As ESG meets resistance in some quarters, organizations are discovering that better measurement of social factors could help counter the skepticism. S-RM’s Natalie Stafford breaks down how companies can transform nebulous social goals into concrete, measurable outcomes.
Discussion about ESG principles — now a fixture on deal desks and in boardrooms across the globe — still focuses predominantly on the environmental aspects of ESG.
In his 2022 Stanford Social Innovation Review article “Fixing the S in ESG,” Jason Saul argued that this is because environmental factors are easier to quantify and measure than social factors. While regulation and technology have ensured that businesses are measuring environmental and climate change impacts, quantifying and reporting on social components of ESG has not continued on the same fast-paced trajectory, nor with as much clarity.
With ESG meeting resistance in some circles, a focus on the multi-faceted elements in the social component can help renew credibility in the overall concept. But it starts with defining what “social” encompasses and developing reporting frameworks for measuring progress and impact.
Defining the ‘S’ in ESG
One reason we are not excelling at tackling social issues at the pace we could be is that definitions for the social pillar of ESG tend to be subjective, hodgepodge and at best vague. As such, they are unfit for purpose. The S&P, one of the largest U.S. ratings agencies, defines the social component of ESG as “the relations between a company and people or institutions outside of it.” Reuters says the S in ESG extends to “all the ways companies interact with their employees and the communities in which they operate.”
These are very broad and rather ambiguous definitions that could potentially extend to every part of every department across every company. With such indefinite parameters, how can we account for, quantify or mark the evolution of what constitutes this component of ESG? Are we in a better position now to make progress on social sustainability than we were in 2022? Perhaps.
While there is still no formal consensus as to exactly what constitutes the social pillar of ESG, the most common issues we look at include human rights, modern slavery, DEI, community programs, health and safety, data protection and privacy, responsible supply chains and labor laws.
Corporate citizenship or corporate responsibility can also fall under this umbrella, and a relative newcomer to the field but one of particular importance at the time of this writing is geopolitical risk. We are seeing companies increasingly spend ESG dollars on understanding geopolitical risk in their supply chains and investors looking to understand their exposure to geopolitical and macroeconomic factors.
So, let’s be clear about what social is. If it can be focused down into distinct categories, then we have something organisations can budget for and measure.
With this dizzying array of factors, what stands out is that while these areas are crucial to the sustainable success of any good business, the vast scope and breadth of issues encompassed in the social pillar needs to permeate as many areas of a business as possible. Any attempts to tackle these issues without standardization, KPIs, targets, metrics and rigor would be ineffectual at best and negligent at worst, leaving us to rely on the old boardroom saying, “You can’t manage what you can’t measure.”
We delved into this in our recent paper, “2024 ESG Report: The rise of social sustainability,” in which we noted that more than two-thirds of the 550 corporate leaders and 200 investors with whom we spoke anticipate their companies’ ESG budgets will increase over the next five years.
Risk and reward
Saul’s 2022 article pointed out that definitions of the social pillar of ESG and the data collected on it tend to focus on identifying and mitigating risks. Indeed, global ratings agencies such as S&P and Moody’s measure social as a means of informing their risk management strategies (through the lens of materiality, or what is impactful to a company’s financial performance). This is to say that definitions and parameters for measuring social indicators are not finely tuned to assess and improve opportunities for social outcomes. It is generally accepted that there are many ways that good social practices can improve a business and add value to the communities in which it operates, making the business itself more valuable and therefore maximizing returns and impact.
Therefore, in order to capitalize on the social pillar, we must first understand the opportunities it brings us to realize this impact — for example, increasing revenues, making operations more efficient and bolstering a company’s reputation. While we take into account and analyze risk when assessing a social factor — what are the risks to revenue, to operations, to reputation, etc.? We should avoid falling into the trap of thinking this is an either/or scenario.
Succeeding at measuring impact
Several approaches have emerged that lead to greater success in measuring the quantifiable outcomes of companies’ social strategies: measuring impact, not activity; linking their programs to their business strategy; and using many stakeholders, both inside and outside of the company, to ideate, measure, source and deliver projects.
A 2023 Kearney study found that less than half of companies are tracking the economic impact of their programs and only one-third are leveraging outside stakeholder input to source and execute on their strategies. It also found that companies headquartered in the UK or in China are significantly more successful than others both in creating successful programs and in measuring their impact.
A big part of this comes down to putting the right framework in place and being clear about the impact a company wishes to generate. A minerals firm we worked with provides a very clear example of how to get this right.
This firm had identified modern slavery and forced labor as their lead social issue to focus on, initially based on the Sustainable Development Goals, like many companies. In this case, it was Target 8.7, take immediate and effective measures to eradicate forced labor, end modern slavery and human trafficking and secure the prohibition and elimination of the worst forms of child labor, including recruitment and use of child soldiers, and by 2025 end child labor in all its forms.
