ESG Investing For Dummies PDF - Chapter 4

IN THIS CHAPTER »» Identifying indicators of a company’s social performance »» Studying a company’s social awareness and impacts »» Determining definitions and measurements for social performance »» Choosing weight factors: Social issues and scenario analysis Chapter 4 Give Me an ‘S’! Investigating...

IN THIS CHAPTER »» Identifying indicators of a company’s social performance »» Studying a company’s social awareness and impacts »» Determining definitions and measurements for social performance »» Choosing weight factors: Social issues and scenario analysis Chapter 4 Give Me an ‘S’! Investigating the Social Aspects of ESG W hat does the ‘S’ in ESG mean? Is it Sustainable? Or Stakeholder? Actually, the “Social” factor suffers from the middle child syndrome! There is a sense of exclusion as the ‘E’ (see Chapter 3) is the poster child that everybody talks about and the ‘G’ (see Chapter 5) is the dependable sibling that has the fundamental traits that everybody relies on. Therefore, while the focus on the ESG family has grown in recent years, the wider market still struggles to agree about what aspects the ‘S’ should take in company evaluation and integration into investment decisions. Companies have made real progress in disclosure on their environmental impact and governance standards, while their social impact and performance measurement is, relatively speaking, the poor stepchild! This can be explained by the urgency surrounding climate change issues and the enhanced governance control even before the 2008 financial crash, both of which have kept ‘S’ in the shadows. CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 63 However, every child gets their chance to shine! In a COVID-19 setting, ‘S’ has been hauled into the spotlight (not quite kicking and screaming!) and will attract much greater attention from investors than previously. The speed, extent, and intensity of the crisis is without parallel in our lifetime, and factors relating to ‘S’ are now among the most urgent issues for companies globally. Entire sectors of the economy are facing a bleak and uncertain future. Therefore, a company’s reputation will be a function of how they engage with and relate the ‘S’ to their stakeholders in a clear and transparent way. Investors have found ‘S’ to be the most difficult to analyze, measure, and integrate into investment strategies. The qualitative nature of social performance and the wide range of related issues contribute toward the difficulty of building consensus in the industry. Therefore, it has often been seen as an interface between the ‘E’ and ‘G,’ while the lack of data and consistency in social reporting from companies has added a further layer of complexity. But getting what you wished for should come with a risk warning! Regulators, government, customers, and employees will scrutinize the corporate story and their social credentials more closely. Issues such as health and safety, human rights, labor standards, diversity, inclusion, and data privacy have gained more prominence. Companies need to take this opportunity to communicate their social activity and progress to all stakeholders. This new emphasis will also bring more scrutiny on third-party rating agencies, reporting frameworks, and standards. Rating agencies, in particular, have been questioned about the lack of correlation between their respective ratings. ‘E’ and ‘G’ issues, which are more easily defined, have a recognized track record of market data and are often associated with strong regulation. Given that social issues are less tangible, with less mature data, there are challenges to showing how they impact a company’s performance. To confuse matters further, these issues are estimated differently in different countries. Therefore, it’s important to have clear definitions and measurements for what represents good social practices and performance to decide what weighting each factor has so that investors can compare different companies and adopt uniform reporting on social issues. This chapter outlines the primary social activities and indicators that companies consider within their social programs. It also considers how to evaluate these factors, determines how to define and measure them, and discusses how specific social indicators could be weighted, both within the ‘S’ element itself and in the broader ESG universe. 64 PART 1 Getting to Know ESG Identifying Factors in a Company’s Social Performance The broad definition of social indicators is that they are essentially statistical measures that express social trends and conditions impacting human well-being. They can represent how a company acts in a social context by evaluating its impact on the life quality of its employees and the local communities in which it operates. Common examples include the rates of accidents and fatalities, poverty, inequality, employment or unemployment rates, supply chain labor standards, life expectancy, and educational attainment. Objective social indicators represent facts independent of personal evaluations, whereas subjective social indicators measure perceptions, self-reports, and evaluations of social conditions. Examples of subjective indicators include trust, confidence, life satisfaction, well-being, and perceived security. The following sections outline specific social indicators that form the basis for the ‘S’ in ESG and elaborate on how they are used to determine the social rating of a company. Customer satisfaction Customer satisfaction can be seen as a task that is both simple and complex to achieve. In general, companies create value by providing the products and services their customers need and aim to build long-lasting relationships by maintaining trust and loyalty. Moreover, to achieve long-term success, companies must operate with high standards and deliver fair outcomes to the customer. If things go wrong, they should act and respond quickly to customer feedback to improve their communication, processes, and