Social Risks, Modern Slavery, And ESG Investing
The ESG Alphabet Soup Series #3. A look at the "S" in ESG and how to identify social factor risks and opportunities.
Hi there,
I hope you’re enjoying this ESG Alphabet Soup series. Today I’m going to write about the social factors of ESG investing. Yesterday, I wrote about environmental factors. As we build up this framework over the coming weeks, a differentiated view on where ESG investing can add value and reduce risk is the goal.
Regards, Brennan
Reading time: 10 minutes.
Defining ESG Investing
I’ll briefly revisit my preferred definition for ESG investing:
“ESG investing is the research and investment strategy framework that evaluates environmental, social, and governance factors as non-financial dimensions of a security’s valuation, performance, and risk profile.” Sherwood & Pollard (2019)
As we’re building up this approach to ESG investing, we know we have to explore each of the three pillars of the framework – the environmental, social, and governance dimensions. We can assess how a company performs on any of the three ESG pillars using this approach:
Identify the risks
Assess what the company is doing to manage them
Identify opportunities for value creation
What are the social risk factors?
The most exhaustive list of ESG factors I’ve seen so far is in an article in Sustainability called “Rating the Raters: Evaluating how ESG Rating Agencies Integrate Sustainability Principles”. Their exhaustive list of social risks and opportunities measured by ESG rating agencies and how they’ve increased between 2008 and 2018 looks like this:
There are a lot of social factors that go into understanding this dimension of a company’s performance, valuation and risk profile. The first step in understanding ESG risk factors is first understanding the business model of the company and how it has implemented an operating model to deliver value to customers. Understanding what the value to the customer is and how it is created will improve outcomes.
There are many sub-dimensions of each area of interest. For example, the relationship between a company and its employees is critical. A manufacturing company with a heavily unionised workforce has an additional dimension of ensuring good relations exist between management, workers and the unions. A technology company with a workforce on individual contracts still has to have good relationships with its employees.
Modern Slavery Example
A good example of one of these dimensions is modern slavery. The proper treatment of workers and eradication of exploitation throughout a firm’s value chain is now a legal requirement in Australia with the Modern Slavery Act.
Any Australian company with more than A$100 million in revenue has to put together a modern slavery risk management and reporting framework. They have to produce their modern slavery statement within six months of the end of their financial year, which will be posted by Border Force on an online register. The report has to include:
the identity of the reporting entity;
the structure, operations and supply chains of the reporting entity;
the risks of modern slavery practices in the operations and supply chains of the reporting entity, and any entities that the reporting entity owns or controls;
the actions taken by the reporting entity and any entity that the reporting entity owns or controls, to assess and address those risks;
how the reporting entity assesses the effectiveness of such actions;
the process of consultation with any entities the reporting entity owns or controls or is issuing a joint modern slavery statement with; and
any other information that the reporting entity, or the entity giving the statement, considers relevant.
For some businesses in New South Wales, there will also be a state reporting requirement. However, this is still not finalised and highlights the complexity of dealing with these additional regulatory reporting obligations at state, federal and even global levels for some new requirements.
Based on this example alone, you can probably figure out why social risks are potentially more complex than environmental risks to investigate and analyse. A lot of the risk identification has to go up and down the company’s value chain and then any remediation has to happen or changes made to the operating model because the reputational risk of having modern slavery in your value chain would be devastating.
The MSCI ESG Ratings Methodology has its social themes centred on human capital, product liability, stakeholder opposition and social opportunities. When compared with the previous diagram, it becomes clear that each different agencies ESG rating could be an input to your ESG investing process, but they won’t all cover every issue. For example, MSCI uses the “supply chain labour standards” theme where any modern slavery issues would be incorporated into the rating.
There will be individual mandates from investors or internal policies that reflect your investing philosophy. Only so much intellectual property development can be outsourced to a 3rd party if you want to stand behind the end-to-end integrity of your investment process and market your funds with ESG labels.
Because the business model of a company is a key part of this ESG investing framework I’m building up, the value streams delivered to customers inside of it are where we can identify social risks and opportunities. Understanding what works well and doesn’t work well for customers, suppliers, employees, regulators, and other stakeholders will assist in identifying social risks and opportunities faced by a company you’re researching.
If you don’t understand the business model of the company, it’s difficult to take an ESG rating and just take it on faith that there has been complete identification of the relevant social risks and opportunities.
For example, forward-looking assessments of the political and regulatory landscape are a key component of risk management. There are also community expectations around appropriate behaviour when it comes to political lobbying or regulatory agency engagement.
Policies of no political donations or limiting participation in industry lobby groups are a common positive social risk factor linked to companies that perform well on these measures.
How are the risks being managed?
Most publicly listed companies will disclose their self-identified social risks in their annual report or a separate sustainability report. A good example of the more detailed single issue disclosure in this space is Commonwealth Bank of Australia’s most recent modern slavery and human trafficking policy statement.
The report includes a section about how they incorporate ESG risks into their lending assessments. Any director or executive in Australia should be aware that access to credit will be increasingly dependent on strong management of any ESG risks in their business.
