Environmental, social and governance (ESG) factors have become an essential part of the investment ecosystem. In recent years, there has been a growing awareness of pandemics, climate change, wildfires and corporate scandals prompting investors to seek out resilient companies that meet high standards in each category.
Let’s look at how ESG assessments have evolved throughout the COVID-19 pandemic and what it means for your portfolio.
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Heightened Awareness of Risks
The COVID-19 pandemic made social inequality and workforce risks painfully clear. For example, employees in low-paying jobs experienced layoffs on a massive scale, while millions lost health insurance coverage when they needed it most. In short, COVID-19 cemented the “S” in ESG, making it a center point for discussions.
At the same time, extreme weather events have highlighted the “E” in ESG. For example, just as many people were looking forward to going outside during the summer of 2020, record-breaking heat sparked massive wildfires across the western United States. Meanwhile, the 2020 hurricane season was the most active on record.
And, finally, the massive increase in wealth seen by billionaires amidst the COVID-19 pandemic sparked outrage among many in the working class. In addition to executive compensation concerns, the George Floyd protests have led to calls for better representation across management teams and boards of directors throughout the country – the “G” in ESG.
Rating agencies have had to adapt to these changes when looking at a company’s financial resilience. For example, analysts typically look at what the company does, where they do it and what kinds of risks are involved – both immediate and over the long term. Finally, they take into account how companies are managing or mitigating these ESG risks.
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Regulatory Frameworks Mature
The U.N. Sustainable Development Goals have been a baseline for many ESG frameworks worldwide, but the lack of uniform standards has been a chronic issue. While the U.S. continues to grapple with setting standards, the E.U. has emerged as a trendsetter in the ESG space. E.U. regulators are in the process of adopting a series of groundbreaking regulations.
The E.U. regulations aim to accomplish three goals:
- Establish a reliable environmental classification framework;
- Require companies and funds to disclose how ESG factors integrate into financial decisions;
- Facilitate the disclosure of reliable, comparable and relevant ESG information by companies.
In addition, Europe’s Shareholder Rights Directive also improves the transparency of the voting process. The directive makes it easier for shareholders to exercise their rights by encouraging modern technology, helping encourage shareholders to take a more activist approach in promoting ESG principles across sectors.
At the same time, many rating agencies continue to update the way that they track ESG factors. For example, the pandemic changed the operating environment for many companies, and models must account for labor force, safety and other recent shifts. The rise of green bonds, social bonds and sustainability-linked loans has also expanded their universe.
Investors Drive ESG Momentum
ESG funds attracted a net inflow of $51 billion in 2020, double the $21.4 billion in 2019 and a 10-fold increase from $5.4 billion in 2018. During the first quarter of 2021, ESG net inflows reached $21.5 billion, exceeding the all-time high of $20.5 billion during the fourth quarter of 2020. These trends reflect the constant acceleration in ESG interest.
Millennials have been a driver of these trends, having a value-driven approach to their investments and careers. Over the coming years, the generation will inherit around $30 trillion of intergenerational wealth from Baby Boomers. Millennials are likely to direct some of these funds to ESG-focused investments aligned with their values.
In addition to adhering to values, ESG funds outperformed most benchmarks throughout the COVID-19 pandemic, meaning investors didn’t have to sacrifice returns for a values-based approach. In fact, according to the Financial Times, the outperformance of ESG funds spans a decade-long period, suggesting benefits beyond the pandemic.
Rating agencies will continue to play a central role in determining ESG eligibility, identifying potential risk factors and helping investors build out value-based portfolios. As more significant amounts of capital pour in, the number of agencies focused in the area is likely to increase, providing investors with a greater number of options when building their portfolio.
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The Bottom Line
ESG funds have become increasingly popular throughout the COVID-19 pandemic. Amid rising awareness of “E,” “S” and “G” factors, ESG net inflows have accelerated to record levels. These rising interest levels have encouraged regulators to continue developing standards to guide companies, funds and investors in the space.
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