Where Does ESG Go In A Recession?

Warren Buffett: “When the tide goes out, you see who’s been swimming naked.”

With markets roiling, and a coronavirus-induced recession knocking at the door, what happens to the flood of capital into ESG investing strategies, corporate commitments to stakeholder purpose, and calls to reimagine capitalism? Are they exposed as “luxury goods” that slide back down the list of priorities until things start to look up, or does economic depression heighten calls for system reform and help us sort out who’s fully committed (and who isn’t)? The way the market is currently going, we will get the answer to those questions very soon. With over 25% of institutional investors saying that they use ESG in their investment process, and over $12 trillion overall influenced by ESG factors, there is a lot at stake. 

Recessions always hit the most economically vulnerable people and communities the hardest. They exacerbate inequalities. The ripple effect can be long and serious, in terms of impacts on health (physical and mental), education, and social support systems. Confidence in institutions is undermined and political divisiveness intensifies. Far from pulling back, this is precisely the time when business and financial leaders within the ESG and impact world need to stand up and be counted. We are already seeing this in the business responses to coronavirus. From Alphabet’s fund to provide sick leave to its contract and temporary workforce to Walmart’s Emergency Leave program, many companies are stepping up to the plate to make sure that employees – including those working on an hourly or contract basis – are supported during this time. If and when economic hardships intensify, I expect to see serious ESG practitioners expand and multiply these kinds of responses. 

In terms of overall commitments to ESG, it’s understandable that in the midst of a Force 10 economic hurricane, businesses and markets instinctively go into short-term survival mode. Investors unconvinced that ESG can be beneficial to returns will likely pull back, and companies that haven’t yet developed muscle memory on the stakeholder model could shelve plans. That said, serious ESG investors today do have a longer-term mindset. Their motivations predispose them to withstand short-term financial turbulence. They believe that underlying portfolio companies that have embraced stakeholder and sustainability leadership tend to be less risky in a downturn. Indeed, according to Credit Suisse, there is evidence that markets are beginning to reward corporate ESG leaders with higher credit contingency and a lower cost of refinancing. None of this is a guarantee of course – recessions affect every company, and ESG-led investors are far from immune – but it does make sense.

There is credible research to back this view up too. In a seminal study done by Harvard’s Bob Eccles, Ioannis Ioannou, and George Serefeim – The Impact of Corporate Sustainability on Organizational Process and Performance – they present compelling evidence that “high sustainability” firms significantly outperformed their low sustainability counterparts over the period 1993-2010, even during downturns. According to the authors, investing $1 at the beginning of 1993 in a value-weighted (equal-weighted) portfolio of sustainable firms would have grown to $22.6 ($14.3) by the end of 2010, based on market prices, versus $15.4 ($11.7) for the sustainability laggards. They also saw statistically significant outperformance with return on assets (ROA) and return on equity (ROE). Interestingly, they found that far from ditching sustainability practices during the 2008 financial crisis, companies actually slightly increased the number of policies.

What did the leaders have in common? They directly involve board governance in sustainability issues and link executive compensation to sustainability objectives; they show a much higher level of stakeholder engagement; they present a longer-term time horizon in their external communications; they attract more long-term investors; they focus on employee engagement; they use ESG standards to help grade suppliers; and they are more transparent in their disclosure of non-financial information.  

A look at the MSCI KLD 400 Social Index versus MSCI US Index over the 1995-2012 period is also interesting. It suggests that, while ESG leaders are by no means immune to economic downturns, they tend to rebound faster. Anecdotally, both the TIAA-CREF (now Nuveen) Social Choice Equity Fund and the PAX ESG Beta Quality Fund showed modest outperformance during the last financial crisis between 2007-2010, although the peak-to-trough experience looks similar to the S&P 500. The Calvert US Large Cap Core Responsible Index Fund shows similar results during the 2008-9 event. Dozens of well-managed active ESG strategies have been around since the early 2000s, and it would be great to see more performance data from them. 

The bottom line is that while immediate-term needs must be met, having a more engaged workforce; a more secure license to operate; a more loyal and satisfied customer and investor base; and a lower cost of capital seem to be critical advantages as you’re battening down the hatches as a business leader, and precisely the kind of features investors would want in their underlying holdings. Needless to say, we will be tracking all of this at JUST within our own indices and fundamental research.