The State of Social: the S of ESG
The S of ESG, a little more nebulous compared to its E and G colleagues, has been having a much deserved moment in the spotlight. Beyond the many conversations on what it is (see here, and here), there is a growing conversation on how to measure and analyze the S, and why it’s so important to the broader ESG perspective. In looking across the many ESG players — the community of investors, corporations, raters, standard setters, guidance providers, and data firms — the S provokes a mixture of hesitation, frustration, innovation, and opportunity. The nuances of social issues clash with the status quo of disclosure and performance analysis. Yet, better corporate social data and alignment on the materiality of key issues is exactly what’s needed to bring the social laggards and leaders forward, improving the quality of ESG investments and opening up the S as an opportunity for alpha.
The S gets its time to shine
The past few years have brought a spotlight onto the S. Between the pandemic’s impact on front line workers, a racial reckoning, and the Great Resignation, there’s been a collective increase in attention on corporate social impact and responsibility. This wave opened eyes to the materiality of social issues, and the long-term impact they can have on corporate sustainability and enterprise value. Further, it coincided with the rise in ESG, creating increased pressure to disclose, analyze, and measure the S — a task that’s not always simple.
Historically, social issues have often been identified as material through dynamic circumstances, and almost always defined by risk. A major human rights abuse, for example, would lead investors to determine the issue material to a certain company or industry. Recently, that perspective and approach is beginning to shift towards viewing social issues as inherently webbed throughout an enterprise, and present themselves not only as risks but opportunities for differentiation. From an investment perspective, a more comprehensive understanding of social impact (internal and external) can mitigate risk and also present an opportunity to generate alpha.
Evaluating the S
Comprehensively evaluating social performance doesn’t fit neatly into existing practices, and results in the S often taking a back seat to the E and G when it comes to valuation. Three players in the broader evaluative landscape — standard setters and guidance providers, corporations, and investors — contribute to a roadblock that’s limiting effective use of social data in investment analysis:
Standard setters and disclosure guidance providers have started to lay the groundwork for disclosure and reporting on social issues, but have given corporations the power to determine materiality. Without explicit requirements or clear directives, the incentive for companies to report social data is diluted. Without access to comprehensive and comparable data across companies, investors deprioritize social performance in analysis and engagement.
If there can be alignment around the need to standardize and take action on measuring and analyzing social performance, as well as specific frameworks and metrics, there is much opportunity to improve the quality of evaluation.
Moving towards alignment and standardization will require navigating the challenges of materiality, and nuances of social data and analysis.
The materiality of social issues poses a challenge to corporate reporting, and subsequently the investors, raters, and analysts that use that data. As mentioned, standard setters have built in guidelines and guidance on social issues, but GRI allows companies to determine the materiality of social issues, and SASB is quite conservative in identifying social issues as material to specific industries. Nearly half of SASB’s 77 industries do not have any human capital issues identified as material. Employee engagement, diversity & inclusion is found to be material for just 12 industries, human rights and community engagement for just six. Without clear guidance and expectations, it can be a challenge for corporations to get buy-in to allocate resources to collect, track, and report on social data and performance.
Even when companies do report, the inherent nature of social issues mean each company faces different risks and opportunities, making context critical. The makeup of their employee base, the communities in which they work, the supply chains they are a part of, all make their social issues nuanced. As a result, it can be difficult to quantify social issues in a comparable way, presenting an added challenge for investors who tend to prefer approaching analysis at scale.
There’s also the measurement and management of social impact throughout and beyond the value chain; looking at companies’ outward impact. Referred to as double materiality, this determines how social issues both impact a company and how a company impacts that issue. Health, education, affordable housing, and rising inequality are a few examples of issues that are challenging to measure and quantify, yet critical to understanding corporate social impact.
But not identifying how to effectively incorporate social risk and opportunity into valuation and investment strategies poses a risk to the case for ESG investing. With environment and governance more universally defined, some investors and ratings agencies overly lean on E and G performance and do not fully capture corporate social impact. What gets measured gets managed, and lack of measurement can result in negative impacts to employees, workers, and communities both local and global. When social risks are not effectively incorporated into valuation, that can translate into investor risk exposure. This can limit the effectiveness of ESG as an investment tool and limit its impactfulness as a driver for improved corporate performance.
Despite the many challenges, there are ratings agencies, data firms, and a growing pool of investors who are using the data available to analyze performance, push for increased disclosure, and make the case for deeper social integration into investment strategies.
There’s a growing discussion on what social issues are universally material. Data on diversity at the executive and board level is becoming a common baseline expectation globally. Treatment of workers and impacts on communities throughout the supply chain is starting to move from focusing only on policy to digging into actual performance. In the US, Human Capital Management (HCM) metrics pose the next frontier. There’s an increasing number of companies starting to disclose workforce demographics at an intersectional level by publishing EEO-1 reports. The US SEC has flagged interest in further standardizing HCM reporting. This could result in standardized expectations for companies to report on internal employee metrics including retention and turnover rates, compensation, skills training, promotions, etc., offering a more comprehensive view into internal social performance.
In the investment space, some asset managers have been bringing more S issues into proxy season proposals and corporate engagement priorities. Governance of social issues, board diversity, and workforce disclosure, are issues BlackRock, State Street, and Goldman Sachs have outlined in their proxy and engagement guidance this year. The above mentioned SEC regulation could lead to increased HCM data disclosure that would allow for comparability across companies, making social data more attractive for investor analysis.
It is worth noting, however, the limitations of regulation when it comes to the global landscape. For US-based multinationals, regulation at the SEC level may support disclosure on the US employee population, but fail to drive disclosure on the full global workforce. Varying regulations across geographies make it difficult to capture a comprehensive full picture for multinational companies, making the need to align on a set of universally material social issues that are incorporated into global standards that much more important.
But the forward movement during proxy season is critical; it’s important to push through some of the ambiguity and be open to shifting away from the status quo to improve social data disclosure and analysis. Not doing so puts the case for ESG investing at risk and can lead to poor outcomes for local and global communities. Effectively evaluating companies’ social performance provides insight into costs, reputation, brand value, innovation capacity, and potential for risk and growth. Further, there’s the potential for tracking external impact on customers, communities and society at large — offering a window into true enterprise value. With the newly formed International Sustainability Standards Board being tasked with creating a unified set of ESG standards, stakeholders should take this opportunity to offer strong, clear proposals around S metrics sooner than later. As a global sustainability community, let’s figure this out.