services. Complaints should be examined and reported to governance forums, while senior management should be measured against customer satisfaction performance. Meanwhile, related staff training should emphasize the importance of recording complaints in order to improve practices, procedures, and systems. Conduct principles need to be embedded into the way products are developed and sold, with strong risk management controls in place to meet customers’ expectations and regulatory requirements. Companies that fail to meet those targets are less likely to maintain revenue and profitability. This summary should be seen as the basic expectations that society has of a company that is delivering customer satisfaction. But investors can monitor other indicators to ensure that the company is preserving those principles: »» Put customer feedback at the center of decision-making in order to identify issues and prioritize change more effectively. CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 65 »» Consider customers’ needs in offering products, review the suitability of recommended products, and monitor sales quality and how salespeople are incentivized. »» Use customer panels and user labs throughout the design process to adapt products. »» Test during the design and development process to ensure a clearly identifiable need in the market, and maintain consistent standards when providing advice and recommendations to customers, including regulations. »» Implement a globally consistent methodology to measure the riskiness of products, which is customized for local regulatory requirements, with a detailed customer risk-profiling methodology, while observing local regulations. »» Monitor for fraudulent activities, as they are a risk and concern to customers; therefore, commitment to impact reduction is required, including fraud prevention systems and communications to raise awareness. »» Introduce procedures for potentially vulnerable customers, with dedicated case managers as appropriate. »» Instill in the corporate culture a sense of responsibility, and incentivize correct behavior and effectively manage poor conduct. »» Introduce a customer-centric framework to enable digital transformation and improve metrics around real-time customer feedback. »» Use artificial intelligence (AI) and Machine Learning (ML) solutions to enable analysis of data, rapidly and with greater distinction. While this technology offers significant potential benefits for customers, companies need to implement procedures around the potential ethical risks that are posed. (I discuss this in more detail in the next section.) »» Introduce mandatory conduct objectives in annual performance assessments. Performance against these and other behavioral ratings is to be considered when determining rating levels and discretionary pay. Data protection and privacy In a nutshell, data protection is about securing data against unauthorized access, so it’s more of a technical issue. Data privacy is about authorized access, but a firm needs to determine who has access and who defines that access, so it’s more of a legal issue. In today’s world, where collecting and processing personal data has become such a significant revenue driver, firms are investigating more ways of deriving revenue from their data but need to manage the downside risks of data 66 PART 1 Getting to Know ESG security, management, and privacy requirements. Given that it can be difficult to determine whether certain information meets local or international regulators’ definitions of personal data, these risks have naturally tended to increase. However, the pace of change in technology, and the way that personal data is leveraged, has substantially outpaced that of data privacy regulation, entailing that people aren’t sure who has their personal data, what it’s used for, or whether it’s protected. Given that there have been some highly publicized data breaches in the news, both regulators and end users are imposing greater restrictions on data usage. The most important regulatory development on a global scale was the introduction of European legislation in the form of the General Data Protection Regulation (GDPR). This came into effect in May 2018, with the goal of giving EU citizens more control over their personal data. Moreover, GDPR explicitly has extraterritorial reach, and so any company conducting business with EU citizens has to be compliant. Many other countries, including Canada, Argentina, and Brazil, as well as the State of California, have now also introduced legislation or increased implementation requirements, taking their lead from elements of the GDPR model. This has resulted in most firms “cleaning house” and ensuring that their use of personal data is compliant. This invariably requires board oversight, the employment of a data protection officer (DPO), and further governance structures that require employees to prioritize data privacy and relationships with customers and suppliers. In response, many companies have implemented a risk-based approach to reaching compliance by covering the more material elements of data that present the highest risk. The principal areas include making sure data is secure, reducing the amount of data stored, collecting only as much data as necessary to complete processing activities, and keeping data for only as long as required. The data should also be pseudonymized or encrypted, or both: »» Pseudonymization masks data by replacing identifying information with artificial identifiers. »» Encryption translates data into code, so that only people with access to a decryption key or password can read it. Moreover, the increasing prominence of “Big Data,” which is complex data sets that are too large to be processed by traditional data processing software, may intensify this issue. There are no clear rules to guide decision-making as Big Data and related AI technologies evolve, and so companies need to have ethical principles in place to ensure consistent and predictable