Baker McKenzie on how COVID-19 has highlighted the need to incorporate ESG into business strategy
Caitlin McErlane, Partner at Baker McKenzie, talks to Climate Action about how COVID-19 has highlighted the importance of incorporating ESG into business strategy.
Q. In your opinion has COVID-19 highlighted why ESG matters?
A. In an environment where financial institutions and commercial companies alike are struggling to stay on top of the financial turbulence unleashed by COVID-19, the level of ongoing debate and interest in ESG throughout the pandemic has taken many by surprise. The focus has not simply been on how to kick start economic recovery, as it might have been in years past; instead, the pause in "business as usual" is giving many the time and space to think about what exactly that economic recovery should look like.
Taking a step back, however, the increased level of interest in ESG during the pandemic has likely been the result of a number of factors. One is the widely circulated reports that ESG-focused funds outperformed the wider market during the pandemic period; it's fair to say that there has been a lot of interest in what exactly motivated that resilience. Another is the fact that sustainable finance and ESG disclosure remains a key policy goal for regulators globally. While many aspects of regulatory reform took a back seat or were postponed as a result of financial disruption in the wake of COVID-19, ESG has remained high on the agenda, with a steady stream of consultations and draft rulemaking coming out from EU authorities in particular.
COVID-19 has also exposed more practical issues touching on the importance of incorporating ESG into business strategy. In some cases, it has generated a significant level of scrutiny into supply chains and whether they are unnecessarily long and complex. As a result of the pandemic, we have been operating in an environment where thinking more locally could mean an increase in reliability as a result of COVID-19 restrictions in place in other jurisdictions, not to mention a reduction in CO2. The consequence is that for some companies, de-risking global supply chains has now become a key component of value creation plans.
Finally, there is a much broader, more systemic issue at play. The current crisis has clearly highlighted the role of biodiversity loss, rapid urbanisation and rising population levels in exposing us to novel pathogens, as humans come into ever closer contact with animals through deforestation. These are all issues that ESG investment strategies aim to address or counter.
With all of these factors in the mix, it is not surprising that many are beginning to see the current upheaval and associated dip in greenhouse gas emissions as an opportunity to rethink our blueprint for how the world should evolve post-COVID-19.
Q. Has it refocused attention on the S of ESG?
A. It is certainly fair to say that the pandemic has moved social investment back up the agenda, with a sizeable increase in issuances of so-called "social bonds". However, the focus of these social bonds has shifted a bit from what we were seeing pre-pandemic. Where we might previously have seen issuances being used to fund projects relating to affordable basic infrastructure or housing, we are now seeing bonds tied far more closely to recovery efforts such as the production of PPE, financing medical equipment and providing support to businesses hoping to retain pre-pandemic levels of employment.
This new breed of social financing demonstrates the versatility and responsiveness of our capital markets, and the increasingly attractive concept of control over where the proceeds of capital raisings are spent. In a world where activist investment has frequently been equated with equity investment, this all goes to show that the more sedate world of fixed income can be adapted to effect genuine change within the real economy, whilst in many cases achieving comparable returns.
Q. Do you think sustainable investment is key to rebuilding wealth in the aftermath of COVID-19?
A. Absolutely, and I am not alone in that view. "Build back better" is not just a slogan; with the delayed 2021 UN Climate Change Conference (COP26) drawing closer, the UK Government has made no secret of the fact that it wants to see increased investment in the transition to a zero carbon economy, and that sustainable recovery from the pandemic will require "clean growth". It has not escaped the attention of politicians that there are significant employment opportunities involved in the transition to a low carbon economy; for example, the UK Conservative party's manifesto set out a pledge to work with industry to deliver two million new jobs in clean growth over the next decade. Projects targeted for investment include building the first fully deployed carbon capture storage cluster by the mid-2020s, supporting energy intensive industries' move to low carbon business techniques, and helping the UK's world-leading offshore wind industry reach 40 GW capacity by 2030. This all comes at a time when US investment in renewable energy recently hit record highs.
The concept of building sustainable wealth does not, of course, simply depend on job creation. A hugely significant development over the past couple of years has been the increasing realisation on the part of institutional investors that income and wealth inequality have the potential to negatively impact the long-term performance of portfolios as a whole. Perhaps for this reason, proposed standards set to be implemented under the EU Disclosure Regulation will require the investor community to report on issues such as whether levels of CEO compensation are excessive compared to that of the general workforce, along with key markers around employee relations. These are all issues that the PRI have previously highlighted as being relevant to income and wealth inequality.
Q. Given the current volume of regulatory activity facing asset and wealth managers is geared towards integrating climate related and wider ESG risks including the Taxonomy Regulation and ESG Disclosure Regulation – do you think regulators will be paying close attention to how these types of COVID-19 ESG issues are being handled across the industry?
A. It is certainly fair to say that more time and effort has been spent by regulators on defining the environmental aspects of "ESG" than, say, the social aspects; there is no "social taxonomy" for example. This is to be expected given the vital need for investment in the transition to a zero carbon economy.
We know, however, that regulators are watching COVID-related developments in the ESG investment space closely; for example, the European Commission recently incorporated an entire section on "social bonds and COVID-19" into its consultation on the establishment of an EU Green Bond standard. More generally, as issues around the interplay between COVID-19 recovery and ESG become increasingly price sensitive, there will no doubt be a proportionate increase in interest from regulators and supervisory authorities.
At a systemic level, regulators may also ask questions in the future about whether the market as a whole has worked to support sustainable economic recovery during the post-pandemic period, or whether the drive for shorter-term profitability has instead worked to destabilise or hold back overall recovery. Based on publications from ESMA and others, we know that there is concern amongst some policymakers that short-term performance pressures on the investor community act as an obstacle to commercial companies embedding sustainability into their investment decisions and strategic planning.
Q. Will the European Commission meet the ambitious goals laid out in the European Commission Action Plan on Sustainable Finance and the EU taxonomy? Will the current crisis delay the implementation?
A. Part of my role as an adviser on financial services regulation is to keep our clients up to date on timing of key regulatory reforms such as the upcoming EU Taxonomy Regulation, which has just been adopted by the European Parliament. This can sometimes feel like staring into a crystal ball, but what I can say is that there is a genuine sense of urgency on the part of the European Union to push through these reforms. The regulatory reforms contemplated under the Action Plan are intended to be a key driver in achieving the EU's 2030 targets agreed in Paris, which will require incentivising the market to fill an investment gap estimated at 180 billion EUR per year - hence the time pressure.
In other words, although the timeline that was originally contemplated may slip a bit, the market should plan on an aggressive implementation schedule. Aside from the Taxonomy Regulation, however, the most pressing concern for many in the market is the fact that the Disclosure Regulation (which forms another central pillar of the sustainable finance package) is set to be implemented in March next year. There is a growing feeling that this timeframe is pretty unworkable, particularly given that the EU has not yet finalised the necessary "Level 2" rulemaking, so that may be an area where we see some movement. Adding Brexit into the mix makes timing even harder to predict, particularly when the UK has not clearly committed to adopting the sustainable finance package in its current form.
If it is the case that COVID-19 results in a delay to the implementation of the taxonomy, however, that would in theory present a valuable opportunity for the market to consider and collaborate on how the taxonomy should be built into investment decisions from an operational perspective. In an ideal world, it would also present an opportunity for global policymakers to work together towards limiting the potential for competing disclosure standards in different jurisdictions.
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