James Brazier | June 15th, 2022

The “S” is likely to be the next big growth area in environmental, social and governance (ESG)-focused investing. With tens of trillions of dollars of capital allocated to ESG, building-out the “social” element will be an important part of finding the $4 trillion needed annually if the world is to meet the UN’s Sustainable Development Goals by 2030. However, past experience suggests that the “S” could prove as contentious as the “E”, not least because different countries have very different ideas over how to improve social conditions.

All eyes on Europe

When it comes to ESG regulation, the European Union is the global standard-bearer. It takes a taxonomy approach to ESG, crafting what are essentially lists of activities that can be considered sustainable from an investment perspective. The bloc has already produced an environmental taxonomy, though work continues to expand it, and it plans to use this as a basis for a social taxonomy.

The experience of the environmental taxonomy, however, suggests that not all will be plain sailing. A January 2022 consultation on the environmental taxonomy met with acrimony after the EU Commission suggested that some nuclear and gas power projects may be ESG compatible. In response, the governments of Spain, Austria and Luxembourg said they would vote to reject the taxonomy outright. Spain’s ecological inclusion minister described the inclusion of gas and nuclear projects as “a big mistake.”

Will the EU’s social taxonomy encounter a similar level of dissent? The immediate answer is probably “no”. First, the issue lacks the same divisive technical questions over what constitutes decarbonisation, some of which stray into futurology. Secondly, the EU’s social taxonomy is not being built de novo; rather it draws inspiration from a variety of existing development, human-rights and labour guidance issued by multilateral organisations like the UN and the OECD.

Trouble is more likely further on down the line, at the implementation stage. The EU expert group working on the social taxonomy has urged the bloc to use it not only to improve the living and working conditions of Europeans but also to “position the EU as a standard setter and frontrunner in implementing global agendas”. This may not be entirely welcome in frontier and emerging markets with relatively fresh memories of European imperialism - especially when European priorities conflict with national ones.

Majorities as a minority

Almost one in seven of the respondents to the EU’s expert working group “did not see any merits in the social taxonomy outlined in the report”. One common concern was potential interference with national legislation and the autonomy of social partners. As the EU document notes, what counts as socially sustainable (or detrimental) depends on national context.

When it comes to ESG investing, there is currently high investor demand for social bonds, use-of-proceeds instruments that support, for example, affordable housing or job-creation for marginalised social groups. What counts as a marginalised group, however, is a good example of where national context comes into play in ESG, and how European ideas of disadvantaged minorities may come up against a majoritarian reality elsewhere.

Take South Africa. In most countries the “E” in ESG has long been the overriding priority, but South Africa is unusual in that not only is it a pioneer of ESG, but it’s a country where the “S” has long predominated, a legacy of decades of white-minority rule in what is now attempting to be a rainbow nation. As early as 1994, the King Report on Corporate Governance recommended that every South African corporation should include affirmative action within its business planning and corporate governance to promote black inclusion, noting that such action was “important for corporations to survive and thrive in the new South Africa”.

This affirmative action would be further codified by South Africa’s governments in the form of broad-based Black Economic Empowerment, designed to encourage the corporate sector to hire and promote more people from the country’s under-represented black majority. By the time King IV was published in 2016, ethical culture and legitimacy had become core to its outlook, with corporate governing bodies expected to set and monitor targets for their racial and gender inclusion.

South Africa’s approach to majority uplift is relatively uncontroversial, but that is not the case elsewhere. For half a century, Malaysia has pursued a bumiputera policy designed to advantage the ethnic Malay majority in relation to the more prosperous Chinese and Indian minorities. The success of the policy is questionable, leading opposition figures to demand a new approach. It has also prompted claims of crony capitalism that has enriched a tiny minority of Malays, and of that discrimination has led to a “brain drain” of Chinese Malaysians from the country.

Where affirmative-action policies target minorities, there is still ample scope for controversy. India’s government maintains a list of marginalised groups that qualify for official affirmative action, but this has become a political football that has prompted large-scale unrest from groups demanding inclusion in the quotas, and from listed groups protesting at their possible dilution. That India’s social-uplift policy encompasses the Hindu concept of caste shows again the difficulty of applying European and North American concepts of diversity and inclusion (D&I) to countries outside those regions.

Even in western Europe, there are serious divisions over D&I. Countries such as France and Germany have resisted collecting data on racial diversity and representation, for example, respectively reflecting a “colourblind” approach and historical concerns over racial categorisation. Brazil has traditionally taken a similar approach but is now seeing an initiative to create ESG Racial Equality Indexes, albeit at a voluntary level.

What the future holds

So far, social and social-impact bonds have not attracted the same controversy as ESG investments focused on the environment, with accusations of environmental “greenwashing” leading to law-enforcement raids on major banks. But it is not cynicism to suspect this relative tranquility will not last in the social investment space, given the highly politicised nature of attempts to improve the fortunes of marginalised communities.

As the EU report notes, ESG risks can be viewed as an interlocking nexus of secondary risks: reputational, market, liquidity, credit, regulatory, operational, and insurance. It also notes that some existing ESG rating systems show wide divergences in their rankings for human rights and product safety, which are both social issues, and that this underscores the need for a consistent way of measuring them. Without such consistency, scope for legal disputes and accusations of “socialwashing” may be inevitable.

One approach to avoiding this is to limit the “S” component of ESG investment to the least controversial areas, such as the provision of clean water and sanitation, one of the UN’s 17 SDGs, but this would severely curtail the scope of investable projects. Going beyond that will require a cautious and research-intensive approach, in a world of widely differing national ideas about gender, indigenous and employment rights. The era of “think global, act local” may need to give way to its mirror image, with investors and issuers thinking locally but acting on a global scale to mobilise capital in support of all aspects of ESG.

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