironically, the “social” winners tend to be junction investments that reduce face-to-face contact with other humans, such as e-tailing, telehealth and online diagnostics, and platforms that support the work-from-home theme such as Zoom; or platforms like Alia – a portable benefits platform and cash-assistance vehicle.
Other impact investors focus on sectors that contribute to income generation, such as financial services (including microfinance) and education, workforce development and skill building.
Others are targeting investment in industries attracting grant capital to the care economy – a fast growing segment given the ageing baby boomers.
It is also a segment that includes a disproportionate number of low-paid, vulnerable jobs, and improving conditions for these workers would be considered a social gain.
The covid losers: Persistent fear of infection (PFIs)
Before hitting the “green” theme, it is worth examining specifically covid-related shifts in consumer demand. Many of these have a strong overlap with the green theme, but the motivations differ.
Citi analysts point to a shift in consumer preferences post-covid relating to what they dub “a persistent fear of infection” (PFI), which will have long term consequences for the aviation, hospitality and international tourism industries.
The key issue is that the well-heeled baby boomers are particularly vulnerable to the effects of covid, and Citi expects they will withdraw their funds from restaurants, theatres and travel with lasting consequences. International tourism is likely to be particularly hard hit.
Baby boomers are also expected to reduce their exposure to any non-essential contact-intensive services: such as doctors, massage therapists, physiotherapists, podiatrists, dance classes, dentists and team-sports.
This should benefit decarbonisation at the expense of jobs; but we quickly examine the covid-hit fossil fuel industries prior to addressing the broader decarbonisation theme.
The aviation sector only constitutes 2% of global emissions suggesting that, provided emissions from the big emitters such as cars and buildings are substantially reduced, the industry will not be strongly targeted. Rather, the industry represents covid “collateral damage”.
Aviation is expected to recover but not to pre-covid levels, with Citi analysts expecting a PFI among baby boomers will weigh on the sector well into 2021 and possibly indefinitely.
The aviation industry is also expected to face an initial recovery followed by a gradual reduction in demand prospects for corporate travel as online and teleconferencing platforms such as Zoom grow in popularity.
Citi estimates the broader US$1.6trn business travel industry is also expected to take a big hit.
It is a similar tale for tourism and hospitality.
According to the World Travel and Tourism Council, the direct contribution of tourism and tourism trade to global growth was US$2.9trn, and the indirect contribution via local services such as restaurants and hotels was more than double that.
The council estimates that the industry’s combined direct and induced impact contributes US$8.9trn to the world’s GDP; 10.3% of global GDP and 330m jobs (one in 10).
In summary, industry losers from covid include: international tourism and hospitality, aviation, fossil fuels, retailers, real-estate, banks, events, public transport, automotive, arts, recreation and personal care.
On the flipside, these covid trends have given other industries a leg up as governments release a flurry of stimulus to mop up unemployment by accelerating the shift to a circular economy by funding new jobs in industries such as renewables and recycling.
For example, Australia’s LNP government has just set aside $250m in the October 2020 budget to build a manufacturing-oriented recycling base (some considered this a disappointment).
For a country such as Australia that has offshored its manufacturing for decades, covid has proved a wake-up call.
Covid proved less of a demand issues as a supply issue for many businesses, as offshore manufacturing imports ground to a halt, shifting grass-roots business perspectives across the globe.
The silver lining for Australia is that it does not have the drag of legacy manufacturing systems, and has an opportunity to rebuild its manufacturing sector on 4IR technology.
Covid also helped shift business focus more locally or regionally sourced production and companies that use local supply chains, suggesting an acceleration of onshoring of operations.
Covid has forced business to improve their focus on work-from-home options, which also dovetails with the decarbonisation theme.
Any technology, process, policy or procedure that supports the work-from-home shift, from software to communications, is expected to be viewed positively by ESG investors. Nitro Software ((NTO)) is one such Australian start-up that has gained a lot of interest during covid, after replacing a major British big-four bank’s Adobe suite. The bank’s employees totalled 67,000. Document signing capabilities are considered critical to the work-from-home theme.
