Is social the most important part of ESG investing?

Key points:

• Integrating social factors can potentially build more sustainable long-term investment portfolios
• Companies that treat their employees well and minimise the social costs of their operations should benefit while also contributing to improvements in social welfare more generally
• Active, responsible investment is the key to understanding how social factors can contribute to superior long-term sustainable returns.

Economics is a social science. It is the study of how people collectively manage scarce resources to generate goods and services that satisfy basic and other needs – and businesses are key building blocks of the economic and social ecosystem.

Businesses themselves are social constructs – they have their own organisations, they interact with others through buying and selling, and they contribute to the general functioning and welfare of society. Just as it is important for investors to think about the interaction of human economic behaviour with the environment, it is equally important to think about how production and consumption impact on the social good. Having a ‘social’ prism in investment analysis is good investing. Right now, as real incomes are being challenged by high inflation, it is more important than ever to understand the social footprint of the companies in which we invest.

Long-term investment returns in equity markets are driven by corporate revenue growth and profitability. In credit, they are determined by the strength of cashflow and health of issuer balance sheets. Behind all of these are the dynamics of costs and revenues. Integrating the consideration of social factors into understanding the cost and revenue curves of a business, as well as its broader operations and strategy, can give investors additional insights and, therefore, potentially help build more sustainable long-term investment portfolios.

There are three dimensions to this: Understanding the risks and efficiencies that can be identified on the cost curve; assessing the potential for boosting revenue growth through the social attractiveness of goods and services; and looking at the non-financial contributions to the greater social good. All economic activity is a result of human behaviour, which then impacts human welfare, so the ‘S’ of ESG – environmental, social and governance – is arguably the most important dimension. After all, we care about climate change because of its short and long-term impact on us and our ability to maintain a cohesive, healthy, and economically viable society.

Understanding material risks

Judging whether any business is a viable investment requires an understanding of the cost structure and the material risks facing that business. Using an ESG framework allows investors to identify material non-financial costs and risks that are associated with a company’s operations. The question then is whether those costs become internalised and have a significant impact on the bottom line. We are already seeing the cost of carbon emissions being internalised – methodologies and getting more robust - and the policy framework provides a solid structure for putting a dollar cost on these risks. In the social sphere it is more difficult, and a challenge for responsible investors is to develop a more robust approach to identifying social risks and their potential financial cost.

How a company manages its workforce – a key asset in any business – is perhaps the starting point. Areas like compensation policies, provision of benefits, terms and conditions and workforce development can tell us much about the quality of management but also where there may be risks. A firm that pays minimum wage, uses ‘zero-hour’ contracts, and offers only minimum benefits like mandatory sick pay is likely to have a less productive workforce than a competitor that values its human capital more. The cost implications could be high levels of turnover, bouts of industrial action, or litigation in areas of employee relations.

Today, inflation is high and real wage growth is negative. Companies face higher costs of production and so need to raise selling prices. How this is managed, the impact on employees through wage settlements and the impact on customers though pricing, is important. Management that understands the social implications of decisions taken in such an environment could ultimately be rewarded by customer and investor preference alike.

Health and safety should be a focus too. This is clear in manufacturing where there can be physical risks to workers. But in all businesses, providing support for the physical and mental health of employees can not only boost productivity but reduces risks of litigation.

Beyond the immediate workforce, it is also important to understand if there are human capital risks in the supply chain. The clothing industry has historically been plagued, for example, by concerns about child labour in textile suppliers in developing countries.

There is increased focus on diversity as a means of bringing greater value to a company at the employee and management levels. Ideas drawn from people of different backgrounds and with contrasting experiences can drive growth and help innovation. Investors need to look at how diverse a company is, how it encourages innovation and idea development, and how its human resource strategy allows identification of forces that work against inclusion and openness.

There are metrics that can be used to judge the quality of human capital management, but engaging with companies on culture is important as well. Management teams that engage with their employees on a regular basis, that foster diversity at all levels, and encourage development, should run fewer risks than one where there is less attention paid to these aspects, and could see benefits in terms of talent attraction and retention.

Assessing the social footprint

It’s not just how companies manage their people that is important from a social perspective, but also how their products and operations impact society. Investors should also pay attention to topics such as product liability, potential health risks, data privacy and financial responsibility. These are broad issues and argue for an active approach to responsible investing. Only then can investors assess the material impact of the risks to the business from the social impact of its operations.

We have already seen how tobacco companies have commonly become excluded from responsible investing universes because of the cataclysmic impact their products have on people’s health. That is an extreme example, but marginal improvements in investment performance can rest on understanding at all levels the risks associated with a product and the potential negative externalities. Food safety, (social) media content, building standards, general pricing policies and customer service quality are some of the many ways that products, services and company operations can impact on broader social wellbeing. Government and regulators have roles to play, but investors to need to understand the social footprint of the business they invest in.

Ultimately, we want to invest in companies that grow and reward investors over time. Companies that have well-managed organisations that focus on getting the best out of their employees should fall into this category. Understanding the risks is important, but so too is understanding the culture that fosters sustainable growth. The post-COVID-19 era is likely to mean employees value a more flexible approach to the numbers of hours worked, location and benefits, while emphasising equal treatment.

Customers too are likely to be more discerning, especially while they navigate a cost-of-living crisis. Household budgets are the immediate and significant concern, but over time consumer tastes are also changing to reflect more awareness about social issues. How companies manage their pricing policies, especially in industries supplying basic needs – food, energy, housing – is something that investors need to consider. Long-term market share might, to some extent, rely on how companies treat their customers during times of economic stress – obviously with a need to balance this with commercial viability.

Positive change – and potential long-term returns

We want to invest in companies that produce goods and services that benefit society. Biotechnology is an example of a sector that should be seen through this social lens, as it has the potential to do profound good in terms of combating disease and prolonging productive lives. The medical sphere is clearly an area when technology and innovation are ultimately geared towards a positive social outcome. In the area of technology, the provision of data security services has a social good as a counter to those who may seek to exploit an ability to access personal information.

There is insufficient room here to list all the potential technologies and services that, if provided in a sustainable way, can contribute to positive changes in social welfare. The challenge for investors is to develop frameworks to understand social risks at companies, identify leaders that make social a key asset in the development of their businesses, and understand the long-term commercial viability of products that generate social good.

Impact investing is one approach. By using the UN Sustainable Development Goals (SDGs), asset managers can provide investment strategies that have clear social objectives, with an investment universe of companies whose activities are expected to contribute to that aim.¹ For example, focusing on the SDGs of ‘Good Health and Well-Being’ and ‘Sustainable Cities and Communities’ highlights a range of companies who products would be relevant. The data is emerging to support these clear social goals and offer an assessment of how products and services are made accessible and affordable to the communities that need them most – which is at the heart of impact investing.

As responsible investors we want to generate long-term sustainable returns without damaging the planet and its people. The best businesses will arguably be those that optimise the value of their most important asset – their people. It sounds simple but the companies that treat their employees well and minimise the social costs of their operations will, we believe, be the ones that succeed in growing by providing goods and services that contribute to improvements in social conditions that may benefit investors more broadly.

Social issues are core to investing as they concern basic activities like the provision of food, energy, and shelter, as well as focusing on access and inclusivity to education, financial services, employment, technology, and entertainment. Across the entire spectrum, active, sustainability-focused investors can support business that score well from a social perspective in all these economic dimensions. Active, responsible investment is the key to understanding how social factors can contribute to superior long-term sustainable returns.