7 minute read 11 Aug 2020
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Three ways ESG factors can make portfolios more resilient post COVID-19

Authors
Alex Birkin

EY Global Wealth & Asset Management Consulting Leader, EY EMEIA Wealth & Asset Management Industry Leader

Wealth and asset management advisor. Passionate about cars. Keen golfer. Husband and father of three.

Patrick Stoess

EY EMEIA Wealth and Asset Management Sustainable Finance Leader; Partner, Consulting Wealth & Asset Management, Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft

Sustainable finance leader. Focused on the intersection of innovation, technology transformation and sustainability. Passionate about driving the dialogue with better questions.

7 minute read 11 Aug 2020

The opportunity offered by this crisis is for asset managers to make the integration of ESG factors across their portfolios the “new normal.”

In brief
  • COVID-19 has shown that ESG is key to crisis-resilient long-term value creation.
  • Enhanced stress tests with ESG factors can improve overall future resilience.

As the global COVID-19 pandemic spread, it initially appeared that environmental and sustainable finance topics might fade into the background while a looming recession cast long shadows. Yet major environmental, social and governance (ESG) funds outperformed classic indices like the S&P 500 during the first weeks of the crisis, and several ESG funds were able to soften the blow to loss in value compared to standard non-ESG benchmarks. This revealed that there were opportunities to utilize ESG to circumnavigate the COVID-19 situation and better protect asset managers and their clients from future turmoil.

As a result, the COVID-19 situation actually served to underline the connection between ESG-driven investing and long-term value creation. High social standards and good company governance emerged as key indicators of resilience against the pandemic’s impact at both country and company level. Furthermore, highly developed digital infrastructure and high digital standards at companies emerged as key factors absorbing the shock, with innovative digital infrastructures becoming a basic necessity.

When supply chains came under stress due to COVID-19 lockdowns, operational resilience and business continuity measures of issuers – as well as their suppliers – directly impacted revenues and share prices. Companies with an agile business culture proved to be more resilient during the shutdowns as they were better able to absorb the shock, and such “soft” social and governance factors emerged as the key indicators for the resilience of investments. By magnifying the effects of interrupted business operations, COVID-19 also foreshadowed stress scenarios to be anticipated by climate change. Effective climate risk mitigation measures will be crucial to circumnavigate future business disruptions and supply chain failures.

How COVID-19 is accelerating the ESG agenda

76%

of EY survey respondents believe goals around ESG should be integrated into the stimulus package designed to help the economy recover from the pandemic.

As we start to learn the lessons of the pandemic, we believe wealth and asset managers should consider employing ESG factors in three different ways to make their investments more resilient:

  1. Enhancing ESG strategy and methodologies to further strengthen social and governance factors.
  2. Implementing further ESG factors and enhanced climate risk methods within the investment due diligence process, risk management processes, and stress tests.
  3. Ensuring their own good governance, operational resilience and business continuity measures, high digital standards, and an agile business culture are in line with their own sustainability standards.

In addition, wealth and asset managers need to consider how they are communicating with their clients and analyze how they have acted during the COVID-19 situation. Client care, transparency, and fairness are the critical factors. Financial reports and annual investment fund reporting will need to describe the impact and actions taken during this time.

Continuously increasing regulatory pressure

Regulatory pressure continues to intensify. The European Union continued to expedite the implementation of the EU Taxonomy, Disclosure Regulation and Benchmark Regulation as well as enhancements of all financial market regulations and directives during the COVID-19 pandemic.

The EU Recovery Funds that are proposed to restore the COVID-19-affected EU economy are designed with an emphasis on long-term projects that meet specific climate and energy plan criteria. Significantly, some 25% of the €750bn will be allocated to the EU climate action program, adding additional pressure to the implementation of the sustainable finance regulations.

Wealth and asset managers are challenged to stay ahead of the regulatory tide and prepare for upcoming application deadlines – while critical technical standards and specifications are still under discussion and not yet finalized.

The current framework for sustainable finance is hard to completely understand and navigate. Overlapping initiatives and requirements need to be streamlined in order to identify the opportunities and challenges ahead.

