ESG Investing For Dummies - Chapter 5 PDF

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 IN THIS CHAPTER »» Determining what “good” corporate governance entails »» Appraising a company’s governance values »» Focusing on how ‘G’ can dictate the ‘E’ and ‘S’ factors »» Checking out the regional differences in governance activities Chapter 5 Give Me a ‘G’! Decoding the Governance Component of ESG C orporate governance principally describes the systems a company uses to balance the competing demands of its diverse stakeholders, including shareholders, employees, customers, suppliers, financiers, and the community. Through this process, it provides the structure to deliver a company’s objectives by covering all aspects of organizational behavior, including planning, risk management, performance measurement, and corporate disclosure. In total, it safeguards appropriate oversight aimed at ensuring long-term, sustainable value creation with due regard for all stakeholders. As such, corporate governance has always been an important topic in its own right, before it took on additional significance within the broader ESG universe. Therefore, among the ‘E,’ ‘G,’ and ‘S’ factors, it can be considered the most relevant to performance as it controls the overall purpose and strategy of a company and how risks are mitigated. If you don’t start with ‘G,’ the other issues aren’t identified or managed, so it’s more difficult to solve for them if a crisis situation occurs. Consequently, the ‘G’ in ESG is considered a mandatory element of any CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 83 due diligence process, with some investors placing increasing emphasis on it as the core component of their investment approach. Moreover, governance data, unlike environmental or social data, has been amassed for a longer period of time, and the norms and standards for what encompasses good governance have been widely debated and accepted. Therefore, the days when governance focused exclusively on maximizing shareholder value have gone; for example, the UK Corporate Governance Code was revised in 2018 to charge boards with establishing a company’s purpose, values, and strategy. This ensures that companies consider creating long-term value for all stakeholders. This chapter outlines how investors determine what “good” corporate governance looks like, how they evaluate governance values, how governance interacts with and influences the ‘E’ and ‘S’ factors within ESG, and how this differs from region to region. Of course, this is all reviewed against the backdrop of the COVID-19 pandemic of 2020, and how corporate governance contributes to management of the current crisis and any similar scenarios in the future. After all, governance can be viewed as the quality of leadership, and leadership is essential in times of crisis. The Good Place: Defining What “Good” Corporate Governance Looks Like In 2001 and 2002, the collapse of two big corporations, Enron and WorldCom, and the ensuing scandals (followed by further collapses at high-profile companies including Arthur Andersen, Global Crossing, and Tyco) were precipitated by corporate governance failures. A common starting point for defining corporate governance is to highlight the four pillars: the board of directors, management, internal auditors, and external auditors. Within this structure, there are a number of key tenets to achieve good governance, which include board quality, independence and attendance, executive remuneration and incentives, ownership, audit and accounting standards, bribery and corruption, and business ethics — all of which are discussed later in this chapter. These tenets need to be responsive to the current and future requirements of the company; they also need to apply caution in decision-making and ensure that the best interests of all stakeholders are considered. These elements have further stimulated the evolution of corporate governance globally. “Good” corporate governance, as you find out in this section, requires that companies respect the needs of all stakeholders, including shareholders, employees, customers, and suppliers, while recognizing any societal or environmental issues and being accountable for their actions. These governance factors allow companies 84 PART 1 Getting to Know ESG to measure the quality and strength of their structure and practices. How good each company is at maintaining their position is open to conjecture, but there are also independent observers that attempt to score and rank each company’s ability (see Chapter 14 for more on this). Governance factors indicate the rules and ­procedures for countries and corporations, and allow investors to screen for applicable practices, as they would for environmental and social factors (covered in­ Chapters 3 and 4). The benefits of good governance Research on governance factors has shown that companies ranking well below average on good governance characteristics are more disposed to mismanagement and risk their ability to capitalize on business opportunities over time. However, good governance is more an insurance policy than a guaranteed way to raise Return on Capital Employed (ROCE), although there is a clear correlation between financially strong firms and those that exhibit effective governance. Given the importance of good governance, investors are giving ‘G’ factors further consideration. In addition, to mitigate governance risks, investors also undertake “engagement,” interacting with managers and directors of companies on business strategy and execution, including sustainability issues and policies. This also extends to agreeing to vote on certain key decisions at shareholder meetings. Consequently, investor engagement and stewardship, which focus on the effect of corporate activity on all stakeholders of the company, are increasingly seen as an integral part of good governance. So, while corporate governance is important to investors to confirm a company’s direction and financial viability, it also needs to demonstrate good corporate ­citizenship through environmental awareness and ethical behavior. Good corporate governance produces a clear set of rules and controls in which shareholders, directors, and employees have aligned incentives. In turn, this helps companies build trust with investors and