The 1.5 meter economy

The effects of the COVID-19 pandemic clearly expose some vulnerabilities of our global economy. We have learned the hard way that macro-level risks that were not on the radar of businesses and governments, such as the massive transport, supply and demand shocks and the massive unemployment we currently encounter, can materialize extremely quickly within a few short weeks. The ripple effect of impacts that are now surfacing, reinforces the case for investors to improve their grip on non-financial risks that affect the companies they invest in and fundamentally and consistently integrate these risks into their decision making moving forward.

It’s certain that we will face events of this scale again, and in our view, this strengthens the case for intensified focus on ESG factors. In the first months of 2020, it seems that sustainable funds are holding up relatively better when compared to their conventional counterparts. Without the intention to claim that this will remain so, it’s reassuring to observe that despite previous fears that sustainable funds had the potential to fall hard in a weak market and amidst warnings in early 2020 of a “green bubble”, until now these funds are holding up. As noted by both Bloomberg Intelligence and Morningstar studies, both U.S. ESG ETFs and European ESG ETFs are performing better than their relative benchmarks (Bloomberg, Morningstar, Environmental Finance). In addition, a JP Morgan survey concludes that the majority of the investors think COVID-19 will be a catalyst for ESG.

Figure 1: Opinions of investors about the question whether COVID-19 will be a catalyst for ESG

^{Source: J.P. Morgan investor survey}

As we are still in the midst of the crisis, we need to continue monitoring how this global trend further develops. However, many reasons have already been put forth by market participants about why ESG funds have been able to some extent resist recent shocks.

One clear reason is the fact that they tend to have lower fossil fuel exposure. The sharply falling oil and coal prices - caused by geo-political tensions leading to higher supply and the economic crisis causing a drop in demand - resulted in cases of pending bankruptcies, credit downgrades, and defaults in the entire fossil fuel sector. In particular the shale oil and coal sectors have been hit hard. It is being suggested that the crisis is speeding up their downfall and whether they are future proof is increasingly called into question, especially for those companies that have not sufficiently managed their material ESG risk (see reuters, forbes, marketwatch).

Other reasons for the higher resilience of ESG funds are that the companies that make part of the funds’ investment universe are generally better managed, better understand their non-financial risks, are more focused on their employees and have deeper insights into their supply chains which helps them better handle unexpected scenarios. Let’s take a closer look at this.

Supply chain resilience

One of the most noteworthy vulnerabilities that has been exposed in the economy in recent weeks relates to the resilience of supply chains across various sectors. The crisis has stressed the critical importance of companies to understand the complexities and to assure long-term resilience of their supply chains, but also of investors to understand how this can impact performance. The speed with which the crisis came about, led to the need for companies to take decisive and immediate measures to ensure continuity of their operations. Supporting the argument for the benefit of strong supply chain management, Sustainalytics has carefully shown that companies with an effective grasp of their supply chains are better prepared for disruptions. It found that companies that had better supply chain management systems have held up slightly better in the period from mid-February to early April – see Figure 2. We see two elements of supply chain management being especially important for assuring long-term supply chain resilience and business continuity. First of all, companies that have built-in flexibility in their supply chains, can more easily mitigate supply chain disruptions.

Secondly, the expectation is that companies that have a broader stakeholder approach, and that make decisions today that support the health and wellness of their own workforce but also consider the continuity and wellbeing of their suppliers, will support the long term development of their operations. More importantly, with such a broader stakeholder approach they also improve system stability and societal durability.

Figure 2: Comparison between the supply chain leaders model portfolio and the FTSE all-world index.

^{Source: Sustainalytics and Morningstar Direct.}

Supply chain flexibility

Already in January, when Chinese exports were suddenly disrupted, many companies – from automotive to electronics and footwear – experienced the impact of their dependency on only one supplier or only one country as well as the absence of disaster or recovery plans. It also became painfully clear that the dependency on China and India for the production of active pharmaceutical ingredients and the reliance on continuous deliveries caused immediate shortages when these countries decided for a lock-down. Many companies admit they have an insufficient overview of their supply chain risks. PepsiCo and Wilbur Curtis are two exceptions who have built supply chain flexibility in their strategies. They plan production and monitor supply chain risks weeks in advance and assure that suppliers are geographically dispersed. Also a family company like Royal Zeelandia Group, a Dutch packaged food company, maintains back-up suppliers for their major ingredients and continuously monitors supply chain risks. Investors have a role to play here. They can encourage companies to better prepare for supply chain risks, but they themselves can also learn from stress tests and scenario analyses the sensitivity of their own funds to supply chain disruptions. Even though the World Economic Forum regularly warns for likely and impactful global risks – especially warning for increasing incidences of environment and climate related natural disasters and for cyberattacks, but also for the spread of infectious diseases - only few companies and investors seriously evaluate these risks.

