Nowadays, both companies and investors are spending more resources on ESG issues. A core question has emerged, that is, which ESG issues are financially material and why. This is important not only for companies to manage their resources properly, but also for investors who seek to optimize their risk-adjusted returns. Materiality, a popular concept in recent years may answer the question. Materiality is originally borrowed from financial accounting, where the Financial Accounting Standards Board defined it as information which would be considered decision relevant to an investor. In ESG investing, materiality refers to the social and environmental topics that matter most to a company’s business and stakeholders.
Materiality matters in ESG investing
Not all ESG issues matter equally. Russell Investment assessed the relationship between a company’s ESG issues with its financial performance and found that not all ESG issues mattered equally. Taking fuel efficiency as an example, it has big impact on the bottom line of an airline, but it hardly has impact on an investment bank. Studies presented evidence that investment in ESG issues could lead to financial outperformance, but only in conditions that the ESG issues were financially material to the firm. In the meantime, a study also found that investment in immaterial ESG issues did not lead to better financial performance and even detracted from performance.
Materiality assessment is the vital starting point of ESG reporting. KPMG considered by using materiality assessment, an organization can get most benefit from their materiality process, in which they apply a sustainability lens to their business risk, opportunity, trend spotting and enterprise risk management. The Global Reporting Initiative (GRI), a globally dominant sustainability reporting standard, made a materiality analysis mandatory in all GRI-aligned reports. Echoing to that, the HKEX also requires materiality assessment both internally and externally by companies.
Materiality better contents investors’ preferences. According to the CFA Institute, the financial relevance of ESG factors varies with different sectors and industries. ESG investors has their own preferences towards the three dimensions: environmental, social and corporate governance. For instance, environmentally aware investors are highly sensitive to a company’s carbon footprint. Then they may set the bottom line with companies that run large fleets of trucks in their portfolios. Meanwhile, socially oriented investors could pay more attention on a company’s commitment on labor practice, such as minimum wage, working hours, and living welfares. The largest institutional investors, such as Vanguard, in their proxy voting guidelines, explicitly stated that they would vote considering the materiality of the sustainability issue in question.
In summary, to investors and organizations, one-size-fits-all approach is no longer a fair action in ESG performance measurement. Sustainability reporting organizations such as the Task Force on Climate-Related Financial Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB) expend resources developing standards that are specific to various business lines. SASB has established the Sustainable Industry Classification System (SICS), which comprises 11 sectors that further divide into 77 industries. Also, ESG data providers such as MSCI and Sustainalytics weight subcategories differently based on the relevance to different industries.
Challenges in materiality analysis
Determining the relative significance of each ESG factor can be very difficult. When investors explore non-financial aspects of an investment or portfolio, they may come across many factors that have impact on their subjects’ ESG performances. Meanwhile, there is no clear line between material issues and immaterial ones. It becomes more challenging when investors consider their investments across multiple industries, where different factors should be weighted differently.
Materiality is dynamic evolving over time. According to a paper of the Harvard Business School, material issues are often seen as internalities to corporations, which mainly attracts attention of capital markets, while immaterial issues are viewed as externalities, which get more focus from NGOs. However, in reality, externalities can be internalized with the pressure of stakeholders and regulators as well as industry development. So, it is crucial to accept the perception that materiality is not a state of being but a process of becoming material over time. To identify emerging issues, there are tools that could be helpful, such as scenario analysis, forward looking assessments, industry specific datasets, and new ways of measuring impacts.
ESG rating approach is helpful but imperfect. With the dynamic nature of materiality, comparability becomes more difficult to achieve. In light of this, ESG raters, such as MSCI and Sustainalytics, are providing comparable tools and processes around each industry’s material issues. This helps expand the recognition of materiality, but it is still imperfect. First, the scores provided by raters are opaque. Second, each rater has its own methodology of ratings, which are not harmonized with others in the market. Third, their materiality measurements are based on industry level rather than the company level.
Which steps companies should take?
Comparing to the static materiality of financial disclosures, ESG disclosures have a dynamic materiality, which is difficult for companies to report their initiatives. Despite this, companies could still build thinking on how sustainability issues become financially material for companies and their investors. There are clear steps that companies can take to prepare themselves:
Conduct a materiality analysis properly. Rather than taking box-checking exercises, a company should consider more to determine its materiality based on its own circumstances, including its industry, sector, and business operations. Stock exchanges like the HKEX have provided tools for firms to better manage their material issues. ESG raters have opened their materiality map for free, which could also be taken as references.
Develop a materiality-driven strategy with top-down consensus. The foundation of a company’s strategy is identifying the material issues. Once material issues are identified, companies should focus on the defined targets and allocate their resources and time accordingly to address the issues. Companies need a clear roadmap, as well as quantitative key performance indicators to drive action and accountability.
Engage the participation of stakeholders. Stakeholder engagement is a purpose of materiality assessment as well as helpful pathway to identify material ESG issues. At the beginning, companies could generate an extensive list of stakeholders, but then it is better to reduce the list into a workable size, concentrating on key stakeholders. To achieve long term sustainability, companies should maintain the stakeholder engagement on an on-going basis.
Still feel difficult to implement all of the above mentioned tasks? Contact us with firstname.lastname@example.org to get more information. We would provide a platform for corporates to better analyze their materiality based on different needs. Whether you want to be externally accountable to investors, or you want to gain trust from your stakeholders internally, we could offer customized solutions for you.
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