the community. Meanwhile, investors have confirmed their willingness to pay a premium for shares of well-governed companies. For example, in the United States, leading institutional investors have continuously asked corporate boards to clarify their companies’ purpose and contribution to society. This has culminated in the Business Roundtable’s statement on corporate purpose, issued in August 2019, declaring their commitment to not only shareholders but all stakeholders. Their members are exclusively the CEOs of 181 of the major U.S. companies, and a key question is “Will they live up to the ­statement in times of stress?” (See the statement at https://opportunity. businessroundtable.org/ourcommitment/.) On the other hand, bad corporate governance casts doubt on a company’s reliability, honesty, and responsibility to stakeholders, which has consequences for a firm’s financial health. For example, the scandal that hit Volkswagen in September CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 85 2015, where they deliberately manipulated engine-emission equipment in order to falsify pollution test results, saw their stock lose nearly half of its value in the days following the announcement. Moreover, the fraudulent practices that bankrupted Enron and WorldCom resulted in the introduction of the Sarbanes-Oxley Act in 2002. This imposed stricter recordkeeping requirements on companies, and introduced rigid criminal penalties for violating them, in order to restore confidence in public companies. More “regular” types of bad governance practices include companies not cooperating sufficiently with auditors, resulting in the publication of noncompliant financial documents, poor executive compensation packages that fail to align with shareholder interests, and badly structured, poorly performing boards where it’s difficult for shareholders to vote out unproductive members. In addition, it’s important to highlight that where countries fail to establish acceptable standards of governance, the companies within those jurisdictions can be found “guilty by association” and find it difficult to attract foreign and institutional investment. Practices and values Corporate governance seems to have been in the news more often in the last 20 years due to the number of scandals that have been reported, leading to the collapse of companies due to mismanagement. This has provoked regulators all over the world to introduce numerous acts and rules to monitor and control negligent corporate behavior that causes harm to shareholders and stakeholders. This oversight essentially “helps companies to help themselves” when considering best practices and values in pursuit of profit maximization. This has acted as a wake-up call for the corporate world to “get its act together.” However, it’s clear that some of the lessons learned haven’t prevented abuse of corporate power (Wirecard in Germany, which was brought down by accounting fraud, is the latest high-profile example) and have also shown that monitoring for ethical business behavior is a constant requirement. Consequently, companies are required to provide increasing levels of nonfinancial information, especially concerning their ESG impacts. Such demands range from specific types of disclosure, such as board composition and executive pay, to calls for extensive periodic reports on companies’ ESG performance. For example, corporate social responsibility (CSR) reporting, or sustainability reporting, has evolved from an ad hoc activity assumed by a few progressive companies to a routine practice at most of the world’s large companies. While there isn’t a legally mandated framework for this reporting, many companies have implemented the standards set out by the Global Reporting Initiative (GRI; see ­Chapters 1 and 15), which cover a broad range of issues from human rights to environmental 86 PART 1 Getting to Know ESG compliance, anti-corruption efforts, and customer privacy. The abundance of sustainability issues has encouraged numerous attempts to narrow and categorize the field. This highlights the art of guiding and controlling an organization by balancing the needs of various stakeholders. This enables the resolution of conflicts of interest between stakeholders and ensures that the organization has the processes, procedures, and policies that they need to promote the principles of transparency and accountability. Such controls need to be balanced against companies’ requirements to maximize profits while safeguarding against companies cutting corners in their pursuit of profits. So, companies need to be managed and directed in accordance with standard norms and procedures that promote ethical conduct. Multiple stakeholder orientation Stakeholder orientation is generally defined as an objective to benefit all parties that are affected by the future success or failure of an organization. Essentially, it’s in companies’ best interests to maintain positive long-term relationships with all stakeholders, understanding their needs and constantly aligning stakeholder requirements with companies’ needs. The current environment has been created by essential changes in shareholder engagement, which has become a dominant topic for public companies and their investors in the 21st century. Public companies have embarked on unparalleled levels of proactive engagement with major shareholders and stakeholders. Institutional investors have also improved their engagement efforts, committing substantial resources to governance issues, company outreach, and the analysis of proposals on voting ballots and voting policies. Furthermore, levels of shareholder activism remain at record highs, enforcing considerable pressures on targeted companies and their boards. Investors seek a greater voice in companies’ strategic decision-making, capital allocation, and overall corporate social responsibility. Many shareholder-driven campaigns are forcing changes to corporate strategies (through spin-offs) or capital allocation strategies (through share repurchase programs), suggesting that their voices are being heard in the boardroom. Given that shareholders are the ultimate owners of the company, this is appropriate; however, concerns are expressed by other stakeholders where activists’ goals are too focused on short-term uses of corporate