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Do – and Should – Asset Managers Care About the ‘S’ in ESG? – Part 1

Dr Anthony Kirby, Head of Regulation and Risk for Asset Management and Capital Markets in Europe at EY, surveys the rapidly-evolving social risk landscape.

The geo-political risks associated with last year’s war in Ukraine plus the current war in the Middle East has pushed the social element of ESG investing to the fore, while the impact of sanctions-screening has raised scrutiny on the social elements such as human rights and community needs still further.

When it comes to sustainable investing, we might relate to the environmental aspects of ESG at a macro-ecosystem level, or the governance aspects in terms of organisational systems. But how much pause do we give to the social elements of ESG, which impact us at a societal, or even personal level?

The answer is surprisingly little, given that the social (‘S’) dimension of ESG concerns people, and there are several strands. The UN’s Sustainable Development Goals (SDGs) 1, 2, 3, 4, 5, 8, 10, 11 and 12 concern social issues, whether directly (e.g., SDG 3 Good Health/Well-being; SDG 5 Gender Equality; SDG 8 Decent Work; SDG 10 Reduced Inequalities; or indirectly (e.g., SDG 1 Ending Poverty SDG 2 Zero Hunger; SDG 4 Quality Education; SDG 11 Sustainable Cities or SDG 12 Responsible Consumption & Production).

The cumulative impacts of the Covid-19 pandemic on populations globally from 2020-23 sharpened the focus on the need to tackle social and economic inequalities. There is little dispute that more Generation X, Y and Z consumers are interested in the larger narrative – more consumers want to track and trace where their products originate from, with demand for authenticity and ethically-sourced goods expanding rapidly this decade.

This raises the stakes for corporations wishing to gain customer loyalty and it is now important for brands to operate end-to-end visibility of their supply chains and offer evidence to back up any claims of ‘sustainability’ and ‘green products’. The technology of bar, QR and RFID codes operating across supply chain logistics makes this a realistic prospect but lagging regulations and mutually agreed supply chain labour standards are critical inhibitors.

Another key social component emerging is the need to demonstrate health and safety for corporations in the working world. One of the key principles of many an ESG-related policy is the need to evidence transparency—not just of the business itself but how the business functions via supply chains inter-sectionally – defined as the interconnected nature of social categorisations such as race, class, and gender, creating interdependent systems of discrimination or disadvantage.

This intersection between the environmental/governance and the various social strands of ESG has been relatively less explored outside the academic discipline of sociology. Often these aspects are considered in silo, in practice – across divisions within financial and non-financial institutions, as well as communities in general – and classification of social categories is not always unambiguous. But the interdependence of people is nearly always the common aspect. Lawyers at Freshfields have described the people aspects across several of the themed areas.

What are global asset managers doing to address social concerns?

According to figures published from Environmental Finance Data, US$889 billion was raised through green, social, sustainability, sustainability-linked and transition bonds in 2022 – taking the cumulative total raised by these instruments to $3.5 trillion. The 2022 total was still a 45% increase on the US$610 billion raised in 2020 – which itself was an annual record at the time – and the social bond component was US$168 billion of the US$889 billion figure for 2022, representing 19% market-share.

Asset managers direct a vast amount of global wealth and are stewards of many influential corporations. This means that their investment policies and practices impact workers and communities across the world, on issues such as unsafe working conditions, widening inequalities, and the proliferation of weapons.

ShareAction’s ‘Point of No Returns 2023’ report assessed 77 of the world’s largest asset managers’ approach to human rights, labour rights, and public health. ShareAction found that most asset managers failed to exclude companies with negative social impacts across all their investments and rarely used their influence to tackle issues such as indigenous rights and life-limiting public health problems.

According to ShareAction: “…Only six per cent of asset managers were excluding investments in human rights-abusing companies across every fund in their portfolio. Only ten asset managers (demonstrated) investment commitments in place that incorporated the UN’s principle of Free, Prior and Informed Consent (FPIC). And asset managers were excusing themselves for not acting on human and health issues by blaming a lack of adequate or sufficient data – with 40% admitting that they were not asking companies to release data about their social impacts.”

The good news is that there is a top quartile of asset managers who are pivoting towards ESG-specialism when it comes to managing social concerns or investing in vehicles such as social bonds.

Regulation – a leading or lagging indicator?

We are seeing more governments stepping up to issue new laws and regulations that force firms to address social issues alongside managing the conflicts of interest that can arise from ethical misconduct. Several of these measures impose governance, risk and control (GRC) requirements linked to compliance obligations that cover a given firm’s own operations, as well as their upstream and downstream value chains. In the UK, for example, the Modern Slavery Act 2015 requires businesses to disclose each year how they are vetting their supply chains to prevent human rights abuses. There are similar measures addressing bonded labour (including child labour) introduced by most G7 and western governments.

Beyond the topic of bonded labour, the need to evidence diversity and inclusion (D&I) will continue to be a focus for various key stakeholders in a business, in particular end investors, customers, and employees. Businesses being held to account by stakeholders need to do a lot more than simply pay lip service to D&I policies for avoidance of risk litigation. The direction of travel of regulators upping the ante means that firms also risk regulatory action and erosion of trust, and thus reputational damage to their brands.

