Social Risks Can Be Credit Risks: Evaluating the 'S' in ESG

Over the past few years there has been an expansion in the range of social factors being considered by investors and other stakeholders. Topics such as health and safety, diversity, worker’s rights, and human rights have become more central to sustainability strategies for a wide range of bond issuers from corporates to sovereigns. This is being supported by a more consistent and comprehensive reporting environment, regulation, and improved market standards.

Frameworks and standards addressing social issues include the UN Sustainable Development Goals, the UN Guiding Principles on Business and Human Rights, and the International Labour Organization’s Decent Work Principles. The latest draft of the EU social taxonomy, published in February 2022, is a comprehensive approach to the role of social factors within a sustainable finance strategy. The draft taxonomy has three core objectives: decent work; adequate living standards and wellbeing for end-users; and inclusive and sustainable communities and societies.

The third objective considers land, indigenous and human rights as well as access to basic infrastructure. The proposal also links an entity’s social impact to operating and capital expenditure, and turnover.

Economic activity that involves land-use changes, resource extraction, large-scale construction or the provision of essential services entail the greatest exposure to community-related credit risk. In some sectors, such as extractive industries, companies operate in politically sensitive regions due to the location of the resources, meaning that community issues can persist over long periods of time. Community issues are most material to entities in the energy, natural resources, utilities, healthcare, consumer finance and infrastructure sectors within Fitch’s rated universe.

Social factors are reflected within Fitch’s ESG Relevance Scores (ESG R.S.), indicating the materiality and relevance of social risk elements on the credit rating outcome, on a scale of ‘1’ (irrelevant) to ‘5’ (a key rating driver). Five general social issues are assessed under Fitch’s framework. These include: labour relations and practices, employee wellbeing, human rights, community relations, access and affordability, customer welfare, and exposure to social impacts. Analyses are conducted to look at the interactions between an issuer and its different stakeholders, both within the entity and in the market, community and broader society.

Social risk in focus: community relations

Community relations can be a serious issue for entities whose operations affect social goods and common resources. This can be relevant for companies operating in extractive industries and energy, chemicals, and commodity processing. If operations have an adverse impact on water, air and soil quality, this can directly impact adjacent communities. It can also be relevant for local government public finance issuers, where community dissatisfaction with economic activities can put demographic and human capital factors, or tax revenue at risk.  

Failure to manage community unrest can financially impact an issuer. This may be caused by higher resourcing requirements to address human rights-related issues – for instance, for extra security or higher pay for workers to cross through protest zones – work stoppages, physical damage and violence, as well as fines from violations. A 2014 Harvard Kennedy School study of extractive-industry companies that had faced community problems estimated that production delays at a major mining project with capex of US$3 billion-US$5 billion, cost an estimated US$20 million a week[1]. This did not include costs associated with addressing negative publicity, repairing physical assets or responding to legal challenges.