Environmental, social and governance (ESG) is receiving ever-increasing attention. However, it can seem that much of it is directed at the Environmental element because of the focus on climate change risk.
The social element of ESG is equally important. New legislation and regulations within the social purpose greatly impact many companies. There is also increasing pressure from investors and consumers to improve the social element.
Steps to supporting ESG's social element
- What is the 'S' in ESG?
- What are the key components of social purpose?
- How does ESG's social element impact companies today?
- What must firms disclose about the 'S' in ESG?
- Do companies make voluntary ESG disclosures?
- Which frameworks can firms use for disclosure?
- How do investors get social element data?
- What is 'social washing'?
- How can compliance teams aid in a social strategy?
1. What is the 'S' in ESG?
The 'S' stands for 'social'; this element of ESG is becoming increasingly important for companies and their stakeholders, such as regulators, investors, employees, and consumers.
S&P defines the 'S' as "the social factors that pose a risk to a company's financial performance." As a rating agency, S&P is naturally focused on risks that could potentially impact a company's ability to meet its financial goals.
So, while the S&P definition is clear, many argue that it focuses too much on downside risks and not enough on the positive benefits for companies embracing the 'S'.
Indeed, some ESG experts say that the S&P definition isn't useful for equity investors who want to identify companies with potential upside because of their engagement with 'S'.
For example, they say that how companies engage with social issues is now a key element in their reputations across all industries. Retail customers are willing to pay more for products from ethical retailers, and consumers' trust in a brand and their loyalty to it is linked to purposeful business practice.
So, when considering the social element of ESG, it helps to consider both downside risks and upside potential.
2. What are the key components of social purpose?
There is a wide range of topics that could be a part of the social component of ESG – what should be included is still the subject of debate, and so this is not yet standardised. However, some topics that come up regularly can be classified into two categories: internal to the company and external to it. They are:
Internal
- Diversity, Equity & Inclusion (DEI)
While there is a range of definitions for this, a useful one is that the term describes policies and programs that promote the representation and participation of different groups of individuals, including people of different ages, races and ethnicities, abilities and disabilities, genders, religions, cultures and sexual orientations. This also covers people with diverse backgrounds, experiences, skills and expertise. A wide variety of HR regulations cover this area, and there are also pressure groups for specific causes, such as more women on boards, which can be fairly high profile in the media.
- Health & Safety
This embraces traditional health & safety issues such as preventing accidents at work. As a result, health & safety is an area with a very high regulatory profile in some industries, such as manufacturing and construction. However, since the start of the COVID pandemic, health & safety has risen in prominence within the services sector. The strains of remote working and isolation from friends and colleagues resulted in well-documented mental health issues. So, mental health has begun to be included in the understanding of what health & safety is, as well as general employee well-being.
- Labour relations between management & workers
Good labour relations within a company can indicate that the organisation is a good place to work. Ways to measure this can range from looking at how management engages with unions to how employees talk about the companies on social media and websites such as GlassDoor. In managing labour relations, companies must abide by existing legislation and regulations that govern this area, and it's a good idea to adopt best practices developed by the industry, too.
External
- Community relations
How a company engages with the community around it is very important today. This includes everything from relationships with the local neighbourhood around a manufacturing facility to the online communities that an organisation may have. In the UK, financial services regulators focus on vulnerable consumers as a particular community. - Modern slavery
Modern slavery is the illegal exploitation of people for personal or commercial gain. It covers various types of abuse and exploitation, including sexual exploitation, domestic servitude, forced labour, criminal exploitation and organ harvesting. Many countries have enacted specific anti-modern slavery regulations, including the UK, Australia, and Germany. Other jurisdictions, such as the US and the EU, are developing new rules. - Bribery & corruption
Corruption includes any illegitimate use of office and may include a range of different types of crime. Bribery is the offering, promising, or giving of something to influence an official. Again, many countries, such as the US and the UK, have specific anti-bribery & corruption rules in place. - Product safety
Companies must ensure that their products are safe for consumers to use. This can mean managing third-party risks and having strict quality controls on their own processes. Specific safety rules may apply to some products, and in financial services, there are increasingly stringent rules about product governance and marketing to consumers in some countries. - Data privacy
While careful management of personal and sensitive data by companies is good practice, many jurisdictions now have specific data privacy laws – such as the EU's General Data Protection Regulation (GDPR) – and more are coming into force.
