Posted inESG

Don’t forget the ‘S’ and the ‘G’

Since the start of the pandemic, the ‘E’ of ESG has been firmly in focus.

Governments have recognised the opportunity to tackle the climate crisis, with vast financial commitments to green energy and infrastructure.

The investment industry has reflected this with a suite of climate-focused fund launches.

However, is it possible that in the new-found enthusiasm for the environment, the importance of ‘S’ (social) and ‘G’ (governance) have been overlooked?

Show me the money

Climate change is the focus for governments, policymakers and corporations.

Here, there is real progress.

By October 2020, over 1,500 organisations had pledged support for the Taskforce on Climate-related Financial Disclosures (TCFD), up 85% on June 2020. Governments are now getting involved.

The UK, for example, announced in November 2020 that TCFD climate risk reporting will be mandatory for large companies and financial institutions as early as 2021.

This has prompted a raft of new fund launches.

Over the past six months, they have included the Invesco Global Clean Energy Ucits ETF, the L&G ESG Green Bond Ucits ETF, L&G Hydrogen Economy Ucits ETF, the Ossiam Food for Biodiversity Ucits ETF, the M&G Climate Solutions fund and the Multi-Asset Climate Solutions (MACS) fund run by Aberdeen Standard – to name but a few.

High ‘S’ and ‘G’ scores equal higher performance

In practice, social or governance considerations have attracted far less attention and certainly far fewer dedicated products.

Those that exist have failed to attract significant interest.

At the end of February, the Legal & General Future World Gender in Leadership UK Index fund was folded into the broader LGIM sustainable index fund, having only raised around £6m.

Yet there are plenty of reasons that investors should care every bit as much about social and governance considerations as they do about the climate.

First, there is persistent data showing that companies that score well on social and governance metrics deliver higher performance.

In the latest Federated Hermes report ‘ESG investing: how Covid-19 accelerated the social awakening’, it says: “Companies with good or improving corporate governance have tended to outperform companies with poor or worsening governance by 24bps per month on average – unchanged from our 2018 study.

“The social premium, however, has marginally increased from an average of 15bps per month in 2018 to 17bps in 2020.”

In contrast, it found that the impact of environmental considerations is not statistically significant: “Although the environmental factor demonstrates the same shape of returns as the social and governance metrics, the magnitude is smaller, the consistency is lower, and the results show considerably more noise.”

Reputations on the line

Equally, these factors are likely to become more important.

For the social factor, 2020 has seen a public awakening with the focus on diversity brought about by Black Lives Matter, a far greater focus from corporates on well-being and a recognition of the vulnerability brought about by weaknesses in supply chains or poor labour rights.

A recent Harvard Law School report, written by Jonathan Neilan, Peter Reilly, and Glenn Fitzpatrick said: “Factors relating to ‘S’ are now among the most pressing issues for companies globally[…].

“Entire sectors of the economy, and not just the weakest players, are facing a stark and uncertain future. We believe now, more than ever, that a company’s reputation—its ‘licence to operate’—will be a function of how it engages and manages it stakeholders through this crisis; and how it communicates that responsibility—the ‘S’—to its stakeholders in a clear and transparent way.”

The authors said that it was also evident that social practices were a barometer for corporate culture. Where companies have a strong and shared culture across the organisation, ‘S’ practices tend to be strong.

Where a culture is poor, or considered ‘toxic’, ‘S’ tends to follow the same pattern.

Equally, nothing happens without the right governance structures in place. Without ‘G’, ‘E’ and ‘S’ won’t happen.

Governance proved particularly important during the pandemic: Federated Hermes said the qualities that mattered during the coronavirus-induced market crash in March were strong balance sheets and operational efficiency.

Delivering results

However, in spite of this, companies aren’t making the strides that might be hoped.

Alexandra Altinger, chief executive at JOHCM says that the events of 2020 have pushed gender equality down the list of priorities, for example. “I still don’t think diversity and inclusion I is sufficiently associated with good governance. It will become stronger and we are seeing signs of it – we are getting some RFPs that ask us about diversity metrics for example – but it is not universal.

“It is really important – investors need to focus on companies that are going to be around in thirty years’ time. We believe investors need to make companies are run in a way that is sustainable for the next generation. To me, that means ensuring inclusivity and diversity. Otherwise, there is a risk that the company is increasingly disconnected from its clients and other stakeholders.

“That’s not sustainable. The decision-making is concentrated in individuals that all think the same.”

Here too, there is a performance reason to focus on this area.

Research by S&P Global Market Intelligence pointed to evidence of the outperformance of female executives relative to their male peers. It showed female chief executive presided over greater value appreciation and improved stock price momentum for their firms.

Rebalancing priorities

Unlike ‘social’ metrics, where the tools for measurement and reporting are less advanced, there are already a lot of governance metrics in place.

The Corporate Governance Code continues to be updated regularly on standards of good practice on the make-up of boards, executive remuneration and accountability. The Principles for Responsible Investment has announced that reporting against governance and strategy indicators will become mandatory, which may make it easier for fund managers to measure and manage to governance metrics.

It has been an unusual year and, of necessity, climate change has become a focus as policymakers try to ‘build back better’.

However, some rebalancing on ‘S’ and ‘G’ is needed, both to drive return and manage risk as these issues become more important for all stakeholders.

Editor’s Note: In association with our sister publications, Expert Investor has launched a Campaign for Better Governance.

It will see us shine a spotlight on investment companies as well as the businesses in which they invest.

Full details can be found here.

Part of the Bonhill Group.