When it comes to predicting which companies will generate the greatest potential return while also posing the least risk, investors and business stakeholders face a difficult task. A company’s financial performance tells only part of the story: there’s much more to business success or failure than just numbers.
In the UK and the EU we are seeing new regulations which mandate new approaches to non-financial reporting, and there is quantifiable risk to those firms which fail to prepare, and ESG investing principles are growing in strength.
ESG (Environment, Social, and Governance) evaluations provide investors with more in-depth insights into potential risks and enable them to select companies that are consistent with their personal values. It is possible to use the ESG principles of reporting to reach out to the public, and proper management of ESG factors can be profitable in a variety of ways.
As environmental, social, and governance (ESG) assessments gain popularity, they will only become more important in the future. This article explores the “S” within ESG, what is it, how is it measured, and what information do you need to know to get your company on track?
Sustainable development and social responsibility are concepts that are taken and applied to quantitative goals and performance indicators in the ESG framework. ESG strategies are built on a foundation of measurable benchmarks, specialised data collection and analysis, and long-term strategic planning. The ESG scores are based on three factors:
Environment: What is the company’s environmental impact, and what steps are being taken to make it more environmentally friendly?
Social: How does the company treat the people with whom it comes into contact, such as employees, customers, suppliers, and members of the surrounding community?
Governance: What is the organisation’s leadership structure, and how is the business run?
Every CEO must realise that social responsibility is linked intrinsically to the demands of the capital markets. Their attention is now firmly on “impact investing”, also referred to as “sustainable investing”. Access to equity, no matter the size of the organisation, has put social criteria firmly in the spotlight. This is one of the key aspects of ESG which is forcing disclosure. After all, a negative social impact suggests that corporate governance is imperfect, and financial markets are generally risk-averse.
Sustainable investing principles also requires grading risk according to the firm’s impact on climate change, its transparency to its stakeholders, its treatment of its workforce, and its contribution to local communities. This is all far beyond the financial measures of a company’s performance. Board members must pay attention.
If you ask anyone what they think “social responsibility” means, you’ll receive a variety of different responses. It is difficult to define, let alone measure, social responsibility because it is context-dependent and shifting. Corporate Social Responsibility (CSR) is similar to environmental, social, and governance (ESG) evaluation – particularly in terms of the social aspect – but it is not the same. As we discussed in a previous post, Corporate Social Responsibility (CSR) is the ideal and provides context for sustainability agendas and corporate responsibility culture.” ESG, on the other hand, is the set of actions that produce a measurable result. To put it another way, CSR can be thought of as the qualitative side, while ESG can be thought of as the quantitative side. ESG adds value.
ESG frameworks draw attention to the specific social interactions that occur within a company and can be quantified in order to predict risk. The ability to demonstrate how your company handles social issues and what goals you’ve set to increase social equity is difficult – but not impossible – to demonstrate.
Even though the social aspect of ESG can be divided into many subcategories, the following five areas are most frequently addressed:
The relationships that your company has with its employees, suppliers, and customers can all be viewed through a quantitative lens, even though it may not appear that way at first glance. Take, for example, whether the wages provided by your company are commensurate with those in your industry. Do the employees enjoy their jobs, and is your staff turnover excessive? Your suppliers and customers’ opinions of working with your company are important, as is their willingness to support your business in the future.
The question isn’t just whether or not people have a positive impression of your company for emotional or promotional reasons. The manner in which a company treats its workforce has an impact on employee retention and productivity. From the standpoint of profitability, happier employees are more productive, and low turnover is less expensive than hiring new employees on a continual basis. The relationships that a company has with its larger social circle, which includes customers and suppliers, can also have a direct financial benefit for the company.
Community relations are concerned with how your company contributes to or detracts from the surrounding community. Hires from within the community, philanthropy, and local sourcing are examples of quantifiable outcomes. Additionally, the environmental aspect of ESG has some crossover because business practices can have an impact on local environments.