capital, such as share repurchases or special dividends. Longer-term stakeholders are demanding that the board consider both long-term and short-term uses of capital to determine the appropriate allocation of that capital to meet the company’s business strategy. ESG considerations are naturally forcing companies to veer toward a longer-term approach with a broader set of stakeholders to be included. CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 87 Walk the Walk: Evaluating a Company’s Governance Values Governance has become a key focus for sustainable investing, particularly as firms navigate their recovery for after the COVID-19 pandemic. Their response to the pandemic has prompted a renewed focus on best practices and has highlighted the requirement for effective corporate governance and review of a company’s purpose and values. While the greater focus on ethical and environmental issues will continue, there is a renewed emphasis on specific business issues around fairness and transparency, which has been the traditional focus for fund managers’ stewardship recognition in the past. (One example of a basic question is “With COVID19 destroying the economy and an impending uncertainty about the extent and duration of the crisis, should companies have been paying dividends?”) As companies make decisions in circumstances that have never been faced before, stakeholders will be constantly scrutinizing and verifying any board decisions and resolutions. However, “no one size fits all” in relation to a company’s response, so each company needs to determine the principles and values that are appropriate in light of its needs and circumstances. The following sections explain how to evaluate a number of these principles and values. All companies should adhere to some core principles: »» In particular, decision-making at the board level should consider the interests of all stakeholders, including employees, customers, suppliers, and the community in which the company operates, in order to achieve long-term value creation. »» The board and management should engage with long-term shareholders to understand concerns and issues that worry them and potentially affect the company’s long-term value creation. »» Shareholders who engage with the board and management in a way that affects decision-making are urged to disclose relevant identifying information and to accept some accountability for the long-term interests of the company and its shareholders. »» As part of this responsibility, shareholders should accept that the board must constantly weigh both short-term and long-term uses of capital when deciding how to allocate it in a manner that is most beneficial to shareholders and to creating long-term value. 88 PART 1 Getting to Know ESG Board responsibilities A corporation’s board is ultimately responsible for the management of its business and directly responsible for given decisions, including relationships with the company auditor and setting executive compensation. Through its oversight function, the board selects and reviews the performance of the Chief Executive Officer (CEO) and ensures that they set a “tone at the top” that establishes an obligation to integrity and legal compliance. In turn, this should establish the basis for corporate culture that is communicated to employees throughout the organization. Furthermore, investors are increasingly expecting greater “buy-in” to ESG issues and for companies to have a strategic approach to corporate social responsibility (CSR). The board needs to have significant participation in formulating the company’s long-term strategy and needs to frequently assess implementation of the plans to ensure long-term value creation. Subsequently, the board and senior management should jointly agree on the company’s risk appetite to achieve those goals and appreciate any major risks involved. This can be achieved by establishing a structure for risk oversight, assigning responsibility to committees, and supervising the designation of senior managers who are accountable for risk management. Moreover, as the risks from ESG issues become more apparent, it’s increasingly important for boards to understand how these risks affect the business. Resultant impacts can be financial, material, and spread across several areas of a business in every sector of the economy. A key part of directors’ fiduciary responsibility is the “duty of care,” where they sufficiently inform themselves on such issues prior to making business decisions. Therefore, the recruitment of directors with experience and exposure to the material ESG issues that the company faces helps satisfy this obligation. However, there is a need to educate the entire board on relevant ESG issues so that they appreciate and assess the risks and engage with relevant stakeholders and shareholders. A useful tool to evaluate the likely impacts of key environmental and social risks on corporate strategy is scenario analysis (introduced in Chapter 4). The board should review all financial statements to ensure they accurately represent the company’s financial situation and existing operations, and ensure full disclosure of other important information highlighting past results or future plans. To achieve this, the company’s internal controls and procedures need to be designed to identify and discourage fraudulent activity. These procedures should also include oversight and approval of annual budgets and operating plans, and input on the capital allocation process, to ensure an adequate balance between short- and long-term funding. Meanwhile, the risk oversight function should CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 89 focus on business resiliency, including topics such as business continuity, cybersecurity, crisis management, and physical security. The company’s compliance program also needs to be robust, and the board should be made aware of any meaningful compliance issues that arise. Directors need to assess whether the company’s Enterprise Risk Management (ERM) process is flexible enough to always identify ESG issues as both current and emerging risks. As a starting point, companies should review the guidance on integrating ESG issues within the company’s ERM process, which has been developed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO; www.coso.org/Pages/guidance.aspx) and