decisions can be made. CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 67 So, data privacy falls into the basic human rights bucket but is at odds with the business models of many successful companies. This increased reliance on data collection, processing, and distribution has also increased potential reputational, litigation, and regulatory risks where there is poor data stewardship. Therefore, ESG investors view such issues as a vital metric when evaluating which companies to invest in and are advocating that companies become more transparent in their processes and privacy safeguards. Effectively, they are pushing companies to selfpolice and self-regulate rather than act on regulatory decrees, as a reactive stance may be more damaging to long-term profitability. The costs associated with proactive risk mitigation are small, compared to the potentially favorable increases in company valuation in the longer term. Gender and diversity Recognition of the existence of gender and ethnic inequalities, and the importance of addressing them in business, has been disappointingly slow, even though evidence of such discrimination has mounted in most occupational sectors globally. However, more recently, regulatory requirements have been imposed to document inequalities in the workplace, particularly equal pay for men and women, which have generated more debate and political consideration. By emphasizing and reporting on key indicators of inequality, such disparities become public and create reputational damage to the organizations involved, which encourages them to be proactive in their response. And multiple reports are showing that this should be beneficial to the performance of the company. In addition, companies that show strong diversity in their workforce, particularly in terms of race, ethnicity, gender, and sexual orientation, and at the board level are more likely to make better business decisions and therefore have financial returns above their national industry medians. Equally, companies with less diversity are less likely to achieve above-average returns. Such results can vary by individual country or sector, but increasingly, more diverse companies are finding that they are better able to win top talent and enhance their customer orientation, employee fulfillment, and decision-making, which help increase returns. Moreover, this promotes all kinds of diversity, including age, sexual orientation, disability (including neurodiversity), and social differences, which can bring a competitive advantage as it promotes an inclusive company culture that can strengthen organizational effectiveness. Investors have increasingly emphasized the value of boardroom diversity, not purely from a social perspective, but also as a way to improve the mix of decision-makers at the board level. This reduces groupthink and legal risk while improving corporate governance. However, they need to actively push companies to disclose more information as there is a lack of basic data to evaluate diversity improvements. Those that have managed to integrate diversity also report that it 68 PART 1 Getting to Know ESG helps decrease company-specific risk in the long term. This leads to a lower cost of capital, as they adjust their discount rate when valuing companies for factors that haven’t been fully priced into the market. Employee engagement Research suggests that a strong corporate culture, a positive working environment, and engaged employees contribute toward the best-performing companies. Increasingly, questions are raised about corporate governance regimes that are only focused on the interests of capital, and not enough on the interests of labor: »» Does the typical “shareholder value” model, which emphasizes using c­ orporate profits for share buybacks and returning dividends to investors, have an inherent bias toward value removal rather than value creation? »» Does this approach impede the promotion of internal, long-term reinvestment in human and physical capital, productive capacity, and research and development? »» Do such entrenched incentives for asset holders and senior management create a natural tendency toward short-termism in both finance and industry? Most European countries explicitly include employee representation on a company’s supervisory board, which gives them formal rights to information and involvement in corporate decision-making. This isn’t viewed as some form of social experiment but a recognition that employee voices at the board level increase trust and co-ownership, and improve insight by bringing different perspectives and information to the table. This encourages employees to feel more engaged and promotes longer-term horizons. After all, workers face the longerterm risks in a company more than other stakeholders and therefore should have more say in corporate governance. Reports conclude that satisfied employees work harder, stay longer, and produce better results for the organization. This will be even more relevant as the workforce becomes increasingly composed of millennials and Generation Zs who are more inclined to bring their values into the workplace. The ESG investor view is that exploiting employees, and local communities and environment, is no longer sustainable, and that some organizations aren’t appropriately focused on employee engagement. After all, if a company’s management treats other stakeholders that way, there is a good chance that they might treat their shareholders just as poorly! An organization’s success should be built on motivated, engaged employees, so employers should reappraise their purpose if they want to attract and retain the best talent. Furthermore, in-work poverty is a reality in some business sectors, so creating a positive corporate culture must be CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 69 difficult when its employees are struggling to get by. Therefore, some investment funds are heavily focused on explicitly targeting firms that promote human capital through areas