Spotlight on the ‘S’ of ESG, Part 1: The rise in prominence of social factors
The integration of environmental, social and governance (ESG) factors is now recognized as a meaningful consideration when analyzing long-term investment opportunities. While the reflection on environmental and governance factors remains at the forefront of asset owners' interests, social issues such as health and safety, human rights, labor rights and equality have recently been pushed into the spotlight.
Our 2020 ESG Manager Survey showed an uptick in social factors, when compared to the previous years' responses. In the first of this two-part series, we explore the meaning behind social factors, as well as the risks and challenges when assessing these issues.
What’s behind the ‘S’ in ESG?
When investors consider social factors, they analyze how a company manages its relationship with employees, suppliers, customers and the communities it operates in. These considerations can be broken down into internal social factors (such as human capital development, human rights and living wage) and external social factors (like animal welfare, social opportunities and product liability).
Today, we are experiencing a more holistic consideration of ESG factors. This is helped by the rise of process innovation, specific ESG products and a greater attempt to capture metrics and data. While environmental and governance factors have been in focus for a number of years, the coronavirus pandemic, along with the Black Lives Matter movement, #MeToo movement and campaigns for equal pay, have increased the focus on social factors.
We are observing varying levels of sophistication within the investment community towards the greater integration of social factors. There are some clear outliers, both positive and negative, as well as the emergence of best practice principles. As an example, taking care of the workforce can be less tangible and harder to quantify but it is crucial not only reputationally, but for the long-term health of any business.
Social factors pose an increased risk for investors
The coronavirus pandemic has highlighted multiple examples of social failure. Across the globe, a number of companies were exposed as having poor social practices—as well as the opposite, revealing which companies have policies that embody long-term stakeholder values.
Research has shown that taking social concerns into account when investing, especially as part of a comprehensive ESG investing strategy, can protect investments in the long-term. A 2019 study showed that social criteria is important for risk management, with the results emphasizing that high social standards could reduce a company’s systematic risk.1
Ultimately, we believe that companies with high social standards can react more robustly to developments such as inflation or periods of economic weakness.
The challenges investors face when incorporating social factors
Despite the clear link between poor social practices and company risk, investors find it more challenging to incorporate social factors into their investment processes. While we are seeing an increase in metrics on how companies are assessed, due to variable data, it is still more challenging to assess a company’s social behavior than the environmental practices. Currently, there is a lack of accepted practice and global standards for reporting by companies and there are gaps and inconsistencies in how social factors are measured. Additionally, there is no agreement on how much weight to place on these social issues.
For investors, the challenge goes beyond data. One of the key issues in incorporating social factors into an investment portfolio is that social factors have various meanings for different investors. During our 2021 EMEA Digital Summit, we posed the question “what comes to mind for you, or the pension scheme that you are involved in, when you think of the ‘S’ in ESG?”. The responses showed a wide range of answers, with a large number mentioning diversity & inclusion, labor conditions or gender equality, but there was no clear majority overall.
Asset owners face disintermediation between the time horizon that best suits an individual investor who is considering how to achieve their desired return, and that of their investment managers when selecting companies in which to invest. It is crucial to stretch these time horizons, if pursuing better ESG outcomes and greater alignment with investment outcomes.
Despite these challenges, we believe that the incorporation of social factors in an investment strategy will imitate the path that we have previously seen in the development of environmental considerations. If the collective experience with environmental concerns is repeated with social issues, progression may take a number of years. At some point, we will likely start to see industry standards and frameworks emerge, which will help with an analysis of the issues highlighted.
Looking ahead: Will social factors rise in prominence?
As we look ahead, issues such as human rights, labor standards and gender equality—and the risks and opportunities they present to investors—will continue to gain prominence. We believe that despite difficulties quantifying social factors, stakeholder-centric issues present real long-term risks for companies.
We are witnessing a dynamic regulatory environment with significant new regulations surrounding responsible investing and the consideration of ESG factors in the European Union (EU)’s upcoming sustainability regulations. Asset owners and industry practitioners will also need to take a leadership role and ensure long-term risks associated with ESG factors are consciously considered. A consistent approach in engaging with companies will enable them to take the steps required, both in their own interest as well as in the interests of wider stakeholders.
In the second part of our spotlight on the ‘S’ of ESG, we will explore how asset owners could take social factors into consideration and provide examples of emerging best practices.