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From Crisis to Resilience: The Rise of Corporate ESG

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The impact of COVID-19 and recent calls for racial equity around the world are propelling the nascent discipline of sustainable finance to new heights, as ESG practices become a must-have rather than a nice-to-have for corporations to attract investors' dollars.

Faced with a world where protecting against reputational risk is key to maintaining the loyalty of investors and consumers, public companies that hesitate to incorporate ESG principles and sustainability into their overall business strategy risk their ability to access capital markets easily. Market analysts are suggesting due diligence around ESG risk is also becoming critical in successful M&A and IPO deals in the post-COVID world. As investors take a magnifying glass to everything from environmental impact and employee health to cybersecurity and supply chains, that scrutiny is only going to intensify. 

 “We’re already seeing a number of private equity and investment funds, especially those with scale, paying more attention to climate change, diversity and other ESG concerns,” PWC said in its M&A outlook for 2020. The firm said ESG matters will likely become an area of even greater focus for investors in the year ahead.

That change is afoot is not lost on CEOs; when social unrest against systemic racism surged in recent weeks, we saw many corporate leaders declare their commitments to racial equity.

The rise of ESG in the collective conscience of investors is reflected in the data. Morningstar Direct, an investment analysis platform, found that more than $12.2 billion flowed into ESG-related retail funds in the first four months of 2020, more than double what went into these funds over the same time period last year, according to a report in The Wall Street Journal.  Assuredly, demand for avenues into sustainable investing remains high.

Hard Lessons

As we’ve seen, credit deterioration has been severe since the pandemic began, impacting companies’ cost of capital as well as future capital expenditures. During the current recession, companies with stronger ESG profiles are expected to have greater access to financial markets and investors.

To be sure, analysts, proxy advisory firms, ESG analytics providers, NGOs and others that track corporate ESG practices, are paying more attention to the spectrum of Environmental, Social and Governance attributes, in areas ranging from executive compensation – CEOs who’ve received big bonuses during a period of mass layoffs have not been looked upon kindly – to supply chain risks, diversity and inclusion and much more.

Writing in the Harvard Law School Forum, Joshua Feltman and Emily Johnson, partners at Wachtell, Lipton, Rosen & Katz, a law firm that specializes in M&A and corporate financing, say that, over time, “We expect companies to find their cost of capital more directly tied to their ESG risk. All of the major credit ratings agencies have signed onto the Principles for Responsible Investment statement that ESG factors can weigh on default probability and consider such factors in their ratings.”

COVID-19 has proven to be a stress test for many businesses, forcing many companies to rethink the relevance of ESG considerations for their businesses. According to a Datamaran analysis of 1400 corporations, by March 31, 41% of U.S.-based companies and 37% of European business acknowledged in their financial reporting that COVID-19 was material to their business. While it may be early days yet, a recent Harvard study of more than 3,000 companies around the world found that more positive sentiment around a company’s response to COVID-19 is associated with less negative returns. 

‘S’ and ‘G’ to weigh heaviest in the months ahead

While the Environmental aspects of ESG remain important, Social ‘S’ and Governance ‘G’ concerns have been pushed to the forefront during  COVID-19 and amid the recent social unrest. The health and safety of employees, labour rights, and what companies do for their communities, are all coming under increasing investor scrutiny.

As the pandemic disrupted essential service industries, ranging from food to energy and medical equipment, we’ve seen growing inspection into how company supply chains work, which speaks to both the S and G and includes issues like responsible sourcing and fair operational practices and organizational governance.

“Buyers need to be aware of the pressure that their suppliers face in this moment of disruption – and of the consequences for their sustainability management and performance,” EcoVadis, a ratings platform that assesses a company’s sustainable procurement, said in a recent report that called for more agile supply chains and sustainability management systems that can help mitigate negative impacts during crises like the COVID-19 pandemic.

Truvalu Labs, an ESG analytics provider, said in a recent report that employee health and safety, labour practices, access and affordability, product quality and safety and supply chain management, are some of the material ESG factors exposed during the COVID-19 crisis.

When it comes to the G – good governance – evidence of strong capital management has long been a concern of investors, but as this crisis continues, investors will ask boards about how they plan to re-open and how they plan to respond to any further issues that arise.

IDB Invest has come up with a questionnaire for boards and investors regarding business continuity during COVID-19 that serves as a helpful guide for companies to demonstrate preparedness with action-oriented plans spearheaded by senior management.

What is clear is that, for many companies, incorporating ESG practices into their business will mean rethinking overall corporate strategy. For some, it will require meaningful efforts to diversify the makeup of their boards and executive teams, as well as forging partnerships to create products for the greater good, like Ford Motor Co.’s recent partnership with Thermo Fisher Scientific to produce hospital gowns and facemasks for frontline workers. Firms need to be adaptable to crisis while taking responsibility for past transgressions.

Stakeholder capitalism remains at the forefront in the pandemic world.

“We recognize the long-term viability of the companies in which we invest is inextricably tied to the welfare of their stakeholders, including their employees, suppliers, customers and the communities in which they operate,” more than 300 institutional investors and service providers, including BMO Global Asset Management, covering more than $9 trillion in AUM, said in a recent Investor Statement on Coronavirus Response. The online petition asked companies to consider five steps in helping limit the COVID-19 damage on the global economy: to provide paid leave, prioritize health and safety, maintain employment during COVID-19, keep supplier and customer relationships and practice financial prudence, which involves suspending share buybacks.

The ‘new normal’

As we emerge from this crisis, under the ‘new normal’, increasing acceptance of ESG considerations in business decision-making will drive sustainable finance on both the buy and sell sides. Going forward, it will be easier for companies with high ESG ratings to issue debt; we’re already seeing a number of organizations issue social bonds to help combat COVID-19. Businesses that do good by incorporating ESG best practices will have more successful IPOs and M&As and inclusion in SRI benchmark indices.

The ‘new normal’ will also see pension funds and asset owners focus on adding more ESG-related products, mutual funds and ETFs, while sell-side analysts will start incorporating more ESG analysis into their work.

It won’t be long before ESG factors are baked into every company’s mission and purpose, not just as the right thing to do, but because it’s also good for business. Some of it will be difficult but necessary work, especially when the world is watching.

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