Educating clients on the social of ESG investing

Not every letter in ESG is created equal. Ask even the savviest investor about this topic, and the conversation often turns quickly to a company’s climate-related commitment.

By definition, however, companies are social enterprises. Meaning they have an implicit social contract with their workers, the communities they serve, and the environment in which they operate — a concept explicitly recognized by the U.S. Business Roundtable in 2019.  What should investors be mindful of when weighing the “S” in ESG?

SOCIAL FACTORS ARE MATERIAL

Social factors can be financially material for companies, with studies demonstrating links between long-term returns and employee satisfaction in certain sectors. Reputational issues surrounding treatment of suppliers or poor relations with employees or unions can have material impact as well, including loss of share price. Mismanagement of human capital can directly affect operations costs for businesses, leading to higher turnover and escalating recruitment and training costs. (The Work Institute estimates the cost of losing just one U.S. worker at $15,000, with costs associated with voluntary employee turnover doubling over the last decade to $617 billion.)

HISTORICALLY UNDER-ADDRESSED FACTORS

Lack of access to high-quality data or disclosures compounds investor challenges in understanding social risks and opportunities. Initiatives such as the Workforce Disclosure Initiative encourage better disclosures of material social data across business operations and supply chains. And the ESG Working Group — a pro bono private-public consortium — is working to increase visibility of the social dimension of ESG, improve indicators, and expand their use.

SOCIAL RISKS AND OPPORTUNITIES

Social trends affect the macroeconomic backdrop and the types of companies in which one might consider investing. For example, “in-work poverty” has spread, with one in eight UK workers —more than four million people — estimated to experience poverty while employed. In the U.S., research suggests that the CARES Act, designed to support workers through the pandemic, provided benefits that exceeded lost earnings for 68% of workers. As social tensions and political polarization have increased, there has been a corresponding wave of social movements in recent years, including Occupy Wall Street and Black Lives Matter. Increasingly, large companies are called upon to be vocal about these challenges and to help address them.

COVID AS CATALYST

The global pandemic has only increased investor focus on the role companies play in society, most notably around the treatment of customers, employees, and suppliers. During the pandemic, workers on nonstandard or temporary contracts were often among the first to be furloughed. And companies that relied on government funding while prioritizing excessive executive pay, shareholder returns, or aggressive taxation practices, often found themselves experiencing reputational blowback — with consumers likely to punish poor actors.

As investors, we believe companies should consider the wider social impact of their employment, which requires consideration of its business model, corporate purpose, and the compatibility of capital allocation and investment decisions with these aims.

It’s true that the scope and qualitative nature of social factors has sometimes made it hard to measure impact and implementation. This absence of data, however, is being filled by engagement activities that call for greater disclosure and clear goals for achieving inclusive and diverse workforces. Strong governance is needed to translate corporate rhetoric into tangible action. Here, shareholders are calling for stronger evidence of intent, starting at the board and executive level, and exercising their voting power to underscore the imperative for change. 

Is the path to future relevance paved with stronger social action and stakeholder management? Consider: just five years ago, climate change was generally acknowledged as a systemic risk, yet it was largely viewed as an externality that didn’t manifest itself in financial returns. Today, nine out of ten of the world’s largest economies have committed to achieving net-zero carbon emissions, one third of the world’s asset managers have joined the Net Zero Asset Management Initiative, and the fossil-fuel industry has been transformed. What was previously a movement led by activists has become an economic imperative that promises to reshape the world.

We find ourselves in a similar hinge moment. In the post-pandemic world, shareholder activism around the social dimension of ESG, promises to lead to richer, more actionable data and, ultimately, better industry standards of measurement. The most prescient corporations, however, appreciate their role today as social entities and recognize that “S” is the new green.

Andrew Parry is Newton Investment Management's head of sustainable investment.