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Do – and Should – Asset Managers Care About the ‘S’ in ESG? – Part 2

Multiple changes are needed to support integration of social factors into investment decisions, says Dr Anthony Kirby, Head of Regulation and Risk for Asset Management and Capital Markets in Europe at EY.

The first part of this article considered key social themes influencing investors and regulators – human and worker rights, diversity and inclusion, health and safety among them – while recognising their interconnectedness with environmental and governance factors.

In this second part, we go a little deeper into these overlaps. After all, the rising profile of social factors has been driven partly the development of the sustainable investment regulations and frameworks aimed primarily at addressing the climate crisis. For this reason, among others, questions about the status of social factors within ESG investing abound.

As the work of the UK’s Transition Plan Taskforce reaches completion, for example, what are the implications for a Just Transition? What about the role of asset owners as stakeholders in the process? What about future extensions of the EU taxonomy into adjacent areas? And where will firms find the data to disclose and report?

The impact of the just transition

Calls for a Just Transition reflect rising concerns for the fair treatment of workers and communities who will be most affected by the shift to clean energy and the phasing out of fossil fuels. It involves investment in new skills and infrastructure while protecting and creating high-quality jobs and employment for a green economy.

A Just Transition applies not only to large multinational corporations and governments; it is also critical that small and medium-sized businesses, which play a crucial role in creating employment and are often at the heart of communities, are involved. Approximately 6.3 million jobs in the UK, equating to around one in five, are likely to be affected by the transition to a green economy, according to the OECD’s Just Transition Jobs Tracker.

There are many smaller scale efforts by unions, employers, and governments to develop transition plans, but relatively few are complete. Last month’s Climate Action 100+ Net Zero Company Benchmark 2.0 study showed that a mere 10% of (the 170) companies assessed had set out just transition plans, with a mere five companies (a miniscule 3%) developing these in consultation with key stakeholders.

What about the asset owners?

More of the leading asset owners, notably pension funds, are increasingly interested in making sure investee companies understand their supply chains and how they price-in social and governance issues. This is particularly the case when firms might be investing in countries operating under questionable government regimes or investing in supply chain activities with dubious or non-transparent working practices, whether unintentionally or not.

The Task Force on Inequality-related Financial Disclosures (TIFD) was conceived as an explicit systemic risk management framework that can reduce inequality created by the private sector. A collaboration among a broad range of stakeholders, it sought to provide guidance, thresholds, targets, and metrics for companies and investors to measure and manage their impacts on inequality, as well as inequality’s impacts on company and investor performance. The TIFD merged with the Taskforce for Social-related Financial Disclosures (TSFD) in August 2023.

Some market participants such as pension funds, sovereign wealth funds (SWFs) and insurers are hopeful that the merged entity could mark a pivot point that sees companies and investors start to consider the impact of their actions on social systems – referred in some European quarters as considering impact materiality. Trustees who do not factor in material financial or impact social factors could face the increasing risk of not fulfilling their fiduciary duty.

More details about the social preferences expressed by asset owners such as pension funds, SWFs, insurers, and corporates will be the subject of a future article.

Role of the EU Social Taxonomy

The EU Taxonomy Regulation 2020/852 was originally published on 20 June 2020 in the Official Journal. Article 18(1) of the regulation states that: “The Minimum (Social) Safeguards … shall be procedures implemented by an undertaking that is carrying out an economic activity to ensure the alignment with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights”.

Notions of minimum social safeguards underpinned by the Platform for Sustainable Finance (PSF) report of July 2022 took a knock when plans to expand the sustainable taxonomy to cover social issues were put on hold indefinitely from August 2022, amid fears that discussions would trigger further infighting between member states. There was a risk that a separate Social Taxonomy risked becoming highly contentious both politically and operationally; this on account of tensions arising from the War in Ukraine and in view of the volume of technical work needed to cover all environmental and social sectors.

In the meantime, the Taskforce for Nature Financial Disclosures (TNFD) issued its beta framework paper, titled ‘Societal Dimensions of nature-related risk management and disclosure’, in November 2022. The TNFD paper helpfully set out several areas connecting nature/biodiversity with social issues, including an overview of the societal dimension of nature related risk, opportunity management and disclosure identified by the taskforce, plus an update as to how societal dimensions could be integrated into the V0.3 beta framework.

