The rise of ‘S’ in ESG investing
After years of relative obscurity, the investment value of measuring a company's response to social issues is increasingly being recognised.
“There is a tendency in science to measure what is measurable and to decide that what you cannot measure must be uninteresting.” With a career encompassing engineering, design and cognitive science, perhaps it’s not surprising that this insight from US academic Don Norman points towards a human trait evident across many disciplines.
In the environmental, social and governance (ESG) investment world, this idea could help explain the dominance of the ‘E’ part of the equation. Today, metrics measuring companies’ environmental credentials are widely followed and clearly have the scope to influence capital flows.
By contrast, the ‘S’ is only now gaining prominence on investors’ radars after many years of being perceived as the poor relation. In part, this may be because some important topics within it – such as employee health and well-being, talent retention, career development, and income prosperity – can be difficult to measure, both in terms of how companies are doing and the financial materiality of their success or failure in these areas.
How can we measure success?
However, we believe this complexity should not stand in the way of progress. From an investment standpoint, a company’s workforce should be seen as the key enabler of a successful growth strategy. Improving culture and employee wellbeing often goes hand-in-hand with enhanced productivity levels and operational efficiency, which can help with pricing negotiations and upselling as part of customer interactions, and as a result drive margin expansion.
The point should also be made that social capital considerations cover multiple areas, including human rights risks (e.g. child labour, modern slavery), health (employee, but also public health) and topics such as income inequality.
Further, given our belief that a company’s track record on social goals has a real bearing on its competitiveness, we put energy into assessing this as part of our regular analysis of companies. To assess these aspects of ESG in an efficient, consistent manner, our framework that captures human and social capital themes is sector-agnostic, but allows us to acknowledge nuances and challenges at an industry level.
From a regulatory standards perspective, there is growing optimism that negotiations around a proposed EU social taxonomy, which will rely heavily on values and existing internationally agreed norms and principles, can act as a framework which unites governments, policymakers, corporates and investors. Importantly, it proposes three social objectives designed to have a direct, positive impact on three main stakeholder groups: employees, customers and communities.
For now, given uncertainties over timeframes for a social taxonomy, there are two types of assessment that we believe can help investors identify companies when it comes to overall ‘S’ credentials, which could potentially translate into increased likelihood of commercial success:
- Evaluating business models that directly facilitate key areas of social progress and mobility. Examples include products and services that address areas such as financial inclusion, affordability, nutrition, personal wellness and digital learning.
- Using a bottom-up lens to understand a company’s organisational culture, people investment and ways of working. Creating a culture that allows people to thrive can bring about a virtuous circle, allowing for better productivity and more innovation, helping to create positive societal change.
Where we are, where we want to go
There’s no denying that investors have in general been slow to identify value through a social lens, although LGIM has an established focus on a variety of social issues, from gender and ethnic diversity to the importance of employee welfare topics such as income inequality, living wage and human capital management.1 Arguably, however, the challenge now lies with corporates to improve investors’ appreciation of their strength in these areas. This is in part due to a lack of coalescence around what S factors are important, and a need for companies to provide meaningful data on S issues that they believe are important to their business.
Encouragingly, we are increasingly seeing greater transparency around organisational culture, labour policies, safety standards, diversity and broader working practices around human capital management. This suggests that corporates are cognisant of the financial materiality of these topics, and that they will be motivated to drive progress.
Today’s big social challenges are unlikely to be solved solely by the redirection of capital flows. But we should recognise that as investors, having a seat at the table enables us to be part of the conversation, and to challenge corporates, to influence improvement.
In part two of this blog, we’ll examine how various sectors are responding to the growing consciousness around ‘S’ issues, and the possible investment opportunities we’re seeing.
1. For examples of LGIM’s work in these areas, please see our ethnic diversity campaign update (https://www.lgimblog.com/categories/esg-and-long-term-themes/ethnic-diversity-on-boards-results-and-reflections-on-our-campaign-so-far/), and more information about our gender diversity campaign (Active Ownership report 2019 - LGIM). For examples of LGIM’s work with the Human Capital Management Coalition in the US, please see LGIM Active Ownership Report 2021 page 53.