Want to Put the “S” in ESG? Start With Human Capital Measurement

Stakeholders are increasingly pushing for human capital disclosures. Here’s how to measure them

When it comes to measuring environmental, social, and governance (ESG), carbon is relatively easy to quantify. Codes of conduct, board composition, and other governance factors—also fairly tangible. But the “Social” part has long been trickier to gauge.

How does one measure community engagement? Progress toward social justice? Or more broadly, “relations between a company and people or institutions outside of it,” as S&P describes it? It’s no wonder that 51 percent of investors in one survey found the S to be the most difficult to analyze and embed in investment strategies.

That’s starting to change, particularly as stakeholders recognize the growing impact of human capital—the economic value of an organization’s people—amid our ongoing shift to a knowledge economy. In fact, when measured by the number of shareholder resolutions, labor and equal employment opportunity was the top ESG issue from 2020 to 2022.

Regulators are following suit. The Securities and Exchange Commission (SEC) is expected to propose rules for human capital disclosure this year. As a result, management must be prepared to make reporting more accurate.

But these disclosures aren’t just about avoiding risk. Effectively measuring human capital—and painting a clearer picture of how a given organization creates value—makes financial sense while supporting broader ESG goals.

A Brief History of Human Capital Disclosures

The economist Theodore Schultz coined the term “human capital” in the 1960s to reflect the value of human capacities—our knowledge, skills, and abilities—theorizing that “human capital is the factor most likely to limit growth.”

For decades, the significance of this factor was largely sidelined by corporations, where the dominant focus was on physical and tangible capital. However, the exponential rise in the knowledge economy has seen a surge in the role that intangible assets, including human capital, play in the bottom line of corporations. A renewed interest in human capital and its measurement naturally follows. As SEC Chairman Gary Gensler said in 2021, “Investors want to better understand one of the most critical assets of a company: its people.”

Historically, however, that information hasn’t been readily available. Due in large part to the lack of human capital measurement, financial reports provide just 5 percent of information relevant to investors, by one measure; roughly only 15 percent of public companies even disclose their labor costs. As Peter Drucker famously said, “What gets measured gets managed.” In other words, if you don’t measure, how can you manage?

Like S factors more broadly, measuring human capital in a standardized, reliable, and comparable way poses significant challenges. There are hundreds of ESG reporting frameworks, and the SEC’s 2020 amendment to Regulation S-K—which lays out reporting requirements for public companies beyond financial statements—offers little guidance. At present, even the most basic elements of human capital have a complete lack of standardized definitions. For example, definitions (when they exist) for who is considered an employee or what compensation includes differ across reporting frameworks and disclosure requirements.

Fortunately, stricter guidelines look to be on the horizon. The Working Group on Human Capital Accounting Disclosure, a group of academics and former SEC commissioners and regulators, has petitioned the agency to require more disclosure in the following areas:

1. Distinguish between labor expenses and investments in labor. In the “Management’s Discussion & Analysis” section of Form 10-K, include what portion of workforce costs should be considered an investment in the firm’s future growth.

2. Mandate detailed tabular disclosure of workforce costs to provide investors with greater insight into compensation. For example, equity compensation may be more likely to be classified as an investment, given its value as a retention tool, versus a labor cost.

3. Investors need detailed information on operating costs, the most important of which is labor, to predict future margins and determine what portion of cash outflows reflect investment.

For now, it remains to be seen what the final SEC rules for human capital disclosures will be.

How to Measure Human Capital

Contrary to popular belief, you can measure human capital in a scientific way. Doing so will ensure accurate and consistent reporting, thereby mitigating the risks inherent in disclosing this information.

The below chart highlights the key measures of human capital:

As illustrated above, most of these areas can be measured via data that companies already have, such as:

• Demographics of workforce (e.g., how many women? People of color? Disabled employees? Veterans?)

• Cost of labor, including total compensation and fringe benefits such as health insurance, and median and average pay

• Hiring, turnover, and promotion rates

• Costs of workforce training, development, and recruitment

• Standardized surveys of employee engagement and well-being

But effective measurement requires diligence, consistency, and effective consultations with outside resources. Some high-level best practices include:

• Decide what your definitions and breakdowns are—and be transparent about them.

  The two big ones are how organizations define “employees” and “compensation.” For instance, are contractors employees? How are you breaking out your employee demographics when, say, calculating pay equity—by race? Gender? Sexual orientation?

  Relatedly, how are you calculating compensation? Which benefits are and are not included? Over what time period? Definitions from the Financial Accounting Standards Board can help.

• Choose what to disclose.

  Will you disclose internal pay equity and statistically significant differences in pay between male and female or minority and nonminority employees, after controlling for their observed characteristics? Will you disclose the unadjusted raw median pay of your employees, which many investor activists argue is an appropriate indicator of the society-wide educational, occupational, and job opportunities and roadblocks? Will you compare diverse employees to white employees while doing so?

  Whatever a company decides to disclose, it needs to make sure that the disclosures are accurate and backed up by objective measures.

• Understand your timeline.

  For what time period do you plan to collect data? Be specific. Better yet, develop year-over-year comparisons. A one-year snapshot is fine, but investors and other stakeholders would ideally like to see how you’re progressing over time. Remember, though, that such comparisons aren’t possible without clear and consistent definitions.

• Be wary of copmany-by-company—or industry—comparisons.

  These comparisons will often be inaccurate given the varying methods and definitions used by different organizations/industries. Again, that’s where regulatory standards that clarify definitions could help.

More Progress for Social ESG Measurement Ahead

The measures of human capital outlined in the previous section are fairly simple—at least on their face. But data scientists and labor economists are pushing the bounds of what can be scientifically measured.

For instance, in 2021 a group of researchers took advantage of unprecedented access to comprehensive data on every US Microsoft employee before and during the COVID-19 pandemic to determine whether they could “causally identify the impact of firm-wide remote work on employees’ collaboration networks and communication practices.”

The authors of the study collected the following data from each employee

1. Remote status before the pandemic

2. Managerial status, business group, and role

3. Length of tenure as of February 2020

4. Length of workweek

5. Weekly summary of amount of time spent in scheduled meetings and unscheduled video/audio calls

6. Emails and instant messages sent

7. Monthly summary of their collaboration network

Using a modified difference-in-difference statistical model—an approach that compares the changes in outcomes over time—the researchers found that remote work caused workers to become more static and siloed. There was a significant decrease in interactions among employees who belonged to different groups, a sustained increase in workweek hours, and overall a substantial impact on both those working remotely and those working in the office (among other key findings).

These results can lead to company policy changes while contributing to measurements of harder-to-quantify human capital factors like employee well-being and organizational culture.

As these disclosures become increasingly important, we can expect more studies like this to help us measure human capital effectively—and begin to put the S in ESG.