In recent years, the social factor (the 'S') in ESG has gained significantly in importance, especially against the backdrop of the pandemic, where employees and their needs have been placed at the core, and the relevance of social factors has been rising. COVID-19 exposed vulnerabilities in value chains, revealed the depth of corporate values, and fostered coordination and cooperation across industries.

Research by Standard and Poor's shows evidence that investors are increasingly favoring products from companies that have a positive social impact. Meanwhile, as companies await the U.S. Securities and Exchange Commission's (SEC) final rule on climate disclosure, many have begun preparing for its impact on operations. Despite the current focus on sustainability reporting, companies also need to adapt to upcoming workforce disclosure regulations in states like California, such as the recently passed Senate Bill 54, which pushes investment firms to make more diversity-related disclosures.

Beyond regulatory pressure, investor demand for ESG ratings is also growing. According to the sustainability consultancy Environmental Resources Management, publicly listed companies spend between $220,000 and $480,000 annually to obtain ESG ratings, while private companies spend up to $425,000, with these ratings typically coming from third-party agencies. Companies rely on multiple rating agencies, such as Sustainalytics, Refinitiv, MSCI, among others, to assess the extent to which they integrate ESG factors into their frameworks.

However, because the social data collected by different companies and industries varies, these results are difficult to standardize and compare. Additionally, differing state data privacy laws in the U.S. pose challenges to data acquisition.

How do different companies define the 'S'?

Most companies define the 'S' in ESG as social responsibility and issues related to business operations, ranging from employee health and safety to diversity and inclusion, or the impact of supply chains and distribution on human rights. S&P research notes that environmental factors focus on a company's impact on the planet, governance factors focus on internal and political functions, while social factors primarily involve 'issues arising from the company's relationships with external people or institutions.'

However, social issues have historically lagged behind environmental and governance factors. PwC attributes this lag to the definitions of 'E' and 'G' being clearer than that of 'S'.

Harvard professor Ethan Rouen says: 'The million-dollar question is: What should companies talk about when discussing their social impact? What matters to employees and what makes a good employer varies by company, industry, and time.' Rouen's research focuses on inequality and the impact and value of human capital. He notes that what leaders in social data choose to share is subjective, mentioning that most of the dozen executives interviewed in his research said they 'use disclosure to tell the human capital story' and 'would never disclose anything that makes them look bad.' For example, pay data and turnover information are often omitted.

As a result, the picture presented by corporate ESG reports is often incomplete, lacking information that points to real risks.

'The million-dollar question is: What should companies talk about when discussing their social impact? What matters to employees and what makes a good employer varies by company, industry, and time.'

—Ethan Rouen, Professor at Harvard Business School

However, Rouen points out that when it comes to the 'S', simplifying metrics for measuring and evaluating social data is not always the solution, as different companies and industries may handle this data in different ways. In a 2022 PwC study, the firm advised clients to determine which social elements best align with their business values and purpose before developing a social strategy. The firm noted that these priorities 'vary by company and are influenced by their purpose, strategy, and sustainability goals and commitments.'

Retail giant Walmart, in its 2023 corporate ESG report, categorized social data into four themes, including 'Opportunity,' 'Ethics and Integrity,' 'Community,' and even 'Sustainability,' showing how disparate social information can be organized. Walmart reported metrics on a wide range of issues, including human capital, equity and inclusion, human rights issues, philanthropy, local economic contributions, and the well-being of workers in its product supply chain.

On the other hand, investment bank Morgan Stanley, in its 2022 ESG report, divided social factors into two categories: 'People and Culture' (focusing on well-being and compensation practices) and 'Diversity and Inclusion' (focusing on DEI efforts across the workforce and society).

Rouen says: 'I strongly support the metrics the SEC is currently proposing,' referring to the regulator's recent update to its workforce disclosure rules, which would require companies to disclose comprehensive workforce data such as pay ranges and employment status. But he says such rules are 'definitely not a panacea' and understands the challenges companies and regulators face on this issue. He says: 'If a tech company reports health and safety information, I don't care. I care about their diversity. But if a mining company doesn't talk about its health and safety, I would be very concerned.'

