The 'butterfly effect' and Covid-19: Implications for sustainable investing

THE reverberations of the Covid-19 pandemic can be imagined through the lens of Edward Lorenz's "butterfly effect", visual imagery the MIT meteorology professor used to suggest that the flap of a butterfly's wings might indirectly cause a tornado, which represents how small change can have large consequences.

The current crisis has spread rapidly and globally through travel routes and supply chains. There's also scientific evidence that the spread of diseases can be exacerbated by prominent, interconnected sustainability issues including rising temperatures, deforestation, and poor sanitation.

The idiosyncratic, non-linear nature of systemic risk from this event makes it challenging to predict where, when, and to what extent the effects will be felt, but we're closely monitoring the near- and longer-term consequences on sustainable investing.

Investors can watch for these five implications:

1. Covid-19 has intensified sustainability challenges, requiring significant bond financing

The most obvious impacts have been social and economic - loss of life, rising unemployment, food insecurity and related health outcomes. According to the United Nations, the pandemic has negatively impacted 13 of the 17 Sustainable Development Goals.

In an effort to drive capital to address these problems, the International Capital Markets Association has published guidance for the issuance of social bonds.

We had already seen a steady rise in themed social- and sustainability-bond issuance ahead of the pandemic, however, this trend has now sharply accelerated.

In April, the World Bank raised US$8 billion for a five-year sustainable development bond that will support Covid-19 response efforts - the largest ever dollar-denominated bond issued by a supranational entity.

Supranationals comprise 53 per cent of year-to-date issuance, while public agencies account for 29 per cent and corporates 17 per cent.

2. Sustainable investing will play a defining role in shaping the recovery

The Covid-19 pandemic has temporarily arrested economic activity; however, the massive fiscal response globally will drive the recovery.

Positive signals are coming from regulators, as some regions integrate sustainability goals into their recovery measures.

For example, the European Commission has highlighted the need for integration of green transition principles into the EU's economic stimulus package.

3. Investors will increasingly focus on integrating sustainability into valuations, and will increasingly engage companies, especially on social issues

The pandemic will increase scrutiny on companies and governments, with investors examining how sustainability factors may impact valuations. Organisations that emerge most successfully from this crisis and earn better brand reputations are the ones that have gone the extra mile, for example, responding to employees' uncertainty around job stability; and maintaining continuity of their operations.

At the other end of the scale, as encouraged by the Principles for Responsible Investment, to which Morgan Stanley Investment Management has been a signatory since 2013, investors will confront companies that are neglecting workers' safety, or favoring executive pay and dividend payments over business sustainability.

Given the expectation that financing a recovery will primarily occur through debt issuance, fixed-income investors can expect to have more influence with issuers as they will be asked to allocate more of their capital more often.

4. Companies will improve holistic risk assessment and disclosure practices.

New holistic approaches, such as the framework established by the Financial Stability Board's Taskforce on Climate-Related Financial Disclosure help companies to understand their true exposure and vulnerability to climate risk and communicate this effectively with investors.

Such models can give investors a clearer idea of how securities might behave in a stressed scenario.

5. Investors will focus more on preparedness and resilience in the face of long-term risks.

Much as companies develop business continuity plans to manage disruptions, we expect investors to account systematically for the resilience of their portfolios to exogenous shocks.

Investors don't expect companies to anticipate all the possible consequences when a butterfly beats its wings, and the goal isn't to eliminate risk, but to minimise disruption and ensure a smoother recovery when disruptions do occur.

For investors, a greater focus on resilience in the long run may translate into more stable cash flows, less price volatility and lower default rates.