Material E, S and G factors in 2021

During 2020 the increased popularity of sustainable investing, and its encouraging performance, during a period of extreme volatility may mark its turning point for overwhelming adoption across investors.

Within this field, the use of environmental, social and governance (ESG) information has been critical to these shifts, and increasingly part of sophisticated investors’ approach to investing. Notably, in October’s 2020 edition of Investing for Global Impact, a survey supported by Barclays of over 300 leading individuals, families, and family offices, an overwhelming 96% of respondents integrate ESG considerations into some (35%), the majority (35%) or all (26%) investment decisions.

Here we highlight selected E, S and G issues we expect companies will likely face in 2021 and what each means for investors. Then, we take a step back to review how ESG factors can inform investors decision-making and, the often overlooked fact that there are various ways to incorporate such data into investment processes.

Material ESG factors: the outlook

Next year we expect to face continued issues from the pandemic and its associated economic and societal implications. Moreover, as we’ve noted before, reversal of globalisation, trade tensions and climate change will add to challenges.

For investors trying to position and navigate their portfolios through the uncertainty, considering ESG can provide a valuable perspective on the material factors affecting companies in 2021. Therefore, in discussion with our discretionary team and industry peers, a selection of key E, S, and G factors are identified that are likely to be material next year.

Note that these factors are neither static nor exhaustive. But they highlight some of the challenges companies might face and which investors may want to understand (see table).

Material “E”nvironmental factors in 2021

The pandemic may have moved environmental awareness down the global agenda as more pressing issues focused our their attention. However, climate breakdown has continued relentlessly and will likely regain pace as output recovers. With hopes of a vaccine being developed and distributed soon, however uncertain this may be, we expect more attention to return to environmental factors, notably in carbon emissions and biodiversity.

Carbon emissions

Green government stimulus efforts and the twenty-sixth United Nations Conference of Parties (COP 26), at which governments report on the Paris Agreement’s efforts and set new targets, should accelerate climate efforts. In turn, delivering committed climate targets and moving to a low-carbon economy may generate greater climate-related transition risks for all companies.

Transition risks include policy and legal, technology, market and reputational risks. Thus far, investor focus has been largely on the most carbon-intensive industries. Sectors such as oil and gas or utilities will again be under more pressure to establish and meet transition pathways to align with the Paris Agreement. As well, the risks of legal action, with associated costs or potential payouts, will climb as the potential financial losses and damage arising from climate change grows.

Additionally, previously less visible sectors, such as agriculture, buildings and industry, will be more exposed to similar risks. As governments act to “green” the economy, these industries also face additional costs for their carbon emissions, higher input costs, possible revenue declines from apathetic customers or required abatement to transition to low carbon technologies.

For investors, protecting value in a portfolio starts with an understanding of carbon exposure, usually through carbon footprinting efforts. Thereafter, investors can assess the preparedness of companies to manage these risks, in absolute terms or relative to industry peers.

Biodiversity

Today humanity’s global consumption of “natural capital”, the goods and services provided and replenished by the natural environment, far outstrips its inherent ability to regenerate. This natural capital is reliant on the variety and resilience of all living organisms and their associated ecosystems, in sum, on biodiversity.

Biodiversity is being damaged by direct exploitation, changes to land or sea use, human pollution, climate change, and invasion of previously alien species. The resultant loss of biodiversity means vital ecosystem services which underpin the continuity of society and business, are being eroded.

Investor awareness has begun to crystallise on the importance and value of biodiversity, both intrinsically as well as to the industries which are affecting it (such as agriculture, mining and transportation) and being affected by it (such as agriculture, textiles and fashion, food and beverage, and tourism). The detractors face similar legal, regulatory, or market risks as stakeholders, governments, and consumers start to hold these industries to account.

Assessing associated risks, ranging from physical risks due to loss of natural material inputs to litigation risks, or policy and regulatory changes, should be considered by investors. More critically than portfolios ensuring continuity of biodiversity, ultimately human society across the globe may depend on it.

Material “S”ocial factors in 2021

While undoubtedly material for certain industries, social factors have generally not received the same attention as environmental and governance ones. The comprehensive and pervasive effects of the pandemic across industries and countries seem to have made social factors more universal and a priority for investors.

