Sharon Bonfield at St James’s Place Wealth Management discusses the current relevance of the social and governance pillars in ESG investing.

The upcoming COP26 climate-change conference in November will see world leaders and environmental experts descend on Glasgow. As the event approaches, much of the talk is of the importance of investment to help combat global warming.

With all this emphasis on the environment, businesses must not lose focus on social and governance factors – the S and G in ESG investing. Governance refers to the way companies are led – for example, how their boards and shareholder groups are made up and remunerated, and how they make decisions.

Social factors look at how companies manage their relationships with workforces, supply chains and communities. These factors are crucial because good practice in S and G can help increase profits and financial sustainability, while bad practice can be disastrous for corporate reputations and share prices.

Well-run companies perform better financially, so fund managers have paid close attention to governance since long before ESG became popular.

The emphasis on social investing is newer and has grown in response to various companies being exposed for neglecting the rights and wellbeing of staff, communities, and workers in supply chains.

Petra Lee, Responsible Investment Analyst at St. James’s Place Wealth Management, says: “The focus on social issues has grown further because COVID-19 brought to light so many problems, such as imbalanced vaccination rates and social inequality. ”

“Supply chains in the fashion industry are also an increasingly recognised problem. It’s great for consumers to buy cheap clothes. But if you think of all the factors that made them that cheap, who has sacrificed what? Social mobility is yet another issue. For example, in the UK alone, the government publishes a long list of companies that have failed to pay minimum wage.”

Linking business performance to social and governance factors
Many studies have shown that social performance contributes to financial performance and therefore share prices. For example, analysis by S&P Global Ratings found accounting for social concerns when investing can protect portfolios, especially as part of a comprehensive ESG investing strategy.

The market tends to reward companies that minimise their exposure to social issues. For example, selling controversial products, relying on materials from geopolitical hot spots, and using an unpredictable labour force can hurt profits and increase volatility, said S&P.

Meanwhile, numerous studies have shown that diversity in boards – an essential aspect of good governance – is positive for long-term performance as it encourages innovation, avoids group think and improves decision making. For example, a 2020 McKinsey report found companies with higher levels of ethnic diversity were 36% more profitable than their peers2.
Investing in social and governance factors

There are several examples of how businesses can invest in social and governance factors via numerous processes and initiatives, from signing modern-slavery and human-rights conventions to making sure supply chains have increased traceability and integrating consideration of communities into our investment decision processes.

Lee says one challenge is that there is increasing consensus about how to measure and benchmark climate-change action, but there is less agreement on social issues, which can involve more complex factors.

A typical dilemma is whether to withdraw investments from a country with a poor human-rights record, even though doing so could impoverish its population further. Another is that using ethically sourced materials can make goods more expensive, so companies need to be sure there is a profitable market for this.

A decision such as this needs to be made on a case-by-case basis, and with much consideration. Where possible, and in the case of St. James’s Place’s fund managers, open dialogue, and active engagement with companies with poorer ESG practices can lead to real change and improvement, rather than simply screening them out of a portfolio entirely.

While the environmental aspect of ESG will often be addressed first by businesses, the ‘S’ and ‘G’ components shouldn’t be overlooked. Social initiatives such as working with sustainable suppliers; building a diverse and inclusive workforce or creating a culture of learning and development, can help establish a business as a socially conscious employer.

This coupled with strong governance practices such as involvement in the FTSE4Good Index, Business in the Community – the Prince’s Responsible Business Network, the Good Business Charter and the UN Global Contact Network UK – all these indicate a business’s investment in becoming a organisation committed to all aspects of ESG.