Since the beginning of the Coronavirus outbreak turned a pandemic, many parallels were drawn with Climate Change Risks. Most environmentalists have not resisted underlining that the world’s greenhouse gas (GHG) emissions have mechanically dropped with resulting clearer skies everywhere. This temporary environmental improvement is a very poor consolation.
Financial market impacts have been very close to the ones that a harsh ecological transition could trigger, also synonymous to a sudden halt of most economic activities. Consensus so far priced a smooth and growth-oriented transition (the framework of the EU Commission can be considered as a template for such a transition). The economic and financial models too (infinite growth in many DCFs). Most polluting companies are being smashed (oil, transports and buildings), though not because they are polluters. Banks are suffering from reflecting in their balance sheets an economic reality that is akin to depression.
It will be a mistake to believe that governments will leave their seats in the economy, once the crisis is over.
A hard ‘climate’ transition will leave many assets stranded, i.e. economic activities becoming obsolete: here the carbon-intensive ones, say 75% of the economy, leading to huge social damages (if the world has not found substitutes). The world economy is experiencing a forced and therefore punishing transition, or rather a pause, if one holds the view that businesses will restart as usual in a few weeks (we doubt it). The economic logic is no longer in command, and even appears at odds with the public health. The market will ask itself later on a handful of essential questions regarding the broad resilience of global businesses and a system, which lost close to $20tn, and whose only salvation seems to lie in contracting more debts with government (i.e. future taxes) backing. This can be summed up in one imperative for investors: re-assessing what was long held as true…
ESG should have played a stronger role in this sense from day one (by challenging what businesses held as forever true). Of course, not by forecasting pandemics, but by planning scenarios of a sudden stop for the global economy, in the light of global warming and rising social tensions. Highlighting current businesses’ weaknesses and exposures would have helped prepare alternative arrangements. This was hardly the case. The biggest achievement so far of ESG going mainstream was to propel higher (artificially) an already over-priced market. We believe that this pandemic crisis will impact the way corporates business models’ robustness will be assessed the day after, as this amounts to an in vivo stress test for all. New collaborations are emerging from this crisis: challenging the so far dominant (Anglo-Saxon) approach of ESG being exclusively driven by shareholders.
We come back below on risk similarities between this pandemic and Climate Fight, both underlining the problem that our societies have with common goods and collective actions. It also illustrates difficulties for corporates to play a decisive role in such cases. This is likely to keep weighing on markets. We then consider the current governments’ ongoing involvements and whether it can lead to the fundamental “reshaping of finance” (in BlackRock’s own words but with a very different meaning this time).
A tale of two risks
One reason that the market’s sell-off has been so violent lies in the combination of what it hates most: uncertainty and non-collaborative strategies. The uncertainty refers to the length of the public health crisis which till this moment remains hard to assess and the non-collaboration refers to the different (geopolitical) tensions that have appeared in contradicting vote-chasing government responses to the crisis. These are two dimensions also found in the fight against global warming. The positive note, though it took time, is that G7 agreed to coordinate their response and do “whatever is necessary”.
ESG practices are not fulfilling their main objectives: ask tough questions to companies, challenge strategy and governance, and seek broader disclosure.
The other point deals with the disruptions of our productive organizations (a crisis in the real economy). This may well shape a new economic model (toward leaner, cleaner and more local productions) and a “new social contract” that corporates should respect to keep operating. This would prove useful in the fight against global warming. Questions that deal with the pace of the recovery (the famous V or U shaped crisis exits), may be missing the point of more structural changes to come. Most Western governments indeed highlighted the importance to draw on the consequences of COVID-19: on strategic partnerships (geopolitical), on the globalisation (economical) and new minimum insurances for their citizens (social).
This left the question of stranded assets open, like in the case of the ongoing global warming. The Coronavirus may lead to share trading suspension, asset write-downs and even nationalisation, as part of a global consistent strategy. Though governments are nominally “bailing out” the whole economy to avoid social disruptions, it will have to make priorities (as the UK clearly indicated). A huge part of our current economic organisation appears at odds with public safety: both in the case of health- or climate-related crises. This is in contradiction with the idea of a smooth transition, driven by positive and growth-oriented strategic moves at companies’ levels.
Long-term consequences for ESG and corporates
We long held the view that current ESG practices are not fulfilling their main objectives: ask tough questions to companies, challenge strategy and governance, and seek broader disclosure. We consider that ESG should instead start with the acknowledgement that most current operating business models are under-pressure (as is the case today), and then identify best aligned ones (a low carbon economy, with high social standards being the reference).
Major environmental, economic and social changes will imply a major reshaping of the corporate landscape (meaning the end of “the most pro-corporate environment” globally). The pandemic is accelerating the agenda and leading to consider businesses’ resiliency under new lights. The market was not ready to answer such questions despite “corporates social responsibility” going mainstream. Now, it has to. Many corporates with shiny ESG credentials have been tripped up by the COVID crisis as they chose to pile up cash as opposed to protect their supply chains for instance.
This public health crisis is challenging the ESG rhetoric, as we mentioned at the beginning of the crisis (China & ESG, an oxymoron). Executives’ pledges to manage for the long term are being tested. For many companies, this has been a huge departure from what effective governance should led to, most notably at the beginning of the crisis in China which was grossly misunderstood by most managers. Investors can expect and come to regret further governance discrepancies ahead, as annual general meetings in April/May, are likely to happen in conditions (remote voting) not fostering shareholders’ democracy while ongoing auditing processes are complicated by travel restrictions.
All of this constitutes a strong challenge to the whole ESG logic so far, which consisted in letting shareholders drive the positive changes at company level and propel, by their responsible decisions, the global economy onto a better path (meaning long-term growth). We now know that, in very serious cases, their actions and even their liberty to undertake initiatives are of no help (and sometimes must be restrained). In such cases, public health’s good implies businesses’ costs. ESG asked so far the question to corporates: how can they help their governments. It is now the governments that are doing “whatever it takes” to save firms long on ESG credentials but thin on proper real-life actions. This is likely to keep confusing investors for some time, as sustainable investing will continue to grow and find itself reinforced by the Coronavirus.
Government, once in the room…
Governments are regaining an unprecedented role in the economy, since the aftermath of WW2. From guaranteeing most economic liabilities to directly writing cheques to their citizens, public authorities are exploring all the fiscal sides to support momentarily-stopped economies and, more directly, their citizens. This is all part of dealing with a public emergency. In the meantime, when governments are to face their new debt burden, and there is not much other choice, this implies major changes in the rules of finance and to what was held true … The sacrosanct EU Commission’s 3% deficit rule has been suspended (and probably dead by now). The next steps may include Eurozone debt mutualisation.
It will be a mistake to believe that governments will leave their seats in the economy, once the crisis is over. With this new grab on the economy, governments are likely to set the tone for what comes next, not corporates… This is against the ESG framework, but it might just as well offer a more realistic one for the environmental challenges to come.
To request access to AlphaValue’s ESG research : click here
Founded in 2007, AlphaValue is the world’s leading provider of Independent European Equity and Credit Research. We provide comprehensive, unconflicted research-only (no execution, no corporate finance) coverage of c. 480 European mid and large cap stocks. We have an average of 46% of negative recommendations at any one time. Learn more at www.alphavalue.com