The protection of human rights is an important pillar of social evaluation in general. Environmental, social, and governance (ESG) strategies must examine internal policies and look for human rights violations throughout the supply chain. Despite the fact that a company cannot be held liable for the actions of every organisation with which it collaborates, investors expect due diligence to be performed to prevent them from supporting companies with a poor record. Areas to take into consideration can include a specific supplier, a specific material, or working within a specific geopolitical region.
The management of the environment, health, and safety (EHS) is a significant factor in evaluating the letter “S.” EHS is concerned with the health and safety of employees and the environment in which they work. Since the outbreak, public and investor scrutiny of environmental, health, and safety (EHS) has increased significantly. Businesses that appeared to be putting people in unnecessary danger have been condemned by the public, while others have been praised for their vigilance.
The level of scrutiny directed at workplace EHS practices is likely to remain permanently elevated in the foreseeable future. Workers’ compensation claims, workplace accidents, policies regarding personal protective equipment (PPE), and other health and safety concerns specific to your industry are all examples of metrics that can be used to assess risk.
Despite the fact that diversity is a politically correct talking point, it has a direct impact on the profitability of a business and is becoming increasingly regulated. According to Forbes, the US Senate Committee on Financial Services recently considered proposals for legislation to promote diversity in the financial services industry.
Gender, race, and ethnicity of leadership were among the topics covered in the proposed legislation, which also included a number of initiatives to increase employee diversity. It is imperative that businesses plan to be held accountable to the public and regulatory bodies, and that they develop and implement meaningful diversity goals and strategies. Manjit Jus, Global Head of Environmental, Social, and Governance Research and Data at S&P Global, offers the following advice:
“Incorporating more women into management positions improves corporate governance, talent attraction, and human capital development, all of which are important factors in maintaining competitiveness over the long term”.
Political affiliations and contributions are two of the most visible and easily identifiable aspects of Social evaluation criteria, as they are both public and easily identifiable. Boycotts based on political alignment have a long history and have the potential to cause significant damage to a company’s reputation. Investors will want to know how your company interacts with political parties, leaders, and legislation, and they will want to know what political risks your company may face in the future if it continues to operate in that environment.
It is also possible that investors will want to make certain that there are no significant conflicts with their own political viewpoints. Politics, like all aspects of environmental, social, and governance (ESG), cannot be considered performative; rather, they will be evaluated based on quantitative measurements and compared to the rhetoric of your company.
Social measurements and criteria, like the other aspects of environmental, social, and governance (ESG), give investors greater confidence that your company will not be harmed by the risks inherent in your industry. Creating goodwill both within and outside of your organisation, as well as providing investors with a company they can feel good about investing in, are also important considerations.
Monitoring how people in your labour force, community, and industry are being treated allows businesses to get ahead of potential disasters and have a positive impact on the environment.
First and foremost, we must gain a better understanding of how S is currently defined in the field. S has been described in a variety of ways by commentators and investors, including as social issues, labour standards, human rights, social dialogue, pay equity, workplace diversity, access to health care, racial justice, customer or product quality issues, data security, industrial relations, and supply-chain issues. Some rating agencies define social in terms of social factors that can negatively impact a company’s financial performance.
What are some of the ways that a company’s workforce requirements and composition can cause problems for the company in the future? Strikes or consumer protests can have a direct impact on a company’s profitability by creating a scarcity of skilled employees or causing controversy that is detrimental to a company’s reputation, respectively.
When it comes to the safety implications of a product or the politics of a company’s supply chain, what risks do you have to consider? Generally speaking, businesses that take steps to ensure that their products and services do not pose a safety risk and/or reduce their exposure to geopolitical conflicts in their supply chains experience less volatility in their operations.
What demographic or consumer changes in the future might cause the market for a company’s products or services to contract? Long-term shifts in consumer preferences are influenced by complex social dynamics, ranging from surges in online public opinion to physical strikes and company boycotts by various groups of people. These are important indicators of the company’s potential, and decision-makers should take them into consideration.
One could argue that the lack of precision in clearly defining “Social” is a major contributing factor for why it’s so badly measured. However, there is a more fundamental existential issue at play here. Some rating agencies look at environmental, social, and governance issues almost exclusively through the lens of materiality (that is, information that has an impact on a company’s financial performance). Because the primary business of those agencies is the rating of corporate and municipal debt, and the primary concern of any investor with respect to debt is, of course, the ability to repay it, this makes perfect sense. The likelihood of repayment is the primary focus of risk analysis.
