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    Sustainability

    The S in ESG: a critical differentiator  

    by Vanina Farber Published 4 July 2023 in Sustainability • 8 min read

    Are you neglecting the ‘S’ in your ESG strategy? Progress on social issues has lagged behind the more clearly defined environmental and governance concerns. However, a combination of changing consumer preferences, employee attitudes and emerging regulations has enabled successful firms to use social issues as key differentiators. If organizations are to thrive, leaders must develop more ambitious and material strategies to address their social challenges.  

    The ESG agenda has changed the way organizations operate. Regulators and investors now weigh up environmental, social and governance credentials alongside financial performance. Businesses have taken note: many are increasing their efforts to become more sustainable. Yet these efforts are often lopsided. ‘S’ is often overshadowed by ‘E’, with investors and businesses prioritizing environmental issues. 

    Of course, no one is saying that environmental action is not important and urgent. And many businesses are doing significant work on social issues. What is missing is an integrative strategy for the social dimension, along with a recognition that environmental and social factors are often deeply interlinked.  

    Time to progress the S 

    To say that social issues have been overshadowed is not to suggest that businesses have disengaged from factors that affect their employees, supply chain workers, customers, or members of the wider community – far from it. The scope of ‘S’ has progressively widened over the past two decades, in part reflecting the evolving business environment of the 21st century where businesses and markets are increasingly comingled. Over and above human rights, labor issues, workplace health and safety, and product safety and quality, ‘S’ factors now also incorporate the impact of modern supply-chain systems and the adoption of technological advances like artificial intelligence and the future of work. 

    Many businesses have taken concrete actions on equity, inclusion, and diversity (EI&D). For example, 402 firms of S&P 500 have implemented an EI&D strategy. Efforts to tackle child labor or improve labor rights have become important topics for multinationals with global supply chains like the cocoa industry. Consider the action on sexual harassment and discrimination after the #MeToo movement, or the extraordinary changes to protect employee health during the pandemic. Companies have been dealing with all these issues, and many are making real advances. There is a much broader acceptance of the key material nature of “S” for the success of a business.  

    The ESG agenda has changed the way organizations operate.
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    But many of these issues elicit reactive responses from organizations. What firms need to do now is systematically identify and integrate proactive actions into their overall business and sustainability strategies beyond specific interventions that address the social topic du jour.  

    What is the problem?  

    There are multiple reasons for that lack of integration. One is that social issues have been seen as tangential to business, more sensitive, or politically controversial. Some CEOs find it harder to have conversations about S than E. While environmental issues can be addressed in technical terms, social issues are often discussed in terms of values, akin to a barometer of corporate culture.  

    Similarly, social issues have been perceived as less tangible – questions of perception rather than objective reality or technical challenge. The divergence of ‘S’ issues is highlighted by third-party rating agencies, such as FTSERussell, MSCI, ISS ESG, RobecoSAM, Refinitiv, and Sustainalytics and reporting frameworks and standards, such as GRI and SASB. Consistent with the views of the Sustainable Finance Disclosure Regulation (SFDR), rating agencies have been criticized for the lack of correlation between their respective ratings. And businesses have failed to develop the data capture processes that are increasingly common for environmental metrics. To some extent that has been encouraged by regulators and investors, who have also approached S and E differently.  

    In the EU, for instance, the SFDR has plenty to say about environmental issues. As regulatory requirements evolve, they have provided businesses with the basis for framing their E efforts. There has not been an equivalent drive behind S. For instance, while the European Commission’s Green Taxonomy has been approved and in force since July 2020, the draft report for the Social Taxonomy has been under revision since summer 2021 with requests for feedback still pending.  

    Many businesses have taken concrete actions on equity, inclusion, and diversity (EI&D). For example, 402 firms of S&P 500 have implemented an EI&D strategy.

    Then there is the question of clarity. Some leaders have failed to distinguish between their organization’s philanthropic activities and the areas that are material to the business. The two are very different. Agency problems in corporate philanthropy often mean that corporate donations are associated with CEO charity preferences unrelated to the primary business activities of the firm. Adding to the complexity is the trend among some organizations to take an activist stance on particular issues – seeking to influence the wider conversation in response to their own perceived needs.  

