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The importance of materiality for ESG impact analysis

There are more and more environmental, social and governance (ESG) information disclosed publicly but it is still challenging to identify, measure and assess which information is more relevant for decision making. The only pertinent ESG information are the material ones, in other words the ones that are reasonably likely to impact the financial condition or operating performance of the company.

The Global Reporting Initiative (GRI) guidelines defines “Materiality’ as “those topics that have a direct or indirect impact on an organization’s ability to create, preserve or erode economic, environmental and social value for itself, its stakeholders and society at large”.

A materiality analysis is a method to identify, measure and prioritize the ESG issues that are most relevant for an organization and its stakeholders. Questions to raise are whether the issues to cover in the sustainability reports and disclosures are important enough to influence a stakeholder’s decisions in relation to the business. Thanks to this analysis, firms can define their long-term ESG strategy, create their pertinent targets and apply the best strategies to report the data found during the process.

The goal is then to clearly identify ESG issues that are relevant to the success of a given strategy when evaluating the ESG awareness of companies and asset managers. In effect, financially material ESG factors that could have a significant impact – both positive and negative – on a company’s business model and value drivers, such as revenue growth, margins, will require capital and risk allocation.

In a recent study by Khan, Serafeim and Yoon (2016), the authors explains how investment in sustainability issues leads to financial outperformance, but if and only if the investment is in sustainability issues that are financially material to the company. The authors also present that investment in non-material sustainability issues does not lead to better financial performance, and may on the contrary deteriorate the performance. It is therefore important to understand that spending resources on immaterial issues is also potentially value destructive.

In order for sustainability to translate into financial performance, it must have an impact on two sides: on either the amount of cash flow generated by the company, and/or on the cost of external financing to the company (the weighted average cost of capital). The research stage usually contains a materiality assessment to identify the ESG issues that are likely to have an impact on the company’s financial performance. Materiality is typically measured both in term of the likelihood and severity of impact.

The ultimate result is a visual representation, named “materiality map”, of which issues should be prioritized according to their importance to the company’s success and stakeholders’ expectations (that can directly affect the first).

Example of materiality matrix, from Unilever :

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Some ESG material issues might vary from company to the other, in a specific industry. For example, water stress can disrupt the operations of mining or beverages companies, which rely heavily on clean water in their production processes, but not in the same way and not on the same operational aspects).

One can deduce that individual companies in different subsectors may be judged to have different material ESG factors impacting the business. So, rather than adopting a one-size-fits-all approach, it is better to develop an ESG scoring framework that is specific or truly material to each company and its profitability.

The relevance of ESG issues varies also industry to industry. For instance, fuel efficiency has a bigger impact on the sector of transportation, like airlines for example, than on the sector of Financials, like banks and insurances.

Here also, instead of adopting a one-size-fits-all approach, industry groups such as the Task Force on Climate-Related Financial Disclosures (TCFD) and sustainability reporting organizations expend considerable resources developing standards that are specific to business lines. ESG data providers weight subcategories differently based on their relevance to different industries.

The materiality map will help to identify and compare topics across different industries and sectors. It is a tool that supports investors to spot the differences between various companies. SASB developed for example the SASB Materiality Map, a display of the potential materiality of 26 sustainability-related business issues, under five dimensions.

Finally, it is important to notice that opportunities exist to develop clearer signals based on other ESG-related goals, such as alignment with Sustainable Development Goals (SDGs) from United Nations. Rather than mapping industries to key issues based on financial materiality, it is also possible to map industries to the SDGs that are relevant to their business lines.

Example from Canon. “The chart below plots each SDG according to stakeholder expectations as gauged via our survey, versus the degree of relevance for Canon’s activities based on the three materiality themes (creating new value and solving social issues, protecting and conserving the environment, responding to people and society as a good corporate citizen)”.

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Investors who primarily see ESG analysis and ESG integration as a way to enhance investment processes are likely to focus on ESG issues they consider financially material. As explained, factors that will have a financial impact in the future, either positive or negative. There are also investors who are more interested in the direct impacts that companies’ practices and products have on the environment and society. Those investors are likely to focus on related high impact ESG issues, even if these issues are not considered as the most material from a financial performance point of view. This distinguished an ethical/impact investor who may judge factors affecting social or environmental returns, but minimal financial returns, from a responsible investor.

To conclude, frameworks such as the materiality maps provided by SASB are helpful in providing some guidance but investment professionals often develop their own view on what is most material and how to measure and report it.

 

Charles Lamoulen,

Head of Portfolio Management

FARAD Investment Management S.A.