such as personal development, autonomy, fairness, job purpose, and work environment. The COVID-19 pandemic provides a real opportunity for firms to strengthen their commitment toward greater employee engagement. Given that flexible working, or “working from home,” will prevail in the “new normal” environment, engaging with a more disparate workforce presents different challenges. This is intertwined with a corporation’s approach to ESG issues, where companies that embrace their ESG strategy into the culture of their organization now seem to be rewarded. Many companies will reactively respond to regulation and investor community pressure, while those that have been proactive should gain a competitive advantage in the fight for talent when the recovery begins. Community relations Community relations represent the ways in which companies establish and maintain a mutually beneficial relationship with the communities in which they operate. By taking an active interest in the well-being of its community, a company gains long-term benefits in terms of community support, loyalty, and goodwill. Organizations are recognized as good citizens when they support programs that improve the quality of life in their community, including education, employment and environmental programs, urban renewal projects, recycling, and restoration. These can also include philanthropy, volunteering, salary sacrifice schemes, and in-kind donation programs. Even smaller businesses can achieve community visibility and create goodwill by sponsoring local sports teams or other events, through financial support or employee participation. Competition and social pressures require changes in the relationship between company and community. By making a commitment to the community part of their core business strategy, companies attract and retain top employees, position themselves positively among customers, and improve their position in the market. This strategic social investment helps establish a consistent brand image and market presence globally and can be the most significant communication activity undertaken by an organization. The company develops relationships to promote its brand, and the community receives assistance from the program — win/win. Meanwhile, for some firms, particularly mining and excavation companies, a strong community relations program is required by law in some countries (including Australia, China, Nigeria, and South Africa). These Community Development Agreements (CDAs) are contracts between investors and communities under which the benefits of a mining project are shared with local communities and 70 PART 1 Getting to Know ESG other stakeholders. A particular example is the Australian Native Title Act, which compels companies with mining licenses to agree and enter into CDAs with Aboriginal communities that have a legal right to the land as native title holders. Human rights International human rights law outlines the duties of governments to act in specific ways or to abstain from certain acts, and to endorse and protect human rights and fundamental freedoms of individuals or groups. These basic rights are based on shared values like dignity, equality, fairness, independence, and respect, and they are inherent to all human beings, regardless of ethnicity, gender, nationality, race, religion, or any other status, without discrimination. Some examples include the right to life and liberty, freedom from slavery and torture, freedom of opinion and expression, and the right to work and education. Therefore, human rights– focused frameworks cover a broader diversity and balance of social issues and tend to concentrate on a specific industry and their most material issues. The standards most commonly used by investors are the Universal Declaration of Human Rights (UNDHR; www.un.org/en/universal-declaration-humanrights/) and the more recently issued UN Guiding Principles (UNGPs) on Business and Human Rights, which identify three pillars: Protect, Respect, and Remedy. Check out www.ungpreporting.org/resources/the-ungps/ for more information. The United Nations has created a comprehensive body of human rights law, representing an internationally protected code that all nations can subscribe to based on internationally accepted rights, including civil, cultural, economic, political, and social rights. Investors should also ensure that companies act on these issues and support the fight against any human rights violations by international companies. As shareholders, investors have the power to change corporate behavior and end any practices that are contrary to human rights by proposing resolutions at a company’s annual general meeting (AGM). Frequently, this is most apparent with companies’ supply chain partners, and this prompted the United Kingdom to introduce legislation, in the 2006 Companies Act, that requires given companies to produce a statement each financial year. This highlights the steps they have taken to ensure that slavery and human trafficking aren’t present in their business or supply chains. In addition, this holds companies accountable, and failure to comply may impact their reputation, their operational effectiveness, and ultimately their financial performance. Investors have demanded more reliable, accessible information about the human rights track records of individual companies. In recent years, a growing number of labor and human rights experts have produced public ratings and rankings that focus explicitly on these issues. They aim to highlight leading and lagging companies in a particular industry, or on a certain social issue, by using indicators that CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 71 include a range of human rights concerns. Given that they are created by human rights experts, in consultation with other stakeholders, these ratings more ­adequately reflect labor and other human rights issues (for example, www. corporatebenchmark.org/). They also have transparent methodologies and indicators that are used