    For leaders, the central question is: what are the material social issues for our business? Activism and philanthropy are valuable but optional, though action on material issues is non-negotiable.  

    S needs a coherent strategy 

    To understand the effect of the failure to develop a coherent strategic approach to social issues, compare it with businesses’ actions on the environment. 

    Take carbon emissions. In line with global agreements, many businesses have now made commitments to reach defined targets by 2030 or 2050. They have developed clear action plans and disclosed their progress, often in collaboration with independent arbiters such as the Science Based Targets initiative (SBTi). The SBTi uses a rigorous scientific methodology to assess and approve targets, ensuring that they are based on the latest climate science and are aligned with the global decarbonization trajectory. 

    Then there is the way in which companies are working with partners to reduce their scope 3 emissions (emissions that are generated up and down the value chain). Many businesses are engaging with suppliers to an unprecedented degree.  

    Now look at efforts to achieve parity for women in top leadership positions. In 2022 fewer than 1 in 10 of the largest listed companies in EU countries have a woman chair or CEO. Companies may set aspirational targets, but they often remain wary of committing to time limits. Do they include that goal in executive compensation decisions? In risk assessments, financing or the way suppliers are selected? Too often, the answer is not yet. 

    On many social issues, the equation for what is material is changing rapidly. And that is why the S of ESG is becoming a key differentiator for leading firms. How do they make the most of it? 

    Four ways to differentiate on S 


    • 1. Define the business need
      Leaders need to articulate why an issue is material to their business, and where they can have a measurable sizable impact beyond being the right thing to do. One effective approach is to tap into the company’s purpose – the guiding ideas that underpin its very reason for being and often reach back to its founders.

      Alternatively, the case may be made from a risk perspective: think of the potential of reputational crises, such as sexual harassment cases, to destroy brand value. Leaders should spell out the strategic value of an issue for the bottom line, and the long-term survival of the business.

    • 2. Focus on governance
      Businesses need to apply a range of tools and techniques to achieve their social goals. Set targets, develop transition plans, and use measurements, benchmarks, qualitative and quantitative evaluations of progress, combined with insights from relevant stakeholders. To put it another way: impact measurement and management are a must.

    • 3. Recognize environmental connections
      Leaders must explore the links between social and environmental issues, because the two do not exist in isolation. This is encapsulated in the notion of a ‘just transition’ to a net zero world – the idea that costs incurred in cutting carbon emissions must be distributed fairly.

      Think of deforestation and business’s impact on communities, cobalt extraction (crucial for lithium-ion batteries) and employment standards in countries where labor rights are not respected, or businesses’ impact on their employees when they decide whether to pay a living wage or support unionization. Successful strategies must recognize the links between E and S.

    • 4. Assign clear leadership responsibility
      Ultimately, CEO leadership is crucial if organizations are to strengthen their position on social issues because leaders can provide clarity on the material relevance and strategic value of action. Below the CEO, specialists can lead the business through technical matters. A chief sustainability officer may be required, perhaps working with the CFO or CEO – but they should not be tasked with leading this agenda alone and isolated from the core business.

      The contrast between how business has stepped up on environmental issues and its approach to social issues has become glaring. We can’t manage what we can’t measure. Yet some of the strategies developed in response to environmental concerns can also be applied to social issues. With a clear focus on materiality and a coherent strategic approach, leaders can raise the bar on social impact measurement, create better S data, and give the market something to price into their models. Doing so will move the needle from net zero to net impact.

    Authors

    Vanina Farber - IMD Professor

    Vanina Farber

    elea Professor of Social Innovation, IMD

    Vanina Farber is an economist and political scientist specializing in social innovation, sustainability, impact investment and sustainable finance with also almost 20 years of teaching, researching and consultancy experience, working with academic institutions, multinational corporations, and international organizations. She is the holder of the elea Chair for Social Innovation and the Program Director of IMD’s Executive MBA program and IMD’s Driving Innovative Finance for Impact program.

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