Fixing the S in ESG

(Photo by iStock/Jirapong Manustrong)

Is the planet really more important than the people? According to CNBC, most money managers who use ESG (environmental, social, governance) factors in their investment analysis have focused on the E, or climate change, as their leading criteria for their decisions. But what about the S, or social dimension of corporate impact? As one fund manager put it to me in a recent conversation: “Planet isn’t necessarily more important than people, it’s just easier to measure. Investors like measuring things that they can put into their models, and carbon is easy to quantify.”

No doubt, quantifying social impact is a challenge. A 2021 Global ESG Survey by BNP Paribas revealed that 51 percent of investors surveyed (covering 356 institutions) found the S to be the most difficult to analyze and embed in investment strategies. The report concluded: “Data is more difficult to come by and there is an acute lack of standardization around social metrics…. Investors have been willing to accept data that does little to actually assess the social performance of the companies in which they invest.” For most investors, S is merely a check-the-box exercise. 

So, what can be done to improve S data?

The Meaning of S

First, we need to better understand how the field currently defines S. Commentators and investors have described S in many different ways: as social issues, labor standards, human rights, social dialogue, pay equity, workplace diversity, access to health care, racial justice, customer or product quality issues, data security, industrial relations, or supply-chain issues. S&P, one of the leading ESG ratings agencies, describes the S in terms of social factors that pose a risk to a company’s financial performance.

In a blog post titled “What is the ‘S’ in ESG?,” S&P outlines three types of S issues:

• How can a company's workforce requirements and composition present problems for the organization in the future? Labor strikes or consumer protests can directly affect a company’s profitability by creating a scarcity of skilled employees or controversy that is damaging to a corporation’s reputation.
• What risks come with the safety implications of a product or the politics of a company’s supply chain? Corporations that ensure their products and services do not pose safety risks, and/or minimize the exposure to geopolitical conflicts in their supply chains, tend to face less volatility in their businesses.
• What future demographic or consumer changes could shrink the market for a company’s products or services? Complex social dynamics, from surges in online public opinion to physical strikes and company boycotts by different groups, affect long-term shifts in consumer preferences. Decision-makers can consider these as important indicators of the company’s potential.

It’s all a bit of a hodge-podge. The purported through-line, as S&P puts it, is “relations between a company and people or institutions outside of it.” That’s a pretty ambiguous definition that can cover a lot of things. One could argue this lack of precision in clearly defining S is a major reason why it’s so poorly measured.

But there’s a deeper existential issue going on here. Rating agencies like Moody’s and S&P view ESG almost exclusively through the lens of materiality (i.e. information that is impactful to a company’s financial performance). That makes sense because the bread and butter of those agencies is rating corporate and municipal debt, and the primary concern of any investor with respect to debt is, of course, repayment. Risk analysis focuses on the likelihood of repayment. The problem is, most of the interest in ESG is not from lenders evaluating credit risk; it’s from investors evaluating equity risk. And equity investors seek to maximize their returns, not just mitigate their risks. Indeed, simply de-risking ESG exposure is unlikely to help investors make affirmative bets on which companies will outperform the market. As State Street Global Advisors noted, “ESG information tends to be the most effective at identifying poor ESG firms that are more likely to underperform as opposed to predicting future outperformers.”

The very nature of social impact isn’t just about risk; it’s also about prosocial behavior. In other words, a company’s actions, policies, and investments can and should positively impact people’s lives. Of course, there are social impacts like human rights violations, labor relations, and supply chain risks that can negatively impact a company’s license to operate and financial stability, and those are important. But there are also many social impacts that can positively affect a company’s financial performance through competitive advantage, business growth, market relevance, brand purpose, and securing license to operate. Positive social impacts are not accounted for in today’s ESG data. Yet, as Larry Fink pointed out in his 2019 letter to CEOs, profits and social impact are “inextricably linked.” 

Michael Porter, George Serafeim, and Mark Kramer, in a 2019 article titled “Where ESG Fails,” argued that “investors who [want to beat the market], as well as those who genuinely care about social issues, have clearly missed the boat by overlooking the significant drivers of economic value arising from the power of social impact that improves shareholder returns.”  

Solving for S

To be relevant, the ESG field must modernize the way it measures S factors. To do so, we must overcome several key conceptual challenges: standardization, quantification, and reporting.  

Standardization. One of the biggest challenges in measuring social impacts has been the absence of a reliable, quantitative measurement standard. The result is that every company (and NGO) defines, measures and reports every social impact differently. For investors, this results in unreliable, incomparable, and low-value data that cannot be used in financial models. While there have been a few attempts to create frameworks for reporting social impacts, most have fallen short. 

