Explainer-What Is The 'S' In ESG Investing?

The "S" in environmental, social and governance (ESG) investing moved into the spotlight during the COVID-19 pandemic as companies faced concerns about employee wellbeing and bold calls for action on social inequality.

Yet more than half of global institutional investors surveyed by French bank BNP Paribas https://securities.cib.bnpparibas/esg-global-survey-2021 last year said social issues were the most difficult to assess and integrate into their investment analysis.

Here is what you need to know about it.

WHAT DOES THE 'S' MEAN?

The social component of ESG covers all the ways companies interact with their employees and the communities in which they operate.

Issues affecting staff could include the company's health and safety track record, its policy on diversity, equity and inclusion (DEI), and its labor relations between management and workers.

External issues that fall under the broad umbrella term could include the company's relationship with local community leaders, whether its suppliers use forced or child labor, and product safety.

HOW IS IT MEASURED?

As with most ESG metrics, investors and independent ratings providers typically assess social factors based on the financial risks and opportunities they pose to a company.

Some risks are evaluated with qualitative questions, for example whether and to what degree a company tracks human rights abuses in its supply chain. Others, such as the gap in compensation between male and female employees or the percentage of racially diverse workers, are measured quantitatively.

Of course, social risks and their potential financial impact vary from industry to industry. For example, investors may give more weight to workplace safety standards at an oil drilling company than at a software firm, while customer data protection may pose a higher risk for the software business than the oil driller.

Investors often obtain this information directly from companies, but they can supplement it with data from other sources such as government and nonprofit databases, news reports and social media.

HOW DO INVESTORS APPLY IT?

The most common process is known as "ESG integration," where fund managers assess environmental, social and governance risks alongside traditional financial issues such as sales and cost projections as a way to improve returns and manage risk.

Other investors take a more active role by explicitly excluding stocks whose social characteristics do not align with their values, for example companies connected to weapons manufacturing, pornography or tobacco.

So-called impact investors go even further, seeking investments that have a measurable social benefit, for example by tracking the number of jobs a company creates at or above the living wage, or evaluating investments in education by hours of training per employee.

Investors also engage directly with companies on social issues, both to elicit information and push for change. When engagement fails, shareholders of companies can propose and vote on resolutions pushing management to undertake human rights risk assessments or disclose internal pay disparities, for example.

ARE THERE ISSUES WITH THE 'S'?

While regulators have required companies to disclose more data on social factors in recent years, investors must still rely on management to provide much of the information, making it difficult to verify claims or compare one company with another.

This is further complicated by ratings agencies' use of different methodologies, metrics and weighting schemes to assess social risks. Scores can vary widely from one firm to another as a result.

Some in the industry have also raised concerns about which social risks are measured. Investors typically focus on "material" risks, or those that have the potential to impact a company's financial performance. In Europe, regulators have increasingly pushed for disclosures about a company's impact on society, as well.