in creating their evaluations. Labor standards Labor standards are defined and protected through international conventions and instruments, including standards suggested by the International Labour Organization (ILO) and the United Nations (UN). It’s assumed that a company’s workforce is a valuable asset and that a positive worker-management relationship is important to the sustainability of a business. Any failure to create and support this relationship, and maintain good labor conditions, could result in a range of additional business costs and impacts. These can include low levels of worker productivity and low-quality output, strikes or other worker action, failure to secure contracts with major and international customers, fines or penalties levied by local regulatory authorities, and ultimately reputational damage. On the contrary, positive labor conditions can enhance the efficiency and productivity of operations, leading to increased revenues and margins. Moreover, many companies require that their suppliers demonstrate policies that align with the ILO Fundamental Conventions and best practices and participate in third-party audits by accredited verifiers to assess compliance. Labor standard issues tend to be found in certain industry sectors and activities, such as “sweatshop” manufacturers in labor-intensive products, such as clothing and footwear, mining for physical commodities, construction activities, and hospitality. However, the legal frameworks in developing countries, where many of the issues are unearthed, don’t comply with good internal practices, and many countries have poor records around the protection and enforcement of workers’ rights (although, as frequently highlighted, such activities are also found in developed nations where the legal frameworks are supposed to protect workers). International companies and investors should ensure that local companies have employment policies in place that at least comply with local laws and regulations and envision establishing the protections recognized by the ILO core conventions. Companies also should ensure that their own practices, and those of companies in their supply chain, ensure compliance with best practices. Investors should also check whether a company is audited regularly to confirm that it observes its own policies. Some companies have been known to create systems that “hide” their infringements! Therefore, a supplier’s competitiveness could be directly related to harmful labor practices. 72 PART 1 Getting to Know ESG Meanwhile, technology has driven the emergence of the gig economy, which describes the creation of more flexible job opportunities, such as ride sharing or food delivery services, which operate under “zero hours” contracts (where an employer isn’t obliged to provide any minimum number of working hours to the employee). These new business models don’t fit traditional labor frameworks, as workers complete tasks similar to those of regular employees but they are classified as “self-employed” individuals or “freelancers.” This entails that they don’t have access to the same rights and benefits legally due to regular employees, including freedom of association and collective bargaining. Therefore, while the gig economy provides more flexible work conditions than regular employment, it presents worrying challenges to labor rights through insecure work, uncertain hours, poor pay, and involuntary overtime. Damaging media reports covering poor labor practices have become regular news headlines. The major difficulty here is that some supply chains have multiple tiers, extending beyond formal suppliers to a large number of less formally organized suppliers. Monitoring practices that ensure good labor standards can be extremely complex. Companies and investors should try to map their suppliers and determine the most material risks and any possible mitigation. However, the stark reality is that this could take months to produce and would involve considerable time, effort, and expense; therefore, there may be a natural exclusion policy that is pragmatic at times. In a worst-case scenario, all of the issues highlighted in this section can lead to a modern form of slavery, including debt bondage (where a person is forced to work for free to pay off a debt), child slavery, domestic servitude, and forced labor, where victims are threatened with violence. Again, some of these practices can be as prevalent in developed as well as developing countries. Evaluating a Company’s Social Performance Corporate social responsibility (CSR) is effectively a voluntary self-regulating approach that encourages a company to be socially accountable to its stakeholders, the public, and itself. By adopting CSR as a part of their business strategy, companies are aware of their impact on different aspects of society. However, it’s a wide-ranging concept that takes different forms, relevant to the company or industry, but incorporates the social indicators outlined earlier in this chapter. Furthermore, it also encompasses companies’ responsibility to the environment, entailing ethical behavior and transparency that contributes to sustainable development. CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 73 Through CSR programs, businesses can benefit local communities and society more broadly while boosting their brands. Introducing CSR policies is now expected, with more companies placing CSR at the center of their corporate, digital communications, and broader strategy. On the other hand, companies that don’t uphold societal standards and practices leave themselves heavily exposed to reputational and other risks. In turn, this can hit both their top and bottom lines through loss of sales, fines, and litigation. The following sections list some tools and information for evaluating a company’s CSR performance. The results are in: Achievements There are no independently objective criteria that define or evaluate how well a company is delivering on their social targets. In part, this