Brendan Bradley - ESG Investing For Dummies

The analysis required can also improve a company’s business strategy, as it forces the company to analyze business risks and opportunities and understand where they are creating or reducing value for society. In providing the process of how to measure different financial, social, and environmental performances, this analysis can spot trends and help anticipate emerging issues. In turn, it can allow companies to focus their efforts on how they allocate resources and develop new products or services to stay ahead of the competition. Therefore, a materiality analysis can create its own business case on why and how a company should report ESG data, and it can be used for communications with individual stakeholder groups like investors, partners, customers, or employees. This also increases the chances of satisfying stakeholders’ demands.

However, companies voluntarily self-report information that they consider materially relevant. Moreover, companies also tend to overreport areas of positive impact and underreport areas of negative impact. As such, for investors performing cross-company or cross-industry comparisons, it can be difficult to find or develop consistent data sets or methodologies that allow a true assessment of materiality (see Chapter 12for more information). Further moves toward mandatory reporting, and clarity on what should be reported and how, should improve this issue in the future.

After you’ve determined that material issues should either impact a company’s business significantly or be important to their stakeholders, or both, it’s important to determine the relative weight that needs to be applied to those issues, which are driven by the respective impact across the value chain. Most service providers for ESG scores refrain from giving transparent, quantitative guidance for the mathematical calculation of materiality. While provision is suggested for the use of benchmarks to calculate materiality, they don’t recommend specific benchmarks or formulas.

For traditional accounting materiality, single-rule methods and variable-size methods have been used to determine weighting. Single-rule methods can include the effect on a given percentage of pretax income, total assets equity, or total revenue. Sliding-scale or variable-size methods apply given percentages to different levels of gross profit. In general, companies use blended methods to combine some or all methods by using appropriate weighting for each element.

Within ESG there are currently no industry norms or globally recognized practices for evaluating and measuring materiality weighting. Moreover, each ESG data provider has developed a method to aggregate and weigh materiality for its summary scores, but these are proprietary judgments made by each provider. Indeed, analyzing the different methodologies used by leading ESG providers highlights the challenge that investors face. There are distinct differences in the way they collect and analyze ESG data, resulting in low correlations between their aggregation metrics; this increases the difficulty in extracting weights given to material issues.

Furthermore, not all weightings have the same importance to every industry (see Chapter 14for more information). Some providers use levels of data disclosure as a proxy for the relative weight of materiality issues for each industry. This data highlights which sectors contribute most, and their proportion of the contribution to the total is used as a proxy for the level of materiality for that sector. For example, greater disclosure on carbon emissions data suggests that they are more material to companies in that sector. In addition, if given companies in a sector aren’t reporting relevant metrics, they may be arbitrarily assigned a score of zero to encourage disclosure and transparency.

Size matters! Given that larger market capitalization companies have more social media hits than smaller companies, some providers have applied a greater weighting on a small company’s material issues as they are likely to have a greater adverse effect. Likewise, every business is impacted by global macro trends and events (such as the coronavirus pandemic) that shape the world and businesses within it. It’s important to monitor those trends to assess their impact on a company’s material issues.

If it wasn’t clear already, ESG and sustainability issues are counted as important long-term factors, and they are the focus for ever-increasing amounts of research to identify them as catalysts for long-term corporate and investment performance. This has encouraged advisors, consultants, investment platform providers, and ratings agencies to develop tools to identify asset managers with the ability to pinpoint those factors and companies and to highlight the advantages in this rapidly increasing market.

There have been major advances in the understanding of how ESG factors may impact performance. The growth in academic and other research is providing evidence to underpin that belief. For the world’s major asset owners and other stewards of capital, how a company classifies and oversees its operational and reputational risks as well as the economic and commercial opportunities from ESG issues is a fundamental gauge of the quality of its board of directors and the overall business. Investors are now seamlessly integrating an assessment of ESG quality with financial analysis to form a holistic view of an enterprise’s risk and the potential to deliver long-term earnings growth and therefore value. This section highlights some of the issues that are driving the need for ESG investing.

The year 2020 marked the start of the “decade of delivery” for the 17 Sustainable Development Goals (SDGs; see Chapter 1for more information). In light of the impact of the COVID-19 pandemic, these words may have more resonance than they did previously for most people, and there is more awareness of the sustainable development issues that impact us all. Indeed, the international community could use the pandemic as a way to get back on track to achieve the SDGs and accelerate progress during this decade to deliver sustainable development. More recently, many countries have carried out Voluntary National Reviews (VNRs) of their implementation of the 2030 Agenda, and companies are reviewing their ESG agendas in tandem.

The science is clear: As greenhouse gas emissions have decreased during the pandemic, there has been a greater focus on the target to continue decreasing emissions by 3.5 percent per year between 2020 and 2030 so that the average temperature on the planet stays well below 2 degrees Celsius by the end of the century. Meanwhile, businesses are paying much more attention to the scarcity of resources than climate change or related natural disasters. While both factors directly affect businesses, and one often causes the other, businesses may feel that they can more proactively tackle resource scarcity with core business practices, such as supply chain management, whereas climate change is a factor over which they have less control. With an estimated addition of 2 billion people by 2050, global demand for resources will drive the need for improvements in infrastructure associated with a growing population. Either way, these factors help explain further why companies and investors are keen to embrace ESG principles. Moreover, businesses are responsible for much of the greenhouse gas emissions that contribute to climate change, so they must adapt in order to help address climate change issues.