The United Nation’s SDGs (sustainable development goals) is among the most prominent of these purported frameworks. However, a 2018 KPMG study titled “How to report on the SDGs: What good looks like and why it matters” found that only 10 percent of companies surveyed had set specific and measurable (SMART) business performance targets related to the global goals, and less than one in ten companies (8 percent) reported a business case for action on the SDGs. Why is this the case? SDGs are primarily designed to track national, population-level statistics such as “mortality rate attributed to unintentional poisoning” or “reduce the global maternal mortality ratio to less than 70 per 100,000 live births.” SDGs were not designed to be directly attributed to any discrete social program or intervention. In addition, the SDG goals were intentionally designed to advance the UN’s agenda of global development by focusing attention on high-priority topics such as over-fishing, poverty reduction, sustainable tourism, clean water and sanitation, reduced illicit arms flows, etc. While these may be important political goals established by the UN, they are not universally relevant to all companies and all communities.

The ESG field needs an objective standard for reporting social outcomes. Outcomes-based standards are designed to measure the quantum of social change that was realized as a result of a program, strategy or intervention. An outcomes-based S standard could be used voluntarily by companies and NGOs to self-select which outcomes they want to report against. Investors could also use outcomes data to conduct more robust social impact analysis. For example, investors might analyze whether the impacts generated were in a company’s headquarters community or at large? Or whether the impacts are advantageous to recruitment, business growth, competitive advantage, diversity, innovation, market development or employee health? What “bang for the buck” or ROI did the company generate on the shareholder funds invested? How did this return compare to other companies or to the industry average? Which populations or communities were most impacted? The power of standardized, comparable social impact data gives rise to a whole new level of S analytics that is more incisive, precise and relevant.

Quantification. Once social impacts are standardized and classified, they must be properly quantified. In the E world, independent bodies like Verra define standards for measuring “units” of environmental impact such as greenhouse gas emissions. Verra refers to these standard units as Verified Carbon Units, or VCUs. Rigorous rules and methodologies are established to ensure consistency and reliability of data across heterogeneous projects. For example, a 1.6 MW Bundled Rice Husk Based Cogeneration Plant in India is measured against the same outcome of VCUs as the Afognak Forest Carbon Offset Project in Alaska.

Social outcomes could be quantified in a similar way. Standards should set thresholds for what constitutes a “unit” of impact for outcomes like hunger, education, and employment. Similar to how carbon credits work, an “impact developer” (i.e. company, NGO, or social enterprise) could report data and have their results verified against the standard. For example, a company might claim that it has helped 1,000 families become “food secure” by providing evidence that each family has achieved the threshold level of criteria for that outcome (i.e. ongoing access to healthy, nutritious food, in a reasonable proximity to their home, on a free or affordable basis).

Using such a standard, ESG analysts could easily roll-up and aggregate a company’s total impact on society. Investors and other stakeholders could actually assess the level of contribution of a business to a critical social issue. Companies could be compared by industry or across industries. Quantification could also be used to price and benchmark social impact. Imagine being able to put a value on a unit of social impact, and eventually trading social impact credits much like carbon? As Scott Kirby, the CEO of United Airlines noted recently in a CNBC interview: “If you put a price on carbon, the public markets will figure it out.” It’s time we set a price for S and let the public markets figure that out too.

Reporting. In the traditional ESG paradigm, reporting is all about disclosure of “material” risks. But as many researchers have pointed out, there are both negative and positive aspects of materiality. Some activities create material risks that could negatively impact corporate performance and merit disclosure. At the same time, some corporate activities create material benefits that could positively impact corporate performance. In fact, the view that materiality only means material risk is inconsistent with the way mainstream financial markets define the concept. Relying on a long history of existing legal precedent, the SEC defines information as “material” under its Selective Disclosure and Insider Trading Rules if there is “a substantial likelihood that a reasonable shareholder would consider it important" in making an investment decision. There’s no suggestion that only risks or negative factors qualify for disclosure. Indeed, many insider trading lawsuits initiated by the SEC are based on materially-positive information that contributed to substantial financial gains.

To improve S reporting, the ESG field must expand its view of materiality. The Sustainability Accounting Standards Board (SASB) initially created its “Materiality Map” in 2014 to help investors identify ESG issues that could negatively affect a company’s financial performance. Today, the ESG market also needs an “Impact Materiality Map” to help investors identify ESG impacts that positively affect a company’s financial performance. An Impact Materiality Map could help investors determine which social impacts are most strategic and beneficial to companies by industry. For example, improving the STEM education pipeline could materially impact innovation and growth in technology firms. For retail grocers, food security and sustainable agriculture could materially influence topline sales. For financial services companies, financial inclusion can materially expand their customer base and market penetration. For health care companies, social determinants of health can materially influence their cost structure and patient well-being. And so on. These social impacts are every bit as “material” an influence on corporate performance as risky social issues. Positive social impacts can also serve as risk mitigation for risky social issues. Take Diversity, Equity, & Inclusion (DE&I) impacts for example. A company’s affirmative investment in DE&I outcomes (not just box-ticking employee numbers) can have a significant impact on mitigating talent loss and reducing risks to company reputation. These impacts are potentially more material than climate change reduction to financial services firms, who already face significant reputational risk in Black communities.