How companies managed their relationships – with employees, suppliers, customers and in its communities – became immediately evident and comparable. We expect, as the economy attempts to recover, attention to grow next year in two areas in particular, employee safety and labour management.

Employee safety and working conditions

Prior to COVID-19, health and safety of employees was often focused on industrial or labour-intensive sectors. However, with the communicability of the virus, more companies seem to be recognising and addressing these social-related issues.

Some industries, or roles, have been able to be delivered remotely, minimising the direct risks of coronavirus. Sectors where remote work isn’t possible, or constrained, have already been forced to adopt health and safety measures to maintain operations. With the hope of reopening economies more permanently in 2021, providing safe working conditions through personal protective equipment, testing and strict sanitisation regimes is essential.

Where interaction between staff and customers is required (for example, in restaurants, hotels, travel, delivery services and the performing arts) the future viability of companies could depend on their ability to maintain protocols.

For investors, assessing a company’s risks associated with workforce continuity, and how they have established and are managing them, should be factored into due diligence. Moreover, companies successful at looking after their employees will likely garner greater loyalty from employees and other stakeholders. In turn, this will probably yield positive reputational benefits in the longer-term.

Labour management

Good labour management practices – simply put, finding the right people, training them and keeping them happy – are crucial for organisations to operate successfully in the longer term. Generally, skilled and engaged employees are more productive. In service industries, good quality employees are directly linked to customer satisfaction. Finally, worker and wider community support can contribute to positive reputational impact.

During the pandemic, unemployment rates have climbed to unprecedented heights and may take years to recover. Many companies have been supported through government bailouts and furlough schemes to retain employees, and eventually these will end. If economic recovery is not sufficiently robust, more workers will be let go.

How companies have managed this process thus far, or if required in the future, will have a meaningful long-term impact on companies. Investors can evaluate a variety of labour practices, such as how employers dealt with contract workers, whether they cut loose employees or kept paying them, whether they used balance sheets or bailouts to fund holding onto employees during shutdowns.

Companies perceived to be laggards risk short-term damage to brand and longer term reputational and financial hits. Those seen as leading should be expected to prosper, perhaps increasing market share or improved employee engagement. For investors, identifying the difference, before it emerges, will matter.

Material “G”overnance factors in 2021

Even before the rise of using ESG factors, governance has been a long-standing, non-financial consideration for many investors. It covers a broad range of corporate activities such as board and management structures, shareholder rights management, remuneration and incentives, board diversity, corporate policies and standards, information disclosure and ethical behaviours.

During 2020, these processes have been stretched repeatedly. For example, the pandemic, calls for more gender and racial equity along with social justice and reversal of globalisation. While these issues will continue into, and beyond, 2021, two aspects are material for investors – the robustness of corporate governance, and alignment of executive remuneration.

Corporate governance

Broadly, corporate governance focuses on the system of internal controls and procedures used to manage companies and how employees behave. They provide a framework that defines the rights, roles and responsibilities of various groups within an organisation. It also includes the checks, balances and incentives a company needs to minimise and manage the conflicting interests between internal and external stakeholders.

When faced with external shocks or changing environment, governance should enable the organisation to realign to this shifting landscape. The pandemic has tested companies’ risk and crisis management organisation and practices. Successful companies tended to have sufficient plans in place and adapted quickly to maintain business continuity. Investors that considered such factors in selection will have found out how accurate and effective they have been.

The quality of corporate governance should continue to be a material factor in how well companies can respond to the economic uncertainty and financial challenges to come. With businesses facing increased economic stresses, bondholders and minority shareholders might want to consider the perceived risks and rewards of their positions, based on how much their rights are recognised and protected.

Executive remuneration

Executive pay continues to be at the forefront of governance considerations for many investors. With high pay levels relatively common, perhaps regardless of performance, shareholders seem to be taking more collective action in response. Additionally, stakeholders such as employees, the media or government are frequently incited by the quantum and potential misalignments, adding to potential reputational issues.

