How Covid-19 has highlighted the importance of ESG investing

ESG issues have become financially material to a company’s success

A protestor wearing a face mask holds a sign during a demonstration against climate change in Augsburg, Germany. Investors should engage directly with companies on relevant, material ESG issues such as climate change, says State Street Global Advisors' Carlo Funk. ReutersShow less

The Covid-19 pandemic highlights how globally interconnected we are, especially in terms of commerce and trade. Where will this lead us when it comes to the value and adoption of ESG and climate investing and what are the implications for the Middle East?

Covid-19 has uncovered the importance of key ESG performance indicators for long-term value creation. The “S”, or social part, has often been perceived as rather vague and insignificant. This crisis proves this to be mistaken. Social and governance aspects including a company’s resilience and contingency planning ability, its ability to uphold commonly accepted workplace labour standards, and employee health and safety measures are crucial for long-term performance.

It has become clear that ESG issues are financially material for a company’s success, hence, the added value of integrating this data in portfolio structures and investment decision making becomes evident.

However, it’s not just the ‘S’ and ‘G’ in ‘ESG’ that are important. Environmental issues, particularly climate change, are also moving up the agenda.

Within the ESG space, climate change and its associated environmental and economic risks have been the dominant topic in recent times. Climate change can be described as a slow-burning pandemic with significant long-term impacts.

The Middle East and North Africa region is particularly vulnerable to the impact of climate change and the associated socioeconomic changes due to the importance of fossil fuel industries as well as relative water scarcity and population density.

Even before the pandemic, fossil fuel demand had been in decline as the role of renewables continues to grow and regulatory pressure over emissions tightens. Investors were starting to worry about financial risks, and governments were increasingly concerned about the public health impact of fossil fuel pollution and import dependency. In short, the sector was already vulnerable.

The subsequent Covid-19 crisis saw fossil fuel demand rapidly decline and some believe that it may never again surpass the peaks of 2019. Indeed, by the time the global economy recovers, most of the growth in energy demand may be met by renewable energy sources.

The impact of climate change and the energy transition therefore represent significant risks, both in the Middle East and globally, but also opportunities for investors.

Governments have an unprecedented ability to drive necessary change. They must oblige companies to avoid greenwashing and take real action.

In the wake of the pandemic, governments are enacting a huge series of stimulus packages to mobilise their economies and avoid a depression. Governments will have to make difficult decisions around fossil fuel subsidies and taxes, but equally, they will need to avoid bankruptcies and large-scale job losses. This presents an opportunity for governments and companies to ensure workers are retrained so they can contribute to the growing renewables revolution. This is especially significant for the Middle East.

This dynamic provides a perfect opportunity for governments to introduce and widen the scope of carbon pricing to shift the balance in favour of renewable energy. A carbon tax could stimulate much-needed employment and growth in the clean low-carbon industries and technologies that are needed to tackle climate change.

We keenly await the results of the US Presidential Election, in which Democratic nominee Joe Biden has proposed a $1.7 trillion climate plan including research and development in clean energy, and incentives to widen the adoption of renewable power and electric vehicles, which will have global implications that will certainly impact the Middle East. In the event that President Trump is re-elected, we would expect some measures to tackle the growing climate threat. In most areas of the world this is already well underway.

There are many ways for investors in the Middle East to address ESG and climate change within their portfolios. Investors can use a range of strategies depending on their investment, ESG and climate-related objectives, and risk tolerance, from exclusionary screening to impact investing.

Regarding climate change, we believe in an investment approach that incorporates both mitigation of greenhouse gas emissions and adaptation to the future impacts of climate change. These are complementary approaches to reducing climate risks and correspond with asset owners’ need to balance short and long-term risks and opportunities.

These include reducing exposure to above-average carbon emitters and ‘brown’ revenues from oil extraction or power generation and increasing exposure to ‘green revenues’ through companies that are adapting business models to climate risks.

Asset stewardship is another inextricable part of any ESG and climate investment approach. Investors should engage directly with companies on relevant, material ESG issues, particularly on the risks and opportunities presented by climate change.

The Covid-19 pandemic is an international emergency that has required swift and comprehensive measures by governments to safeguard public health. But when the crisis passes and the moment for sober reflection arrives, we will have a unique opportunity to transition to a cleaner, more sustainable future.

In this new world, ESG issues will only rise up the agenda for investors in the Middle East as they look to move away from fossil fuels that they have relied on for decades – and this transition is also an opportunity.

Carlo Funk is Europe, Middle East and Africa head of ESG Investment Strategy at State Street Global Advisors, a member of The Gulf Bond and Sukuk Association