Some social impacts are emerging as universally material to all companies. These can and will change over time, depending on social and political dynamics. Among these “social impact macro factors” are:

1. Public health and its social determinants. If the COVID-19 pandemic taught us anything, it’s that major public health crises can affect every business, every industry, and every geography. How companies respond to and address public health needs can be hugely influential over business survival and success. A related issue is health equity, or social determinants of health. The impact of such factors as housing, financial health, and social capital, among others, on chronic illness, employee productivity and consumer health is directly relevant to all companies.
2. Racial equality. This is more than just a matter of risk and reputation. To compete and grow, companies must focus on inclusivity in their workforce, respond to racism in society at large and make their products and services equitably accessible to all communities. It affects sales, business partnerships, government regulation, employee performance, and competitive positioning.
3. Income inequality and financial inclusion. Of all US households, approximately 44 percent or 50 million people are considered low-income, according to Brookings Institute. That’s a pretty massive market segment. Globally, that number is even more significant: 71 percent of the world’s population remain low-income or poor, living off $10 or less per day, according to Pew Research Center. To grow and prosper, companies must be able to find ways to include these marginalized populations in the economy and expand the reach of their products and services. 
4. Workforce development. Developing a diverse pipeline of talent is critical for every industry and every company. It’s not just a positive social impact, it’s a key barrier to business growth. Cummins, one of the largest diesel engine manufacturers, can’t service its customers in Africa without trained technicians. Boeing can’t build more airplanes without STEM graduates coming out of the public schools. And according to Generation T (an initiative of Lowe’s Companies), more than three million trade skills jobs will sit vacant through 2028, which will significantly affect the growth of their business. Growing the nation’s workforce, particularly by including underserved populations, has a direct bearing on the growth of almost every business.  

Social impacts can also be more or less “material” for different stakeholders: employees, customers, suppliers, or community members. More analysis of social impact materiality will emerge as this data becomes readily available to the investment analyst community. 

The Future of S

The markets have become transfixed with ESG, and the demand for more and better ESG data will only grow in the years ahead. The success of E data has laid the groundwork for a thriving carbon market—especially the voluntary carbon market. It has also proven that intangible commodities can be standardized, priced and traded. This can and will lead to greater impact on the environment than mere advocacy or philanthropic efforts. Indeed, more money is traded through markets every day than is spent by all world governments every year. To function efficiently, markets must rely on simple, consistent, reliable data. But that data has to signal something. Statistics devoid of meaning have no influence. It’s time that the markets value S as much as E and G. The only thing that stands in the way is better data.

There are three practical steps that ESG investors, rating agencies, and companies can do to elevate the importance of S to the markets:

First, and most importantly, companies should start reporting S impact data consistently. Standards have to start from the ground-up. There’s no need to wait for rating agencies to catch up or standard-setters to adapt. Irrespective of these players, companies have their own independent fiduciary duty to measure and disclose material S information to their shareholders. Companies should start voluntarily measuring and report their S impacts and get independently verified. This data can then be included in a company’s own sustainability reports and 10-Ks. It can also be reported proactively to rating agencies like MSCI, DJSI, Sustainalytics, Moody’s, and others. The corporate sector will have a lot more influence over what standards are set if they start producing the underlying data now instead of waiting for the world to agree on it. 

Second, ESG investors should start asking for S impact data and making it a requirement. Impact investors like Forthlane Partners in Toronto, Baillie Gifford in Edinburgh, and Planet First Partners in London are already asking for this data. But the process is still manual, the data being requested is inconsistent, and the S analysis isn’t as directly linked to corporate performance as it could be. By banding together around a standard for S, data will flow more readily and with less burden on portfolio companies. Over time, with leadership, other investors will join and ask for the same standard S data. The funds that start using this data early will gain a significant edge over competitors. And they will also likely attract new capital faster than run-of-the-mill ESG funds that struggle to answer the fundamental question of so many investors these days: “What impact is my money having?”

Finally, ESG rating agencies, standard-setting bodies, and data providers should align with a specialized S data provider to up-level the value of their data. S impact data is complex; it cannot be simply captured in a one-dimensional box-ticking survey. Reliable, high-quality S data requires specialized taxonomies, questionnaires, and independent verification. This will also create a whole new level of ESG S analysis—that shared value advocates and academic researchers have long argued for. Using this S impact data, rating agencies and others can now begin to evaluate a company’s competitive advantage, growth potential, employee resilience, access to new markets, enhanced value chain productivity, and improved operating environment.

As of today, approximately one-fifth (21 percent) of the world’s 2,000 largest public companies have committed to meet net zero targets. Reducing carbon emissions and mitigating the risks of climate change for investors is a major accomplishment. But to achieve true sustainability, we must also improve the quality of life for the people who live on this planet. We can’t manage what we can’t measure. It’s time we raise the bar on social impact measurement, create better S data and give the market something to price into their models. It’s time to go from net zero to net impact.

Read more stories by Jason Saul.