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Putting the Social in ESG Investing

Jeremy Taylor

Head of Capital Markets Business Consulting, EPAM
Blog
  • Financial Services

Today, financial services firms face ever-increasing scrutiny from not only regulators—as it once was—but also from society at large. The rise of social media, big data, artificial intelligence and machine learning have provided greater transparency into the operations and strategies of both public- and privately-managed companies. As the movement of capital and assets migrates to millennials and Gen Z, investment aspirations will change to include not just preventing climate change but also achieving gender equality, social justice and fairer workplace environments. The corollary of this is that the information technology revolution has increased the importance of intangible assets, such as brand value, and has increased financial service firms’ reputational risk.

Throughout this series, we have discussed why ESG investing is no longer a niche activity conducted by a minority of socially-minded individuals and corporations but a business imperative for keeping pace with the competition. While there has been—quite rightly—a focus on climate change and the environment, there has been a growing awareness of the need to address social inequalities and corporations’ roles in that.

What Is the Social Responsibility of Businesses?

Social considerations refer to the prevention of inequality, investing in human capital and communities, human rights issues, and relationships with employees, suppliers and customers.

These include:

  • Customer relations and product features
  • Data protection and privacy
  • Diversity and inclusion
  • Employee engagement
  • Community relations
  • Human rights
  • Labor standards
  • Responsible marketing and research and development
  • Health and safety—of both employees and customers

The simplest way to explain what the ‘S’ in ESG means in terms of the values company should espouse and operate by can be described as how one would describe a respected individual. Is the person empathetic? Thoughtful? Do they take great care of their community? Do they show respect to their own communities? Are they trustworthy, honest, ethical, transparent and an overall decent person?

These traits when exhibited in a company—and are coupled with sound governance—create a behavioral and value proposition that every part of the stakeholder map can proudly buy into, facilitating a virtuous circle of sustainable enrichment for all.

In some ways, this is a challenge to the purpose of a business and shareholder primacy. The Nobel Prize-winning economist Milton Friedman wrote nearly 50 years ago “the social responsibility of a business is to increase its profit,” and promptly created a set of related principles in his book Capitalism and Freedom. In today’s ever more complex world, corporates need to start balancing the expectations of shareholders with those of other stakeholders and society at large. There is a growing sense that the interests of both society and investors are best served by businesses that prioritize value creation for the benefit of all their stakeholders, not just shareholders.

Since social responsibility and company ethics are becoming critical investment metrics, internal processes will need to be developed to create and define these indices that will feed into the broader data universe to support decision making. Below, we discuss how creating a strong corporate social responsibility program can benefit all of your stakeholders. 

Employees & Prospective Employees

Starting with employees, companies are in a war for talent. In order to recruit—and retain—the brightest and the best young career-starters, companies must position themselves favorably against competitors in this market.

To be competitive, companies must maintain high standards in their workforce management, diversity and inclusion and local community relations.

While implementing culture changes, processes, training, governance and compliance across every department—including procurement, HR, client relations and investment relations—at every level might appear onerous, the benefits are huge and likely to be existential.

Clients

As we’ve discussed earlier in the series, clients and investors are now much more aware and discerning in who they want to give their money to and be associated, with back-tested assessments currently being performed by ratings agencies on whether poor ratings on the social and governance indices a leading indicator of future failure or lower returns are.

In Fidelity’s report “Putting Sustainability to the Test”, stocks at the top of the fund house’s ESG rating scale from January to September 2020 outperformed those with weaker ratings in every month apart from April. Sustainable investing is now regarded by many as a strategy for gaining higher returns.

Good CSR scores can also improve customers' perception of a brand in a variety of ways, including:

  • Trust in corporations has been decreasing over the last 25 years. To have a successful brand and retain customers, businesses must create trust. Having a CSR strategy can help build a good reputation earn trust and loyalty among clients.
  • Social responsibility can help customers perceive corporations as a positive force in society.
  • Consumer loyalty is based on consumers expectations. Millennials and Gen Z do not want brands and businesses to be just about making a profit but to give back to society.
  • According to a 2016 report by Aflac, investments in CSR are not typically viewed by investors as a waste of money, but rather an "indicator of a corporate culture less likely to produce expensive missteps like financial fraud." The study said 61% of investors consider CSR a sign of "ethical corporate behavior, which reduces investment risk."
The Public

Finally, no company is an island unto itself. Businesses exist within local communities and must care for each other in much the same way individual neighbors are expected to.

The recent coronavirus pandemic has forced many businesses to adapt to a new operating environment. This has changed the social contract between corporations and society.

Lockdowns have forced many businesses whose workers cannot do their jobs from home to lay off staff or work with governments to underwrite workers’ salaries.

The social contract between businesses and society has also changed. The subsidization of businesses by governments using taxpayer money has placed those businesses under much closer scrutiny and requires them to respond by behaving in a more responsible way that benefits society. Those companies that have responded positively—like turning factories over to making medical supplies, for example—have earned respect and brand recognition. Those companies that have not been supportive of their workers and whose top managers refused to give up their pay have faced a furious backlash in the media and from politicians.

In general, companies do seem to be seeking to regain and retain public trust. A recent proclamation by the Business Roundtable, an organization of 200 US CEOs, stated that they would no longer focus on shareholder primacy and redefine corporate purpose to foster an economic environment that “serves all Americans.”

The “social” component in ESG previously has been the most neglected of the three. The questions of workers’ rights and companies’ broader effect on society had been under-explored. The coronavirus crisis has shifted this balance.

As engagement on these matters increases among the general public and inconsistency or bad practice is amplified globally on social media, it is imperative that companies prioritize the ‘S’ in ESG.

Again, good corporate infrastructure and data can not only help businesses become more transparent but also help top management develop more sustainable strategies that support the stakeholder capitalism model. Developing internal ‘dashboards’ that can provide information and analytics on current measures of equality, training and socially beneficial initiatives are key. Setting targets and the ability to monitor progress are also key to developing a CSR based strategy and providing decision support.

Companies must assess and adjust every aspect of their internal and external activities to avoid the labels of opportunism or hypocrisy, terms that are inconsistent with the positive human characteristics referred to above. Quite simply, every decision made by every employee needs to meet the bar set by the values’ proposition communicated in a firm’s ‘glossy’ brochures and slick websites.

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