Stakeholder focus in supply chains

In addition, we see several companies whose resilience and operational continuity benefit from their long-term stakeholder approach, in which they maintain strong relationships with their own workforce, but also with suppliers. This is to assure their continuity, wellbeing and loyalty. For instance, within the apparel sector, due to the impact of measures taken to address the corona virus some retailers have declined to take the delivery of already produced goods from suppliers. Others, such as H&M, PVH Corp., Target and Inditex have committed to doing this, as well to paying for the goods in production using payment terms previously agreed upon. These decisions are beneficial in helping protect the rights of vulnerable garment workers in Asia and align with the commitments they have made to respect human rights. Before the crisis, PVH Corp. and H&M were already demonstrating stronger understanding and oversight of their supply chains. They have leading transparency on suppliers, extensive auditing programs and preference for selecting suppliers based on strong labor management performance, alongside price and quality criteria. These companies were in a position to make more forward-looking decisions that will have lasting impacts not only from a financial perspective but also from a human rights perspective. 

Figure 3: Share of textiles sector in exports for a number of south-east Asian countries

^{Source: oec.world.en}

For several south-east Asian countries, who depend on the textile industry for a considerable share of their exports – see Figure 3 - it is of vital importance that companies consider these workers’ rights, as cancellations of already produced orders and unexpected supply shocks may be devastating for their economies. So, even though the apparel sector may not be large from an investment point of view – less than 1.5% of the ACWI - choices made in this sector have much broader economic impacts, globally.

How choices made within a company have broader impacts up- and downstream in the supply chain is also shown in the food sector. For instance, the closure of the Smithfield pork-processing facility in South Dakota after a corona virus outbreak as well as similar problems in meat facilities of JBS and Tyson Foods Inc. , where they were unable to control outbreaks, have highlighted pre-existing weaknesses in their operating practices related to health, safety and animal welfare. Their recent difficulties in implementing safety measures and in realizing social distancing have led to them being “hot spots” of the pandemic.

This has impacted the health of their workers resulting in required shut-down of factories, which has in turn negatively influenced the rest of the food supply chain. As an active shareholder, investors should be aware of the influence they can exert on individual companies; to call during the current crisis for instance for less crowding, improved health and safety conditions within factories and better animal welfare practices. But they should also be aware that this influence goes beyond these companies, but can also improve the strength of the rest of the food supply chain and even macro-economic stability.

Conclusions

When assessing the ESG data that Truvalue Labs collects about financial materiality, it found that supply chain management has emerged as one of the top five material issues related to the spread of COVID-19 – see figure 4. While this isn’t necessarily surprising given the large volume of news on the topic, investors need to be aware that supply chain management is undeniably an issue where greater attention is needed. The examples discussed above show us that this is not only necessary for mitigating for unexpected disruptions, but also for preventing the impacts from spreading throughout the economy. The influence of investors goes much further than their own investments. By paying more attention to supply chain and operational risks of their own investments, they may improve resilience of entire supply chains and reduce macro-level risks that lay on the horizon. At the same time, it may make their own funds less volatile.

Figure 4: Change in core financially material ESG-topics

^{Source: Shepley, A., Truvalue Labs Research Team. Coronavirus ESG Trends, 2 April 2020}

We have seen through this crisis that now more than ever, it is vital for investors to have a clear view about what sustainability means across different sectors to help them assess which companies have a viable long term business plan and management strategies that are centered around our future collective needs. There is an opportunity for investors to divert funds to companies that will responsibly manage their way through this crisis, to those that focus on their stakeholders, their supply chains, their employees and their communities. ACTIAM’s sustainability policy is structured to identify these types of companies and to guide our investment decisions in this direction. We assess which sectors and companies have viable long term business strategies and select those that we think the future needs.

We expect to see that companies and investors that already have ESG well integrated into their business decisions, to take even further steps, as they see now that it pays off. Depending on how governments support the economic recovery, other companies who have not invested in ESG related initiatives may take initial steps. If the right decisions are made today, we can accommodate the 1.5 meters economy and transition to a sustainable economy.