The ‘S’ of ESG – Part 1: A challenging factor

We explore the difficulties in integrating the ‘S’ of ESG, including definitions, measuring impact, interpreting data, and interconnections with other ESG metrics.

Institutional investors are increasingly embedding Environmental, Social and Governance (ESG) factors into their investment frameworks to enhance investment returns, protect brand reputation and mitigate long-term risk. But of these components, the Social factor is proving the hardest to define and integrate. In BNP Paribas’ 2019 Global ESG Survey, 46% found it the most difficult to analyse and embed in their strategies.

Social metrics include a company’s treatment of its employees, as well as its impact on wider society through its relationships with customers, suppliers and local communities. In this sense it is not just about limiting potential damage but also creating social benefit. This can make it more challenging to assess than environmental factors, which tend to focus on reducing harm, or governance, which tends to operate within existing legal or stewardship frameworks.

In order to understand the issues surrounding the integration of the ‘S’ of ESG, we must start with the most fundamental question of all – what does ‘social’ actually mean?

What’s in a name – defining the ‘S’

Firstly, one major challenge is the huge range of metrics that can constitute a social issue, including anything from labour relations, to workforce diversity, to procurement and supply chain practices. “Investors want evidence as to whether there is a real social impact”, says Anjuli Pandit, Primary Sustainability Manager at BNP Paribas. “In the non-profit sector, reporting on social impact has probably been the most contested and debated topic – NGOs have not yet completely resolved this, even though for many of them, reporting on social impact is their sole focus. Therefore, we should only expect this to be hard for corporates too, many of whom are trying to build this capability from scratch.”

Another issue is the regional and cultural variance in the definitions and importance given to different social issues. “In mainland Europe, climate change is the number one ESG issue among investors, followed by social issues such as labour and human rights”, says Leon Kamhi, Head of Responsibility at Hermes Investment Management. “In addition, in the UK, concern about diversity has picked up. In the US, asset owners, especially public funds, have historically been very focused on governance, although this has changed and topics such as climate and diversity are high on the agenda.”

Index providers have made progress in devising indices that combine and benchmark the many different Social, Environmental and Governance factors. However, the proliferation of specific ESG indices has been dominated by environmental issues, with far fewer indices that  specifically incorporate social issues; MSCI, for example, has 10 thematic indices of which half are environmental, and  only two specifically focus on the ‘S’. There is no industry-wide, singular ‘social’ benchmark that most investors would agree on.

Measuring change

Even when a relevant social factor has been identified, it can be hard to measure its impact. “Defining whether a stream of revenue provides a social benefit is a challenge”, says David Harris, Group Head of Sustainable Business at London Stock Exchange Group & Head of Sustainable Investment at FTSE Russell. “For example, does education provide a social benefit if the private-sector company is educating wealthier children?”

Unlike environmental measurements, such as reducing carbon emissions, with social indicators there is often no clear start and finish point. “Let’s take, for example, employment”, says Pandit of BNP Paribas. “A company may be employing people in rural areas where work is scarce. But the question then comes: is it employing both men and women? And is it paying them a minimum wage or a living wage? Is it employing them as casual labour, or as full-time workers with job security? The questions are endless.”

The data challenge

The qualitative nature of many social programmes therefore makes it difficult to translate them into meaningful KPIs that can be used effectively by investors. Compounding this problem is the lack of available data. Investors have historically prioritised environmental factors, so issuers have developed systems and reporting frameworks on issues such as carbon emissions, fossil fuel reserves and the use of clean energy. On the other hand, few companies have the necessary reporting frameworks to report on data relating to social issues.

“Globally, approximately 40% of large and mid-cap companies report carbon emissions, and these companies account for about 70% of total emissions”,. “However, less than a third of large and mid-cap companies in the relevant sectors report the number of workplace fatalities. Investors need to encourage better disclosure for some of the key social metrics.”

David Harris, Group Head of Sustainable Business at London Stock Exchange Group and Head of Sustainable Investment, FTSE Russell.

A lack of standardised reporting also means that data providers must use a combination of factors to make their own assumptions and assign weightings. As a result there is very little correlation between data provided by different vendors, with research from Schroders published in August 2018 showing a correlation as low as 0.3 for social issues.

Presently, the best investors can do is view available data on social factors as a guide rather than a single source of truth. “The important thing is for investors to really drill down into those underlying factors and understanding what’s driving those ESG scores, and, today, this is a mixture of having the right resources (both people and technology), the right capabilities to do the analytics, and after that there will always be an element of subjective interpretation”, says Frank Roden, Head of Institutional Investors UK, BNP Paribas Securities Services.”

Connecting the dots

Meanwhile, it is becoming increasingly clear that the elements of ESG are fundamentally interconnected. Social issues are often connected to the environment, and improving or alleviating one area can have a positive impact on the other. For example, global warming must be curtailed with the minimum amount of suffering possible to poorer people in society, such as subsistence farmers – a concept known as Just Transition. Funding education and family planning for girls in developing countries can help to lower the birth rate, which reduces environmental pressure on the planet.

“The majority of social issues we have today have a very strong link with the environment. They cannot be worked on in exclusivity”

Anjuli Pandit, Primary Sustainability Manager, BNP Paribas.

However this also increases complexity. A social metric can compete with an environmental indicator, or even with another social one. As large-scale migration to cities improves employment rates and skills development, for example, it increases the strain on the environment through pollution and utilities electricity consumption, as well as creating social issues such as overcrowding and lack of affordable housing. With 65% of institutional investors aligning their investment frameworks to the SDGs (BNP Paribas Survey 2019), firms are balancing these demands carefully as they look to further integrate social factors

A solution is essential

Despite the challenges, analysing and integrating social factors is an imperative, with growing evidence of the link between positive social practice and financial outcomes at companies. Research from Deutsche Asset & Wealth Management and Hamburg University, published in 2015, found a positive correlation between good social performance and good financial performance.

There remains cause for optimism: regulators, exchanges and investors are successfully demanding that companies provide better data, and analyst are increasingly making imaginative use of technology to provide new perspectives. In part two of this series, we will explore these solutions in more detail.