the World Business Council for Sustainable Development (WBCSD; www.wbcsd.org/). Board composition Increasing attention has been focused on the relative diversity of a company’s board, in terms of the mix of women, ethnic minorities, and others with diverse cultural backgrounds, which has been proven to avoid “groupthink.” Diversity should also promote representation from a broader range of society, which has been shown to improve board performance and encourage the creation of longterm shareholder value. BlackRock, one of the largest global asset managers, has made it clear that boards looking for their support will have to focus on board diversity, with generational diversity seen as an indicator for greater integration of ESG factors. These traits should be combined with the general characteristics of integrity, strength of character, sound judgment, objectivity, and an ability to represent the welfare of all stakeholders. This also assumes that the directors are independent and don’t have relationships that might impair their ability to apply independent judgment. As such, a significant majority of the board’s directors should be independent, according to appropriate rules and regulations or as determined by the board. In addition, the tenure of long-standing, independent board members should be reviewed and limited, as there may be a perception that they are not, over time, as independent. Audit committee structure The audit committee’s role has traditionally been to provide oversight and monitoring of the financial reporting process, the audit process, the company’s system of internal controls, and compliance with laws and regulations. However, as investors persist in requiring more insight into organizations’ strategies, impacts, and dependencies related to ESG issues, they may expect an independent group, such as the audit committee, to take ESG oversight as part of their regular risk and 90 PART 1 Getting to Know ESG regulatory compliance activities. While the board should participate in recognizing the ESG risks that influence corporate strategy, oversight should be formalized in a specific committee, and the audit committee could be best placed to cover that function given their responsibilities for overseeing the organization’s assurance and disclosure processes. But the audit committee should ensure that executive management identify and assess any significant ESG threats, policies, and judgments required to systematically identify ESG risks and determine how they should be improved, including particular risk (for example, climate change and diversity) and macro trend analyses. The board should then establish systems for committees to work together on ESG risk oversight and provide disclosures that meet investor expectations on material issues. ESG risks are established across industry sectors and can present systemic risks that need to be addressed by companies. The audit committee must understand how to oversee ESG risks through their regular approach of risk identification, prioritization, and mitigation processes. In turn, they need to adequately structure and disclose their ESG oversight to investors and other stakeholders. Yet, in many jurisdictions, no regulatory body or mandate explicitly requires organizations to provide ESG disclosure. As a result, no single standard or structure guides organizations on how to present such information to stakeholders. A number of sustainability standard-setting and reporting initiatives are developing standardization and consistency in ESG disclosure, such as the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), and Task Force on Climate-related Financial Disclosures (TCFD). In addition, several jurisdictions mandate some form of corporate ESG disclosure through their capital markets regulators, or through stock exchange listing requirements. Such standards are gaining traction, and the vast majority of firms are providing some form of sustainability disclosure to the market. Find out more about these initiatives in Chapter 1. Given their oversight of the financial reporting process, audit committees are best positioned to proactively engage and challenge management in appropriate discussion and advise how information is presented to investors. For example: »» They are familiar with requesting information from finance, treasury, investor relations, operations, supply chain, and even third parties through their oversight of internal controls and compliance. »» Their risk assessment and management responsibilities should contribute to an understanding of whether ESG issues are being considered in isolation or proactively through an ERM lens, covering the full range of risks relevant to the organization and investors. CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 91 »» They should establish an internal governance structure around ESG factors in the company, developing roles, responsibilities, data management, reporting, and disclosure. »» They also have responsibility for selecting and retaining external auditors; therefore, they could analyze the current plethora of external market ESG evaluators (providing scores, ranking, and analysis) and determine which firms to engage with to “showcase” the company’s ESG profile. However, this should also entail establishing procedures for any compliance concerns related to the company’s code of conduct that ESG risks create. Ultimately, the audit committee should mirror its regular responsibilities for the financial reporting and audit process into the ESG reporting and oversight process. They should be satisfied that the ESG reporting and related disclosures prepared by management present the company’s ESG “credentials” accurately and ensure that internal ESG reporting staff have adequate resources and support to carry out their role. This process should consider ESG regulations and potential litigation, with anticipation of any fines or penalties that might arise from ESG violations. Depending on the type of company, this might include extreme weather events disrupting operations, workplace injuries or deaths, or data privacy or security breaches. The key factor is to guard against risks such as market devaluations, loss of assets, reduced profits, or reputational damage from an ESG