In line with the European Commission’s direction from its consultation on Sustainable Finance, EY teams share the view that it will be critical to leverage the private sector, and in particular, the financial sector to support the transition to a sustainable economy, which should be complemented by government action which supports industry efforts.

Challenges and opportunities for ESG investments

While the COVID-19 pandemic provided different challenges and opportunities for the different asset classes, all investments might profit from the further inclusion of ESG factors. By considering additional ESG factors within the investment due diligence process, more information can be gained on a company’s culture, operational resilience, and risk mitigations. An enhanced ESG investment process as well as climate risk and stress test modeling might also improve protection against tail risks.

Accessing the additional data and information on social and governance factors might prove challenging. Considering the “S” and “G” factors within stress tests requires quantitative and comparable input data, but unlike environmental data, social and governance data are often hard to obtain.

Wealth and asset managers must prepare for upcoming sustainable finance regulations, implementing the EU taxonomy as well as disclosure requirements that will support a comparability of ESG investments.

Further opportunities may also arise for new categories of impact funds. As discussed, social impact, health and wellbeing, and access to digital infrastructure appear to be key aspects of a successful pandemic response. Therefore, EY believes that impact funds focusing on these topics can provide further the next opportunity for product innovation in wealth and asset management.

Finally, given that several governments have already announced recovery plans connected with sustainability requirements, new ESG infrastructure investment opportunities are to be expected, thus paving the way for more ESG integration within the alternative investment fund sector.

EY teams are already working with leading asset managers to help with:

  • Regulatory gap and impact analysis and implementation support
  • Stress test and modeling including ESG risks
  • Enhancement and implementation of ESG strategy and methodology
  • End-to-end product design including impact funds
  • Fund structuring and implementation of new processes and interfaces to administer the new products

Making the case for responsible investing

EY teams helped a leading UK asset owner explore the implications of adopting a responsible investment strategy.

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What’s next

Looking further ahead, asset and wealth managers will be expected to enhance their ESG strategy to include additional social and governance factors which cover the supply chains of their investments: Having oversight of downstream third-party service providers will help ensure sound operational resilience and stable business continuity.

Major issues faced by wealth and asset managers during the pandemic were fund liquidity risks and asset valuation difficulties. EY believes that going forward, both investors and regulators will demand enhanced climate risk and stress tests which include ESG factors related to liquidity and valuations in order to navigate through potential tail risk events and improve overall future resilience, and upcoming regulation is likely to require the disclosure of utilized models and scenarios.

With the application dates of the EU sustainable finance regulations approaching, wealth and asset managers need to prepare for regulatory compliance, and implement taxonomy and disclosure requirements.

New opportunities will arise for new categories of impact funds on further sustainable development goals, including social standards, health and wellbeing, or access to digital infrastructure. Government recovery plans provide opportunities for new ESG infrastructure investment.

Prior to COVID-19, ESG investing was often considered a compromise between returns and sustainable investing goals – you might not achieve one without compromising on the other. Now, we know that during a major global pandemic, ESG funds actually outperformed classic indices, and ESG factors emerged as major indicators of resilience in this crisis. The opportunity offered by this crisis is for asset managers to make the integration of ESG factors across their portfolios the “new normal,” because COVID-19 has shown that ESG investing is the key to sustainable, crisis-resilient long-term value creation. While the challenge may be big, the opportunity is greater – and it may not linger.

Summary

The COVID-19 pandemic showed that a company’s ability to circumnavigate economic and market disruptions is closely related to the degree of sustainability within said company. Wealth and asset managers are well advised to further integrate ESG factors within their investment due diligence process and to enhance their ESG strategy, methodology, and stress tests.

About this article

Authors
Alex Birkin

EY Global Wealth & Asset Management Consulting Leader, EY EMEIA Wealth & Asset Management Industry Leader

Wealth and asset management advisor. Passionate about cars. Keen golfer. Husband and father of three.

Patrick Stoess

EY EMEIA Wealth and Asset Management Sustainable Finance Leader; Partner, Consulting Wealth & Asset Management, Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft

Sustainable finance leader. Focused on the intersection of innovation, technology transformation and sustainability. Passionate about driving the dialogue with better questions.