The EU’s new Sustainable Finance Disclosure Regulation (SFDR) brings Environmental, Social and Governance (ESG) concerns into sharp focus. Paul Young and Irina Velkova take a closer look at why ESG social factors are so important to investors.
ESG is not a new idea, but it is a broad term and firms often have a vague idea of what each factor means in practice. The introduction of SFDR, which comes into force on 10 March 2021, is part of a wider movement towards sustainable finance. It includes the EU Taxonomy Regulation and, in the UK, the introduction of mandatory Taskforce on Climate-related Financial Disclosures (TCFD)-aligned disclosure requirements, among others. Collectively, these activities demonstrate that responsible investing has become a mainstream expectation and is no longer a niche concern.
What is the SFDR?
The SFDR compels financial market participants to justify their decisions with regards to sustainable investments. Companies must be able to demonstrate how they monitor and measure ESG indicators before they can make claims of 'sustainable practices'. They must also measure their performance against each of the environmental, social and governance factors.
ESG: the social factors
Companies are already familiar with the environmental and governance factors of ESG, with requirements embedded in a myriad of regulations, but many firms are yet to embed the ‘social’ factor in their policy frame works. It’s hardly surprising, given the urgency around environmental considerations and the unquantifiable, complex nature of social issues, but the current circumstances have moved forward to concerns around employee well-being, health and safety, data security and privacy challenges – all founding components of the ESG social factors.
When social issues are handled poorly, they can affect a company’s value and increase investor risk. As a result, firms must demonstrate their readiness to make the relevant disclosures, measure their social performance and report on it. To do this successfully, firms must:
define the remit of the social factors under ESG as applicable to their business
implement policies and procedures that support this social framework
establish key indicators for monitoring
agree what information they will be looking to disclose
introduce improvements in their practices where required, to demonstrate that they are fully engaged
Making progress on the social factors demands a common understanding of what they constitute. Some recurring themes are emerging from the Sustainability Development Goals, the United Nations Principles for Responsible Investment (PRI) and various reporting standards.
Health and safety
Most firms already have health and safety policies in place, but it’s only now that investors are factoring them into risk assessments. Companies that rank high in ESG ratings actively demonstrate their commitment to employee health and safety and involve them in developing future policies and standards. This helps prevent employee harm but also actively generates value for a business.
Perhaps the biggest shift around health and safety is the increased focus on overall wellbeing and the role of employers in providing access to services such as lifestyle advice. COVID-19 lockdowns have highlighted the importance of mental health and moved wellbeing up the corporate agenda. Not only does this demonstrate that companies care about their people, but it also reflects the theory that improved wellbeing increases productivity, and consequentially investor valuations.
Historically, a strong and positive corporate culture was seen as ‘nice to have’ with little thought to the business value it adds. With so many people working from home over the last year, firms have seen greater employee engagement around well-being, satisfaction, and motivation, with a wider range of platforms to raise their concerns. Once this level of employee engagement becomes the norm, it’s reasonable to assume expectations of a wider dialogue moving forward.
It will be down to companies to decide what information they wish to disclose, but the specific parameters investors will likely use to evaluate employee engagement will include:
employees’ perception of corporate culture
employees and the firm’s leadership
opportunities for employees’ personal development
share reward schemes
ways of rewarding employees
the firm’s own engagement in sustainability initiatives
This is because investors have become much more aware of the fact that happy employees and a positive corporate culture significantly increase the retention of good, skilled people and improve motivation, which in turn raises productivity and performance. This claim stands up well to scrutiny too – many years of academic research has proved a positive correlation between employee satisfaction and shareholder returns.1 Furthermore, a number of recent studies have proved that companies that have a corporate culture of sustainability significantly outperform those that don’t.2
The difference now is that investors start from the position that poor corporate culture and lack of employee engagement create additional risk, and that will form part of companies’ valuations.
Diversity and equality
Still on the people agenda, diversity and equality remains an area of active debate. Disclosures around diversity and gender pay gaps are already in place and companies face significant public scrutiny on their practices. Increased pressure over ESG concerns will likely force change for good, as companies must demonstrate how they perform against these criteria, rather than simply explaining their policies and successes.
Diversity is not always easy to achieve, particularly in some sectors. But with so much known about the benefits of having a diverse workforce, it is hard to believe the level of scepticism that is still out there. Companies often make impressive mission statements but don’t action them, so this is one area where investor decisions may shape firms’ behaviours. Similarly, the gender pay gap is a key indicator for companies’ approach es to equality, so investors may shun firms that are slow to change.
Labour issues, modern slavery and human rights
In a world of unprecedented globalisation, international supply chains and remote working, labour issues, modern slavery and human rights have once again topped investor concerns. Although mandatory reporting on modern slavery has been around for a long time in the UK and other developed economies, it is unfortunately still an issue across the globe. From an ESG standpoint, the onus is on companies to demonstrate that they can manage modern slavery and human rights risk. Failures are no longer socially acceptable and companies face reputational damage and loss of investor confidence.
Data privacy and security
Socially responsible companies prioritise the data privacy of their customers, employees, suppliers and all other stakeholders. Investors are particularly concerned by data because breaches affect consumer trust and lead to reputational damage, which devalues a business. High profile companies have seen a drop in their share price due to large scale data breaches – including Yahoo, Facebook and Nintendo, to name a few . Data privacy risk is one that companies already have to quantify and manage from a regulatory standpoint, but it is an increasing area of focus for investors too in the context of ESG.
Investors have looked at customer metrics to assess company performance for a long time. Disclosing customer satisfaction is an integral part of ESG reporting moving forward. The Global Reporting Initiative (GRI), gives some examples of how to achieve this by suggesting measuring the quality of the product and the impact it has on customers’ health. Linked to this, businesses should demonstrate compliance with the requirements for the labelling and marketing of their products
The future of ESG and the SFDR
Over the last few years, the concept of ESG has become more tangible than ever, primarily due to emerging disclosure requirements. Establishing a benchmark of what each component consists of will make these elements more measurable and set firms up for long term success. While it’s important to note that the UK has not adopted SFDR, voluntary alignment will boost investor confidence and improve transparency.
Contact Paul Young for more information on ESG risks and the SDFR.
1 Welch, Kyle and Yoon, Aaron, ‘Corporate Sustainability and Stock Returns: Evidence from Employee Satisfaction’ , June 2, 2020
2 Eccles, Ioannou, and Serafeim, ‘The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance’; 'PRI Impact Management Project'