Biodiversity, alpha activism and equality – Mark Dunne looks at the ESG trends everyone could be talking about in the year ahead.
Christmas came a day early in 2020. On December 24, the UK and the European Union (EU) unexpectedly agreed a trade deal with only days of the transition period remaining. In the first full day of trading that followed, the FTSE100 closed at a 10-month high.
Days later, there was more good news. With the new year almost upon us, the UK approved a second vaccine for Covid-19, the virus that killed almost 2 million people globally and decimated economies in 2020.
The pandemic and uncertainty surrounding the terms of the UK’s departure from the EU dominated the headlines in 2020. A bitterly fought US election and equality protests around the world helped to make it an unforgettable year.
While trade agreements, vaccines and a new US president will not guarantee social and economic improvements in 2021, they provide optimism that some form of normalcy will return. If this is the case, how should investors manage their sustainable portfolios?
“2021 is coming off a tricky year,” says Peter Mennie, head of ESG integration and research at Manulife Investment Management. “Once the vaccines are rolled out and Covid is receding, a key issue will be to make sure that the programmes coming out of the EU and the UK are focused on a green recovery, a green approach to generating jobs.”
This year could also see a more fundamental approach towards the key issues embodied by ESG. Less of a focus on integration and more substantial thinking about sustainability: the energy transition, environmental sustainability and equality, says Jane Ambachtsheer, global head of sustainability at BNP Paribas Asset Management. “We have passed the point of normalcy for people to integrate ESG. Everybody is doing it to some extent. It is less sexy now,” she adds. “A key trend will be asset owners digging deeper into the fundamental issues.”
Making an impact
With bushfires, social justice protests and a global pandemic, demand for investments that solve environmental and social problems increased in 2020. “This trend is going to continue,” says Geri McMahon, principal, responsible investment at Aon.
Her colleague and head of UK responsible investment Tim Manuel added that this approach is about making a difference. “Whereas a lot of the focus in 2020 was on understanding how ESG risks are managed, 2021 is the year of impact.
“It is not about protecting yourself from the world around you, but how the investments that you make are positively contributing to the challenges that the world around you is facing,” he says.
Manuel is not the only one who believes that this approach is maturing. “The definition of impact investing is changing,” says Caroline Ramscar, head of sustainability solutions at Legal & General Investment Management (LGIM). “In the traditional sense, it means measurable, quantifiable action alongside a financial return.
“Investors are now looking at how their traditional investments can make an impact and they want greater transparency on their holdings and to make more of a difference through voting and engagement,” she adds.
The social club
The social elements of investing fell under the spotlight in 2020 like never before, fueled, in part, by the pandemic. George Floyd was another factor. The protests that followed his death in police custody are changing the way many investors are seeing social issues. “How businesses deal with stakeholders from a social point of view, such as employee rights, is becoming more material,” says Chris Varco, Cambridge Associates’ managing director of sustainable and impact investing.
Another development in the changing attitudes towards the social aspects of ESG is that regional leadership is changing. “Europe is generally ahead of the US on ESG, but the movement around social justice and diversity is gathering pace in the States and I expect that to continue in 2021,” Varco says.
Masja Zandbergen-Albers, head of sustainability integration at Robeco, says that the events of 2020 have accelerated conversations around diversity, pay inequality and labour standards. “They are all relevant, but in 2021 perhaps they will be more relevant,” she adds.
Ian Burger, head of responsible investment at Newton Investment Management, expects to see better quality data in the year ahead. “Up until now, diversity has focused on gender because that is where the data is,” he says. “Diversity extends beyond gender but accessing reliable and quality data is tough when it comes to ethnicity. We will, however, start to see that coming through in 2021 spurred on by Black Lives Matter.”
It is not just racial disclosures that Aon’s McMahon expects to see. “There has been an increased focus on racial issues in the past eight months, but we have been talking about gender for a long time and we have started talking about disability inclusion. We are going to see an increased focus on having truly inclusive company boards.
“This is an area where we are going to see real attention through the setting of targets,” she adds.
