By Ingo Steinhaeuser
November 12, 2021
Environmental, social and governance (ESG) factors could be more effective than any regulatory enforcement action mandated by law in human rights-related wrongdoing. Potentially, they have the power and influence to change behavior and serve as a mechanism for enforcement because of the prospective enforcers themselves: financial institutions and consumers.
With ESG becoming mainstream, there is a powerful convergence of the still voluntary collection and usage of data in investment and the mandatory actions arising from anti-money laundering (AML) and human rights-related regulations and enforcements. In the EU, the European Financial Reporting Advisory Group has been commissioned to develop sustainability reporting standards.
Risks both relevant to ESG scores and compliance and regulatory AML standards typically include environmental crimes, slavery and human rights abuses, bribery, corruption and conflict minerals to name a few.
In a recent report published by the regulatory intelligence service of Thomson Reuters, financial authorities worldwide have made it clear that a broad range of issues, including climate change, human rights, and human diversity, need to be managed alongside other more traditional risks. This fits well into a series of quantitative studies that show companies with higher ESG ratings are linked to improved financial performance and lower risk.
Since ESG started becoming risk-relevant, it has been dominated by the E category, which covers environmental risk criteria, such as greenhouse gas emissions, resource use and innovation. Over time, the E category has been expanded with data points that measure the environmental performance of companies.
The social category has been different, as most criteria included, for a long time, company disclosures with binary responses (yes or no) to questions about human rights policy, workforce and product responsibility, among others. But this approach is of little use in making numeric comparisons between companies and determining whether there is real social risk present in companies and their supply chains.
Since the COVID pandemic, in particular, the dynamic has shifted. Social is receiving equal importance as a risk, pushed by consumers and financial institutions alike. How can social play a vital role and serve as an important tool in reducing risk overall and in creating more transparency on social issues in companies and supply chains?
Five Common Investor Myths
The ESG Initiative, which comprises the TR Foundation, Refinitiv, UNPRI, Mekong Club, White & Chase and the Sustainable Finance Center, conducted substantial mapping and consultation work that resulted in the designation of five common investor myths on using the S criteria.
- Social criteria are less financially material than environmental indicators.
- Assessing social performance is too difficult.
- Measuring, collecting and comparing relevant data points is too difficult.
- Qualitative surveys or questionnaires are the best methods to tackle social issues and analyze the social aspects of performance.
- Integrating social criteria is relevant for impact investors only.
The reality is that the converse is true in all the above statements. In the fifth investor myth, the integration is relevant to the investment community in general, as it helps to identify more resilient and profitable investments.
Following the suggested actions will provide financial institutions with a good roadmap. But there is work to be done, as even the current data points and collection methods require continuous review and adaptation of new data-gathering capabilities.
Technological innovation in data-gathering capabilities is driving the ESG industry to a great extent. Artificial intelligence, machine learning and geoanalysis through the usage of sensors on internet-connected devices allow for real-time data generation that can dig deep into information about social performance.
Do consumers and financial institutions possess the power to hold companies accountable and drive change? If consumers and financial institutions are reacting to social issues such as slave labor, inequality, or other relevant social criteria, the investment community will observe this and be proactive in calculating the financial risk. Financial risk is often a result of reputational risk followed by legal challenges, consumer dissent, or even boycott of products and services by conscious consumers.
Today’s consumers appear to care more about social justice and the environment than previous generations. In a recent study by Deloitte, millennials and Generation Z say climate change and protecting the environment are vital issues – at the top for Gen Z and third for millennials. Both have “serious misgivings about discrimination and inequality.”
Leading consumer companies such as H&M, Gap, Uniqlo, Adidas, Zara, and New Balance have made statements about sourcing cotton from the Xingjiang region after various Chinese companies were sanctioned under the Global Magnitsky Human Rights Accountability Act for involvement in building internment camps in the Uygur region. The Business Center for Human Rights has compiled statements from these companies. These confirm how serious human rights violations are viewed by companies sourcing from that region.
The implications are – and this is one of the key takeaways of the recent ESG initiative on social criteria – that company disclosures, while important to set company policies and procedures, are of limited use.
More external data provision continues to power ESG scores. At the same time, data collection efforts within companies are expanding.
Nasdaq’s ESG data hub, for example, powered by data provider RepRisk, contains data from more than 175,000 companies, making it the world’s largest ESG data set. Companies not reporting on ESG-related risks could face negative reactions resulting in significant financial harm.
The case for ESG has already been made and won in consumer-facing companies and Western economies, where sensitivity to social factors is already prevalent. ESG appears to be scrutinized more than any regulatory requirement.
But there are sectors and regions where ESG criteria are wildly absent and where AML and human rights-related enforcement actions by Western democracies are the main drivers of change.
Emerging Market Companies Lack ESG Data
The challenge ahead is to include companies in developing countries to report on ESG. Developing countries lack a strong framework for social issues, usually because of lack of inclusion and limited regulation.
Industrial sectors with low ESG scores are in developing countries as well. Also, hidden compliance risk from environmental crimes and human rights abuses is high in developing countries. This implies that a real impact can be achieved only through regulatory action when ESG data is unavailable.
There are also positive examples where countries are moving in the right direction. Vietnam, for example, signed a free trade agreement with the EU that explicitly included ESG provisions such as labor rights and sustainable development.
If emerging countries implement ESG-type regulations, this can lead to a more active approach in developing ESG-type data for companies and investors operating there. ESG data will create the necessary transparency that investors and consumers need to make decisions with ultimately greater impact.
More data will lead to greater regional coverage and add meaningful social data for a balanced ESG-risk framework.
Ingo Steinhaeuser has over 25 years sales and consulting experience, which he gained working in Europe and the Americas. Ingo works for Thomson Reuters in Washington, DC and advises financial institutions on risk mitigation strategies. He is a graduate of Mannheim University in Germany.