Narrowing income inequity through ESG

July 18, 2022

Katerina Tzouganatos, principal, Risk and financial advisory | Deloitte & Touche LLP
Mohak Bhuta, senior analyst, Center for Financial Services | Deloitte Support Services India Private Limited

Can ESG investing help improve pay equity? Can ESG investing increase employees’ access to sick leave, insurance, and other employment benefits? Can ESG investing really help reduce gender based pay discrimination? The COVID-19 pandemic exacerbated the income inequity situation as it impacted lower income groups to a greater degree than higher income groups.¹ Globally, three to four years of work on reducing extreme poverty has been lost because of the pandemic.² However, investment managers with an ESG mandate focusing specially on social and governance issues have the potential to reverse this trend.

Effective capital allocation, targeted guidance, and directions from investment managers of ESG-mandated funds—assets that are forecasted to constitute 58.2% of total global professionally managed assets by 2025—can propel actions that help reduce the income inequity gap globally.³

Let’s take a closer look at how ESG actions to reduce income inequity can benefit investment managers and help reduce income inequity.

What’s in it for investment management firms and their investee companies?

While ESG-mandated funds can influence actions that reduce income inequity gaps at investee companies, some proposed measures—such as higher wages, pay equity, and better working conditions—require additional expenditures and would reduce margins in the short term. However, allocating more resources to the workforce should not be viewed as a short-term cost but rather an investment to help firms realize long-term gains. These long-term gains may help investment management firms and their investee companies win stakeholder trust and generate long-term financial benefits for investors and companies alike.

Win stakeholder trust

Better working conditions and improved wages may lead to more innovation and employee loyalty over the long term.⁴ According to research, a one-standard-deviation increase in labor levels at a major bookstore increased profit margins by 10% over the course of a year.⁵ The increase in margins, while at the same time increasing the number of employees, can most likely be attributed to engaged employees being more productive and providing better service.⁶ Investment management firms that integrate ESG issues, such as job quality, in their investment decision processes could also generate higher investor interest. A Dutch pension fund studied this issue and found that 70% of its investors were in favor of expanded engagement with companies on job quality and other ESG issues—even if it meant reduced profitability and investment returns.⁷ Firms that strive to achieve better social outcomes, such as income equity, may win stakeholder trust.

Generate long-term financial benefit

Research also suggests that investee companies that voluntarily integrate ESG policies into their business model may outperform their peers in terms of return on assets (ROA) and stock performance.⁸ Such improved performance by investee companies can directly increase revenue for some investment managers, improve fund performance, and investment flows. According to a recent academic study analyzing 1,000 research papers exploring linkage of ESG and financial performance, there was consensus that good management of ESG issues, including income inequity, can lead to improved operational metrics such as ROA or stock price.⁹ Moreover, steps to tackle income inequity may go a long way to maintain stability in the economy where the investee companies operate.¹⁰ Economic stability can indirectly help investee company performance. Firms that focus on achieving non-financial benefits such as income equity in the near term may also generate long-term financial benefits.

Actions investment managers can take for narrowing income inequity through ESG

Two key dimensions to tackling income inequity include increasing the quantity and quality of jobs since quality jobs for the unemployed could have a dramatic impact on income inequity.¹¹ To increase the quantity of jobs, investment managers will have to influence the implementation of inclusive labor practices that allow groups with lower employment rates to participate fully.¹² Practices such as paid parental leave and workplace family measures that promote higher working parent participation, or expansion of quality apprenticeships to help disadvantaged youth, can help improve the quantity of jobs.¹³ Improving job quality may require investment managers to influence the implementation of policies that promote equitable wages and safer working conditions.¹⁴ ESG investing that considers investee company policy decisions about job quality and quantity when crafting their capital allocation and stewardship plans can help narrow the income inequity gap.

