Defining the “S” in ESG

Regulators and industry continue to be challenged by implementation of the EU Taxonomy Regulation — the dictionary of what is environmentally sustainable (the E in ESG) — and the drafting of further detailed rules to underpin it. Firms and customers seek further clarity around disclosures and how to assess the sustainability credentials of potential investments. At global level, the work of the new International Sustainability Standards Board (ISSB) on climate change reporting standards is underway, and the UK continues to develop its own green taxonomy.

Meanwhile, initial policy work on defining “socially sustainable” (the S in ESG) suggests that an “S” Taxonomy will present even more challenges than the “E”. S objectives may prove more difficult to draft and agree, quantitative measures will need to be formulated from scratch in many areas, and the availability and reliability of the data needed to calculate those measures are largely absent at present. It is recognised that S factors can be the most difficult to analyse and embed in investment strategies.

There is also a fundamental question about how the S Taxonomy will sit with the E Taxonomy. For example, the closing of heavily-polluting industries, while helping the achievement of E objectives, can have a negative impact on workers and local communities, at least in the short term. And will there be one combined disclosure on taxonomy-alignment, or two separate disclosures, or a dashboard approach? A recent report by the EU Platform on Sustainable Finance (Platform) describes these and other challenges, and paves the way for a legislative proposal from the European Commission.

Despite the considerable challenges, there is strong political will behind an S Taxonomy in the EU, in part due to the impact of COVID-19. According to the UN Sustainable Development Goals 2021 report, the pandemic reversed much of the progress made previously, with extreme poverty rising in 2020 for the first time since the Asian financial crisis of the late 1990s. Projections suggest that the global poverty rate will be 7 per cent (approximately 600 million people) by 2030, unless “immediate and significant” action is taken. Other indicators, for example around hunger, health, education and gender equality have also declined.

It is essential that the financial services industry and other interested stakeholders join the social taxonomy debate at this early stage to help policymakers move towards requirements that are operationally workable and result in meaningful disclosures for investors and customers.

There are existing standards and laws in this area, but they focus on different S factors and take different approaches. In September 2015, all Member States adopted the United Nations Sustainable Development Goals (SDGs) to end poverty, protect the planet and ensure prosperity for all. The SDGs express 17 ideal global outcomes and suggest the high-level targets or policy steps needed to attain them.

The framework of the Sustainability Accounting Standard Board (SASB) — a US, non-profit organisation — focuses on disclosure standards. 77 industry-specific sustainability standards set out accounting and activity metrics for a set of disclosure topics, and protocols provide guidance on definitions, scope, compilation and presentation. The disclosure topics include:

Social Capital:

• Human rights and community relations
• Customer privacy
• Data security
• Access and affordability
• Product quality and safety
• Customer welfare
• Selling practices and product labelling

Human Capital:

• Labour practices
• Employee health and safety
• Employee engagement, diversity and inclusion

Definitions of S are already written into pieces of financial services regulation. The EU Sustainable Finance Disclosures Regulation (SFDR) describes the type of activities that could be counted as socially sustainable: those that contribute to tackling inequality or foster social cohesion, social integration and labour relations, or that relate to human capital or economically or socially disadvantaged communities.

On the other hand, the EU Social Entrepreneurship Funds Regulation 2013 takes a prescriptive approach. It defines a social undertaking as an operator in the social economy (services or goods to vulnerable, marginalised, disadvantaged or excluded persons), the main objective of which is “to have a social impact rather than to make a profit for its owners or shareholders”. A social undertaking must be managed in an accountable and transparent manner, in particular by involving employees, consumers and stakeholders that are affected by its commercial activities. Only undertakings that meet this definition are eligible investments for such funds.

More broadly, the S Taxonomy cannot over-ride or replace national laws on healthcare, treatment of workers, landlord obligations, wage setting etc. It must complement them. Differences in national laws may therefore have a bigger influence on the drafting of criteria for S factors than they do for E factors. Possible approaches include referring to international standards and guidelines that are valid across many jurisdictions, or defining positive contributions to S factors as those that go beyond basic national legal requirements or European principles.

The Platform report suggests that the S Taxonomy should mirror the structure of the E Taxonomy, with a set of objectives, types of substantial contributions to those objectives, “do no significant harm” (DNSH) criteria and minimum safeguards. However, it should deviate from the E Taxonomy by:

• Containing sub-objectives that spell out different aspects of the social objectives
• Linking substantial contribution to capital expenditure (CapEx), operational expenditure (OpEx) or turnover, so as to align the S Taxonomy with company reporting requirements

In existing standards and declarations, there is a common distinction between civil and political rights on the one hand, and economic, social and cultural rights on the other. However, these rights are interdependent and indivisible. There is also a relationship between E and S objectives. While most economic activities have detrimental impacts on the environment, the creation of decent jobs, paying taxes and production of socially beneficial goods and services can be considered inherently socially beneficial.

The Platform therefore suggests that the S Taxonomy must distinguish between such inherent benefits and the additional social benefits that directly contribute to the realisation of human rights, such as improving access to quality healthcare or ensuring decent jobs. It further suggests that the S objectives should take account of the type of stakeholders for whom an economic activity can make a positive contribution to their lives and livelihoods:

1. An entity's own workforce (including value-chain workers)
2. End-users/consumers
3. Affected communities (directly or through the value chain)

This leads to three suggested objectives, each of which addresses a different group of stakeholders:

• Decent work (including for value-chain workers)
• Adequate living standards and well-being for end-users
• Inclusive and sustainable communities and societies

Sub-objectives would address key aspects such as health and safety, healthcare, housing, wages, non-discrimination, consumer health and communities' livelihoods.

