Why the S in ESG is no longer silent

The momentum behind environmental, social and governance (ESG) investing has become seemingly unstoppable in recent years, a fact reinforced by the COP26 summit in Glasgow. But while the motivations of investors embracing the sustainable investing trend are undoubtedly noble, there are still many nagging questions — among them what happens when the E, the S and G elements contradict each other. Striking the right balance social issues and environmental ones is fraught with complexity.

The Rio case

Back in 2018, global resources giant Rio Tinto earned brownie points among investors campaigning for greater corporate action on climate change when it became the first mining major to dump the last of its coal assets.

While Rio insisted it made the decision because it saw better opportunities elsewhere, it followed this up in early 2020 with a pledge to cut its greenhouse gas emissions to zero by 2050 and invest $US1bn over five years in climate-related projects.

So ESG-minded investors who wanted to maintain some exposure to the mining industry in the interests of diversification might have been tempted at that stage to return Rio Tinto to their global portfolios.

But hold on a minute. In May 2020, Rio suddenly found itself on the outer after it blew up a 46,000-year-old culturally significant Aboriginal cave in a remote area of Western Australia as part of its aggressive iron ore expansion.

Such was the controversy over the destruction of these rock shelters, dating back to the ice age, that it sparked an Australian parliamentary inquiry. Rio issued a carefully-worded apology and docked bonuses. But this wasn’t enough and, ultimately, the company’s global CEO and several other executives walked the plank.

In other words, a company that two years before was hailed for meeting the ‘E’ category in the ESG equation was suddenly on the defensive over the ‘S’ or social element.Investors might ask what was the point of Rio declaring itself environmentally responsible if it was to ride roughshod over indigenous communities in such a way?

Social issues — the new frontline

In essence, ESG is getting a lot more complicated. Now that there is broad corporate consensus on transitioning from fossil fuels, we are seeing social issues — like how companies treat local and indigenous communities, workers, suppliers and customers — rapidly turning into the new frontline of the sustainable investing movement.

In fact, S&P Global, in a recent report, highlighted social issues as a key trend in ESG investment strategies, with labour rights breaches and supply chain disruptions resulting from the pandemic likely to be a growing focus for institutional investors.

“Beyond the resilience of supply chains, we also think that social issues in supply chains will garner greater attention, particularly as efforts grow to curb human rights abuses and improve labour conditions,” S&P Global said.

Until now, company due diligence and disclosures on human rights and other issues in supply chains have been voluntary, but under new and prospective laws in the EU companies will be required to identify ESG risks in their supply chains.

The measurement issue

Of course, the big issue here for investment managers is how do you track and take account of these social risks? It is one thing to measure a company’s climate footprint. That data is usually easy to access. But supply chains are complex and rarely taken into account by ratings agencies such as Bloomberg and MSCI.

This problem is already evident in the environmental corner of ESG, where emissions are measured at three stages — Scope 1 (the company’s internally-generated direct emissions), Scope 2 (indirect emissions from the power sources it buys) and Scope 3 (emissions generated up and down the company’s supply chain).

As many experts have noted, the Scope 1 and Scope 2 categories are at least within a company’s control. However, it’s Scope 3 where most of the impact often is found, but where control can be hardest to maintain and measure.

Now, think about that challenge on the social front, where there is such a broad range of issues to consider, many harder to measure, and where there is not much consensus on what should be included – from corporate culture to diversity programs to treatment of labour unions to health and safety policies.

In a recent advance, the Global Reporting Initiative, an independent group that helps businesses take responsibility for their impacts, has issued revised global standards for reporting publicly on ESG issues, which will apply from January, 2023.

However, these standards are voluminous and cover – to name just a few — company procurement practices, corruption, anti-competitive behaviour, occupational health and safety, child and forced labour, indigenous people’s rights, and customer privacy.

An impossible task?

Now consider the challenge for investment managers trying to measure thousands of companies, and their global supply chains, on all these variables. And think about the challenge for investors and their advisers seeking to judge one ESG strategy against another. The task is formidable — many would say impossible.

Remember also that managers have to tick all of these boxes while maintaining solid investment returns and keeping fees contained.

Now, we are starting to see the backlash. In a recent commentary for Institutional Investor magazine, John Bowman of the Chartered Alternative Investment Analyst Association (CAIA) said the sheer number and array of goals brought under the ESG umbrella was simply becoming unmanageable.

“Would this aged and unsightly Frankenstein of a concept make even Mary Shelley grimace today?” Bowman wrote. “With ESG investment products, certifications, standards, and data sets proliferating daily, I believe that this medley of mayhem has become a hindrance to further advancement.”

“Consider a few examples: Should racial diversity on corporate boards be compared to activities such as water conservation? Should employee safety offset carbon footprint? Should our children’s social media protection be hampered by efforts to reduce income inequality? I think if we’re honest, today’s amalgamation of and competition between such a broad array of material sustainability goals seems odd. And disagreements over how to calculate, measure, and weigh these factors further cloud the issue.”

A simpler approach

Bowman’s suggestion is that the ESG label be retired completely and primary attention should be given instead to the existential threat of climate change. That isn’t to say the other issues are unimportant, he says, but that the industry should stop looking at them all as part of a shopping list of concerns and focus instead on the overall sustainability of a company’s operations, one that incorporates human, financial and physical capital.

None of this is to downplay the very real concerns that many investors have about any one of these issues that comprise E, S and G. But it does highlight the practical considerations and importance of knowing what the goal of the strategy is and how we plan to measure it.