Structuring and aligning executive compensation in the interests of shareholders, or other stakeholders, is a persistent challenge. While there is general agreement on the importance of aligning pay with long-term performance and strategy delivery, most plans are predominantly linked to company stock prices. These do not always reflect long-term, and sustainable, value creation or executives’ contribution to this end.

In 2020, the divergence of overall capital markets performance relative to the economic downturn has been particularly notable. Many executives waived or donated their compensation in solidarity with the challenges being faced by their employees and wider society. Whether this practice persists next year remains to be seen. However, this principal-agent challenge remains a risk for investors to consider.

A final small note to indicate the growing influence of ESG factors. In a small, but growing, number of companies executive pay is being tied to overall ESG ratings or specific metrics. As this shifts, both the attention and hopefully performance around wider societal factors will increase.

Using ESG to select quality investments

Having identified some of the key E, S and G factors for next year, investors have to incorporate them effectively into their investment process.

The reality is investors consider a variety of factors when deciding whether to select, or hold, an investment. Adding ESG factors can enhance existing investment processes by including non-financial information – hopefully to make more informed investment decisions.

Traditionally investors’ primary data points have been financial ones with sources such as annual reports, management presentations and earnings statements. Several traditional performance indicators may be disrupted next year in such unusual times, relying solely on this information may limit the ability to select companies that will perform better in such challenging conditions. Consider how simple incorporation of ESG factors into indices has predominantly outperformed during 2020 (see figure one).

Non-financial information

At the same time, the amount and variety of information available to investors have swelled. Social media provides signals, for example of consumer sentiment or employee satisfaction, as leading indicators to company health. Satellites provide real-time data so investors can scrutinise car parks or crop fields to assess productivity.

Non-financial data has come to be organised into three general categories – environmental, social or governance, which tend to be abbreviated as ESG. The data span many issues, such as carbon emissions, labour and human rights practices and corporate governance structures.

Critically, ESG metrics are fundamentally about the internal practices of the organisation. They have been established to provide data about how a company operates; and not the outcomes of its goods or services.

It’s possible to have the ESG data on any business. Moreover, a company can potentially have very good ESG scores, even if its goods or services (such as tobacco or weapons) may not be acceptable to some investors. Similarly, it’s possible to have companies producing goods and services that generally viewed as beneficial for society (say renewable energy or elderly care homes) but are very poor when it comes to the ESG aspects of how they operate.

So while investors can make moral judgements about ESG performance or set certain thresholds or standards for their investment, the primary aim of ESG data is to indicate how well run a company is, not its intrinsic value to society. In fact, the motivation to integrate the data can be primarily financially driven – it serves as another tool to inform decisions that seek the best long-term, risk-adjusted return for investors.

Financially material ESG factors

The core premise is that by considering ESG factors, an investor can take account of a broader set of data to make a better judgement about the financial performance and longer term value of a company. However, not all factors are equally relevant to all companies.

Given the wide range of ESG issues a company may face, an investor should narrow them to a set that is most relevant and translates into financial performance, impacting either free cash flow or eventually the cost of external financing. This materiality is important to identify which of these factors will influence, positively or negatively, a firm’s business model and value drivers.

Having determined the material ESG factors, investors can identify where a company can be at risk or have an advantage relative to their peers. For example, organisational practices and culture can affect a license to operate, or make a company more/less prone to scandals or fines. By introducing leading environmental sustainability practices, greater operational effectiveness can be achieved. Or greater connection with employees and customers can be made through a company’s market positioning and activities.

Diverse approaches to integration

Investors have various options in how they assess and integrate ESG considerations into investment practices. While “ESG investing” is generally discussed as a homogeneous practice, there are substantial differences in investors’ approaches. At the broadest, two methods emerge – screening or incorporation.

Screening on ESG factors relies primarily on using either a single metric or a rating, which are a composite assessment of the relevant data points, calculated through weighing mechanisms. Investors can use the ratings from various agencies (such as MSCI, Sustainalytics, FTSE Russell or Refinitiv) or develop their in-house rating systems. Given the differences in underlying data and methodological calculations, scores don’t necessarily have high correlations between ratings’ providers.