liability. However, it should also be viewed as an opportunity to determine how the organization can leverage any ESG opportunities by fully integrating and embracing any emerging ESG trends. Bribery and corruption Even though the ‘G’ of ESG is largely identified with aspects of board oversight, from board structure and responsibility to specific sustainability targets, it’s bribery and corruption that remains one of the biggest business risks, with the United Nations (UN) stating that it is “one of the biggest impediments to achieving the Sustainable Development Goals (SDGs).” Many institutional investors are concerned about corporate corruption and its impact on both investment returns and economic growth. Corruption takes various forms, including bribery, embezzlement, money laundering, and tax evasion, and it costs the global economy over US$3 trillion each year, according to the UN. Bribery and corruption risks tend to be more prevalent within developing economies, where the rule of law can be weaker and enforcement may be lacking, but it’s in reality a global issue. For example, in many developed countries, it continues to be an issue in the real estate and construction sectors. However, while corruption isn’t unique to lower-income countries, it has a disproportionate impact on the poor and most vulnerable economies and people, reducing access to 92 PART 1 Getting to Know ESG education, health, and justice services. And both the World Bank and the World Economic Forum (WEF) have reminded people that much of the world’s corruption couldn’t happen without the actions of organizations in wealthy nations! Investors know that bribery and corruption are ESG factors to be considered in their investment portfolios and recognize that there are regional difficulties in terms of governance structures. Investors are mindful of certain affiliations and recognize that many developed countries accept the export and enablement of bribery and corruption by their corporate and individual citizens, whether that be financial institutions accepting corrupt proceeds or intermediaries facilitating fraudulent transactions. Corruption can add up to 10 percent of the cost of doing business globally and up to a quarter of the cost of procurement contracts in developing countries! ESG due diligence should not only look at the effectiveness of controls for risk prevention and uncovering bribery and corruption, but also at how they interact with the business model of the company and the “incentives” that are available for misdemeanors. In addition, standards introduced should also consider the advantages for the business of receiving more revenue for products sold, given that money “escaped” through corruption can be reduced or slashed from the purchase process. Therefore, many companies view a budget allocated to such measures as an investment rather than an expense. Moreover, companies that establish these policies and procedures are building a sustainable business for the future by meeting the UN Global Compact’s 10th Principle against corruption and are in a better position to fulfill SDG 16. (Read about these principles at www.unglobalcompact.org/what-is-gc/mission/principles/principle-10 and www.un.org/ruleoflaw/sdg-16/.) Ultimately, this helps companies reduce damage to their brand, reputation, and share price, potential exclusion from new business opportunities, liability to pay substantial fines, and use of management time dealing with investigations or prosecutions. Furthermore, investors risk reputational damage and reduced return on assets if they are implicated in corruption, especially if the resulting scandal is badly managed by the portfolio company. Given that corruption represents substantial legal and economic risk for companies doing business around the world, the U.S. Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) are waging an international fight against corruption by increasing the number of investigations, settlements, and prosecutions for violations of the Foreign Corrupt Practices Act (FCPA). The FCPA contains both anti-bribery prohibitions and accounting requirements, the latter being designed to block accounting practices intended to hide fraudulent payments and ensure shareholders and the SEC have an accurate overview of a company’s finances. To prevent violation, the SEC and DOJ can administer hefty fines CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 93 and imprisonment. Find out more about the FCPA at www.justice.gov/criminalfraud/foreign-corrupt-practices-act and www.sec.gov/spotlight/foreigncorrupt-practices-act.shtml. Executive compensation In general, executive compensation should align the interests of senior management, the company, and its shareholders to promote long-term value creation and success for the company. Therefore, it should include performance-based components that reward the realization of targets tied to the company’s strategic plan, but that are discarded if the targets aren’t met. Executive compensation represents one of the major components of corporate governance discussions and tensions between institutional shareholders and companies, and it’s accepted that executive pay should incentivize long-term performance. However, such packages need to optimize financial results and promote sustainable behavior without creating systemic risks that damage investors’ long-term interests. Companies have started studying alternative ways to integrate ESG factors into incentive programs, but there is no standard method to link ESG metrics to executive pay. In addition, companies from different sectors and industries are influenced by different market forces or constraints; subsequently, distinct materiality can be applied to different ESG factors. For example, while environmental issues are specifically relevant to companies with a large environmental impact, other sectors will focus on community relations or ensuring health and safety in the workforce. However, this may not always be practical due to difficulties in measuring ESG factors or the lack of evidence highlighting the precise impact on overall company performance. Therefore, there is no “one size fits all” approach to integrating ESG factors into executive compensation schemes. Sustainable value creation will have different definitions for each