Rather than muddled targets, the minerals business clearly delineated its approach by the supply chain, external stakeholders (predominantly local communities and non-governmental organizations) and internal stakeholders (employees and contractors). This meant that the risks in each of these areas could be understood and an ideal future state identified — in their case, aiming for industry-leading standards (and defining what these were) within three years for their internal and external stakeholders, while meeting compliance requirements for their supply chain within three years, before progressing on to be industry-leading in five years.
From this, we could conduct a gap analysis to clearly understand the data, policy and implementation requirements and map out a viable roadmap to make progress in each of these areas. Because the firm was focused on a manageable number of ESG targets, it meant we could take the time to build a proper and robust range of measurements and engage with stakeholders before implementing them to ensure the data collection was actually viable and would generate information of value. This company showed that if you get the foundations right and take the time to understand the social issue and the impact you want to achieve, rather than rushing in and implementing policies and metrics too quickly, you will create a much more successful program for the social of ESG.
Solving for ‘S’: The risk vs. opportunity equation
Understanding how best to tackle the risk involved in social principles — particularly the reputational and market value risks — requires a view into the regulatory environment around them. For the social issues of ESG, there is a huge range of regulation and legislation, either in place now or coming online within the next five years.
Hot-button issues like human rights, modern slavery, DEI, labor rights, supply chains, geopolitical risk and data protection and privacy are all areas increasingly driven by regulation, including the EU’s Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive (CSDDD). These are European regulations, but they bring many US companies with a footprint in the Eurozone into their scope. Echoes of this can be seen in US domestic modern slavery and supply chain legislation or DEI disclosures and listing requirements such as the NASDAQ board diversity reporting requirement.
One piece of legislation requiring more attention, the CSDDD, is a far-reaching legal framework for companies conducting business in the EU that requires human rights and environmental considerations to be placed in operations and corporate governance. S-RM’s survey of 750 firms highlighted the CSDDD as being the regulation of most concern to US investors. This is because the CSDDD and CSRD are de facto global standards, even for companies that don’t technically fall within their scope. And it has teeth in terms of measurable (in this case, negative) impact: Noncompliance can lead to civil liability and financial penalties of up to 5% of a company’s net global turnover.
Yet with all the risk involved — and the heavy compliance burden these new regulations bring — there is also opportunity for positive impact. A quarter of the respondents to our survey told us that a primary benefit of the social pillar of ESG will eventually be a reduction in legal and compliance costs over time. This was particularly strong for shipping, logistics and infrastructure firms, where 40% considered this a primary benefit.
A focus on social factors also has the potential to bring a lower cost of capital and more preferable financing arrangements. ESG’s environmental pillar may be the most mature, but its social areas can learn some lessons from this. We have recently seen the launch of the Taskforce on Inequality and Social-Related Financial Disclosures (TISFD), following in the footsteps of the Taskforce on Nature-Related Financial Disclosures (TNFD) and TCFD (Taskforce on Climate-Related Financial Disclosures). It does not need to take the social pillar as long as it took the environmental pillar to be mainstreamed within an organization’s corporate strategy and reporting — the basics are there and the wheel does not need to be reinvented.
A truly global approach to standardization, quantification and reporting will ultimately create better governance programs in addition to better supply chains, as social issues become more transparently integrated across the functions of a business. In the short term, the growing shift toward measuring impact rather than just gathering data to show something is being done will help firms whose ESG program is not sufficiently well-embedded — generating positive impact for investors, consumers and regulators.
The future of social: compliance & cross-functionality
Regulations like CSRD and CSDDD are leading the way forward for the S of ESG, with calls for consistency and transparency in reporting and standard metrics and data points to reveal companies’ performance. In the next five years and beyond, companies not already doing so will need to incorporate double materiality into their ESG strategies — namely, reporting that encompasses both financial and nonfinancial perspectives. This will be a critical step in determining what they will need to disclose in their regulatory and compliance reporting.
While finding standardized ways to measure impact and outcomes of social initiatives and programs will be a key part of any robust ESG strategy, it’s worth noting that the future holds a few new wrinkles for the already complex array of social concerns for ESG.
One of these, as mentioned, is geopolitical risk. Historically ESG and sustainability programs have developed in a geopolitical vacuum, with KPIs and policies that fail to account for regional instability and political change. In light of the past two years’ turbulent geopolitical situation in many areas of the world, companies will need to fundamentally rethink their approach to geopolitical considerations and integrate this into ESG strategies, whether operating in new conflict zones or thinking about the location and threats to their supply chain.
This and all other initiatives will require not only a better understanding of political and security developments and their impact on businesses’ social commitments but a thorough commitment to integrating the social agenda throughout the organization, bringing together human resources departments with legal, corporate affairs and risk for truly cross-functional decision-making.
Social issues, not environmental or governance issues, registered highest in our research as areas of future concern for corporate leaders. With heavier allocations to the social pillar of ESG, investors will increasingly demand accountability, while consumers and regulators lead the public face of social corporate responsibility themes. A mapping of the risks and potential benefits of social decisions, and proactive scanning for potential issues in the near- and long term, will allow companies to keep a finger on the pulse of the fast-moving social pillar of ESG.