The S in ESG

Humans don’t like chaos. We don’t even feel comfortable with disorder and untidiness. Our brains are hard wired to look for patterns (we see faces in the clouds and in the bark on trees). We are natural tidy-uppers. We like things to make sense, preferably in relatively simple ways.

Herein lies the rub. The S in ESG may not be chaotic but it certainly is complex and it is requiring those in the financial and allied world to think about things they have never really thought about before and are not trained in. Our response is to try to tidy things up, to regulate for the S in ESG. This is where the problems start.

Just within the European Union we are experiencing a multitude of regulations focused on the ESG-related performance of companies and investors. We have the EU Taxonomy, the Task force on Climate Related Financial Disclosure (TCFD), the Sustainable Finance Disclosure Regulations (SFDR), Corporate Sustainability Reporting Directive (CSRD), the International Capital Market Association (ICMA) regulations for Green, Social and Sustainable Bonds, plus a host of pre-existing and new accounting rules and regulations. One should also point out that this is but a small fraction of the activity that is going on at the present time.

Of course, these different regulations do not necessarily (or even by design) regulate exactly the same things, although there is overlap between all of them. These various regulations may use different words to mean the same thing (e.g. Society, Social and Sustainable all have different definitions and interpretations across the regulations) and the range of buzz-words is proliferating (materiality, double materiality, circularity, sustainable, sustainability, Green etc). All adding to the complexity of the field.

Even for large companies and investors, coping with (let alone complying with) all these regulations is complex and expensive (particularly as some reporting is annual) – whether the reporting is done in-house or out-sourced. For many SMEs, it is quite simply out of reach.

To make matters worse (as if they could be), as I stated above, these regulations have emanated just from the European Union. Parallel sets of (sometimes contradictory, sometimes incompatible) regulations are also being produced by many countries around the World. Imagine if you are an SME that sources raw materials from five different continents and sells products in three different continents how can you possibly (materially or financially) negotiate your way through to compliance with all these regulations – and how, as an investor, are you supposed to make sense of all of this?

A large part of the problem in getting to grips with the S in ESG is, therefore, not in our understanding of S but it is to be found in the manner in which we are trying to bring order to chaos, but, in fact, just creating more chaos.

To a certain extent, this state of confusion (let’s call it) surrounding the regulation of S is understandable. As I said above, we’re expecting people who are not trained social scientists to define S, to determine the scope of S and describe how S should be measured. Also, it must be mentioned, that cross-cutting all of the above are the UN originated Social Development Goals which have become central to many companies and investors, around the World, in their efforts to ‘build back better, build back different’. We cannot (certainly should not) ignore the SDGs – especially in the context of economic and financial recovery for many less well-off countries around the World.

the financial world is accustomed to structure and certainty. Money is, after all, just numbers and numbers can be counted, added up, subtracted, multiplied and divided with certainty and consistency. This is the inherent attraction of finance. It was these properties that led the Thatcher government of the 1980s in the UK to introduce the Financial management Initiative into the public sector (designed to bring the certainty of financial management to public sector social services) and the creation of the Audit Commission. The initiative was, in short, a disaster and the Audit Commission was ultimately abolished. The root cause of the failure of the FMI was, in short, in the basic inability of government to reduce 'social' matters to consistent, certain and countable numbers. There are lessons to be learned from this experience.

In this scenario it is not surprising that many have rushed to different ‘solutions’ and made basic mistakes along the way.

Even as we write this, there are those who are trying to address some of the above problems. For example, building on the 'European financial transparency gateway' project, the EU will set up a single access point to financial and non-financial company information. Also a partnership of influential ‘big hitters’ (details in the report: https://esg.trust.org/application/velocity/_newgen/assets/InvestorMythBuster.pdf) have produced a report ‘Amplifying the “S” in ESG: Investor Myth Buster’. The partners in this venture are committed to ‘amplifying’ the importance of S in investor decision making, as well as improving and expanding the use of S indicators.

The authors of the report identify five myths about S and then set about debunking them:

‘Financial materiality: Social performance is less financially material than environmental performance 

• Reality: Social issues are key risks to all investors and their beneficiaries
  

Data: The “S” indicators are too hard to measure; there is no reliable and comparable data 

• Reality: It is possible and necessary to start using social indicators more 
  

Starting point: It is too difficult to know how and where to start assessing social performance

• Reality: The link between business and human rights is well established 
  

Integration process: Qualitative surveys or questionnaires are the best method for tackling social issues and analysing the social aspects of performance 

• Reality: Qualitative approaches can be enriched by data driven elements 
  

Relevance to investors: Integrating “S” indicators is only relevant for impact investors 

• Reality: “S” indicator integration can help to identify more resilient and profitable investment opportunities’
  

Space precludes a full exposition of the report authors’ arguments and a full step-by-step critique, but I want to make three basic points.

• The report has been prepared from an investor perspective, yet much of the reporting burden falls directly on companies.
  

• In order to try to make progress the authors have separated S from E and G. This is a mistake. E and S and G are heavily intertwined and co-dependent. Progress in one is intimately linked to actions in the other two. E, S and G is a holy trinity – an unity concept: ESG. They are indivisible.
  

• Many of the assumptions in the report about defining S, the scope of S and measuring S are only partially true, they are only accurate under some quite specific circumstances. This is an extremely complex area and specialist advice (beyond that available in the report) would be needed to act with confidence in this respect. 
  

Going back to where we started: the basic human proclivity for imposing order on chaos may well have set us all on the wrong path. The search for order, clarity and understanding may be a chimera. As social scientists we are very well familiar (if not comfortable) with the messiness of the social world. We understand that our knowledge of the social world is incomplete (and possibly faulty), that much of our knowledge is context specific and that the more we know, the less the understand. This (uncertainty) is the natural order of things.

So how do we put things right? How can we get onto a better, more effective course? I’m afraid I don’t have all the answers, but I have one. We need to go back to basics. We have to ask: What is all of this (regulation) for? Why are we doing all of this? It seems to me there are two basic reasons: 1) to minimise corruption and 2) to make an impact. We also have to ask ourselves: are our current efforts consistent with these two outcomes?