By Tamara Close
In global economic growth environments and bull markets it can be tempting to rely on more peripheral ESG analyses. However, in slowdowns and market uncertainty, any lack of in-depth analysis quickly becomes apparent. Below are 3 issues, that while they have always existed, are now quickly rising to the surface.
Sophisticated ESG-minded investors will already have internal ESG analysis structures in place to adapt to these issues so as to effectively mitigate any risks and leverage any opportunities that might arise. Investors at an earlier stage of ESG integration will want to increase their level of maturity to ensure these issues are taken into account in their investment and risk management practices.
In brief:
1. Dynamic materiality of ESG issues: the COVID-19 pandemic is highlighting the dynamic materiality of ESG issues
2. ESG data disconnect: the timeliness challenge of mainstream ESG data providers is rising to the surface in today’s market environment spotlighting the advantages of real time AI and ML ESG data providers
3. Board governance practices in the spotlight: issues that may/are arising include red flag accounting practices, a renewed focus on stakeholders vs shareholders, and pressure to balance crisis management and strategic thinking
Read below for a more detailed analysis
One: Dynamic Materiality of ESG Issues
The most sophisticated investors understand that material ESG issues are dynamic and evolve with industry changes and economic cycles. The current market environment under the COVID-19 pandemic is a perfect example of the dynamic materiality of ESG issues. We are seeing a global shift to issues such as “employee health and safety” and “labor practices” that may not have been considered material just 2 months ago in industries such as Financial Services. These are rapidly becoming material issues, not only for firms that have seen their businesses shut down or reduced but also for those that are considered “essential services” as they need to ensure employee safety.
While past measurement and assessment of these issues may have focussed mainly on policies and procedures within a firm, the current crisis is creating new metrics and new sources of data.[1]
Sophisticated ESG-minded investors already have in place flexible, integrated ESG analysis frameworks allowing them to update material ESG issues and include new sources of data in their investment decisions.
For more on dynamic materiality:
See the below paper from the WEF and BCG which offers a framework to guide both investors and companies on how to better anticipate emerging ESG issues.
See the below research paper from Truvalue Labs which shows that every company and industry has a “unique materiality signature” that evolves over time.
[1] For instance, see JUST capital’s COVID-19 Corporate Response Tracker: How America’s Largest Employers Are Treating Stakeholders Amid the Coronavirus Crisis.
Two: ESG Data Disconnect
One of the known challenges with using ESG data from mainstream ESG data providers is the timeliness of the data. Sources of data for these providers is often publicly available information and official reporting from companies (sustainability reports, etc.), which may only be available 3-6 months after fiscal year end. This can result in stale data inputs for the ESG ratings. In addition, ESG data providers may not update their ratings more frequently than annually. Investors, therefore, may be looking at ESG ratings based on information that can be as much as 18 months old.
In the current market environment, as ESG issues are evolving, this challenge may become more of a constraint for users of the ESG ratings as mainstream data providers may not be able to update their ratings as frequently as required to reflect a company’s ESG exposure. While some investors may view these exposures as longer term in nature, such as climate change issues, current market and regulatory changes can impact the ESG profile of an issuer.
For instance, how companies react to the recent announcement from the EPA to suspend the enforcement of their environmental laws – telling companies they would not need to meet environmental standards during the coronavirus outbreak, basically giving industries broad authority to pollute with little oversight from the agency[1] - will highlight the environmental rigor of a company (e.g. how are they reacting to the EPA suspension? Are they loosening their standards or are they continuing to follow the guidelines since they already had in place a solid and robust measurement and monitoring framework?).
Artificial intelligence (AI) and machine learning (ML) ESG data providers[2] help to solve this challenge by providing ESG data on a near real-time basis using news-flow driven ESG data.
Sophisticated ESG investors already have in place ESG data management frameworks that include real-time ESG data providers, and already perform their own internal ESG analyses. They will be able to integrate any changes in the ESG profile of companies more quickly into their investment decisions.
[2] Such as Truvalue Labs (https://www.truvaluelabs.com/) which uses a customizable AI engine that employs machine learning and natural language processing to analyze unstructured data in real time and extract material ESG metrics.
Three: Board Governance Practices in the Spotlight
Certain issues may become apparent during the pandemic that will renew the focus on the quality and cognitive diversity of corporate boards.
Red flag accounting practices may appear[1]. Economic slowdowns tend to reveal any questionable accounting practices that are easier to implement during economic booms. For instance non-GAAP adjustments to EBITDA that help to increase profits will come under greater scrutiny.
Renewed focus on stakeholders vs shareholders: Boards have a wider fiduciary duty to consider the needs of the stakeholders of a company (employees, customers, suppliers, investors, regulators, etc.) versus solely the needs of investors and shareholders. Now more than ever is a critical time for boards to ensure they are considering stakeholder needs. Those boards that have already implemented this will be well-placed to better manage the current pandemic’s impact on their companies.
Corporate boards are increasingly under pressure to balance crisis management skills with longer-term strategic thinking. Companies are turning to their boards now more than ever for guidance as to how to balance short-term liquidity and capital requirements versus investment in longer-term R&D and innovation initiatives. Corporate boards that are more diversified in strategic and tactical thinking are better placed to make the decisions required both to successfully manage the current crisis and to also ensure longer term strategic and competitive advantages for their companies.
Sophisticated ESG-minded investors are already looking at the above ESG issues when assessing the quality of boards and corporate governance structures of their investee companies.
For more on corporate strategy during times of economic crisis, see the below webinar and paper from Ioannis Ioannou of the London Business School:
Ioannis Ioannou, London Business School, Leading through a pandemic: lessons from the Great Recession YouTube as a recording link here
Flammer, Caroline and Ioannou, Ioannis. 2018. “To Save or to Invest? Strategic Management during the Financial Crisis”. SSRN: https://ssrn.com/abstract=2621247 or http://dx.doi.org/10.2139/ssrn.2621247
A summary version of the above paper can be found at: https://hbr.org/2019/05/save-or-invest-how-companies-should-navigate-recessions
[1] The Economist. April 18, 2020. “The economic crisis will expose a decade’s worth of corporate fraud.” https://www.economist.com/business/2020/04/18/the-economic-crisis-will-expose-a-decades-worth-of-corporate-fraud