The report suggests another list of three for the types of substantial contribution:

1. Avoiding and addressing negative impacts on workers, consumers and communities 
2. Additional inherent social benefits of the activity itself (i.e. enhancing the positive impact inherent in the economic activity)
3. Enabling activities, which enable other activities to provide social benefits

While E objectives and criteria can largely be based on science, this is not the case for S objectives or criteria. Although there are some existing measures for the “decent work” objective, including on health and safety, anti-discrimination and employment generation, it will initially be more difficult to develop quantifiable criteria for other aspects. 

The concept of a “just transition” will be of special relevance for the S Taxonomy. The transition to an environmentally-sustainable economy requires fundamental changes in many sectors, which will have profound impacts on the lives of workers and communities. National context and geographical circumstances will influence whether activities can be defined as socially sustainable or socially detrimental. 

The DNSH criteria will serve the same purpose as in the E Taxonomy, but there will need to be more granular criteria for the sub-objectives. The criteria will be more important where it might be challenging to draw up substantial contribution criteria, or when avoiding and addressing an activity that is illegal (e.g. child labour). It is not clear at this stage whether there would be generic DNSH criteria (i.e. identical criteria for all economic activities) or objective-specific DNSH criteria.

The E taxonomy includes certain minimum S safeguards. Should the S Taxonomy include minimum E safeguards, to prevent activities from being classified as S even though they violate E standards? Should it also include minimum S safeguards for topics for which no substantial contribution or DNSH criteria can be drawn up? And if so, should those minimum S safeguards be identical in both the S Taxonomy and the E Taxonomy?

As for the E taxonomy, a rationale for prioritising sectors for each S objective and sub-objective will be required.  It will need to be based on a comprehensive overview and prioritisation of economic activities, and robust classifications. The Platform suggests that the sector framework should be built on the NACE industrial classification system, supplemented by additional categories, where the current level of granularity within NACE is not sufficient.

The selection of sectors and activities would focus on high-risk NACE sectors and use sector-orientated standards, guidance and benchmarks. For example, high-risk sectors regarding a living wage sub-objective would include sectors with a high prevalence of contingent workers or workers earning the minimum wage.

However, for some sub-objectives, such as diversity and inclusion or social dialogue, a high-risk-sector approach may not be relevant and feasible, because the issue is sector-agnostic. Instead, generic DNSH criteria might apply (as in the climate change adaptation rules under the E Taxonomy).

The aim could be a single taxonomy defining E and S sustainability. However, would activities then have to comply with both the E and S requirements to be regarded as sustainable? Would there be a single disclosure that covers a company's E and S sustainability, and expressed as percentages of what? Equally, two completely independent taxonomies would give rise to difficulties and is already effectively ruled out because the E Taxonomy includes minimum S safeguards.

An option somewhere in between, which respects the principle of the equality of the two taxonomies, could be the aim, but will prove difficult for lawmakers to produce in a workable form.

On 23 February 2022, the European Commission adopted a proposal for a Directive on corporate sustainability due diligence. This focuses on the role of companies in building a sustainable economy and society, and the impacts of their activities on human rights and the environment. The proposal aims to foster sustainable and responsible corporate behaviour throughout global value chains, in line with UN Guiding Principles and OECD guidelines. Companies will have to identify and act on upstream and downstream risks. They will need to report on company policy, processes, activities and findings, measures taken and the outcomes of those measures — data which may provide useful in relation to the E and S Taxonomies.

The Platform suggests that the current requirements to report E taxonomy-aligned capital and operational expenditure and turnover, should be extended to the S taxonomy. Investments made by a company to address and reduce a negative impact would count as a social contribution. For activities that contribute substantially by enhancing existing inherent social benefit, the turnover made from the sale of respective products and services would count as S. For enabling activities, the company selling the product or service that enables another company to address and avoid negative impacts would count the turnover derived from these products or services as S.

The Platform makes some initial suggestions for disclosures by investment funds, social bonds and social loans:

• Equity funds: the percentage of the fund that complies with the S Taxonomy and a breakdown by social objectives. If the emphasis is on “enhanced products and services with inherent social benefit”, funds would disclose the taxonomy-aligned turnover. Funds with the objective of “avoiding and addressing negative impacts on stakeholders” would disclose investments employed to achieve this objective
• Fixed income funds: as for equity funds, with the additional requirement to disclose the percentage of investments in social bonds that are taxonomy-aligned
• Social bonds: an explanation of why and how the investments will be taxonomy-aligned, and periodic disclosures on how the proceeds have been, or are being, allocated
• Social loans: financiers to follow similar procedures to those for issuers of social bonds; borrowers of social loans would be obliged to inform lenders on how the loans are used and why the project financed is taxonomy-aligned

We await the Commission's response and publication of a draft regulation. Timing is uncertain given the protracted discussions on further Level 2 rules under the E taxonomy and the further thinking required on how the S Taxonomy should be structured.