is because each program can be as unique as the companies following it and the communities being helped. Many companies adhere to expected buzzwords and highlight “buy-in” from senior management, and “strategic alignment” between their services and their social impact. However, transparency on progress toward their goals, community assessment on their improvements, and peer evaluation, compared to firms that have a long track record of CSR, give a clearer picture of their achievements. Generally, the CSR initiatives that achieve the greatest impacts incorporate feedback loops that enrich programs as they evolve. Constant refinement of what you measure, allied with clearly defined Key Performance Indicators (KPIs), will increase the efficiency of a program and lead to better results. Some industry-standard tools that can assist further include the following: »» B Corp Certification, which aligns company practices to social goals (https://bcorporation.uk/about-b-corps). »» CommunityMark, which is a measurement tool for community involvement (www.laing.com/uploads/assets/CommunityMarks%20monitoring%20 boards%20-%20FINAL.pdf). »» Global Reporting Initiative (GRI), which provides global standards for sustainability reporting, including but not limited to social considerations (www.globalreporting.org/standards/). »» International Labour Organization (ILO), which ensures human rights within the supply chain (www.ilo.org/). »» Sustainability Accounting Standards Board (SASB), which measures the financial impacts of sustainability, including but not limited to social considerations (www.sasb.org/). 74 PART 1 Getting to Know ESG When in Rome: Differentiating on a national or regional basis Internationally developed standards and objectives, such as the UN Sustainable Development Goals (www.un.org/sustainabledevelopment/sustainabledevelopment-goals/; see Chapter 1), guide countries and organizations toward greater sustainability and corporate responsibility. Some of these goals clearly highlight that the scope of social impact that companies can consider varies considerably in different jurisdictions. More broadly, this could be considered within a continent as much as within a given country, and developing countries will be evaluated differently than developed countries, as developing countries often don’t have effective legal or regulation procedures, or don’t systematically enforce them with respect to appropriate programs. Moreover, the point of engagement may be different; for example, a large, multinational corporation may directly support social activities from its headquarters or certain regional offices, or provide that support indirectly through its suppliers in developing countries. Evaluation of how well those programs then perform may also require different metrics based on the organizations and indicators involved. From an investor’s point of view, reports suggest that there are differing focuses: Companies in different countries or continents tend to focus more or less on social activities within the ESG triumvirate. Evidence suggests that European companies engage in social responsibility programs more than those on other continents. Determining Measurements for Social Performance Given that research shows that socially responsible corporate programs are aligned with corporate success, the measurement of a program’s performance — the topic of this section — has become essential. Such measurement allows organizations to make better choices about which programs to support, and how to improve the efficiency of their CSR initiatives and enroll stakeholders to support them. However, most social measurement assesses what is most convenient, not always what is most material. In the current environment, most measurement concentrates on data that companies have easy access to and are prepared to disclose. This ultimately rewards companies for developing programs that relate to social issues, but not for the results of those efforts. This system allows companies to produce a lot of information, much of which is not relevant; therefore, this CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 75 doesn’t deliver any meaningful benefit in assessing companies’ social performance. Moreover, it’s challenging to find objective measures for material impact, so there is a tendency to measure processes rather than specific outcomes. The lack of consistent standards for evaluating social measurement increases costs and doesn’t highlight the true social leaders, as most people don’t know what “good” looks like! Therefore, “social” evaluation trails behind its ESG “siblings” in terms of consistent indicators used to measure company performance in a way that is useful to investors. However, post COVID-19, companies will be more closely identified with the concept of “purpose.” How committed were they to deliver value to customers, invest in their employees, deal fairly with their suppliers, support the communities in which they operate, and generate long-term value for investors? Both society and investors will hold companies accountable and include this analysis in their ESG research. Here are some important aspects to consider: »» Was customer feedback moved to the center of decision-making so that companies could recognize issues and prioritize actions more efficiently? »» Were actions taken proactively to assist employees’ well-being, and what effect will company actions have on employee loyalty and approval in the future? »» How was the handling of furloughs and layoffs dealt with, including the example set by executive management in sharing their load of the burden? »» What did a company contribute toward broader societal impacts, and did they provide access to their capability or facilities to help society at large? The alignment of social and economic responsibilities Evidence suggests that more analysis is required to produce a useful system of reporting to validate the alignment of corporate programs with the needs of society. Commentators have suggested that it requires its own global accounting standard to improve comparability. Therefore, the need to integrate social issues is clear because, for example, a company’s supply chain is unlikely to be secure if it has poor labor practices and human rights violations. Operational performance could be damaged by increased worker turnover and decreasing motivation and productivity. By successfully managing social issues, companies can obtain access to environmental resources, build human capital to safeguard a productive workforce, strengthen their supply chains, and benefit overall from a competitive advantage in the market. 