Compliance teams need to understand the specific legislation and regulation that applies to their company in these areas. Today, many companies wish to go beyond compliance and have an even more robust approach to social issues. However, it's important to ensure full compliance first.
3. How does ESG's social element impact firms?
Taking the right social stance on key issues can deliver substantial benefits for a company. For example, Walmart became more attractive to investors and consumers alike when it announced that it would restrict the types of firearm ammunition that it sells, according to S&P Global Market Intelligence.
Two of the company's stores had experienced shootings – and mass shootings are a highly political issue in the US. The move to restrict sales reduced the potential for reputational damage that selling ammunition posed to Walmart's image.
On the negative side, a decision to destroy a historic 46,000-year-old aboriginal site in Australia caused the chief executive and other senior executives to resign from an international mining company.
Investor pressure led to resignations, and in other cases, asset managers have actively divested from companies that do not meet their social requirements. In one example, asset management firms publicly announced they were withdrawing their investment from a retailer that had not responded robustly enough to allegations of modern slavery in its supply chain.
In 2021, many large institutional investors decided not to participate in an IPO for delivery company Deliveroo over concerns about how the company treated its deliverers.
A lack of focus on social can also lead to litigation. For example, in August 2022, former workers at Malaysian rubber glove maker Brightway Holdings filed a lawsuit in the United States against Kimberly-Clark and Ansell, accusing them of "knowingly profiting" from the alleged use of forced labour at the supplier.
And, of course, social failures can lead to regulatory fines. Financial firms are expected to participate in the fight against money laundering (AML), but many fail even to meet the compliance standards required by regulators. In 2021, the UK FCA fined top banks a total of $672 million for AML failures, more than tripling from $206 million in 2020.
In short, getting the social element of ESG right can have substantial benefits for a company, while getting it wrong could prove disastrous and lead to compliance risk, financial risk, reputational risk, and more.
4. What must firms disclose about the 'S' in ESG?
There are some social elements that companies have to disclose – either to regulators or to the public – under the rules that apply in some jurisdictions. Examples of these include:
- Specific ESG data, such as what the EU's Sustainable Finance Disclosures Regulation (SFDR) requires
- EDI statistics, such as gender pay gap reporting
- Bribery & corruption policies
- Modern slavery policies and due diligence practices, for example, under Germany's Supply Chain Due Diligence Act
- Health & safety statistics
- Product safety recalls
- Data privacy breaches, such as under the EU's General Data Protection Regulation (GDPR)
Compliance teams should know what disclosures are required under the laws and regulations. In addition, compliance teams should also consider what isn't disclosable but would have a negative impact if it were known.
Lastly, compliance teams should see what other companies in their industry are disclosing publicly in compliance-related areas.
5. Do companies make voluntary ESG disclosures?
Yes, many companies are now choosing to make additional public, voluntary disclosures, often in accordance with a particular standard they have adopted.
These are usually a mix of quantitative and qualitative elements. For example, a company may publish quantitative statistics about the diversity of its workforce or the equity of its compensation structure. Or it might put robust data about its health & safety track record or financial amounts of donations to community charities in its annual report.
Qualitative disclosures might include a description of its third-party risk management programme to prevent modern slavery in the supply chain or discuss the employee well-being programmes they have implemented due to the COVID pandemic.
In general, investors and consumers value transparency from companies about the efforts they are making around the social element. However, companies must think carefully about what they disclose and how they disclose it. Information should be as accurate and timely as possible.
