The Rise of ‘S’ in ESG in Reducing Corporate Risk
/It’s a good time for ESG – investors, governments, and companies are making commitments to sustainability. In Larry Fink’s 2021 Letter to CEOs, he stated “I believe that the pandemic has presented such an existential crisis – such a stark reminder of our fragility – that it has driven us to confront the global threat of climate change more forcefully and to consider how, like the pandemic, it will alter our lives. It has reminded us how the biggest crises, whether medical or environmental, demand a global and ambitious response… Because better sustainability disclosures are in companies’ as well as investors’ own interest, I urge companies to move quickly to issue them”. And, even during one of the most significant disruption of markets, the S&P 500 ESG Index is outperforming the S&P 500 by 2.47% as of April 6, 2021.
ESG – A Risk Management Framework
ESG (Environmental, Social and Governance) measures the sustainability and societal impact of an investment in a company or business. It provides a framework for considering ‘E’, ‘S’ and ‘G’ issues facing a company and to score them either individually or collectively to identify where they sit relative to each other. It is generally seen as a risk management framework for evaluating companies by identifying non-financial risks across environmental, social, and governance pillars:
Environmental Responsibility:
includes climate change, water management, energy use, waste management, biodiversity, deforestation
Social Responsibility:
includes labor relations, human rights, gender and diversity, data protection and privacy, community relations, and product liability
Governance:
includes compliance, board composition, political contributions, business ethics, controls, and procedures
Significant progress around disclosing the ‘E’ can be explained by the urgency of climate change issues. There has also been much progress disclosing the ‘G’ surrounding the global financial crisis. And now, ‘S’ has emerged from the Covid-19 Pandemic in the ESG spotlight.
Why is the Social pillar in ESG so important?
The simplest reason is that ‘S’ factors make companies more resilient to risk. A recent study shared by Deutsche Bank Wealth Management demonstrates the importance of the social pillar in ESG.
The social pillar significantly reduces all three types of risk examined, i.e. systemic risk, idiosyncratic risk and total firm risk.
The social pillar is the only factor [of ESG] that reduces systemic risk.
Environmental and governance criteria have an influence only on total and idiosyncratic risks, but not on undiversifiable risk. Therefore, the social pillar seems to be the most effective in reducing corporate risk.
Furthermore, there is evidence that the social pillar’s effect on risk will be stronger during the financial crisis and potentially in the post-crisis period.
Given that factors that fall within the ‘S’ pillar are as common (and more so for some companies) as those inside the ‘E’ and ‘G’ pillars in contributing to business risk and ultimately causing lasting damage to a company’s reputation, why has ‘S’ reporting lagged behind ‘E’ and ‘G’?
What are the challenges in evaluating Social factors?
Social indicators are harder to establish and integrate into investment strategies for several reasons, including:
social issues are harder to analyze and measure;
social issues cover a range of topics; and
social issues are evaluated differently in different countries.
This results in a general lack of consistent standards for evaluating ‘S’, where companies have not adopted uniform reporting on social issues.
‘S’ will no doubt attract more attention from investors and more scrutiny from regulators, governments, customers, and employees, and it has never been more relevant for a company’s productivity and long-term success. As Jenn-Hui Tan, Global Head of Stewardship and Sustainable Investing, Fidelity International pointed out, investors recognize that “companies that were well managed and looked after their employees and supply chains were more robust and able to survive through a pandemic”.
Likewise, companies with ‘S’ failings can have lasting damage. As discussed in the article “Time to Rethink the S in ESG” posted on the Harvard Law School Forum on Corporate Governance, ‘S failings’ are an “indication that even in ‘normal’ circumstances, the ‘S’ requires more focus than it has received up to now. In the current environment, and in a post COVID-19 world, risks associated with the ‘S’ have been magnified”.
How to incorporate Social Responsibility into company goals:
Proactively incorporating ‘S’ into company goals will require reorienting strategy and capital allocation to properly identify and value ‘S’ issues. Companies are often over-indexed on efficiency making it difficult to invest in intangible attributes that will position them to grow and survive disruption (i.e. pandemic or competition). This is a qualification challenge where then ROI needs to measure intangibles. A company’s reporting needs to be robust and draw a direct line between activities and the organization’s strategy to create value. Like its counterparts in ‘E’ and ‘G’, ‘S’ reporting must capture the value creation, and the more specific it is, the better.
There are several reporting methodologies, including the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB). While complementary, GRI and SASB, cover ‘S’ issues differently. Companies often report both GRI and SASB standards to meet the needs of their audiences.
If you are interested in learning how to identify and value, or use the various reporting Standards and Frameworks, to publish your company’s sustainability report, working with an experienced Sustainability consulting firm or engaging in Sustainability Reporting training is the best way to start.
KERAMIDA provides Sustainability Reporting consulting to organizations throughout the U.S. as well as one-on-one disclosure review sessions. For more information about our Sustainability and ESG Consulting Services, please contact us or call us today at (800) 508-8034.
Blog Author
Becky Twohey, Ph.D.
Senior Sustainability Analyst
KERAMIDA Inc.
Contact Becky at btwohey@keramida.com.