Data collection is inconsistent and difficult to obtain

According to the United Nations Principles for Responsible Investment (UN PRI), the social factor in ESG may be the most difficult part for investors to assess. The organization attributes this to a lack of mature market data records and robust regulation regarding the 'S', making it 'less tangible' and 'lacking mature data to show how it affects company performance.' PRI evaluated feedback from multiple asset management companies and research firms, including Allianz, Morgan Stanley, ClearBridge Investments, and research and ESG rating company MSCI, among others.

Which social factors companies should measure is a complex question, but how to obtain the data is equally daunting, made more difficult by the varying data privacy and security laws across U.S. states. Elodie Timmermans, Managing Director at EY, says: 'Depending on what 'S' content you disclose, you have to be careful about data privacy laws and the source of the information (if it's third-party data).' Timmermans, who focuses on climate change and sustainability services, says the differences in state data privacy laws also pose a barrier. While some states (such as New York, California, Colorado, and Washington) have implemented pay transparency laws, most have not, hindering the collection of company-wide recruitment, compensation, and diversity data. She notes this is why pay equity and compensation information do not appear in most companies' sustainability reports.

Although the U.S. has passed laws protecting children's online information, medical and educational records, there is no overarching law covering data privacy across all types. These varying regulations can make it harder for employers to obtain certain employee demographic information, as it falls under protected data. Alyssa Stankiewicz, Associate Director of Sustainability Research at Morningstar, says: 'While climate-related data reporting is indeed inconsistent across markets, it is not as protected as diversity-related data.'

Furthermore, handling diversity data (if available) is a delicate matter. According to a report in the Harvard Business Review, companies must ensure that gender- or race-based hiring practices are only implemented when there is 'evidence of company-wide or industry-wide hiring discrimination' and to 'correct initial imbalances.' Otherwise, under laws enforced by the U.S. Equal Employment Opportunity Commission, racial data should not determine or influence hiring decisions.

The social component of ESG is also difficult to collect because it is primarily a qualitative metric that needs to be accounted for in a quantitative manner to generate an overall score. According to ADEC Innovations, a sustainability consultancy and data management company, while some social initiatives (such as auditing suppliers and vendors for fair compensation) can be quantified, most components cannot. ADEC says many organizations find it difficult to quantify or assign monetary value to services or benefits such as employee mental health support or creating an inclusive environment. Rouen notes: 'It's hard to define what we mean by treating employees well, and it's hard to create a set of rules that applies to all companies.'

Where is this heading in the future?

Despite the obstacles in defining and measuring the 'S', regulatory momentum for social disclosure in the U.S. is building. The SEC's Investor Advisory Committee proposed a new rule to the agency in September requiring public companies to disclose more comprehensive workforce data, including pay ranges, employment status, and workforce demographics. Shortly thereafter, California Governor Gavin Newsom signed SB 54 in October, which requires venture capital companies headquartered in California or with significant operations there to annually report the number of diverse founders they invest in, disclosing their race, sexual orientation, gender identity, disability, and veteran status, as well as investment amounts.

Overall, Timmermans believes that companies are making progress in collecting and disclosing data on environmental and social activities due to the convergence of multiple reporting frameworks. In recent years, several reporting frameworks have begun to converge under the International Sustainability Standards Board (ISSB) of the International Financial Reporting Standards Foundation (IFRS), which was established in 2021. The ISSB has so far consolidated the work of four reporting bodies: the Sustainability Accounting Standards Board (SASB) of the Value Reporting Foundation (VRF), the Task Force on Climate-related Financial Disclosures (TCFD), the Climate Disclosure Standards Board (CDSB), and the International Integrated Reporting Framework (IRF).

'From an ESG disclosure perspective, we are trying to do a lot in a short period of time. We are trying to accomplish in three years what the financial world took 100 years to do.'

—Elodie Timmermans, Managing Director at EY

'I do believe the convergence of reporting frameworks will help, whether it's CSRD or ISSB,' she says. 'What matters for the 'S' for one company is different from another, so there will be nuances, and not everyone will disclose the same things, but this convergence will help.' In August, a coalition of multinational investors also urged the ISSB to prioritize human rights and worker rights on its next agenda.

However, Timmermans notes that the convergence of reporting standards takes time, and simplifying ESG disclosure practices across different companies and industries—especially regarding the 'S'—will be gradual and cannot be accelerated. She says: 'From an ESG disclosure perspective, we are trying to do a lot in a short period of time. We are trying to accomplish in three years what the financial world took 100 years to do.'