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How can investors assess labour and human rights risks?

A guide to one of the most difficult challenges in the ESG field.

A growing number of institutional investors and global lenders are trying to assess the long-term sustainability risks posed by corporate labour and human rights practices. Their efforts are part of the broader movement to incorporate corporate environmental, social, and governance (ESG) behavior into portfolio and lending decisions. In contrast to socially responsible investing, which promotes moral values, the aim of most mainstream ESG analysis is to achieve conventional investment goals such as boosting portfolio returns and reducing risk. Pioneers in the field include leading European and U.S. pension funds as well as financial firms such as Goldman Sachs, RiskMetrics, and Mercer. Their thinking about labour and human rights (LHR) sustainability risks is similar to investor concerns about environmental impacts: a company’s performance – and hence its stock price – could be endangered if its business practices run the risk of violating national or international social standards or causing adverse impacts on local communities and cultures. Such violations may damage a company’s reputation, undermining its standing with consumers, regulators, and lawmakers.They also may weaken its operational performance by increasing employee turnover and inhibiting worker motivation and productivity. For many of the same reasons, some investors are attempting to track related human capital metrics such as health and safety, team production systems, compensation, training, and worker skill levels.
An investment analysis of LHR factors poses some of the most difficult challenges in the ESG field. A major problem is the lack of objective, quantitative data about corporate activities in these areas. Most research efforts on the subject to date usually start with some or all of the labour standards issued by the International Labor Organization (ILO). However, some investment analysts use different or additional criteria as well. A further difficulty is that most existing labour standards were developed to advance moral and social concerns, not portfolio returns, so it’s not clear whether they are best suited for that purpose. Obtaining robust data relating to companies’ LHR risks is challenging as well, usually more so than for other ESG factors. There are few independently audited sources of information about

any non-financial corporate behavior. As a result, investors generally are left to rely on whatever happens to turn up in news accounts and information provided by the companies themselves. Although many large Western companies issue annual corporate responsibility reports that may discuss LHR issues, their accounts typically lack the detail investors need to make a thorough risk assessment. Furthermore, companies may be even less willing to issue accurate reports on LHR than on either traditional financial results or other extra-financial behavior involving the environment or governance. Many of the LHR practices likely to pose investment risks, such as child labour or physical abuse of workers, are against the law in most countries. Companies may be less inclined to look for or report such violations on their own initiative, even if prompted by investors. After all, a corporation’s report of low earnings or high debt may damage its stock price or ability to borrow, but it typically will not pose a legal or regulatory threat. Even companies that may want to give robust LHR reports face significant obstacles in doing so. Much of the concern in these areas has focused on global supply chains, usually involving factories in developing countries. In the past two decades, many Western multinationals have issued labour codes of conduct for such factories and set up sometimes elaborate systems to monitor them for compliance. All have struggled for years to come up with meaningful inspection methods. Many experts, including those at groups co-managed by corporations, concede that problems abound. Abused workers can be afraid to speak honestly to factory auditors, especially ifinterviews take place at the workplace where supervisors are present.Critics complain that supplier managers often coach workers on what to say to compliance auditors and keep two sets of books to hide abuses such as wage under-payment or non-payment or excessive overtime. Still, supply-chain LHR monitoring by multinationals offers a potentially rich source of hard data that investors could tap to assess corporate sustainability risks in this area.

“A further difficulty is that most existing labour standards were developed to advance moral and social concerns, not portfolio returns, so it’s not clear whether they are best suited for that purpose.”

One possible model can be found in the only publicly available database on specific labour violations, which is maintained by the Fair Labour Association (FLA), a nonprofit comprised of major U.S. garment and footwear companies, human rights groups, and other nongovernmental organizations. The FLA independently audits a random sample of member companies’ supply-chain factories to ensure adherence to the FLA’s labour code. Investors could start with that approach and broaden it to apply to other global corporations. There are significant obstacles to doing so. Companies have many valid reasons to treat LHR factory audits as
proprietary. Their release could spur LHR advocates and other critics to attack a company’s behaviour, potentially harming its reputation (and perhaps its profits and stock price). Such fears would be heightened for companies that perform LHR factory audits when their rivals do not. LHR auditing also can be a source of competitive advantage, particularly given how many companies have struggled for years to come up with workable and affordable factory monitoring systems.One potential solution is for investors to demand that companies submit factory audits and audit systems to independent review, much as they hire accounting firms to audit their financial statements. Given the likely resistance they would face, the investment community almost certainly would need to adopt the same kind of shareholder engagement tactics used to pressure companies about environmental and governance risks.

This article is drawn from “Incorporating Labour and Human Rights Risk Into Investment Decisions,” by Aaron Bernstein, a Wertheim Fellow and Senior Research Associate at the Harvard Law School Labour and Worklife Program.

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