What institutional investors need to know about the ‘S’ in ESG

Today the PRI is publishing a landmark human rights framework for institutional investors: Why and how investors should act on human rights, thereby deepening its own focus on human rights and establishing a multi-year program of work to embed the UN Guiding Principles on Business and Human Rights (UNGPs) into investment activities. Why this topic? And why now? We will explain.

The UN Human Rights Council unanimously endorsed the UNGPs in 2011. The OECD immediately incorporated the relevant parts into its Guidelines for Multinational Enterprises. Uptake by individual companies across sectors and geographies, business associations and even global sports organisations like FIFA and the International Olympic Committee has been impressive. The early ESG adopters were supportive from the start. Mainstream investing, however, has been slow to the party.

But three developments are opening doors. The first is the remarkable rise in ESG investing following the 2008 financial sector meltdown, coupled with the increased recognition that most of the ‘S’ factors in ESG are human rights related. The second is the inescapable materiality of many human rights concerns, even on the narrowest definition of materiality. The third is COVID-19, which has shone a bright light on the ‘S’ in ESG, including the unsustainable economic and social inequalities built into our current economic system.

Examine the high-level ‘S’ themes employed by an ESG data provider and you will find a list of human rights related factors. They lead to questions such as these: What is the quality of a company’s relations with workers and communities? Does it practice real gender and racial equity and social inclusion or just cosmetic compliance? Does the company engage in responsible marketing and R&D? Are security guards protecting company assets adequately trained to avoid the use of excessive force, and to not exploit their position of power vis-à-vis vulnerable villagers? Are social media firms doing all they can to prevent their platforms from being used to disseminate hate speech and incite communal discord and conflict? How credibly is the company managing the risk of forced or child labour in its supply chain?

An oft-repeated argument against ESG investing, especially the “softer” human rights factors, is poor data quality. But that may be on the way to being fixed. A race is on to set international authoritative ESG standards and metrics. Its drivers include the European Commission, the IFRS Foundation (whose financial reporting standards are required by more than 140 jurisdictions), large asset managers, and coalitions of accounting firms, with several smaller initiatives that are active in this space forming coalitions and hoping for a seat at the table. COVID-19 has sent a powerful message to these processes to ensure that the ‘S’ in ESG receives attention equal to the others.

The second development attracting greater investor attention to human rights issues is their materiality. Many companies have miscalculated human rights risks on lack of materiality grounds and paid high costs for their mistake because they were “material” to victims. Now the conceptual gap between the two is narrowing because growing numbers of jurisdictions are transposing elements of the UNGPs into domestic hard law. To date, all involve the core construct of human rights due diligence (HRDD). The UNGPs spell out a process for companies to identify, prevent, mitigate and account for their involvement adverse human rights impacts and outcomes, through their own activities and business relationships.

The hardening of HRDD into domestic law began with modern slavery reporting legislation, as in California, the United Kingdom and now Australia. None of these imposes serious legal penalties for non-compliance. The scope of the French “Duty of Vigilance” law adopted in 2017 goes further to require human rights and environmental due diligence of the largest French companies, and foreign firms with a significant business presence in France. Civil penalties are possible where harm occurs in connection with certain business relationships. The more recent Netherlands Child Labour Due Diligence Act applies to companies that sell or supply goods or services to Dutch end-users, regardless of where they are based or registered, and involves potential criminal penalties for directors.

Finally, the European Commission has announced that in Q1 2021 it will issue a legislative directive mandating human rights and environmental due diligence for companies based within the EU and again foreign firms with a significant business presence. Specific mechanisms of accountability, including civil liability, are under debate.

Similarly, recent years have seen a surge in industry initiatives such as the Investor Alliance for Human Rights, who released a toolkit for investors earlier this year, or the Liechtenstein Initiative Financial Sector Commission on Modern Slavery and Human Trafficking, which made recommendations for the finance sector on how to tackle human trafficking last year. Undoubtedly this list will grow longer as time goes on, so the PRI’s human rights initiative and paper for institutional investors couldn’t be more timely.

The PRI and the UN Guiding Principles both had modest UN beginnings but came to play leading roles in their respective global spheres. ESG investing has brought them together in the critical mission to align values and value in securing a better future for people and planet.

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.

Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.

If you have any questions, please contact us at [email protected].