LGIM’s Ramscar expects that the themes which emerged last year will continue in client conversations in 2021. “There has been a focus on the S and the G, on things like healthcare and inequality. It’s not going to be solely about the E this year. “There was an evolution in 2020,” she adds. “People were interested in climate going into the year, but after the pandemic hit, we have had more meetings asking about the S and the G.”
For Ramscar, the trend is clear. “The social aspects of investing will be important this year,” she says.
Old issue, new approach
Despite the events of 2020 focusing investors’ minds on the social aspects of ESG, climate issues are unlikely to take a backseat. De-carbonising portfolios will remain high on asset owners’ priory list thanks to stakeholder pressure, government targets of being net zero by 2050, regulation, Joe Biden in the White House and COP 26 being held in Glasgow. “On the climate side, it is going to be an important year,” Mennie says.
As such, investors are stepping up their stewardship efforts in this area, says Burger. “Large companies are turning up the heat on climate change by setting some encouraging carbon neutrality targets,” he adds. “But investor focus will be on diving into the detail of how companies are going to achieve their headline targets and commitments.”
Yet Varco believes that the approach to achieving this could change, building on the momentum he has seen in recent years. “We are moving away from fossil fuel divestment to a more holistic view of alignment with de-carbonisation trends,” he adds. “The move towards net zero by 2050 in climatealigned portfolios with much more sophistication is gathering pace.”
This will be a material change as the regulator is pushing asset owners for greater disclosure on the carbon footprint of their portfolios.
There is another catalyst. Varco says that the Covid pandemic has sharpened minds on the need to reverse the damage we are causing the environment. Fewer people traveling in the spring meant that the top of the Himalayas became visible from the ground and Venice’s canals were clearer. “There is a view that Covid brought some kind of green shine to the world,” he says.
Persistent concerns over climate change will continue to influence investors. “We cannot ignore the regulatory angle here,” Ramscar says. “As we emerge from the virus and with COP 26 coming up, it is also going to be climate, climate, climate this year. “Given COP 26, given DWP regulations, given the changes to the Pensions Bill that will align schemes to TCFD reporting, investors are either thinking about or starting to think about what such regulation means for them.
“It is a more explicit climate theme this year,” she adds. “It is not just about what you can do from an environmental perspective. It is people getting explicit around the need to align to TCFD and the Paris Agreement.”
Ambachtsheer expects a big trend in the energy transition to be how asset owners measure corporate progress on de-carbonisation and alignment to net-zero by 2050. “Engaging with companies during the transition will be a key topic again this year,” she adds. “The question isn’t if they will transition, it’s how and how quickly.”
On this last point, BNP Paribas is part of the Voluntary Carbon Markets Taskforce focussing on offsets in carbon markets. “It is bringing more detail and credibility to the tools and the system to help support the pathway to net zero,” Ambachtsheer says.
This rise in credibility means that assets need to be chosen carefully. “Asset managers are launching ESG funds left, right and centre,” Ramscar says. “It is not just about new fund launches, it is about providing diagnostic, climate risk and reporting capability to investors.
“It will be huge,” she adds. “We will see asset managers develop tooling to supporting their clients. The industry is becoming more advanced in this space.”
A good year
ESG outperformance was one of the big stories last year. This has, according to Varco, moved the discussion from how much ESG costs to how much will it cost not to do it. A Morningstar study shows that ESG funds outperformed their traditional peers over one, three and five years. This was largely thanks to 2020, a year where carbon-intensive industries, such as airlines, were hit hard by the pandemic, while years of investment in renewable sources of power saw the S&P Global Clean Energy index double. “The degree to which 2020 accelerated everything we have been talking about for a decade has been surprising,” Varco says.
It appears that last year was a turning point for proving the credentials of ESG funds. “2020 was the year ESG funds were tested, and demonstrably so,” Ramscar says. “From active and passive perspectives, they came through it and the experience of 2020 has made people think more about how they are positioned for the climate emergency.”
