How to measure the "social" side of a company
Social considerations — the "S" in ESG — seem to be garnering more attention lately but also appear harder to measure than the other two components. In this article, my colleague Ravi Varghese, head of sustainable investing at Epoch, breaks down what we look for in companies as it relates to the “S” component?
It’s true that the social component is often the most nebulous and perhaps subjective of the three. There are various ways you can think about analyzing social considerations. Generally, when we talk about ESG, we focus on the concept of financial materiality, referring to the impact some ESG consideration has on the financial performance of a company. Those things can range from being very quantifiable to being extremely subjective. In the “S” group of factors, those can be a little bit more subjective.
Even within financial materiality, there are various time frames or different lenses you can use. You could use, for example, the very narrow lens of an investor assessing if some ESG factor has a material impact on the prospects of the company. Alternatively, you could take the approach of being a universal owner. Increasingly, we see large asset owners taking the position that, even if they don’t believe that something is material in a very narrow sense for a company, the company’s actions may be imposing externalities on the world at large, and therefore may be penalising other companies or other sectors in which the asset owner has a stake.
Another lens that people sometimes use is a more top-down approach, starting with a specific group of “S” factors and trying to understand how each company they own scores on, or contributes to, those factors. This could be diversity and inclusion, human capital management or even macro considerations like wealth inequality.
That’s not the approach we’ve taken at Epoch on “S” factors. We have relied more on the bottom-up approach, trying to understand what the important factors are at each specific company or industry.
How has the war in Ukraine revealed some of the inconsistencies within the ESG industry?
We think the war in Ukraine has really shone a light on some of the imprecise ways that the “S” factor is being talked about by investors and particularly the media. Energy, defence and Big Tech are excellent examples. Previously, there was the view in some quarters that these companies were engaged in socially harmful activities. Now there’s a view that they’re engaged in socially desirable activities. That’s obviously a pretty dramatic turnaround. Our view is that it was incorrect to label them as socially harmful in the first place.
Let’s take energy, for example. It is obviously a sector that has challenges in the sense that traditional energy produces carbon emissions that are a source of climate change. But even fossil fuels, which are problematic from a climate change perspective, provide us all with things like heat, mobility and electricity — clearly very important things in our lives — as well as energy security.
Similarly, defence companies are back in favour as the public starts to reassess the importance of strong defence industry. And some of the critics of Big Tech are perhaps softening their stance as it becomes clear that, in many ways, strong technology sectors are an ally against foreign aggression.
Our view here is clear: We want to design an ESG framework that does not simply react to world events.
It should be robust to different scenarios and grounded in rigorous analysis. Equally importantly, it should not be swayed by the price performance of different sectors. It makes no sense to be hard on energy and defence from an ESG perspective when their returns are poor only to reverse course when they start to outperform. The right framework should be consistent throughout the cycle.
What are your thoughts on divestment from certain types of companies?
This is a tricky topic and we think it speaks to the different roles the ESG industry is being asked to play. The first one we’ve already discussed is a question of financial materiality and using the ESG lens as a complementary lens to traditional investing analysis. The second role is to think more about the ethical or reputational aspects of companies or investments. That’s a far more subjective role. Sometimes the two roles are in conflict. The divestment debate is an example where this can be true.
While it may be appropriate for some investors to think about divestment to express their ethical or reputational concerns, it’s generally not our preferred strategy. There are a few reasons we generally avoid divestment, except at a client’s specific request. We'll define divestment as the wholesale exclusion of companies or industries for nonfinancial reasons.
First, when you divest, you automatically shrink the investment universe, meaning there is a trade-off. As fiduciaries, we think we need to be very conscious and cautious of making that trade-off unless explicitly directed by a client. Second, when you sell the stock of a company, you lose your seat at the table, meaning you lose a lot of leverage to effect change at the company. Third, there’s a very important question when divesting about who the buyer of that security is.
It doesn’t strike us as ideal if all the socially conscious investors sell their stakes and ownership of these potentially problematic companies ends up in the hands of people who aren’t concerned about ESG issues. Nor do we want to penalise public companies in markets with strong ESG disclosure at the expense of private companies or companies listed in jurisdictions with weak ESG oversight.
Engagement is really the strategy that we have opted for, which means retaining our ownership stake in these companies while trying to think very carefully about how we would like them to act. Then we work with the companies to try and, first of all, understand their positions. These are incredibly complex companies, and sometimes we find out that they have a very complex set of stakeholders that we don’t quite understand as outside investors. We also work closely with them to share our viewpoint and, when necessary, nudge them toward a path that we think benefits us as long-term shareholders.
Incidentally, we think engagement is something we do well as active managers. Our ESG team works very closely with other members of the Investment team to understand the full context of a company’s circumstances and then consider the ideal approach. Of course, the ability to sell a security is a valuable tool to have at our disposal if we encounter companies that don’t take ESG issues seriously.
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John is a portfolio manager for Epoch’s Equity Shareholder Yield strategies. Prior to joining Epoch in 2012, John taught undergraduate economics as a lecturer at Fordham University. Before that he spent four years at HSBC Global Asset...