A 2017 survey by the CFA Institute found that 73% of chartered financial analysts consider environmental, social, and governance (ESG) issues in their investment analysis and decisions. As ESG analysis becomes firmly entrenched in the investment world, it has become increasingly critical for investors to discern the value generated by these assessments. As a result, many in the investment community are giving special attention to ESG materiality, or the context around the effectiveness and financial relevance of ESG measures.
Take the environmental considerations of an apparel and footwear manufacturer, for example. Its efforts to tap renewable energy sources to power its headquarters might be commendable, but environmental impacts along its supply chain, such as the management of wastewater and chemicals, hold more potential to derail the business—and its financial performance.
Research from Harvard University concluded that the way a company manages ESG factors of a material nature is more likely to influence its performance than how it addresses nonmaterial ones, both absolutely and relative to peers.
ESG Materiality Reflects Relevance
As a concept, materiality is something of a moving target in the financial world. Some of the shifting sands stem from the debate over whether accountants or attorneys are the ultimate arbiters of what may or may not have a material impact on a company’s financial performance. Regardless, ESG investors are well-armed with the following definition from the Sustainability Accounting Standards Board (SASB): financially material issues are those “reasonably likely to impact the financial condition or operating performance of a company and therefore are the most important to investors.”
For instance, environmentally aware investors are highly attuned to a company’s carbon footprint. Such a profile can have a direct effect on the bottom line with companies that run large fleets of trucks, such as distributors of food, beverages, and health care products. Meanwhile, socially oriented investors may look for a company’s commitment to paying a living wage. In the context of materiality considerations, an assessment of a company that relies on lower-skilled hourly workers has to account for its preparedness for the potential impacts of a rising minimum wage.
The financial relevance of ESG factors varies within different sectors and industies. To help investors navigate the differences, SASB developed the SASB Materiality Map, a display of the potential materiality of 26 sustainability-related business issues.
Incorporating Materiality in ESG Investing
A number of organizations generate ESG data at the company level, including Bloomberg, MSCI, Dow Jones, and Sustainalytics. This data, however, offers little insight into ESG materiality or the likelihood that ESG factors could sway a company’s financial returns.
To bridge the gap, money manager Russell Investments has created a scoring system that meshes company-level findings from Sustainalytics with SASB’s materiality map. The resulting material ESG score “identifies and evaluates only those issues that are financially important to a company.” Similar development of other ESG materiality assessments is poised to grow, especially as the CFA Institute called accounting for material ESG information and considerations “an important component of a complete and thorough financial analysis for any actively managed fundamental investment portfolio.”
Some investors also see it as a matter of advanced risk assessment. At a 2017 seminar for financial analysts, chief investment officer of the California State Teachers’ Retirement System Christopher Ailman said that despite valuing ESG analysis for its ability to root out long-term operational risk, “materiality is still going to be our big struggle when it comes to ESG . . . [Y]ou’ve got to start at the level that is material.”
Ultimately, a blanket approach to ESG analysis will likely prove ineffective, both in terms of outcomes and investment returns. By incorporating thorough research and measurement around ESG materiality, however, investors may sharpen the impact and performance of such sustainability-focused efforts.