Andrew Brown, Institutional Business Group Director
The almost silent S in ESG
The financial implications of Environmental, Social and Governance (ESG) risk factors are becoming increasingly important considerations in pension schemes’ investment decisions. Many Defined Contribution (DC) schemes, having successfully incorporated the environmental, notably climate, and corporate governance aspects of ESG into their investment principles, continue to struggle with explicitly analysing, managing and embedding social factors into investment strategies. This is partly a consequence of social factors being seemingly difficult to define and quantify.
What are social risks?
Social risks, although wide ranging, principally relate to people, starting with individuals’ basic human rights. These comprise how people work, whether they suffer unfair or unsafe working conditions, whether they’re allowed to associate with who they like and are free from bonded labour. In recent years, numerous suppliers to equally numerous high-profile companies have been called out for blatantly compromising these basic principles. Not only have the reputations of the latter been compromised, so have the integrity and sustainability of their operations. As such, social issues are intrinsically linked to corporate governance issues. Likewise environmental issues.
Then there’s social inequality – a term which typically crops up when speaking about the world’s less well-developed economies but which equally applies to the rich OECD nations, such as the UK. Social inequality defines the extent to which differences exist between distinct groups in society. Indeed, at a macro level, if left unaddressed, deeply engrained social inequalities and regional disparities will inevitably hold back economic development, productivity and ultimately economic growth – a point recognised by the UK government in seeking to implement a widescale, and much publicised, levelling up policy. However, such an ambitious agenda can only be achieved with the added monetary clout of the private sector, principally institutional asset owners – including DC pension schemes’ money, and only if the returns are sufficiently attractive and the risks acceptable.
DC pension schemes, with their positive cashflows and long-term investment horizons, are ideally placed to invest in social bonds, affordable housing and social infrastructure, especially in the more deprived areas of the UK. Indeed, each can prospectively offer DC default funds the financial rewards they seek from asset ownership. Crucially, in each case, the preconception that one needs to sacrifice financial returns in order to achieve positive social outcomes simply doesn’t hold.
Social bonds, as distinct from other “specific use of proceeds” bonds such as green and sustainable bonds, are defined by the International Capital Markets Association (ICMA) as, “use of proceeds bonds that raise funds for new and existing projects with positive social outcomes.”
Social bonds really came into their own during the global pandemic, with governments, supranational entities and corporates across the world raising funds through this mechanism in order to exclusively channel the proceeds to pre-identified projects with defined social outcomes aimed at alleviating the pandemic.
A key aspect of levelling up across the UK is the more widespread provision of quality, affordable private rented housing for low to middle income groups, not least key workers.
The principal means by which these developments and their subsequent operation are funded is via housing associations working with real estate asset managers. With the asset manager securing the funding and the packaging up of multiple developments into an evergreen pooled investment fund and working with the housing association to ensure the units are professionally managed, such investments provide members with a sustainable, long-term indexed-linked income stream and strong social impact credentials.
Whereas infrastructure describes those facilities, structures and services that act as a foundation for economic activity, social infrastructure comprises those foundational services and structures that support a nation’s social development and quality of life. Think schools, hospitals, universities, student accommodation, libraries, community recreation and leisure facilities and transport solutions – all of which have the potential to address social inequality, ultimately improving the nation’s quality of life.
In addition to offering very different return drivers to publicly traded assets, thereby acting as a genuine diversifier of equity and credit risk within a default fund strategy, many social infrastructure assets offer secure long-term cash flows, often with an implicit or explicit/contractual inflation linkage – a characteristic increasingly valued when faced with high inflation.
Why does this matter?
The almost silent S in ESG has recently been propelled into the spotlight, a consequence of requisite responses to the global pandemic, and this heightened sensitivity towards social issues seems likely to stay.
Aside from many social impact investments offering very different return drivers to publicly traded assets, most offer secure long-term cash flows, often with an implicit or explicit/contractual inflation linkage. Of course, if left unchecked, social factors can not only introduce unwelcome financial risks to a member’s savings but also significant reputational risk for the scheme and, quite possibly, its sponsor.
In short, taking this risk and the return point together, it is becoming readily apparent that “social” can no longer be the almost silent consonant or the missing part of the ESG jigsaw.
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