Matthieu Guignard, Amundi’s global head of product development and capital markets for ETF indexing and smart beta, says that 2020 was a strong year for passive ESG strategies. “ESG was a strong trend in the ETF market in 2020 as investors were risk-off,” he adds. “By June, 100% of flows were into ESG as investors switched from vanilla approaches.”
Indeed, of the €42bn (£37.5bn) of net new assets that the European ETF market witnessed in the whole of 2020, about €26bn (£23.2bn) flowed into ESG, so around 60%. “There was a strong trend for ESG with record figures in 2020,” Guignard says.
Last year, the ‘better’ ESG stocks performed strongly. “Investors are reinforcing their ESG investment because they believe they can get outperformance,” he says.
Guignard also points to risk reduction and regulation as other drivers of flows into various ESG strategies. “These are the three reasons why we may witness a strong ESG trend again this year,” he says.
But Zandbergen-Albers warns that if economies recover, sustainable funds could be in for a bumpy ride. “If we see a sustained recovery due to vaccines or the economy returning to normal, we could see some volatility around sustainable funds because they are less invested in the cyclical parts of the economy.
“It is a base case scenario in what we expect for next year, but long term we are convinced sustainable companies will perform well,” she adds.
All creatures great and small
Discussions on sustainability will widen this year to include biodiversity, Mennie believes. “Covid-19 is a zoonotic disease,” he says. “A UN report says that about 60% of human infections are estimated to have an animal origin and that some 75% of all new and emerging human infectious diseases ‘jump species’ from animals to people. That should emphasize the importance of biodiversity, a focus on nature and how we handle food products in 2021.”
Manuel also sees this issue becoming more important. “Biodiversity and species loss are moving up the agenda and will come to more prominence in 2021.”
Action is already being taken with a working group looking into establishing a taskforce to push for nature-related financial disclosures. “There is scope for sustainability to have an extra boost by focusing on biodiversity,” Mennie says.
Biodiversity will become mainstream for investors this year due to the crisis the world is facing, says Jane Ambachtsheer. “A million species face extinction, many within decades.”
Human activities are threatening around a quarter of identified plant and animal species, while half of global GDP is threatened by nature loss. “These are massive issues,” she adds. “Biodiversity loss and deforestation create risk for investors. We need to better understand that risk through understanding the impact the companies we invest in have on nature, as well as their dependencies on it.”
Investors need to think about the connection between environmental sustainability, biodiversity loss and climate change, Ambachtsheer says. “It is about preserving natural capital. Reforestation, preserving land, managing land use and its impacts in nature.”
Biodiversity influences many ESG factors, as does food. Burger lists supply chain, security of supply, human rights, labour conditions and the climate change implications of the food industry as the key issues that sustainable investors need to consider. “Livestock accounts for almost 15% of global greenhouse-gas emissions, which is the same as transport,” he adds.
This has led to a rise in demand for alternative proteins. “There is a whole raft of technologies and new farming techniques coming through,” Burger says. “With global populations expected to rise in the coming decades, the environmental implications of mass farming are becoming more evident. 2021 could see investors thinking harder about that space.”
Going the extra yard
Burger says that regulation around ESG will be tighter in 2021. “For asset managers, it is no longer okay to simply have responsible investment, ESG or sustainable policies. They will have to demonstrate their credentials in that space through reporting,” he says.This could have a positive impact on corporates. “More stocks could soon be trading at a premium because of their strong ESG credentials, as funds need to demonstrate that they are successfully integrating ESG into their stock-selection process,” Burger adds.
The collaboration between SASB and the Global Reporting Initiative last year was designed to improve corporate disclosure standards. The expectations of society have grown thanks to social media, where the spread of information and feedback have become almost instant.
The result is, according to Varco, improved corporate transparency, especially in supply chains. “The gap between high governance standards in your home market and lower governance standards in your supply chain never made sense. That is closing fast.
“The momentum is strong for improving governance standards in emerging markets,” Varco says. “Not owning certain poorly governed state-owned companies in emerging markets can be the gift that keeps giving.”