company, so it’s necessary to determine appropriate ESG metrics that impact the long-term viability of operations and introduce assessments that include unique definitions for sustainability. These may include industry-specific regulations, regional economic conditions, access to resources and capital, environmental or political conditions, workforce composition, and growth opportunities. ESG metrics related to external sustainability indexes are discouraged because they aren’t necessarily relevant to companies’ circumstances. For example, Royal Dutch Shell introduced a scheme to tie executive pay to three- to five-year targets for their net carbon footprint from 2020. This sets an important precedent and should encourage their peers and other industry players to consider similar programs. More generally, the inclusion of ESG and CSR targets within executive compensation highlights that, rather than aligning incentives only with shareholders, there should be a broader focus on key stakeholder groups; it also signals a commitment to the company’s value objectives as much as the value of the company. Therefore, 94 PART 1 Getting to Know ESG companies should introduce clear guidance on how material ESG metrics are identified and related to sustainable shareholder returns, company strategy, and executive compensation. ESG targets should also be integrated into an appropriate time horizon that is in line with business, and form a meaningful component of the overall remuneration compensation. It goes without saying that this should sit within a proper governance structure (if not alongside the existing compensation approach) and be conducted in an ethical way such that ESG targets are rigorous and challenging to ensure outperformance is incentivized. Lobbying In general, lobbying can be described as the act of lawfully attempting to influence the actions, policies, or decisions of government officials or members of regulatory agencies through persuasion or interest representation. In a worst-case scenario, political donations and lobbying expenditures are used to unduly exert influence over public policy and regulatory systems. Despite this, most companies don’t have a formal lobbying oversight system and don’t fully disclose how those monies are spent. In some cases, companies may engage in activities that are effectively corrupt, but permissible by law! In the United States, in particular, companies have substantial sway over public policy resolutions at federal and state levels via direct lobbying, as well as through think tanks and third-party trade associations. Studies suggest that business interests spent over US$30 billion on federal lobbying over the last 20 years, without there being an effective system for citizens to check the full scope of corporate influence. Disclosure databases only provide an aggregated quarterly total of money spent, and lobbying through trade associations provides companies with “political cover” when supporting policies that are unpopular or untransparent with respect to SDG sub-target 16.6. This target aims to “develop effective, accountable and transparent institutions at all levels.” (Visit www.un.org/ sustainabledevelopment/peace-justice/ and click the tab “Goal 16 targets.”) The level of spending on lobbying can lead to an unfair representation of company interests over public interest, and the lack of accountability can also enable companies to support public policy positions that prevent action on other SDGs, such as SDG 13 (climate action; visit https://sdgs.un.org/goals/goal13). However, a company may face reputational and/or operational risks if its lobbying activity is exposed and conflicts with stated company goals or implicates the company in public controversy. Therefore, far-reaching lobbying disclosure can offer broader public accountability and guarding against corruption. This ultimately helps increase trust in people and institutions, while allowing the signposting of critical ESG issues with company leaders. CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 95 Political contributions Contributions are the most common source of election campaign support, whereby a contribution is considered as anything of value given, loaned, or advanced to influence a federal election. However, a board should reflect on its position with respect to political contributions by considering their purpose, benefits, risks, and boundaries. After all, by definition, a donation is a gift made without expectation of return, and any political contributions must assist the political process and not be linked in any way to a direct business advantage! Therefore, due to stakeholder misgivings of corporate political engagement, the potential for erroneous perceptions of companies’ objectives, and the risk of bribery, it’s reasonable that many companies prohibit all political contributions. This trend is further reinforced by the conclusion that they benefit more from lobbying (see the previous section) and other forms of political activity. They have greater legitimacy, permit a higher degree of management and control, and allow for simpler measurement of returns. In principle, companies shouldn’t make political donations; however, if they are made, they should be as a representation of corporate responsibility, offering general support to the political parties to support a genuine democratic process. As such, they could be made in emerging or fragile democracies where, for example, the company has a leading market share and the international community agrees that funding could strengthen the democratic process. It should ensure that there is no suggestion of any immediate business advantage for the company and in all cases that donations are being appropriately disclosed. Moreover, many companies are being challenged by shareholders and corporate governance advocates to disclose information on their political contributions. Therefore, many firms are increasingly voluntarily disclosing their political contributions, even though no mandates are forcing them to do so, as an indication of best governance practice. Boards should also consider benchmarking their political contributions disclosure versus their peers and their industry to monitor if their disclosure practices vary from those of their competitors. If this