The S in ESG – the social factor

11 July 2022

Alasdair Wilson, investments techspert at The Verve Group, considers the S in ESG – the social factor – and finds investing is not as simple as it might seem

Much like the wider financial press and fund house literature, something I’ve perhaps been a little guilty of in the past is focusing too much on the environmental aspects of ESG-integrated investing. However, understanding the social and governance factors and how they fit in with fund house and portfolio manager scoring systems will help explain to clients why certain companies (heavy polluters, fossil fuel extractors) are present in their ESG investment portfolio.

Before we get into those, I feel it’s always important to stress that when ESG strategies are referred to as ‘sustainable’ it has nothing to do with being green. ESG strategies are sustainable in terms of their long-term growth and returns, and are often limited in their ethical stance on the majority of common issues.

Firstly, we’ll have a look at the social factors that influence a fund manager’s ESG score of a company, and the impact they could have on the business that might disrupt the sustainability of their returns. A company’s adherence to human rights, child labour and modern slavery laws will be fairly well enforced regarding their operations in developed nations. However, they may still fall foul where they outsource any aspect of their operations to emerging markets where such labour laws either don’t exist, or aren’t strictly enforced.

The responsibility for this falls on the outsourcing company to ensure the workforce is not being exploited. Fund managers will carry out their own due diligence on the company in order to assess whether any areas in the supply and manufacture of goods and services could fall foul of these social aspects and present a risk to the earnings or profitability of the company. Risks could include a press exposé and a subsequent public backlash or boycott; or the governments where the exploitation is taking place firming up laws and making it costlier (and therefore less profitable) for companies to operate.

Well publicised examples in recent history include children being employed to mine the mineral Mica for the cosmetics industry. Their physically smaller stature makes them more favourable to send down into the cramped mines, as well as the reduced wages their employers pay. Similarly, child labour is commonplace in clothing manufacturing, with many popular western brands outsourcing to Vietnam and Bangladesh.

Where lies the responsibility?

Factory conditions in emerging markets are also less than ideal by western standards, and outsourcing companies are obviously aware of this. However, the labour is cheap and the output is high meaning the bank balance is strong. Again, another well publicised example is that of Foxconn in China where there are widespread reports of poor working conditions to the extent that the company has installed suicide nets. More recently, it has also been said that they have forced workers to remain on-site away from their families and friends during the strict Covid lockdowns in order to limit disruption to product supply chains.

Are companies like Apple, Google, Microsoft and Asus aware of these issues? Yes, of course they are. Are they going to step in or stop using outsourced manufacturers like Foxconn as a result of these issues? No, of course not. Are the same issues going to result in those tech companies being excluded from all ESG integrated funds because of this? Also no! Because these problems could be deemed Foxconn’s problem rather than the tech companies themselves.

Governance factors focus on the strength of a company’s senior leadership, and how that is reflected in the company culture. They can be very wide ranging, and we’ll start with bribery and corruption. This is where members of senior leadership take cash in order to serve the interest of the donating party paying the bribe. A hypothetical example could be a big multi-national oil company paying the senior executives of a car company not to produce electric cars.

Executive pay level is another factor often assessed by an ESG fund manager – very large pay and bonus packages for the senior leadership teams could reflect very badly on a company, particularly if they are found to underpay and / or overwork their lower paid staff members.

Political lobbying and donations can also have an adverse effect on companies. Where a company donating significant amounts of money to politicians to further their agenda, be it fossil fuel extractors lobbying to vote down climate change legislation, internet service providers lobbying to overturn net neutrality protections, housing companies lobbying to lift red tape around developing green spaces, even companies across many areas lobbying to vote down legislation around the controlling of political donations, might pay dividends (pun absolutely intended) in the short term; a change of government that is less sympathetic could wipe out this advantage very quickly.

Lastly, a company’s tax strategy could also be a major consideration. Many multinationals have both a main headquarters along with regional headquarters that are often situated in countries with very low or no corporation tax in order to keep as much of their revenue as possible; there’s a reason why so many of them have European headquarters in Luxembourg, Switzerland and Ireland! While these strategies may work well for a time, there is nothing stopping governments and trade blocs closing tax loopholes or raising rates at relatively short notice (particularly in a pinch), ultimately impacting upon company profits.

Not quite as simple as it might seem

As you can see, ESG integration is not quite as simple as allocating a significant portion of the collective investment to solar panel and windfarm companies. There are many other factors that will weigh into the assessment of whether they are deemed worthy of an ESG integrated fund. This is also why it is difficult to come up with a standardised process across fund houses as many factors, particularly in the social and governance aspects, are very difficult to quantify. This is unlike the environmental side where there is a relative abundance of data made available, particularly on waste and carbon dioxide emissions. The amount and level of detail in ESG data is also at the discretion of the companies – they don’t have to disclose any of it to third parties if they don’t want to, and could also manipulate the figures to paint themselves in a better light to third parties.

This explains why companies like BP, Unilever and the like, who have very poor environmental track records, can still appear in the holdings of ESG funds. Yes, they may score very poorly on the environment, but there is a lot to be said for a well-paid workforce and strong leadership when it comes to the long-term sustainability of growth and profit which is what ESG funds are actually all about.

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