76 PART 1 Getting to Know ESG Also, there is a growing awareness that good social performance can deliver better relationships with local communities. However, companies should remember that while they are genuinely delivering social programs, they should ensure that social and economic responsibilities are aligned and agree on such balance with key stakeholders. In this way companies can benefit economically, while being socially responsible, through increased sales and customer loyalty. Studies suggest that businesses that improve their social responsibility perception see consumer recommendations increase. Therefore, companies can establish themselves as socially responsible and good corporate citizens while adding greater value to their business. All of these aspects show that purpose can be aligned with corporate success. Asking companies to run their business with the main purpose of creating value for society seems a long way off, but it may increase the total value created in the future. Long-term change for people and communities The availability of skilled workers is one of the key aspects in becoming a successful company. To tackle the skills-gap challenge, companies must invest more in training and reskilling their workforce. According to the World Economic Forum (WEF), more than half of all employees will require significant reskilling by 2022, but the problem is likely to be even more acute in specific regions. In addition, research shows that companies that prioritize their values, create social impact, and build a more diverse and inclusive culture are better placed to improve employee engagement and productivity, and they have an advantage in attracting and retaining skilled talent. Ultimately, companies will be measured on how well they have adapted to the new environment, and an indication of that will be whether they attract the right workforce and how they utilize those employees thereafter. The WEF theme “Skills for Your Future” focuses on investing in training, education, and skills to optimize human resource management and help organizations attract and nurture the best talent. The nature of work, the workforce, and the workplace is being transformed by new tools and technologies, and companies need to use this opportunity. See www.weforum.org/focus/skills-for-yourfuture for more information. CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 77 The COVID-19 crisis has brought social factors to the foreground, and these have increased focus for many investors. There has been additional analysis of how companies deal with their customers, employees, suppliers, and stakeholders in general. Investors will appreciate more fully what stakeholder management means in their investment process, as going forward this will have an impact on company profitability and return on investment. Deciding on Weight Factors Investors haven’t focused on how companies have performed socially in the past (as much as environmental performance; see Chapter 3) because companies haven’t adopted uniform reporting on social issues in the same way that they have for other ESG factors. For example, greater attention to environmental factors has led investors to create systems and reporting methods for topics such as carbon emissions and clean energy usage. However, while social factors have been the trickiest part of ESG for companies and their investors to measure and monitor, as data related to social issues becomes more accessible and refined, it’s anticipated that investors will systematically value social factors alongside other financial factors. Furthermore, regulatory drivers related to social aspects — such as the UK’s and Australia’s Modern Slavery Acts or the increased attention created by the adoption of the UN Sustainable Development Goals (see Chapter 1) — support this alternative approach. But despite the positive progress being made, there is still a long road to travel before social issues are systematically integrated into investment decision-making processes. Nonetheless, more investors are considering how they integrate their relative weighting towards ‘E,’ ‘S,’ or ‘G’ issues for specific companies and sectors. Even within ‘S’ alone, there will be different weighting considerations based on specific social indicators, which may be driven by industry sector or region-specific considerations. The following sections dig deeper into weight factors (see Chapter 8 for more information). Take your pick: Different social issues Social issues cover a wide range of topics: consumer protection, product safety, labor law and safety at work, diversity, the fight against corruption, and respect for human rights throughout the supply chain. Therefore, they are inherently more qualitative and judgmental indicators, and so, investors find it challenging to integrate them into financial analysis and models because they are difficult to quantify. 