is the case, they should analyze the motives behind that strategy and decide whether an alternative approach could be in the best interest of the board, the company, and its shareholders and other stakeholders. For example, the large asset manager BlackRock states that companies can engage in certain political activities where they want to influence public policy in line with the companies’ values and strategies; however, it believes that it’s also the duty of boards and management to determine the appropriate level of disclosure of such types of corporate activity. Consequently, some firms believe that 96 PART 1 Getting to Know ESG engagement in the political process is critical to their success, as their growth is dependent on forward-thinking legislation and regulation that improves public infrastructure. Without the benefit of information from the commercial sector, policymakers may risk missing opportunities to fully exploit technology or cause unintended consequences; therefore, they suggest that their contributions are designed to educate policymakers. Whistleblower schemes Whistleblowing is a term used when a person passes on information concerning wrongdoing. This is referred to as “making a disclosure” or “blowing the whistle.” The worker informs on a person or organization they regard as being involved in illegal and unethical practices. Corporate or employee misconduct presents challenges to corporate governance, largely because it undermines positive corporate culture and ethical business conduct and impedes economic growth; therefore, whistleblower policies are seen as an indication of good-quality corporate governance. Workers are often the first people to witness wrongdoing within an organization, and their information can prevent escalation of the problem, which may damage an organization’s reputation. However, where an organization hasn’t created an open and supportive culture for whistleblowing, workers may not feel comfortable making a disclosure, for fear of any consequences. The two main issues they fear are concerns of reprisal and that no action will be taken if they make the disclosure. One high-profile example of this was the case of whistleblowing at Barclays Bank in 2016. Barclays was found to have violated local banking laws and its own procedures during the handling of a whistleblower disclosure by the New York State Department of Financial Services (DFS) and subsequently fined US$15 million. The information was not dealt with by the bank’s investigations and whistleblower team, but distributed among senior management, at which point the CEO allegedly asked for the whistleblower(s) to be uncovered. The DFS investigation uncovered actions that exposed the bank to risk and created an atmosphere in which employees might hesitate to raise issues of concern. The CEO himself was also fined £642,430 by UK regulators for breaking rules by trying to find the people who forwarded the information, and his bonus was cut by £500,000. So, the landscape is changing, and companies with poor whistleblowing policies potentially increase risk for their investors by losing the chance to recognize misbehavior taking place internally and subjecting themselves to litigation. As an employer, it’s good practice to generate an open, clear, and safe working environment where workers feel able to speak up. Even though the law doesn’t require employers to have a whistleblowing policy in place, the existence of such a policy CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 97 demonstrates an employer’s responsibility to listen to the concerns of workers. By having transparent policies and procedures in place, an organization shows that it welcomes information being shared with management, and it’s a vital component of an effective corporate compliance program. Progressive corporate leadership is also directing similar procedures to critical workforce-culture concerns such as bullying, gender inequality, sexual harassment, and any other issues of personal conduct and ethics. Lead the Way: Emphasizing How ‘G’ Can Dictate the ‘E’ and ‘S’ Factors Governance can never be isolated from environmental and social issues, as you find out in this section. Excelling in governance requires an understanding of the spirit of an issue or regulation rather than mastering the letter of the law. Therefore, identifying potential violations before they occur or ensuring transparency and discussions with regulators, rather than “ticking the box” and submitting a report, highlights that understanding the ‘G’ in ESG is critical. Ultimately a company’s governance approach will determine how they respond to environmental and social issues relating to the company, as well as covering cultural, economic, and political concerns. Governance can expand authority, policies, and procedures to address sustainability issues and create a culture that supports its acceptance. Likewise, when sustainability permeates governance, executives become more accountable for environmental and social performance, such as energy, water, and emissions issues; equal opportunity, health, and safety; and well-being topics. The ways in which sustainability governance can affect environmental and social performance include developing a comprehensive set of policies, directives, and standards that direct fulfillment, creating a sustainability office that coordinates corporate-wide environmental and social strategy and activities, and appointing a board committee with primary responsibility for reviewing such matters. Governance as an overarching principle for ESG Good governance was deeply rooted in the culture of many firms well before environmental and social issues began to take center stage. Similarly, fund managers and investors have included corporate governance quality within their investment decision-making long before the exponential interest in ESG investment that has 98 PART 1 Getting to Know ESG been seen in recent years. The stewardship investor influence in high-quality governance is still critical, including understanding the management, their longterm planning, and executive compensation structures. This is demonstrated by the recommendation of the Principles for Responsible Investment (PRI) to changes in the UK Corporate Governance and UK Stewardship Codes, suggesting