“Assessing potential transactions for Environmental, Social and Governance (ESG) risks is a key step in our due diligence process. All Institutional Bank loans, as well as larger loans in other business units, are evaluated through the Bank’s compulsory ESG risk assessment process which completes an initial assessment based on country of operations and more than 500 industry sectors. Our ESG assessment criteria includes labour conditions and human rights, and we review our industry sector risk ratings every year. Additional due diligence is required for transactions with a medium or high ESG risk profile. All project finance loans follow the Equator Principles’ comprehensive environmental and social risk management process.”
They also provide some insight into how seriously firms need to take uplifting their capability in this area. In the gloom of the COVID-19 recession, there should still be much consulting work available to uplift further the ability of corporate Australia in ESG reporting and governance.
“In preparation for compliance with new Australian modern slavery legislation, we have commenced a program of work to start embedding the legislated requirements into the Supplier Lifecycle Framework, incorporating policy, procedure, people, process and technology considerations. Over the year we sought human rights expertise to assist with the mapping of current state against the new legislative requirements, and to provide advice on opportunities for improvement for the 2020 financial year. In addition to this, our Responsible Procurement team oversaw a pilot questionnaire which was sent out to 30 suppliers to gauge levels of awareness around new modern slavery legislation. We found that awareness amongst smaller companies was lower compared to larger ones, and differed across industries, indicating that different types and levels of communication, support and engagement may be needed for our suppliers.”
CBA also discloses a lot of other social risk and opportunity information on their website and in their FY19 annual report including their Reconciliation Action Plan, their Smart Start program for schools, and extension disclosure of risks and metrics in their annual report around matters like diversity & inclusion.
Their most recent ASX trading update includes some commentary on the support of customers and people during the COVID-19 pandemic. They also include extensive metrics documenting this support, which is basically the new minimum level of disclosure expected from banks on these matters.
Of course, these are just the company disclosures. Assessing how well they are delivering on them has to be done against your own policies and objectives. For example, your assessment of the social risks CBA faces may have been influenced by the Royal Commission report.
Where are the value creation opportunities?
The recent COVID-19 pandemic has been a great example of managing social risks and opportunities in a crisis. Companies with strong direction and capability have done what they can to:
protect worker health & safety
protect customers health & safety
treat suppliers fairly
adhere to their compliance and regulatory obligations
focused on implementing their business continuity plans
In a sense, COVID-19 has been a litmus test for what companies claimed at the World Economic Forum in January or by signing the Business Roundtable commitment and what they believe about how they should treat stakeholders. Claiming subsidies and furloughing employees in industries less affected by the lockdowns around the world is certainly a negative indicator for management capability.
Lots of companies will tie their social opportunities to how they can adjust their operations to support one of the United Nations Sustainable Development Goals. For example, treating employees and contractors well can support the achievement of Goal 8 “Decent Work and Economic Growth for all”.
The value creation in this area is partly driven by the higher level of resilience of business to negative economic shocks when there are strong stakeholder relationships and high levels of regulatory compliance.
This is the concept of ESG factors being a quality screen for boards and managers. If they score highly on managing the risks and opportunities of these factors, they’re more likely to run a robust and profitable firm that delivers value to society.
The treatment of workers and contractors is also an opportunity for value creation. If employee and contractor satisfaction is high, turnover is lower, and the value delivered to customers will be more consistent and dependable. This will drop down to productivity in the workplace and profitability.
There are obvious cost avoidance benefits from fines you didn’t have to pay and reputation risk protection from implying obeying the law and meeting your regulatory and compliance obligations in full. It’s amazing to have to write that, but as many corporate scandals in the recent past, doing the right thing can sometimes be too hard for some boards and executives.
Having the strength of character to resist short-term earnings estimate pressure to build profitable and responsible businesses that deliver higher value to shareholders in the long-run should be the bare minimum level of ambition for our corporate leaders. The increasingly common expectation of the public is that companies act appropriately and asset managers invest their money in line with ethical principles and ESG factor awareness.
In our ESG investing framework we’re building up, there’s no need to temper your sense of justice when it comes to identifying ESG risks and opportunities. If you are a company director or executive thinking about how to get ahead of questions from stakeholders on these issues, the more disclosure and reporting produced that reflects changes made to your operating model the better.
In fact, ESG due diligence and shareholder advisory is a specialist area of support that more companies should be considering if they haven’t already to sense check their internal identification of the ESG risks they face and the actions they’ve taken to implement best practice.
What Will We Learn Next?
Thanks for reading. On Sunday, you’ll receive my weekly roundup as usual. The next topic in this series is the “G” in ESG – the governance factors, which will hit your inbox next Tuesday. If you have any feedback or comments you can let me know by replying to this email.
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The ESG Alphabet Soup Series
Is ESG Investing Just Marketing Spin? [definitions]
Is ESG Investing Just About Climate Change? [environmental factors]
Social Risks, Modern Slavery, And ESG Investing [social factors]