Different kinds of ESG stewardship by various investment managers can impact a range of activities that directly or indirectly influence income inequity. Active and passive mutual fund managers can influence the investee company’s labor practices through regular dialogue, engagement, and proxy voting. Engagement and dialogue may include communication through letters, one-on-one meetings, meeting with specific teams or board members, filing or voting on shareholder resolutions, and seeking commitments. One of the world’s largest investment managers has taken a step in this direction by updating its engagement process to increase the accountability of its portfolio companies on the prevention of human rights abuses and to encourage companies to provide robust disclosures about those practices.¹⁵ Hedge funds, through investor activism, can influence an investee company’s executive remuneration through non-binding “say-on-pay” vote results, a part of the Dodd-Frank act.¹⁶ Finally, private equity funds, through board representation, can assert significant influence on the portfolio companies to take actions such as conducting pay equity audits that can directly impact income inequity.

Capital allocation represents another potent tool at investment managers’ disposal to create a long-term impact in the direction of income equity. Well-thought-out capital allocation policies can, over the long term, help firms increase accessibility of capital and reduce the cost of capital for companies that support income equity. Take the example of an investment management firm, which discouraged practices that negatively impacted income equity by refusing access to IPO capital to a company that was exhibiting weak labor practices related to minimum wages, sick pay, and holidays.¹⁷ Capital allocation is significantly more relevant for active mutual fund and separate account managers that, unlike passive mutual funds and exchange-traded funds (ETFs), have the liberty to favor companies with strong income equity practices and vice versa. These investment managers have the opportunity to incorporate the long-term consequences of factors that increase income inequity, specifically pay inequity, worker conditions, and labor rights, into their capital allocation process.

Finally, investment management firms can also promote income equity by integrating ESG principles that promote income equity into their own operations. One way to integrate ESG principles in own operations may be to link executive compensation to firm’s performance on specific diversity and inclusion goals.¹⁸

Genuine and focused efforts by investment management firms can help reduce income inequity

Income inequity can be addressed when investment management firms’ guidance to investee companies includes granular details within the broader ESG context. In order to be genuine, ESG principles should influence the corporate policy of investment management firms and their investee companies. Investment management firms are in a unique position to modify their own operations to credibly influence various ESG policies at investee firms through capital allocation and stewardship. These investment manager interventions can help support investee company performance in the long term and positively impact income inequity at a global scale.

End Notes

¹ Ruth Hill et al., “Poverty, median incomes, and inequality in 2021: A diverging recovery,” World Bank, September 7, 2021.
² Ibid.
³ Tania Lynn Taylor and Sean Collins, “Ingraining sustainability in the next era of ESG investing,” Deloitte Insights, April 5, 2022.
⁴ Jeff Schwartz, Kraig Eaton, and David Mallon, “The worker-employer relationship disrupted,” Deloitte Insights, July 21, 2021.
⁵ Zeynep Ton, “Why ‘good jobs’ are good for retailers,” Harvard Business Review (January–February 2012).
⁶ Ibid.
⁷ Casey O’Connor-Willis, “Making ESG work: How investors can help improve low-wage labor and ease income inequality,” NYU Stern, October 2021.
⁸ Tensie Whelan, Ulrich Atz, Tracy Van Holt, and Casey Clark, CFA, “ESG and financial performance: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015 – 2020,” NYU Stern, 2021.
⁹ Ibid.
¹⁰ Matthew Wilburn King, “Why the next stage of capitalism is coming, ” BBC, May 27, 2021.
¹¹ Céline Thévenot, “Labour market structure and wages: Policies to reduce inequality in OECD countries,” paper presented at the United Nations’ Expert Meeting on Policies to Tackle Inequality, June 25–27, 2017.
¹² Ibid.
¹³ Ibid.
¹⁴ Ibid.
¹⁵ BlackRock, Inc., “Our approach to engagement with companies on their human rights impacts,” 2022.
¹⁶ Dean Baker, Josh Bivens, and Jessica Schieder, Reining in CEO compensation and curbing the rise of inequality, Economic Policy Institute, June 4, 2019.
¹⁷ The Investment Integration Project, “Systemic stewardship: Investing to address income inequality,” 2021, p. 33.
¹⁸ Sonali Basak, “Carlyle to award $2 million to staff for focusing on diversity,” Bloomberg, August 2, 2021.

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