Citi estimates that if 52% of the US workforce were to work from home one day a week, this alone would lead to an annual fall in carbon emissions of -2.5% from 2020 to 2030. Roads account for 13% of carbon emissions; while building light and heat constitutes 20%.
In summary, covid winners include any industries that support the work-from home theme; online commerce; and the covid-health theme. This includes e-commerce, online entertainment, biotechs, renewables, domestic tourism, groceries, hardware, uber eats, work-from-home software providers, and cloud initiatives for software sharing.
The green theme – decarbonisation accelerated
Covid has accelerated the decarbonisation trend.
Throughout covid, climate change remained the central sustainability theme, its focus extending from energy, to supply chain management and onshoring.
In the US, residential electricity demand rose 3% to 7% in April but commercial demand slumped -5% to -15%; while energy demand generally plunged -5% to -25%, notes Citi analysts.
The International Energy Agency predicts global carbon emissions from the power sector will fall more than -70% by 2040 despite electricity generation rising 46% over the period.
This translates to a massive investment in renewable energy and the IEA forecasts US$550bn will be invested each year in energy efficiency solutions.
Green winners and losers
The big losers from covid were companies associated with the fossil fuel industry: upstream producers, and downstream middle-men and end-users.
The world’s largest renewable utilities proved remarkably resilient during covid thanks to long-term contracts with governments or private off-takers.
These contracts naturally worked against fossil fuel producers, compounding covid lockdown losses.
In Europe, renewable resilience was also supported by government policy, green generators being given priority access to the grid in many countries, forcing fossil fuels to switch off first, and dealing fossil fuels a third blow.
“Renewable developers remain more resilient than conventional power generators, especially nuclear and coal, and energy suppliers,” wrote Bloomberg Intelligence analysts for S&P Global intelligence.
S&P expects the brunt of the impact to register in 2021 and 2022 as a result of reduced forward prices and potentially lower power demand.
Thermal and hydro power plants also tend to have a greater exposure to wholesale prices. We will examine the ESG prospects for uranium in a separate article.
Utilities companies have also struggled.
In Australia, even though many long-term contracts are in place, some domestic energy companies have cancelled earnings guidance, unable to estimate the fall in power demand, and a potential rise in bad consumer debts.
Water management is also a key environmental theme.
Both climate change and quality water supply threaten to create instability and conflict, which in turn creates an environment that hampers debt repayment, suggesting a growing focus on credit quality of finance providers.
There are several key take-outs for boards post-covid. These include:
-Growing scrutiny on boards and management from a compliance perspective;
-An onus on boards to broaden their stakeholder focus – particularly to employees, suppliers and consumers. Stakeholder engagement and risk management will be particularly important;
-Increased accountability for boards for their corporate culture. For example, bullying and harassment are less likely to be tolerated; the recent reprimand of Cleanaway Waste Management’s ((CWY)) chief Vik Bansal being a case in point;
-A heightened focus on anti-competitive behaviour. Regulators are expected to be increasingly sensitive to behaviours that stifle productivity, competition or technological innovation. The prospect of trust busting is a reality, particularly if inflation rises in response to stimulus, given breaking up monopolies loosens supply constraints. (Tempering this is the understanding that in new sectors such as e-tailing, cross-industry consolidation may rise); and
-Closer monitoring of fossil fuel exposures: again, should inflation rise, tax increases may be levelled at fossil fuel firms, and lack of recent upstream investment in the sector could also cause sharp price increases for end users.
The Governance Institute reports on more practical changes arising from covid:
-Virtual meetings are here to stay;
-Agile decision-making is crucial;
-Contingency planning should be a regular agenda item; and
-Boards should focus on alleviating rather than adding to management’s workload.
Geopolitic implications – it's a brave new world
The geopolitical transformation triggered by the Covid-induced oil-price plunge is also likely to accelerate the ESG focus.
Covid has played to onshoring and supply-chain management themes, by highlighting supply vulnerabilities.
Onshoring and supply chain issues raise the prospect of geopolitical conflict, which in turn reinforces the argument for further onshoring, and the feedback loop continues.
It has also accelerated the switch to renewables.
The Economist reports that the West, in particular, is concerned that China may gain dominance of the clean energy market through its manufacturing base; so there are more than climate-issues driving the prioritisation of development in the renewables market.
