Social climbing: ESG investors get their heads around social risks

Covid-19 has brought out the best and the worst of the corporate world. Carmakers are producing ventilators, and consumer firms are making hand-cleaning gels. Some others, though, have drawn complaints for their treatment of their employees during the pandemic.

Such considerations touch on what sustainable investors call “social” risks, part of the environmental, social and governance (ESG) basket of factors that has grown popular in recent years. Climate change and corporate scandals have led investors to focus on the “E” and the “G”. The pandemic brings the “S” into the limelight.

Social issues can range from the impact of demography on a firm to its relations with the local community. Moody’s, a rating agency, says that $8trn of the debt it rates is exposed to social risks—four times that exposed to environmental ones.

Some investors use social factors in the hope of improving the world: these invest in small listed firms, such as educational outfits, or in private projects. Others do so to improve returns. But there is little consensus on which social risks matter. A green asset manager can assess a firm’s carbon footprint; few gauges exist for socially minded investors. One exception is employee satisfaction, which studies link to a company’s performance. But a focus on that alone can lead to perverse outcomes, by simply giving greater weight to companies with relatively few employees. A recent study by Vincent Deluard of INTL FCStone, a broker, found that ESG-focused funds did precisely this.

Other social factors, such as a company’s culture, are harder to quantify. As a result, ESG-rating firms rely on inputs rather than outputs to calculate their scores, says George Serafeim of Harvard Business School. Instead of measuring gender balance, for instance, they ask if firms have a policy on diversity. Of the 61 questions underlying one rating firm’s social score, 24 look at whether companies have a specific policy or code of conduct.

Read more: The pandemic's gender bias needs urgent fixing

Whizzy data analysis might fill the gap. Thinknum Alternative Data, a research firm, looks at online reviews of companies written by staff members. Before employees at Wells Fargo, a bank, were found to be setting up fake customer accounts, they were complaining about having to do so. RepRisk, another data firm, analyses news articles and think-tank reports. Its risk ratings for Johnson & Johnson, Purdue Pharma and Teva Pharmaceuticals were already high in 2017, before America’s opioid crisis hit the headlines. All have since been sued for allegedly playing down the risks of prescribing opioids.

Read more: We must not sacrifice the environmental crisis just to resolve an economic one

A third data firm, Truvalue Labs, assesses the sentiment of news coverage. Using this, Mr Serafeim and researchers from State Street, an asset manager, found that positive coverage of a company’s response to covid-19 was linked to smaller-than-average subsequent declines in stockmarket returns in February and March, controlling for size and industry.

The rigour is helpful, but the challenge will be showing that such data can be consistently useful for investors. New social risks will arise as lockdowns end—for instance, relating to how companies make offices covid-proof. Plenty still to keep the number-crunchers on their toes.

© [June 2020] The Economist Newspaper Limited. All rights reserved. From The Economist, published under license. The original article can be found here.