78 PART 1 Getting to Know ESG To complicate matters further, social issues are evaluated differently in different countries. For example, some countries place greater emphasis on respecting human rights and avoiding child labor, while others may place issues around workplace diversity higher up their value chain, and such differences may also be amplified by the region of the world in which they are investing. As a result, it’s more difficult for investors to highlight the financial impact that social issues have on risks and long-term investments. To change this perception, it’s necessary to have clear definitions and measurements for what constitutes a “social” company. Furthermore, it’s necessary to determine what weight to give to diverse social issues so that investors can better evaluate given companies and sectors in social terms. It has been more usual to analyze social factors through qualitative analysis, but investors are increasingly quantifying and integrating social factors into financial forecasting and company valuation models, in alignment with other financial factors. Some social issues lend themselves to quantification (for example, the gender pay gap), but there also needs to be an understanding of what the company’s approach is to managing and addressing them, which can also be achieved through stakeholder engagement. By integrating social issues into fundamental analysis, investors can treat social factors in the same way as any other financial issue with existing quantitative methodologies. (See Chapter 15 and www.unpri.org/listed-equity/esg-integration-inquantitative-strategies/13.article for more details.) Think outside the box: Scenario analysis Social factors can be integrated through a range of techniques, including revenue, operating margins, capital expenditure, discount rate, and scenario analysis. A common approach is for investors to forecast revenue, typically taking a view on how fast the industry is growing and whether a specific company will gain or lose market share. Social factors can be integrated into these forecasts by increasing or decreasing the company’s revenue growth rate by an amount that reflects the level of investment opportunities or risks. Social factors can also be used to estimate the influence on assets’ future anticipated cash flow — such as by forcing long-term or permanent closures (as with the COVID-19 lockdown) — and thereby alter their net present value (NPV) by applying a discount rate to future cash flows. The impact is likely to be a reduction in NPV, resulting in an impairment charge, which brings down the book value accordingly. An asset revaluation can result in lower future earnings, a smaller balance sheet, additional operating and investment costs, and a lower fair value for the company. CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 79 Another example of an impact to asset book value is where a local community protest could lead to work stoppages at mines or even to mine closures, which reduces the future cash flow of the mining company. If an investor believes that future cash flow will be significantly less than the current estimate, the investor may charge an impairment charge to the book value of the mines and the income statement of the mining company. Alternatively, a less common approach to help understand the impact of ESG factors on the fair value of a company is to conduct a scenario analysis, where an ESG-integrated company valuation is calculated and compared to an initial valuation. Quant strategies and smart beta providers tend to evaluate the differences between the two scenarios that can be used to calculate the materiality and magnitude of social factors affecting a company. This is particularly relevant for certain companies, given that social factors are more industry-specific and tend to appear in financial measures over a longer time frame. These challenges help explain the facts suggested by surveys, that there are greater long-term returns to be made from environmental and governance factors than from social factors. Unfortunately, there seems to be greater anticipation of downside risk with social factors than upside benefits. On the other hand, research implies that companies with high social standards appear to react stronger to incidences such as inflation or periods of economic weakness, thereby reducing a company’s systematic risk. Moreover, it suggests that the “social” factor pillar considerably reduces all three types of risk — namely idiosyncratic and total firm risk, as well as systematic risk — and that the social factor is the only one, within ESG, that reduces systematic risk. The conclusion is that social factors should be considered as effective, when managed well, in reducing corporate risk. Therefore, ‘S’ could help investors to build a portfolio that responds in a less volatile way to market changes. In modern portfolio theory, systematic risk is defined as the risk to which all companies are exposed that cannot be reduced by diversification. Research suggests that factors that fall within the ‘S’ of ESG are as common as (and more so for some companies) those inside ‘E’ and ‘G’ in contributing to business risk and ultimately causing lasting damage to a company’s reputation. Some ways in which social factors could be integrated into an investor’s portfolio to create a combined ESG score include the following: »» Equal weighting applied to each of the three factors, regardless of the data transparency issues 80 PART 1 Getting to Know ESG »» Optimization of weighting based on historical data »» Industry-specific weightings Studies suggest that in the short term, both equal-weighted and optimized approaches performed better because they had higher exposures to governance issues. However, an industry-specific weighted approach that changed weightings over time showed the strongest financial performance. The ‘S’ in ESG has never been more relevant for corporate productivity and, as a consequence, investment returns. And yet, from the plethora of ESG-related investment products, studies have revealed that a much smaller percentage of S-ratings-based products target investors as the primary audience, versus the vast majority of E- and G-ratings-based products. In addition, it’s suggested that the UNGPs on Business and Human Rights should inform what analysts, raters, and investors measure when it comes to ‘S.’ CHAPTER 4 Give Me an ‘S’! Investigating the Social Aspects of ESG 81