ESG – what about the “S”?

By Jim Rusagara

In a recent letter to other CEOs, Larry Fink (CEO of world’s largest asset manager) urged fellow leaders to join him on the Environment, Social and Governance [ESG] investment train as he stressed the need for companies to serve a propose and contribute to society or fall short of their full potential[1]. The “positive contribution to society” Mr. Fink refers to has recently been co-opted and conflated with issues of climate change and more micro-environmental challenges, often mixing terms, expressions and acronyms like “ESG”, “sustainable finance”, “impact investing”, “SRI” and “green bonds” (to name just a few). But at its heart is financing issues that might be seen as more social good than concrete returns. However, this article less on the headline issues of the environment (the “E”) and the governance (the “G”) factors, but looks at the social (the “S”) factor; perhaps the most important aspect of all following the 2008 crises and the growing displacement of peoples due to changes in the workforce and its subsequent implications.

Reasons as to why the “S” tends to be forgotten are multiple but some are more compelling than others. One could argue that the “G” was more relevant in the aftermath of the financial crisis and solved by new compliance rules and that the “E” is of immediate impact to our daily lives (think global warming and COP21 targets). The “S” was and is still cannibalized by concepts such as corporate social responsibility [CSR] and by the more recent social responsible investment (SRI) momentum. Furthermore, it could also be argued that the social has historically been a responsibility of the state or tackled by non-profit organisations.

But we believe the more potent reason behind a lack of momentum for the “S” is the inherent difficulty of measuring social impact and of its consequential complicated translation into investment returns. One organization’s assessment of what is a social “net positive” might not necessarily be the same for another organisation. Can we quantify an organisation’s culture? Or provide a score and an associated return on investing in better programmes on gender pay equality, as an example? Is compliance to an equal opportunity corporate policy measurable? Or can we create a subjective framework to assess a company’s management active investment in bettering the working conditions of its workforce? What about programmes aimed at homelessness or education? How can this be turned into something attractive for private investment when the returns are often seemingly intangible?

Institutional investors of all sorts (pension funds, university endowments, asset managers and activist hedge funds) seem to think all of the above is possible (especially in Europe)[2]. This interest is not spurred by a sudden or whimsical attraction to a “higher purpose” but simply because clients increasingly demand products with an ESG footprint to be part of their portfolio/investment strategy and because despite providing some long-term upside, protection on the downside is an important reason why professional asset allocators opt for an ESG instrument[3]. Typical ESG products/investment strategies either adopt an exclusionary approach (think of Norway’s SWF divesting from tobacco related companies or Vanguard’s SRI European Stock Funds offering to some extent the same prohibitions) or ignore the social altogether and focus on more mature products aimed at the environmental and governance.

So is there an ideal approach? Would an environment in which the market or individual institutional investors take the time to build investment-ready social metrics and frameworks be preferable? What can policy and more specifically EU policy do to ensure that the “S” comes of age and benefits from the same sustained momentum recently enjoyed by the “E”?

For private finance to spur social investment, asset managers will need to be reassured by the attractiveness of stable, long term returns. This means creating a class of investment which incentivises this investment and much of that starts with governmental policies.

As first order of business, national governments need to distance themselves from a “wait and see” approach and favour more pro-active engagement like the French government did when it enacted a legislative proposal that would make it considerably more attractive to adjust one’s investments reporting towards climate change targets[4]. The newly enacted French law was a catalyst to ESG related investment strategies in France as it fuelled a 60% increase in social responsible investments [SRI] related assets under management in the last 2 years[5]. Similar legislative initiatives could be adapted to social projects. Waiting for a comprehensive pan-European solution might simply take too long or never materialise in one’s envisaged form. It is therefore incumbent on “best-in class” member states to lead and gradually raise the bar, sending a signal to Brussels on how to adopt a supportive ESG set of policies.

A second point of order would be for ancillary legislative projects at the EU level to be promoted further. The recently adopted European Shareholders Rights Directive[6] is a great example of the EU’s regulatory commitment to the enabling of more engaged investors (much like in the French law, a disclosure focus was preferred). Other existing EU legislation like the Institutions for Occupational Retirement Provision Directive (IORPs)[7] or the Non-Financial Reporting Guidelines[8] will also be essential bases to the development of a social specific framework. The European Commission’s High Level Expert Group (HLEG) on sustainable finance recommendations (due to come out by March/April of this year) will arguably be the more comprehensive and recent contribution to the environmental and the governance. Perhaps validating our earlier point as to the relegation of the social, the HLEG is still at a very early stage in terms of its consideration of the “S”[9]. As mentioned above, a good place to start would be in exploration of private/non-profit collaboration frameworks (matching Deutsche Bank with the European Women’s lobby to work on a “women empowerment” exchange traded fund for example). Leaving both parties to contribute to the ETF with their respective expertise.

Finally, a complete change in thought process is required. The importance of yield generation is constantly being preached by market players when asked to comment the long-term viability of ESG investments with the common argumentation going along the following line: investment fundamentals first, ESG factors preferably in support of those fundamentals second and social activism if there is time. Progress on all fronts will have to be made concurrently with different metrics to assess what is deemed successful. This progress will have to come fast.

Expressed in the same term the “E”, the “S” and the “G” have unfortunately not experienced the same interest and by association not benefited from the same development.

Let us jump on the “S” carriage of the ESG train.

[1] Bloomberg View, January 17th 2018. See here.

[2] RBC GAM, Responsible Investment: the Evolution of Ownership, Executive Summary 2017. See here.

[3] Financial Times, “Why Activists are Cheerleaders for Corporate Social Responsibility”, December 26th 2017. See here.

[4] Frenchsif, Article 173-VI: Understanding the French regulation on investor climate reporting, October 2016. See here.

[5] Eurosif, European SRI Study 2016, Country Reports, p.70. See here.

[6] Directive (EU) 2017/828 of the European Parliament and of the Council of 17 May 2017 amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement (Text with EEA relevance).

[7] Directive 2003/41/EC  of the European Parliament and of the Council of  3  June  2003 on  the  activities  and supervision  of institutions  for occupational  retirement  provision.

[8] Communication from the Commission — Guidelines on non-financial reporting (methodology for reporting non-financial information). See here.

[9] Sixth meeting of the High Level Expert Group on Sustainable Finance Meeting Report, p.2. See here. & The HLEG interim report: financing a sustainable European economy, p.63. See here.