Feb 06, 2020 Sustainability

The "S" in ESG: hard to grasp but important for risk management

When making sustainable investments, many investors concentrate mainly on the "E" and "G" in the so-called ESG criteria. But "S" has interesting implications for portfolio risk as well.

  • Many investors have until now concentrated primarily on environmental factors (E) and corporate governance (G) when analysing sustainable investments.
  • Social factors (S), which together with these other two elements form the so-called ESG triad, are comparatively difficult to classify.
  • However, a study now suggests that companies that are ahead on social issues react more robustly to general risks.
3 minutes to read

For more and more people, living a sustainable and responsible life now also means selecting companies to invest in that pay attention to such matters. Index providers use so-called ESG criteria to assess companies from this angle. The "E" stands for environmental, the "S" for social and the "G" for governance. Because the climate crisis currently features high on the political and news agenda, many investors seem to be focusing primarily on the "E" in ESG.

The article "Good corporate governance pays off" considers the fact that shares in companies with good governance can lead to better performance. But what influence do social aspects have on investments? And what is the effect on an investment portfolio of selecting companies that are particularly socially minded?

Which sustainable investment factor is most important to you?

What does social mean?

You can tell that investors have not yet paid much attention to companies‘ social standards  because companies have, for example, not yet adopted uniform reporting on social issues. Only a few companies have a reporting system for presenting data on social issues to investors. By comparison, a strong focus on environmental factors has led securities issuers to develop systems and reporting methods for issues such as carbon emissions, fossil fuel reserves and clean energy use.

A contributing factor here is the difficulty in establishing any social indicators. After all, social issues cover a wide range of topics: from consumer protection to product safety, labour law and safety at work, diversity, the fight against corruption and respect for human rights throughout the supply chain.

To complicate matters further, these issues are evaluated differently in different countries. Germans tend on average to place greater emphasis on respecting human rights and avoiding child labour. In the UK, by contrast, the issue of workplace diversity has become increasingly important in recent years.

"In order to make progress in this area, it is important to have clear definitions and measurements for what constitutes a social company," explains Robin Braun, responsible investment officer at DWS. "The next step is to decide how much weight to give to different issues so that investors can better compare different companies and sectors in social terms."

What constitutes a socially responsible company for you?

Social factors are extremely important for risk assessment

It is challenging to assess social factors, but in practice companies that for example pay their employees poorly face considerable difficulties. Thus, a passenger transport service supplier in London lost its licence due to poor working conditions. And one airline recorded a decline in passenger numbers after it was revealed that it pays its pilots comparatively poorly. Another example is the media outcry over collapsed sewing factories in Bangladesh, which put pressure on the fashion industry.

"These examples support the view that companies that adhere to social standards can operate more stably," says Braun. "If a company’s social grievances come to light, experience shows that stakeholders usually[1] penalise it."

A study by Professor Alfonso Del Giudice of the Catholic University in Milan also shows that social criteria are important for risk management[2]. He analysed more than 1,000 companies from 18 countries over a period of 14 years. The results show that high social standards can reduce a company‘s systematic risk. In portfolio theory, systematic risk is defined as the risk to which all companies are exposed that cannot be reduced by diversification[3]. Del Giudice could not prove the same effect for the "E" and "G" factors.

According to the study, companies with high social standards appear to react more robustly to occurrences such as inflation or periods of economic weakness. This means that "S" could help investors to build a portfolio that responds in a less volatile way to market changes.

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1. Stakeholders are people who have an interest in the way a particular company behaves, including shareholders, employees, customers and suppliers.

2. https://deutschewealth.com/content/dam/deutschewealth/cio-perspectives/cio-special-assets/s-in-esg/CIO%20Special%20-%20The%20S%20in%20ESG.pdf

3. Diversification is understood to mean a broad spread of capital across several countries, sectors and securities. This enables investors to reduce their risk of loss on the one hand and increase their chances of returns on the other.

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