The problem is that most of the interest in environmental, social, and governance (ESG) comes not from lenders evaluating credit risk, but from investors evaluating equity risk. Equity investors, on the other hand, seek to maximise their returns rather than simply mitigate their risks. Indeed, simply reducing the risk associated with environmental, social, and governance exposure is unlikely to assist investors in making positive bets on which companies will outperform the market.
Because of the nature of social impact, it is not only about risk, but also about encouraging others to do good. In other words, the actions, policies, and investments of a company have the potential to have a positive impact on the lives of others. Of course, there are social consequences such as human rights violations, labor relations issues, and supply chain risks that can have a negative impact on a company’s ability to operate and maintain financial stability, and these are significant.
The good news is that there are a variety of social impacts that can have a positive impact on a company’s financial performance. These include things like competitive advantage, business growth, market relevance, brand purpose, and obtaining a license to do business. Positive social consequences are not taken into account in today’s ESG data.
The markets have become obsessed with environmental, social, and governance issues, and the demand for more and better ESG data will only increase in the years to come. It is past time for the markets to place equal value on Social as they do on Environment and Governance. The only thing that stands between us and better data is a lack of data. In order to increase the importance of Social in the markets, there are three practical steps that ESG investors, rating agencies, and companies can take:
The first and most important step is for companies to begin reporting Social impact data on a consistent basis. Company directors and officers have an independent fiduciary obligation to measure and disclose material Social information to their shareholders, regardless of who the other players are. Companies should begin voluntarily measuring and reporting their Social impacts, and they should seek independent verification of their results. Afterwards, this information can be included in a company’s own sustainability reports. If corporations begin producing the underlying data now, rather than waiting for the rest of the world to agree on it, they will have a significant amount of influence over the standards that are established.
Second, ESG investors should begin requesting and mandating Social impact data as a condition of doing business. Despite this, the process is still entirely manual, the data being requested is inconsistent, and the Social analysis isn’t as closely linked to corporate performance as it might be. It will be easier to move data and less burdensome on portfolio companies if everyone works together to establish a standard for Social matters. Over time, as a result of the efforts of the leadership, other investors will join and demand the same standard S data. The funds that take advantage of this information as soon as possible will have a significant advantage over their competitors. They will also likely attract new capital more quickly than traditional environmental, social, and governance funds, which are struggling to answer the fundamental question that so many investors are asking these days: “What impact is my money having?”
Finally, ESG rating agencies, standard-setting bodies, and data providers should collaborate with a specialised Social data provider in order to raise the value of their data to a higher level of sophistication. Social impact data is complex, and it cannot be captured in a one-dimensional survey with a checkbox at the end of it. High-quality S data that is reliable and consistent requires specialised taxonomies, questionnaires, and independent verification. This will also open the door to a whole new level of ESG Social analysis, something that advocates for shared values and academic researchers have long advocated for. Rating agencies and others will be able to evaluate a company’s competitive advantage, growth potential, employee resilience, access to new markets, increased value chain productivity, and improved operating environment based on this Social impact data in the future.
Today, approximately one-fifth (21 percent) of the world’s largest public companies have committed to achieving net zero emissions targets. The reduction of carbon emissions and the mitigation of climate change risks for investors represents a significant achievement. However, in order to achieve true sustainability, we must also work to improve the quality of life for the people who live on our planet. Things that we can’t measure, we can’t manage. It’s past time to raise the bar on social impact measurement, create better S data, and provide the market with something to factor into their models. It is past time to make the transition from net zero to net impact.
Leads the daily operations at ESG PRO, he specialises in matters of corporate governance. Humperdinck hails from Bermuda, has twice sailed the Atlantic solo, and recently devoted a few years to fighting poachers in Kenya. Writing about business matters, he’s a published author, and his articles have been published in The Times, The Telegraph and various business journals.
I hope you enjoy reading this article.
Wherever you are on your ESG reporting journey you should talk to us!.
Swipe-up for help!