The UK’s regulator, the Financial Conduct Authority (FCA), has published several important papers on the topic of D&I as shown below:

  • DP21/02: Diversity and inclusion in the financial sector – working together to drive change, issued July 2021, highlighted – 1) the existing requirements and expectations of firms; 2) how the regulator would measure progress by way of data collection and reporting for ongoing monitoring and 3) how the regulator would drive change by way of culture and policy. The paper also featured FAQs and examples of developing metrics in terms of diversity dimensions and inclusion initiatives to consider;
  • PS22/03: Diversity and inclusion on company boards and executive management, issued April 2022, highlighted recommended changes to corporate governance rules on existing disclosures of board diversity policies, possible requirements concerning a numerical disclosure table approach (and the format of the data), including data protection issues. Following the publication of the Parker Review, it is becoming clearer by the day that progressive businesses view diversity as a strategic priority, understanding that more diverse views, backgrounds and experience play a vital role in identifying and responding to risks, resulting in more effective boards;
  • CP23/20: Diversity and inclusion in the financial sector – working together to drive change issued September 2023, highlighted – 1) The wider context in terms of securing an appropriate degree of protection for consumers, promoting effective competition in the interests of consumers plus equality and diversity considerations; 2) The FCA’s proposed framework covering governance, threshold conditions for non-financial misconduct, data reporting and disclosure, and D&I Ssrategies, including setting targets for risk; 3) A timetable for possible implementation under 5.69-5.74. The FCA proposed the following metrics for disclosure inter alia under the Listing Rule – sex or gender identity; ethnicity; religion; age; socio-economic background and disability/long-term health condition(s).

Regulatory measures are not merely directed at wealth and asset managers but at upstream segments within the asset owner community as well. In February, the UK’s Department for Work and Pensions (DWP) launched a Taskforce on Social Factors (TSF) whose aim is to assist pension scheme trustees and the wider UK occupational pensions industry seize the opportunities of the social element in the context of pension scheme investments. The taskforce will operate for one year and includes representatives from pension schemes, asset managers, data providers, cross-industry collaboration groups and civil society. Government departments and regulators including the FCA and The Pensions Regulator (TPR) will be observers on the taskforce, while the DWP is to provide secretariat support.

The TSF has issued a draft guidance document last month featuring 35 recommendations aimed at pensions industry stakeholders throughout the investment chain. Social factors in the context of pension scheme investments includes a breadth of issues such as organisations’ workforce conditions and supply chain transparency, community engagement, consumer protection and responding to the challenges of modern slavery. This approach complements the approach taken by the FCA in achieving greater gender balance and ensuring that boardrooms reflect the diversity of the customers and societies they serve.

Movements in the UK are paralleled with tectonic developments in the EU:

A) CSRD: The Corporate Sustainability Reporting Directive (CSRD) will revise and enhance the current ESG reporting rules in the Non-Financial Reporting Directive and apply the measures to an estimated 49,000 firms. The key policy objective of the new CSRD is to ensure that a much broader range of companies report reliable, coherent and comparable sustainability information for the benefit of investors and other stakeholders. CSRD is underpinned by a comprehensive set of standards (European Sustainability Reporting Standards = ESRS) that will become mandatory starting FY 2024. From a social standpoint, ESRS requires firms to identify impact, risks and opportunities with regards to a pre-defined number of topics set out in the ‘topical standards’ – S1: own workforce; S2: workers in the value chain; S3: affected communities; s4: consumers and end-users – through the lenses of:

  • Financial materiality (ESG topic is material when it generates / may generate risks or opportunities that significantly influence / are likely to significantly influence the undertakings future cash flows over the short-, medium- or long term);
  • Impact materiality (ESG topic is material when it pertains to the undertaking’s actual or potential impacts on people or the environment).

B) CSDDD: The new proposal for the Corporate Sustainability Due Diligence Directive (CSDDD) sets out a corporate due diligence process to identify, mitigate, prevent, end, and account for adverse human rights and environmental impacts in the companies’ operations, their subsidiaries, and their value chains. CSDDD builds on the UN’s Guiding Principles on Business and Human Rights and OECD Guidelines for Multinational Enterprises and responsible business conduct. Companies that fall within its scope will be required to: 1) Integrate due diligence into policies; 2) Identify actual or potential adverse HR&E impacts: 3) Establish and maintain a complaints procedure; 4) Monitor effectiveness of due diligence policy/measures: 5) Prevent or mitigate potential impacts; and 6) Publicly communicate on due diligence.

Where to next?

Governance, policies and procedures for data collection and social governance structures will be enhanced, in preparation for alignment with TCFD/TNFD and ISSB/ESRS reporting as well as the myriad of other mandatory ESG reporting requirements coming through into law starting in 2024.

Asset manager firms and their asset owner clients should be able to take a more holistic and standardised approach to risk assessment, spanning the three pillars of internal controls and assurance, disclosure, and reporting, and implementing the social roadmap fit for the short and medium terms.

Dr Anthony Kirby is writing in a personal capacity and his views on this subject do not reflect those of EY. 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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