11th May 2021

The S Factor

We are all aware of the recent DWP call for evidence, putting greater emphasis on the social element of ESG in trustee policies and practices.

Environmental factors are widely understood, and whilst there is not yet one consistent methodology for disclosure and measurement, there is movement towards this. Likewise, as a result of a number of high-profile corporate failures going back to the early 90s, there is a good understanding of governance factors, and we see increasing instances of asset owners engaging in active stewardship with investee companies in respect of governance issues.

So why do the social factors so often appear as an afterthought? Part of the issue is that the S factors are much more multi-faceted and wide-ranging than E or G factors. It can therefore be a challenge to have a policy or approach that addresses all the S factors as they are so diverse, with different impacts and timelines. How can they be incorporated into investment decision-making? Should they all be included and is it even feasible to do this? It can often be resigned to the “too hard” box.

S factors broadly split into two broad categories, the first of which comprises social impacts that affect business valuations (and therefore investment values) directly.  Violations of human and workers’ rights, employee health and safety, and product recalls due to safety issues are more often than not nestled in the supply chain and difficult to spot. An obvious recent example of this would be the Boohoo case which was widely publicised. 

These types of S factors are fairly easy to determine and can be measured, albeit there are several ways to measure the impact on the valuation of the company. Reputational impact is more intangible and hard to measure but proxies can be used. Increasingly, investment managers are looking closely into the supply chain of organisations to identify and quantify these S factors and include them in models for analysis and decision making.

The second category has a completely different set of characteristics. These are long-term social changes that have a structural and fundamental impact on societies, governments and economies.  They do impact on value but in a less direct way than the first category. They are often referred to as “social megatrends” and include globalisation, automation and AI in manufacturing and service sectors, inequality and wealth creation, changing demographics, health and longevity, urbanisation, changes to work, leisure time and education, digital disruption and social media etc.

With COVID, we are in a fairly unique situation where we have seen several of these megatrends coming together, almost overnight, to fundamentally change many aspects of the economy and our lives from where and how we choose to live and work, how we shop, and how we interact with each other. Not only that, but unusually, this has simultaneously impacted right across the globe.

Consider how things have changed in just 12-15 months where working from home is now the norm for many of us, causing us to re-evaluate our homes, seeking additional rooms or outdoor space. There’s no longer an imperative to live in an expensive city purely because that’s where the corporate office is. In fact, some organisations have chosen to instigate working from home as a permanent measure with potential knock-on impact for the values of commercial property. And Zoom and MS Teams are now part of the fabric of our social and working lives.

COVID is of course an extreme example. Pre-COVID, any attempt to model such an extreme scenario in portfolio stress testing would have appeared completely unrealistic and would probably have been dismissed as a complete outlier as never likely to happen. However, there is now wider appreciation of the importance of scenario analysis and stress testing of the potential impacts of these social trends in understanding the risk (and opportunities) to the portfolio. 

There is an additional challenge from these social trends insofar as they can have a high level of correlation (positive and negative).  For example, increased automation, AI and digital disruption can lead to the loss of lower-paid jobs, and therefore may contribute to an increase in inequality and wealth creation. 

Because of the positive correlation between the three factors of E, S and G, focusing on one or even two is not going to give a holistic view of the potential risk or opportunities for the portfolio.  They are inextricably linked, so it is important from a Trustee perspective to ensure that the Investment Manager has an integrated ESG approach, and is placing enough emphasis on both categories of S characteristics discussed herein.

Next time, we’ll tackle the ‘too hard’ challenge – what are the practical considerations when implementing a comprehensive ESG strategy?  Following that, we’ll zoom out to the big picture and examine ESG policies and practices in the context of trustee stewardship.