Morgan Stanley
  • Investment Management
  • May 28, 2020

Coronavirus and the Butterfly Effect

How an increasingly interconnected world has amplified COVID-19’s repercussions and its ramifications for sustainable investing.

The reverberations of the COVID-19 pandemic can be imagined through the lens of Edward Lorenz’s “butterfly effect,”1 visual imagery that 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 is said to have started in a provincial market in China, before spreading rapidly round the world through travel routes and supply chains. There’s also clear scientific evidence that the spread of diseases can be exacerbated by rising temperatures,2 deforestation,3 loss of biodiversity,4 and poor sanitation5—all of which are prominent, interconnected sustainability issues.

The idiosyncratic, nonlinear nature of systemic risk from events like a pandemic 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, especially with respect to bond markets, financial valuations and dialogue between companies and their backers.

Investors can watch for these six implications that the COVID-19 environment may have on sustainable investing:

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

We had already seen a steady rise in social- and sustainability-bond issuance; this trend has now sharply accelerated in response to coronavirus.

The most obvious impacts of the pandemic have been its social and economic costs—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, with effects that include inadequate access to clean water and loss of income, leading vulnerable segments of society to fall below the poverty line.6

In an effort to drive capital to address these issues, the International Capital Markets Association has published guidance for the issuance of social bonds to finance the COVID-19 response. We had already seen a steady rise in social- and sustainability-bond issuance ahead of the pandemic, as investors increasingly focused on social as well as environmental issues; however, this trend has now sharply accelerated, with themed bond issuance in response to coronavirus. In April, the World Bank raised $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.7 Supranationals comprise 53% of year-to-date issuance, while public agencies account for 29% and corporates 17%.

Global Issuance of Social and Sustainability Bonds Since 2015
($ Billions)

Source: Environmental Finance

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. What will that recovery look like? One silver lining of recent stay-home measures has been the temporary reduction in greenhouse gas emissions; however, the urgency of stimulating economic recovery may very well delay progress on global climate change initiatives and policies.

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 and in Canada the government has made access to its Large Employer Emergency Financing Facility contingent on companies highlighting how their future operations will support environmental sustainability and national climate goals.

The investment community will play a pivotal role in supporting these initiatives by allocating capital toward constructing a stable and sustainability-focused recovery.

3. Investors will increasingly focus on integrating sustainability into valuations.

The pandemic has resulted in increased scrutiny on companies and governments, with investors examining how sustainability factors may impact valuations, and how successfully issuers emerge from this crisis. We believe that the organizations that will fare the best are the ones that have gone the extra mile, for example, ensuring labor standards aren’t compromised along stressed supply chains; responding to employees’ uncertainty around job stability8; and maintaining continuity of their operations. Companies that have invested in social inclusion and in expanding access to essential goods and services, such as health care and digital telecommunications, may benefit from both a more stable consumer base and a better brand reputation.

4. Fixed-income investors will increasingly engage companies, especially on social issues.

While climate-change impacts have spotlighted the environmental risks in investment considerations in recent years, the pandemic has spurred renewed social and governance issues. This isn’t a new concept. The Principles for Responsible Investment, to which Investment Management has been a signatory since 2013, encourage investors to engage with companies that are neglecting their workers’ safety, or favoring executive pay and dividend payments over business sustainability.9

Given the expectation that financing the pandemic response and recovery will primarily occur through debt issuance, fixed-income investors will be asked to allocate more of their capital more often, increasing their dialogue and influence with issuers. 

With new awareness of infectious disease risk, we anticipate the need for companies to develop and communicate holistic risk models applied to other sustainability risks.

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

Our collective understanding of climate risk has evolved significantly over the past decade.10 As a result, we have seen new holistic approaches, such as the framework established by the Financial Stability Board’s Taskforce on Climate-Related Financial Disclosure. Such frameworks help companies to understand their true exposure and vulnerability to climate risk and communicate this effectively with investors. With new awareness of infectious disease risk, in particular, we anticipate the need for companies to develop and communicate holistic risk models applied to other sustainability risks beyond climate c---hange, to give investors a clearer idea in advance of how securities might behave in a stressed scenario.

6. 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 resilience of their portfolios to exogenous shocks. Investors in infrastructure developments, for instance, may question whether a bridge in a monsoon-prone part of the world is engineered to withstand climate-change related extreme weather events. The goal isn’t to eliminate risk, but to minimize disruption and ensure a smoother recovery when disruptions do occur. Investors don’t expect companies to anticipate all the possible consequences when a butterfly beats its wings, but they will expect them to identify and address the areas where the effects may be most acutely felt. For fixed-income investors, a greater focus on resilience in the long run may translate into more stable cash flows, less bond price volatility and lower default rates.

With many sustainability challenges like climate change, the effects might already be visible—for example, rising sea levels, changing weather and an increase in wildfires. However, the major, and potentially more disastrous, consequences may only become apparent in years to come. In contrast, coronavirus has had an immediate and profound effect. We believe this stark warning will serve as a wake-up call, further driving a modal shift toward sustainable investing and a renewed focus on sustainability risks and opportunities.

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