On the more positive front, analysts speculate that the removal of oil-induced conflict could usher in an era of improved global relations.
Some claim the social aspect of ESG represents a new dawn for investment in emerging economies.
The World Bank’s International Finance Corporation estimates 30% of impact funds have invested in emerging markets compared to 20% for conventional funds; 58% in sub-Saharan Africa; and 41% in Latin America.
Not strictly covid related, but definitely related to ESG and geopolitics, Michael West Media reports on the unconscionable use of Investor State Dispute Settlement clauses in Free Trade Agreements.
Mining companies globally “are being awarded billions based on dubious calculations of potential lost profits by unaccountable international tribunals”, writes journalist Patricia Ranald.
This has devolved to the point of “forum shopping” wherein miners deliberately seek out such opportunities, and has spawned a thriving industry in third-party funding of ISDS cases, wherein speculators fund cases in return for a share of the compensation.
“This has led to many cases where the pursuit of profit is at odds with health and environmental regulation,” says Ranald.
The potential for geopolitical conflict here is clear.
It also contradicts the spirit of ESG.
“ISDS arrangements place no obligations on those corporations to abide by human rights or environmental standards,” says Ranald.
Theoretically, ESG investors could starve the likes of Barrick Gold (an offender mentioned in the article) and its parents of capital. The other option is to downgrade the sovereign ratings of countries that house offending companies, but that is unlikely to deter a corrupt government.
This is of particular interest to Australia, given Adani and other resource companies have lobbied governments to approve similar dubious coal and coal-seam-gas projects, potentially setting up Australia for similar pillaging.
It will be areas such as these that will be the true test of the legitimacy and spirit of ESG given its claims that less-biased market forces, operating within a regulatory framework, will bypass the corruption of tribunals and international politics and temper the rapaciousness of capitalism.
Apart from the usual conflict associated with fossil fuels, it is the social theme that most closely allies with geopolitics. In the past, more powerful governments have sought to exert their influence by supporting tin-pot dictatorships and terrorist groups in smaller nations, who often siphon aid and funds from their economies.
In an interview with David Letterman, George Clooney noted that, despite strongly publicising human rights abuses, the only success he had experienced on the human rights front was to track the accounts of some of these individuals, and approach the banks holding these funds to pressure them to freeze the funds under threat of exposure.
Under an ESG regime, one assumes the pressure on financial institutions in this regard will rise. Westpac’s ((WBC)) recent chastisement proves a case in point.
This has the potential to disempower dictators and corrupt officials, raising the prospect that they could be reduced to the equivalent of a corporation’s chief executive officer. This has massive implications for sovereign nations.
Alternatively, it also has the potential to do the opposite and reinforce corrupt power should the institutions prove more fickle than the ESG framework suggests.
This could have a profound impact on the way geopolitics and even national security is conducted.
It will be interesting to see how this pans out.
Since the fall of the Soviet Union, it has been demonstrated that the vast majority of the world’s wealth has become concentrated in the hands of fewer than a hundred individuals, who invest in markets through labyrinthine networks of funds and companies, exerting power behind the veils of democracy (as has largely been the case since democracy’s invention but technological changes have added new dimensions).
Filling the power vacuum left by the collapsed Soviet Union has been a preoccupation for these elites for the past three decades, but it has been widely flagged that the world is now moving into an era of enforcement: or to reverse an analogy from Aravind Adiga’s Booker Prize winning novel White Tiger, we appear to be moving from a jungle to a zoo.
It is also largely these elites who have been responsible for geopolitical relations and the establishment of tin pot dictatorships in the past, so it is difficult to see where they are heading with the ESG framework from a geopolitical perspective.
One assumes that ESG is their initiative (given they own most of the funds), so it is hard to imagine how the framework can be truly impartial. Will it be used to reinforce and protect geopolitical determinations (including tin pot dictatorships and corrupt trade tribunals), or to temper them? History suggests that power typically gravitates towards its own consolidation.
As with Modern Monetary Theory, the proof will be in the pudding.
This is Part 3 in a three-part series on ESG investing in a covid-impacted world.
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
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