Demystifying ESG social factors: How to access the “S” in ESG

Social issues, if left unaddressed, can have a detrimental impact on investment returns. Yet social factors are less well known to many sustainable investors compared to environmental and governance factors. Head of EMEA Funds Massimo Greco spoke to Global Head of Sustainable Investing Jennifer Wu and Investment Stewardship Specialist Minal Davé to find out why investors are now paying more attention to the “S” in ESG.

Why do social factors matter?

Jennifer Wu - The contribution of the social component of ESG to sustainable investment outcomes may be less intuitive than environmental factors, or even governance, but it’s no less crucial. Companies that fail to treat their employees or customers fairly, use unscrupulous suppliers, or who have little regard for the communities in which they operate, are unlikely to prosper in the long run.

The reasons are clear. A company that doesn’t provide a safe and healthy working environment, for example, is less likely to have a happy and productive workforce. Similarly, a company that cuts corners on product safety, mis-sells products or has poor controls on data privacy risks long-term reputational damage.

Social issues can arise right along the supply chain, with companies facing penalties if they deal with suppliers that treat their workers badly, or that are causing damage to the environment. And companies may face large fines, or litigation, if their operations are detrimental to local communities, due to issues such as pollution, or poor resource management.

What are the main “S” issues facing companies?

Minal Davé - Human capital management is a major focus, particularly since the Covid outbreak. Many companies have taken a much keener interest in their employees’ health and wellbeing, providing cleaner and better ventilated workplaces and additional healthcare benefits, including a focus on mental health. A company that puts human capital management at the forefront of its plans is likely to be better able to retain and develop its top talent—with clear advantages for its future performance.

Another key theme is diversity, equity and inclusion, which is something we firmly believe is not only important for social cohesion, but can also create shareholder value over the long run. For example, research studies have suggested that having more women in senior leadership positions can be beneficial for a company’s financial returns.

Diversity, equity and inclusion is not just something we expect from others, however. It’s important to J.P. Morgan too. We want to be a good company to work with as well as an investor in good companies. To improve social and racial equity, for example, we’ve made a multi-year, multi-billion dollar commitment to invest in underprivileged and under-represented communities around the world. And we’ve joined global campaigns to boost workforce diversity, such as the 30% Club, which aims to improve women’s representation on boards, and which is expanding to support racial equity.

Why is now the time to focus on the “S”?

Jennifer Wu - The game changer for “S” investing has been the “big data” revolution. The explosion in alternative data sources has provided a window into companies that investors have never had before, and is helping to reveal risks and opportunities that have not previously been available from company disclosures alone.

At the same time, the development of artificial intelligence and machine learning technologies is enabling investors to interpret all this data quickly and efficiently, using metrics that can identify stocks with the potential to benefit from social factors, while also weeding out companies that face significant risks, or that are only paying lip service to social change. The result is that investors today have the opportunity, for the first time, to deploy capital at scale to drive positive social change.

What social factors can be identified using Big Data?

Jennifer Wu - Our Data Science team trawls through hundreds of thousands of data sources to identify social factors in stocks that could have a real impact on sustainable outcomes, as well as future financial performance.

Take diversity, equity and inclusion, for example. Company disclosures tend to focus on quotas, or headline numbers, to measure the number of women as a percentage of the workforce, or a company’s ethnic diversity. However, while quotas can provide an important baseline to encourage diversity, simply having the mandated number of women on the board is not enough to make a company diverse. To get the full picture, investors require more detailed information, such as mobility data for women across the organization, and they also need to see how the company performs on broader diversity measures, such as race, sexual orientation, age and disability.

This information is available, but you need to know where to look. Our data scientists analyse employee reviews on the employment platform Glassdoor to gain a better understanding of issues that could have a negative impact on performance, such as poor staff morale or a bullying work culture. And the team can scour LinkedIn to reveal other potential red flags, such as high staff turnover, which in turn can shed light on issues such as competitiveness and staff treatment. We’re also able to target issues that are specific to certain sectors, such as health and safety in the mining sector, where we can analyse complaints data reported to non-governmental organizations to see what is happening on the ground, in terms of potential human rights violations or environmental damage.

We always look to validate and test the data we use for biases, while we use third-party sources to ensure data anonymity. The result is a much more detailed and nuanced picture of the opportunities and risks facing companies than can be gained from simply looking at the headline numbers published by the companies themselves.

How can investors maximize exposure to positive social change?

Minal Davé - Once “S” issues have been identified, investors need to decide whether they can be addressed within a reasonable timescale, or whether the risk is too great for engagement to be effective. Companies that have misused customer information, for example, may take a very long time to recover from the reputational damage caused.

In many cases, however, investors can look to drive positive change and encourage sustainable outcomes through engagement. We believe that asking tough questions of the companies in which we invest, and working with companies to help them bring about change, can have a positive impact on society and also lead to better financial performance.

To illustrate, we recently raised concerns with a UK fast fashion retailer after reports of low wages and poor working conditions in its warehouses, and health and safety worries at some of its suppliers, threatened to undermine shareholder value. The company has since committed to publish an annual sustainability report and to disclose its list of suppliers, providing much needed transparency and creating the opportunity to achieve a positive sustainable outcome.

We also look to actively encourage action to improve the gender and ethnic mix on boards, and across organizations, given the positive impact that we believe diverse and inclusive teams can have on financial performance. We work closely with companies that are lagging in terms of diversity to find out why and to see what can be done to improve matters.

What can investors do if engagement doesn’t work?

Minal Davé - We find engagement to be an effective tool to drive sustainable outcomes, and engagement therefore plays a key role in our ESG research. But if a company doesn’t take action in a reasonable timescale to address the issues raised, we can send a strong signal to the board to take our concerns seriously by voting against the company at its annual general meeting. If voting against the company doesn’t work, we can engage with other investors to divest the stock, as a last resort.

Sustainable investing with J.P. Morgan Asset Management

The rigorous analysis of social factors is fully integrated into all our investment research across the globe, along with environmental and governance factors. Learn more about our commitment to sustainable investing and find out how you can capitalise on the “S” in ESG.