The TNFD identified four key societal dimensions of nature-related risk management:

  • Consideration of human rights / environmental rights – Access to a clean, healthy & sustainable environment for all people, recognised by UN General Assembly as a universal human right;
  • The stewardship role, rights and traditional knowledge of indigenous peoples and local communities (IPLCs);
  • Access and benefit sharing from the use of genetic resources and other environmental assets and related traditional knowledge;
  • The issue of social justice and equity for a Just Transition to a nature positive and net-zero economy.

Where’s the data coming from?

A paper titled ‘Principal Adverse Impacts Reporting – Practical insights for the next stage of SFDR implementation’, published by Irish Funds in May 2021, illustrated the scale of the problems facing investors when trying to source social data from third-party providers to fulfil the Principal Adverse Impact (PAI) reporting requirements under SFDR.

Page 10 shows the extent of some of the gaps when it came to reported data sourcing – impacting a given firm’s ability to evidence:

  • Violations of UN Global Compact principles and Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises;
  • Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises;
  • Unadjusted pay gap (particularly, despite general availability of board diversity figures);
  • Exposure to controversial weapons (anti-personnel mines, cluster munitions, chemical weapons and biological weapons);
  • Investee countries subject to social violations.

Sources of social data relevant to investors are diverse and expanding, including:

  • NGOs and/or national/supra-national bodies (in alphabetical order) include ILO/ILS (statistics on employment); OECD (social expenditure database); ONS (Gini coefficient); The UK’s Parker Review; Transparency International; UNGC (women empowerment et al); World Benchmark Alliance (Corporate Human Rights Benchmark – [CHRB] and Gender Benchmark)
  • Benchmark providers (in alphabetical order) include the 30% Club; CEO Action for D&I; The Neurodiversity Index; ShareAction – Point of No Return Report; Stonewall; ‘Walk Free’
  • Around 35% of commercial ESG data vendors also publish social data. Names (in alphabetical order) include Arabesque (S-Ray); ClarityAI; ESG Clarity (‘reboot’); Ethos; FactSet TruValue Labs; ISS (Ethix and Oekom); Moodys Vigeo; MorningStar Sustainalytics; MSCI; RepRisk; S&P Trucost; Salesforce; UTIL; Verisk Maplecroft.

Where to next?

There are cultural barriers to overcome before we get too excited by the increasing ‘deluge of data’ that awaits us, as we seek to quantify the social risks and impacts of investment decisions. In contrast to climate risk mitigation and adaption, the ESG ‘industry’ lacks a G20-style holistic approach, and piecemeal approaches – whether by taxonomy, territory, or taskforces – ignore the inter-linkage and inter-dependencies of social issues as the ‘catalyst’ that powers ecosystem improvements.

From an industry perspective, the International Sustainability Standards Board recognising and accommodating the dual materiality implicit in the EU’s approach is an important milestone, just as much as the EU must recognise and accommodate the need to evidence fiduciary duty under the US system.

And from a governmental perspective at COP28, countries need to address the polarities in wealth and power between the populations of the richer and poorer nations to see any realistic prospect of transition to a greener economy globally. COP28 will hopefully grasp that world communities cannot solve E issues such as carbon pricing or negotiated Article 6 contributions without the S and the G. They’re inextricably linked.

There are also technological barriers to overcome. Meeting any new regulatory requirements warrants a quantum upskilling of supply chain management (SCM) techniques, including the application of AI large language models capable of aggregating SCM datasets. New technologies that increase oversight and transparency of supply chains can improve efficiency and resilience while also helping the business to comply with regulatory and stakeholder expectations.

There is already talk of artificial intelligence use-case tools capable of creating and running virtual models of a company’s entire value chain, both upstream and downstream. These could be used to plan scenarios and stress test to run alerts, identify weak links or pinpoint ‘amber-trending-red’ flags.

A community-based approach in areas such as mandatory vigilance reporting across logistics firms such as deep-sea freight arrangements could offer more insights into how supply chain design could reduce emissions, address MSHT (Modern Slavery Human Trafficking) concerns, source ‘root-cause’ capability gaps, and help address the ESG operational risks of third-party suppliers to mitigate reputational risks.

The latter risks in this area could be managed and mitigated by having clear policies and procedures in place and fostering a culture of transparency throughout supply chains to allow for incidents to be investigated and managed appropriately. Firms can benefit operationally from engaging and collaborating industry-wide and sharing their data on supply chain members’ ESG credentials. Firms can benefit financially by demonstrating to maritime insurers that they have appropriate oversight of overseas operations.

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

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