Measuring the 'S' in ESG

This week we will look at how data providers measure Social score

It is probably not an exaggeration to say that among the key categories of ESG, S or Social receives the least attention.

E or Environmental hogs the limelight, especially given the intense debate over climate change and its noticeable impact on our lives and livelihoods. G or Governance, on the other hand, has its claims as the predecessor of the whole ESG movement as corporate governance has always been a major theme for investors.

In this week’s post, we will look at a few data vendors’ methodology documents to see how they measure the Social aspect of ESG.

Let’s begin!

Photo by EqualStock on Unsplash

Definitions

Under MSCI, we see that the data provider classifies the following themes under the Social pillar: Human Capital, Product Liability, Stakeholder Opposition and Social Opportunities.

Source: MSCI ESG Ratings Key Issue Framework

For another data provider Sustainalytics, ESG risks are not nicely bucketed into each category of E, S and G. Instead, it uses a Material ESG issues framework below, and each sub-industry has issues that are more applicable to them:

Source: Sustainalytics

Among the key issues above, the ones that I find to be most related to the Social aspect are Access to Basic Services, Community Relations, Data Privacy and Cybersecurity, E&S Impact of Products and Services, Human Rights, Human Rights - Supply Chain, Human Capital, Occupational Health and Safety, as well as Product Governance.

Before we jump into another data provider, it’s not hard to see that there are some overlap with the key issues from MSCI. These mostly relate to human capital, product safety and access to services. What is quite surprising is that data and cybersecurity is also a key theme of the Social aspect of ESG, but thinking deeper, data and cybersecurity are somewhat related to product safety and user experience.

Let’s look at one more data provider, Refinitiv, which takes a similar approach to MSCI by grouping key issues into each of the E, S and G bucket.

Source: Refinitiv

Again, the key themes under Social seem to be Workforce, Human Rights, Community and Product Responsibility. Refinitiv also provides a breakdown of the number of metrics for each category (the numbers in the doughnut chart above). As you can imagine, the Workforce category is probably the easiest to quantify, hence it has the highest number of metrics. Human Rights, on the other hand, may be a bit more subjective and harder to measure.

Measuring S Scores

Among the data providers, MSCI has the most transparent and accessible methodology documents, so we will use that as a baseline.

Recall that under MSCI, the four key themes are Human Capital, Product Liability, Stakeholder Opposition and Social Opportunities. There are several key issues under these themes, but we will not jump into all of them here and will only highlight a couple of the more pertinent and interesting ones.

Let’s put on our ESG rating agency hat for a second: how would you gauge if a company is doing well in Human Capital?

At the very least, the company has to pay a decent wage, workers have a healthy work environment and employees are not discriminated against.

Let’s look at how MSCI measures this by diving into the key issue known as Labor Management, under Human Capital:

Source: MSCI

The Labor Management management score¹, in turn, is the average of these three scores:

Formula to calculate Labor Management management score. Source: MSCI

Under Strategy Score, a company is measured on the following:

• Employee equity programs

• Workforce eligible for non-pay benefits (including pensions and 401k)

• Workforce eligible for variable pay

Under Programs & Initiatives Score, the following metrics apply:

• Employee satisfaction survey frequency

• Restructuring policies and programs

• Scope of skills and knowledge development training

• Support for degree programs or certifications for employees

Lastly, under Performance Score, these are the relevant metrics:

• Employee turnover

• Employee productivity

• Strikes

• External recognition

This seems like a fair representation of a company’s management of its workforce. Happier employees should lead to lower turnover, higher productivity and fewer strikes. It seems like our earlier attempt was not too far off the mark!

The next key issue that we would look at is on Community Relations, given that both Refinitiv and Sustainalytics also have this as one of their categories under S.

The Community Relations management score uses the formula below:

Formula to calculate the Community Relations management score. Source: MSCI.

Let’s look at each of the score used in the formula.

The Community Impact and Disturbance Score measures the following:

• Commitment to refrain from operating in protected areas, such as World Heritage sites

• Company conducts community impact assessment prior to settling in new areas

• Indigenous peoples policy

• Local community engagement approach

The Conflict and Human Rights Score, meanwhile, looks at:

• Company monitors the effectiveness of its human rights policy

• Employee training on human rights protection

• Ethical conduct policy covers contract security providers

• Human rights policy: Has the company adopted a formal human rights policy?

• Violence and conflict policy: Does the company have a formal policy related to violence and conflict?

The Distribution of Benefits score relates to how the company supports the local community by looking at its:

• Local procurement policy

• Programs to support local communities

As you can see, the scores above probably do not apply to many companies out there, unless their business involves working with the local community. Furthermore, these scores may also have a positive bias on larger companies, as these firms tend to have the resources and manpower to formally document their human rights and violence policies. Instead of really measuring a company’s real ability in managing community relations, sometimes this exercise just ends up rewarding companies that report well.

We should also point out that MSCI would also subtract scores from the overall management score for this key issue if the company is involved in controversies surrounding human rights, community impact and indigenous peoples. Therefore, it is important to avoid controversies to score well in this aspect.

Summary

Compared to E and G, I always find the Social component of ESG to be the hardest to understand and measure. Across the three major ESG data providers (MSCI, Sustainalytics and Refinitiv), there appears to be significant overlap in themes for this issue, particularly regarding a company's workforce, community relations, human rights, and product safety.

While we didn't delve deeply into product safety in this post, it represents a significant risk for any company beyond ESG considerations. Any recalls or safety-related breaches would undoubtedly harm the company's finances and reputation. Similarly, a company's workforce is crucial in its own right, not just for ESG reasons. A company with poor human resources management may struggle to compete or even survive in the long term.

My point is that most well-run companies already excel in these aspects (maintaining low employee turnover and ensuring product safety) without needing a dedicated ESG department. These practices are fundamental to good business operations. For any successful company, these aspects are the non-negotiable cornerstones of operation.

However, when it comes to establishing official policies on human rights, workforce diversity, and implementing outreach programs to support local communities, an ESG specialist may be required. Not all companies need or have the resources to pursue these initiatives.

So, the next time you come across a company with a poor S score, it is important to distinguish what it is being marked down for: is it due to poor labor management or the absence of a formal community outreach program? The former is essential for a company’s survival, while the latter, though valuable, is more of a nice-to-have feature.

1. MSCI measures both Exposure and Management scores for each key issue. The former evaluates a company’s exposures to the particular risks and the latter evaluates how a company manages said risk. For the sake of our discussion, we will only include the breakdown of the management score and skip the exposure score.