Another interesting talking-point in 2021 could be the emergence of a new engagement trend. Corporates could soon face scrutiny on their sustainability profile from a new area, if they are not already. ESG fund managers have typically been the ones to push corporates into improving their ESG performance and levels of disclosure, but now more traditional investors are seeing the benefits.
Varco points to an example of a hedge fund manager pursuing “aggressive engagement” with managers around de-carbonisation. “This hedge fund manager wants every company in his portfolio to measure their emissions and have a plan to reduce them,” he says.
“This is not an ESG manager. This is a successful hedge fund. It is coming from a space that most cynics of ESG regard as one of their own.
“This is the emergence of climate activism alpha,” Varco says. “By creating a portfolio of companies that are on the front foot when it comes to de-carbonisation and climate alignment he is seeking to create a better portfolio that will have better alpha. He is not doing it for the sake of mankind.
“He is framing things in economic terms, which is impressive,” Varco says. “The spread of activism beyond ESG managers is exciting because this is an economic issue as much as an ethical one.”
Voting on pension funds’ equity holdings will be a new battleground this year, Manuel says. “If you invest in a pooled fund you have little choice around how the shares are voted,” he adds. “You have to follow the policy of the fund manager.”
Attention has been drawn to this issue in recent years by the Association of Member Nominated Trustees and ShareAction. “This year we will see a battleground emerge around how to enable investors to exercise their own voting policies,” Manuel says. “That was bubbling beneath the surface in 2020, but this year there will be a big industry-wide discussion above the surface.”
Guignard says that one of the focuses for his clients in the coming year will be how Amundi engages with the companies in which it invests. “More and more investors want to know how we vote at AGMs and how our dialogue influences companies regarding ESG, this has been a strong commitment of Amundi for years.
“This is interesting in passive because usually when you invest passively you invest long term,” he adds. “As along as a company is in the index that you replicate you are invested in it. Therefore, the engagement you have with the company can influence that business.
“Investors are digging deeper into this topic and want to know understand our policies on voting and engagement in the companies we invest,” he adds. “There has been a maturation of ESG knowledge and implementation from our clients.”
Whatever happens with the pandemic and economy, the popularity of ESG-led investing will be strong, thanks, in part, to last year. “The events of 2020 will have an impact on ESG in 2021,” Zandbergen-Albers says. “People will stop and think about things more. Despite the pandemic, when it comes to climate, the awareness that we need to solve this issue became even bigger.”
The main theme of 2020 was the social impact of Covid and the various protests witnessed around the globe. Momentum is strong, so it is likely to continue into this year, and it needs to. “Some institutes estimate that when it comes to achieving the Sustainable Development Goals that the Covid crisis set us back 10 years, while others say 60 years,” Zandbergen-Albers says. “So, we need to work hard to achieve these social topics.
“Rising inequality and labour standards in supply chains were already issues, but Covid has put a spotlight on them,” Zandbergen-Albers says. “Covid has made some things more important.”
One positive from the Covid pandemic, Mennie believes, was the international community pulling together. “There was a remarkable amount of effort put into developing vaccines for Covid.
“We knew it would be extremely challenging to have a vaccine ready by the end of the year. Now we have three with high efficacy rates that have been approved or are close to it.
“That is remarkable and shows that where there is a collective will to do something, there is the ability to do it,” Mennie adds. “The lesson is that if people are aware of sustainability issues there is an opportunity to create the push for them to be solved.”
Overall, the outlook for the year ahead is finely balanced, Mennie says. “2020 was a tough year, especially on the debt side for governments and on the employment side for many people, but we have the political impetus with COP 26 coming up and evidence of the ability to act when we need to. It is going to be an interesting year.”
Approaches to ESG were already maturing from why we should adopt such a strategy to how do we measure performance. The events of 2020 highlighted the benefits of following such strategies, but the hard work did not end when Big Ben chimed 12 on New Year’s Eve.
“2021 is when we have to get serious about sustainable investing,” Zandbergen-Albers says. “We have to dive into the deep end. We have to dive into not only setting ambition on climate change but work out what they mean. This is what is needed in 2021.”