Environmental risks tend to drive the environmental, social and governance (ESG) agenda in Asia. Carbon emissions, climate change and biodiversity garner plenty of media and regulatory attention. But as investors seek profitable and sustainable assets, there is an increased awareness of the importance of social issues.
Failing to understand and manage social factors can do just as much damage to an investment as ignoring environmental issues. As well as presenting reputational, operational and legal risks, it might also mean missing critical opportunities for impact and value creation.
Social issues present unique risks and opportunities
Social risks are relevant to all organisations irrespective of their industry and geographical footprint. They manifest in a broad range of the most sensitive areas: human rights; occupational health and safety; training and education; diversity, equity and inclusion (DE&I); data privacy; community engagement; labour standards; and security practices.
When embedded into a company’s growth strategy, social factors present unique opportunities for resilience building, value creation and impact. However, the reputational risks associated with mismanaging social issues are high. Controversies are increasingly being played out in public and the negative impact on brand and value can be direct and immediate.
There are several reasons that social factors are increasingly on the agenda for investors, asset managers and their stakeholders. These include rising pressure and scrutiny from consumers, employees, financiers, and activists. Within Asia, key sectors like manufacturing, agriculture and e-commerce have found their social practices in the spotlight. Companies are now expected to be social actors on topics such as forced labour in supply chains, the rights of gig economy workers, and gender parity.
But the biggest driver for many organisations is a rapidly changing regulatory environment. While most businesses in Asia are already bound by national regulations on core topics such as modern slavery and child labour, new developments will force organisations to take a broader, global view of their social risks and impacts. Asia-based investors and their portfolios will not be immune to legislative shifts in Europe, where social issues are a focus for regulators at EU and national levels.
European regulations will have a wide-reaching impact
Investors are busy deciphering the EU’s new Sustainable Finance Disclosure Regulation (SFDR) and Taxonomy requirements. Under the SFDR, firms will need to publicise if their investments have a negative impact on a set of environmental and social indicators, including gender pay gap and board diversity. The Taxonomy provides a classification system for sustainable investment: when aligning with the Taxonomy’s environmental objectives, firms must also commit to respecting basic human rights and labour standards. These requirements can apply extra-territorially to EU financial market participants who make claims about the sustainability credentials of their products. This could include investors in Asia who may be marketing or fundraising within the EU.
New regulations on human rights due diligence, spearheaded by the EU’s proposed Corporate Sustainability Due Diligence Directive (CSDDD), will also require specific disclosure on how businesses are managing social factors across their value chains. A company does not need to have a physical presence in the EU to fall within the scope of CSDDD – if they meet certain thresholds, Asia-based companies with value chains or established business relationships within the EU will need to comply.
There are signs that these trends are shaping policymaking in Asia. Japan has issued the first regional guidelines on human rights due diligence and has urged Japanese companies to assess human rights across their supply chains, partnerships and investment portfolios. While not legally binding, one of the guidelines’ objectives is to help Japanese companies respond to emerging international requirements on human rights. The Singapore Exchange has recently tightened ESG disclosure rules for listed companies, including requiring issuers to set and disclose a board diversity policy in annual reports. In Hong Kong, listed companies now need to measure gender diversity throughout the workforce and disclose how they plan to achieve gender diversity. Single gender boards will be prohibited from 2025.
Globally, these developments mark a shift towards mandatory measurement and disclosure of social factors for operators and investors. It also places stricter requirements on asset managers to track negative and positive impacts throughout the ownership period.
Evaluating material social risks in a deal cycle
It is important to identify, assess and plan for critical social issues at the beginning of the deal cycle. Pre-investment due diligence should evaluate material topics that account for a combination of factors specific to the investor and a target:
- Best practices in the target company’s industry
- The target’s operational footprint and any local contextual considerations
- The regulatory obligations the investor or target is exposed to
- An investor’s internal sustainability strategy, sector exposure and investment profile
- Shareholder and stakeholder expectations on metrics and reporting
Third-party relationships in the form of suppliers and clients present a major vulnerability for social risks, particularly in certain markets and sectors in Asia. Alongside assessing the principal investment target, transactional diligence should identify social risks that may manifest away from a target’s headquarters and core operations. A risk-based approach sharpens focus on priority third parties either in higher risk countries or industries, or in relation to their importance to the target. In recent cases, we have assessed social issues on plantations in Indonesia, across seafood supply chains in Thailand, and at remote digital infrastructure assets in the Philippines. A critical aspect of this work was evaluating whether corporate policies and messaging set at the target’s headquarters were being followed in practice on the ground.
There is a strong link between poor governance and social non-compliance. Due diligence should also capture social “governance” – how well a target is set up to align with social risk-specific regulations and whether there is a track record of non-compliance. Control Risks’ private market clients now regularly ask us to focus on understanding the culture and leadership of a target company during pre-deal due diligence. These funds know that evaluating an organisation’s progress on social factors such as DE&I, and the management team’s stance on employee wellbeing, are two areas that can give them critical insight into how a business is governed and how the “tone from the top” is set. It can also flag potential corporate governance failures that could affect social risks: in one recent M&A deal, our diligence found that a target had been bribing authorities to pass safety inspections at one of its factories, potentially endangering its workers.
A key output of pre-deal due diligence is recommendations for remediation, risk management and value creation. A post-deal roadmap should include quantified costs, timescales and resource allocation.
Impact and value creation opportunities can be divided into short-term, “quick win” corrections to a target’s governance controls framework and internal processes, and longer-term shifts such as changes in culture and improvement of management practices. Some small but significant adjustments can be made in the post-deal period that will not affect a company’s commercial model but can still have a tangible impact. These include implementing new workplace safety policies or increasing training opportunities for employees.
Investors should consider what measures and Key Performance Indicators (KPIs) are useful to assess progress and to demonstrate that improving social standards are creating value and impact during the ownership period. These metrics should account for stakeholder expectations and any regulatory requirements on ESG disclosures.
There is a perception that it is challenging to quantify social risk and impact (unlike environment and climate change risks, which tend to follow science-led measurements and targets). However, there are a range of indicators to use: gender pay gap; diversity; executive remuneration; workforce and key stakeholder sentiment; retention statistics; and controversy tracking. It is important to select indicators that are transparent and verifiable, and then be honest about where progress is lagging, or where metrics are not proving useful.
Technology solutions can streamline data collection and reporting. But these tools should not replace a considered approach to localising metric-setting and ESG integration – this is particularly important for social factors in Asia, which are often shaped by local nuances, market dynamics and cultural context.
- Social issues are relevant to all organisations irrespective of geography and industry. Employee activism, shifting consumer and investor preferences, and new regulatory requirements mean ever more attention is being paid to social risks.
- Legislative changes in the EU are catalysing global efforts to measure and publicise an organisations’ social risk and impact. Investors and portfolio companies in Asia may fall under the scope of extra-territorial requirements.
- Social factors should be assessed during pre-deal due diligence. Research should identify and evaluate material social risk factors that account for factors relevant to the investor and the target: assessment and reporting standards; investment strategy; industry best practices; regulatory obligations; and the target’s operational footprint and its third-party relationships.
- Post-deal risk mitigation and value creation. Changes can be short term quick wins or longer-term structural improvements, with KPIs used to monitor performance and measure impact.