It's also important for companies to consider disclosing information according to one of the best practice frameworks available so that the disclosure is structured in a way others are also using.
6. Which frameworks can firms use for disclosures?
There are many different frameworks available for companies to adopt for voluntary social element reporting, including:
- UN Global Compact – Sustainable Development Goals (UN SDGs)
- Global Steering Group for Impact Investment (GSG)
- UN Guiding Principles Reporting Framework (UNGPRF)
- World Benchmarking Alliance (WBA)
- Global Reporting Initiative (GRI)
- Sustainability Accounting Standards Board (SASB)
- Impact Reporting and Investment Standards (IRIS)
- World Economic Forum (WEF)
Analysis of these frameworks by KPMG and the International Regulatory Strategy Group highlighted that there are "a significant number of frameworks with underlying goals, principles, standards and recommendations which are overlapping in their purpose and coverage of social issues yet lacking in granular measurement and reporting requirements."
While adopting a framework can reassure investors and customers that a company's disclosures are well-considered, the issues pointed out in the KPMG report highlight that disclosures still have some way to go towards maturity. As a result, it's important to keep an eye on how best practice is evolving in this space.
7. How do investors get social element data?
Investors often obtain much of their information directly from the companies, but they also supplement it with various sources. These can include:
- Government websites and databases
- Regulators
- Rating agencies
- Commercial databases and alternative data sources
- News sources
- Social media and social media analysis
However, this variety of information sources can be more confusing than enlightening. For example, analysis by rating agencies and other analysts can differ widely in methodology, and it can be difficult to verify the claims made by individual companies.
For compliance teams, it's important to monitor these sources for mentions of the company. Where it is possible to proactively engage – for example, with rating agencies and regulators – it can be a good idea to do so.
8. What is 'social washing'?
Most people will have heard of the term 'greenwashing' for Environmental issues – disinformation disseminated by an organisation to present an environmentally responsible public image.
Social washing is the same type of activity conducted by companies that want to falsely present themselves as socially responsible when their underlying activities do not match this stance.
Since social issues are considered qualitatively more often than quantitatively, experts are concerned that social washing could be a bigger issue for investors than greenwashing.
That's because, over the past few years, the environmental element has developed a greater range of quantitative metrics that are easier to compare apples-to-apples. Qualitative data is harder to compare, creating risks for investors and companies alike.
Compliance teams can work across all three lines of defence to help guard against either intentional or unintentional social washing within the organisation. In some cases, compliance may already have a formal role to play – for example, required marketing reviews can help catch potential issues.
9. How can compliance teams aid in social strategy?
Compliance teams can provide important information and even play a key role in shaping the social element of a company's ESG programme. Key ways compliance can contribute include:
- Identifying the social themes that touch the company from a compliance point of view – for example, bribery & corruption, anti-money laundering, and health & safety
- Creating a comprehensive list of existing compliance requirements in these areas that the company must comply with, from legislation, regulation, and industry standards
- Performing a gap analysis to better understand where the company may not meet existing demands, where it meets those demands, and where it may potentially exceed them
- Helping the company to understand what it needs to do to meet existing requirements so the company is fully compliant
- Working with teams across the company to identify ways the organisation could go beyond existing compliance requirements – without impinging on other requirements
- Developing, in collaboration with other teams, controls to improve social elements and metrics to track performance alignment to social element goals
- Monitoring social element programme adherence and regularly reporting to the business, senior management and the board on those factors, as well as to any special ESG team that may exist.
So, compliance teams play a key role within companies, helping them ensure they are meeting existing social element regulatory obligations. In addition, compliance teams have specialist knowledge that can enable organisations to enhance their social element contribution.
Compliance teams can help companies stay within the rules as they seek to improve the social element in different ways. Also, compliance people have specialist knowledge of policies and processes that can support companies as they develop those to reach more ambitious social element goals.
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