Once having a set of ratings, investors can choose to exclude companies (or negatively screen) based on a particular issue or the overall score of a company. The result is the companies with poor ratings are not included in the portfolio. Alternatively, though similarly, some investors use scores only to select companies rated “best-in-class”, so that selection is relative to the industry peer group rather than all companies.

Passive funds and exchange-traded funds have to rely on screening to integrate ESG considerations. Therefore, an investor is reliant on the underlying data and rating methodology. Even active managers, though, can use screening as a primary filter as part of their investment process and still assert they are using these considerations. Overall, screening provides a lower cost and simple method to integrate such factors.

Incorporation

Incorporation is a high-effort and more-nuanced approach, where investors or investment teams include ESG factors into their investment assessment, discussion and decision- making. This can mean using ratings as part of the process, but they also tend to delve into the accompanying qualitative research reports and underlying data to the factors. With an incorporation approach, ESG becomes one of the factors to inform decision-making rather than a rigid, filtering one. Notably, the person in the team that carries out, expresses and considers such factors influences how useful it can be.

At the minimum, the ESG factor can serve as a reference point, so while not explicitly a screen, in some ways a de facto one. Or the information can be an input to the discussion where requested or it is a critical or controversial issue. Alternatively, it might be presented and discussed as a separate item in the process.

Frequently assessments are undertaken and provided by an ESG analyst rather than one of the accountable investment managers. The level of attention and deliberation in the above cases can widely vary from passing to thoughtful. Finally, though least frequently, such considerations can be assimilated into investment discussions, where E, S and G factors may be discussed without even explicitly using the labels.

Looking at ESG in 2021 and beyond

With sustainable investing becoming more prevalent, more investors are factoring environmental, social, and governance data into their decision-making.

If investors can use ESG insight to understand better the complexities of associated risks and opportunities in how companies operate, they can position their portfolios accordingly. Additionally, more widespread use of such considerations and requirements to report such data, may help encourage companies to make a positive change in how they operate on these factors.

In what looks like being a low-return era for investors, ESG integration provides additional tools for investors to select companies and build portfolios with the aim of generating long-term returns for 2021 and beyond.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

This communication:

• Has been prepared by Barclays Private Bank and is provided for information purposes only
• Is not research nor a product of the Barclays Research department. Any views expressed in this communication may differ from those of the Barclays Research department
• All opinions and estimates are given as of the date of this communication and are subject to change. Barclays Private Bank is not obliged to inform recipients of this communication of any change to such opinions or estimates
• Is general in nature and does not take into account any specific investment objectives, financial situation or particular needs of any particular person
• Does not constitute an offer, an invitation or a recommendation to enter into any product or service and does not constitute investment advice, solicitation to buy or sell securities and/or a personal recommendation.  Any entry into any product or service requires Barclays’ subsequent formal agreement which will be subject to internal approvals and execution of binding documents
• Is confidential and is for the benefit of the recipient. No part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays Private Bank
• Has not been reviewed or approved by any regulatory authority.

Any past or simulated past performance including back-testing, modelling or scenario analysis, or future projections contained in this communication is no indication as to future performance. No representation is made as to the accuracy of the assumptions made in this communication, or completeness of, any modelling, scenario analysis or back-testing. The value of any investment may also fluctuate as a result of market changes.

Barclays is a full service bank.  In the normal course of offering products and services, Barclays may act in several capacities and simultaneously, giving rise to potential conflicts of interest which may impact the performance of the products.

Where information in this communication has been obtained from third party sources, we believe those sources to be reliable but we do not guarantee the information’s accuracy and you should note that it may be incomplete or condensed.

Neither Barclays nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation. Law or regulation in certain countries may restrict the manner of distribution of this communication and the availability of the products and services, and persons who come into possession of this publication are required to inform themselves of and observe such restrictions.

You have sole responsibility for the management of your tax and legal affairs including making any applicable filings and payments and complying with any applicable laws and regulations. We have not and will not provide you with tax or legal advice and recommend that you obtain independent tax and legal advice tailored to your individual circumstances.

THIS COMMUNICATION IS PROVIDED FOR INFORMATION PURPOSES ONLY AND IS SUBJECT TO CHANGE. IT IS INDICATIVE ONLY AND IS NOT BINDING.