more attention should be paid to ESG issues. Furthermore, in particular, the UK Stewardship Code explicitly states that environmental and social issues are important drivers of long-term investment value and are part of the fiduciary duty that investors owe to their clients and beneficiaries. Research suggests that external ESG ratings are able to measure up to 80 percent of environmental and social impacts within a company but fail to capture 20 percent of governance issues, even though governance may be considered to be the most important of the ‘E-S-G’ triumvirate. For example, in the climate change–related bankruptcy of the Pacific Gas and Electric Company (PG&E), external ESG ratings failed to fully gauge the governance component of ESG. While it highlighted the climate change component expected in a utility company, it failed to fully assess the internal management of those risks. Meanwhile, industry peers suggested that the company’s internal ESG risk management processes weren’t particularly strong. Furthermore, such different assessments of ESG governance between outside ESG-ranking entities and industry peers can be even more relevant, given that reports suggest that the vast majority of investment firms view governance as the highest influence on investment decisions among ESG factors. The reality appears to be that companies don’t always act on red flags, even when they are staring them in the face. Moreover, investment research company MSCI undertook research on ESG factors on the performance of companies in different sectors to establish whether the governance factor is the most important driver of performance for companies, and whether the weighting of ‘E,’ ‘S,’ and ‘G’ factors makes any difference to long-term performance. Their findings showed that governance does have more impact on companies’ performance in the short term (one year). However, over longer time periods, all three ESG factors are vital to outperformance. The research also showed that the weighting of ‘E,’ ‘S,’ and ‘G’ factors within each industry can have a great bearing on the performance of an ESG index over long time periods. For example, governance is considered to be the main ESG risk for banks. ­Governance quality is primarily essential for banks because they operate with greater leverage and are usually more confidence-sensitive than businesses in other sectors, especially regarding their funding arrangements. The results of a governance violation usually go beyond the direct impact, such as a financial ­penalty, but can lead to reputational damage, causing franchise erosion, a loss of CHAPTER 5 Give Me a ‘G’! Decoding the Governance Component of ESG 99 business, or clients withdrawing funds. Yet, in public disclosure documents, many banks treat the governance factor of ESG almost as an afterthought, focusing more on environmental issues that may not be material. Despite this, governance failings continue in the banking sector, leading to clients being disillusioned by reputational damage caused by those failings, which affects their profitability and liquidity and therefore banks’ earnings capacity. The role of governments In parallel to actions by companies, investors, and ratings agencies, governments, policymakers, and regulators are also driving change to take ESG into account. Here are some examples: »» The UK government has launched a Green Finance Strategy, requiring that it will be mandatory for all listed companies and large asset owners to disclose the environmental impact of their activities by 2022. This approach is in line with the Task Force on Climate-related Financial Disclosures (TCFD), a body that exists to promote disclosure of climate-related risks (and opportunities) in order to enable assessment of investment risks and ultimately risks to the financial sector, thereby enabling more informed decision-making by investors about how investee companies are managing climate change–related risks and opportunities. The UK government is an early adopter of the aims of the TCFD, and their policy is to associate private sector financial flows with clean, environmentally sustainable, and resilient growth. All listed firms will have to be fully transparent about the climate effect of their actions. See www. gov.uk/government/publications/green-finance-strategy and www. fsb-tcfd.org/ for more information. »» The European Union (EU) Taxonomy is a classification tool that includes a list of economic activities and performance levels specifying what threshold of environmental performance a service should have to influence Europe’s environmental objectives. The adoption of the Taxonomy Regulation follows the entry into force of the Sustainable Finance Disclosure Regulation (SFDR) in December 2019, which effectively assumes that good governance is a prerequisite of good corporate sustainability. The first phase of integration reviews activities that can noticeably contribute to climate change mitigation or adaptation. An action will only be coherent with the taxonomy if it does no substantial harm to the other environmental targets, and meets minimum safeguards, specified in line with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. The taxonomy is a significant effort by financial regulators to mandate disclosure against a sustainability objective, rather than a financial one, and will transform EU-wide sustainability goals into a tool that investors and 100 PART 1 Getting to Know ESG corporations can work with. Taxonomy disclosures will help corporations and issuers access green financing to decarbonize high-emitting sectors and grow low-carbon sectors (see Chapter 15 for more information). Initially, the climate change mitigation objective is Europe’s pledge to net-zero carbon emissions by 2050. The taxonomy will be supported by regulation, with the list of economic actions and performance levels being issued as part of the precise legal requirements from the European Commission by the end of 2020. Financial market players and businesses will be required to finalize their first set of taxonomy disclosures, including activities that significantly contribute to climate change mitigation and adaptation, by December 31, 2021. Investors with funds in Europe will be obliged to reveal against the taxonomy where the fund is marketed as cont