Focus on business relevance
For anyone who has followed the ESG movement in finance, and specifically in investment management in the last twenty years, the current headwinds stemming from ESG critics represent a temporary and perhaps even necessary correction in a long-term journey. It brings non-financial risk and opportunity management closer to an integrated approach in mainstream investing. In fact, this temporary re-assessment indicates that, far from being abandoned, the topic has reached a level of maturity that calls for more rigorous definitions, more sector-specific refined practices and a move towards aligning sustainability goals with core business values that primarily focus on financial materiality.
By Julia Wittenburg
Materiality in risk-adjusted decision-making
The anti-ESG sentiment has centered on the perception that ESG imposes social values at the expense of financial returns and that this clashes with an investor’s fiduciary duty. But when approached through the lens of business relevance, non-financial risk and opportunity management is not about imposing morality – it’s about understanding risk-adjusted return. Not only is the consideration of industry- and business-relevant ESG factors prudent, but essential to any robust investment analysis. In a world of increasing uncertainty and transparency, ignoring material ESG factors is not just shortsighted – it can be a risk in itself.
For those having worked in this space for some time, assessing ESG aspects in investments is not based on an altruistic motive, but on a data-driven and qualitative analysis approach that is integrated into a more traditional financials-based analysis. A values-based approach may still be applied, for example in the form of an exclusion, that reflects the beliefs of the underlying investor, such as a decision not to invest in companies involved in producing genetically modified organisms (GMOs) or in gambling. ESG methodologies in investment management have evolved over time, hand-in-hand with the increased availability of companyspecific information. Transparency increases in corporate reporting were often triggered by regulation after the occurrence of major corporate crises and calls on company owners to more closely monitor their investee companies.
France’s 2001 “Nouvelles Régulations Économiques” Act is such an example when, primarily in response to corporate governance-related scandals (e.g. Enron in the U.S., Vivendi Universal in France), the country witnessed growing demand for insights into companies’ governance practices and management of social and environmental considerations. Similarly, the Principles of Responsible Investment (PRI) and its call to integrate ESG factors into investment analyses significantly gained momentum amongst investors in the wake of the 2008 financial crisis.
The value of transparency
Materiality in this context is key and refers to factors that have a demonstrable impact on a company’s financial performance, competitive positioning, or enterprise value. It should therefore not come as a surprise that a company’s proper management of non-financial risks – ranging from energy and resource efficiency to workforce safety and data privacy – can have significant consequences on a company’s financial performance. While these risks may not be reflected in quarterly earnings, failure in managing these risks over time can lead to reputational damage, regulatory sanctions or supply disruptions – each of which can carry real financial consequences that can impact company valuations and hence, the value of investments. Managing non-financial factors can also present business opportunities, a fact that is often forgotten. Companies integrating material ESG considerations into their product or services offering will often be more forward-thinking and lead in innovation, which in turn can benefit customer loyalty, as well as higher employee engagement, potentially even affording companies a competitive advantage.
Transparency on key issues is certainly the first necessary step for investors to understand a company’s ESG profile. More often than not, key questions are:
What type of information does the company disclose and does materiality of the issues align with investors’ views on the sector and/or company?
How does the company choose to disclose the information? Does the information tell a story stemming from a knowledgebased sustainability journey or is it a compliance exercise merely seeking to meet regulatory obligations?
How well do top management and the company’s Board of Directors understand the issues and with what knowledge and conviction do they respond to investor questions when engaged with?
Some of the most convincing non-financial reports available reflect the extent to which company leaders are engaged in the day-to-day management of material sustainability issues, including in strategy- and priority-setting, topic-matter expertise and conviction.
Managing the dual lens of materiality: the regulatory landscape
When it comes to the regulatory landscape and framework developments of assessing materiality, the creation of the International Sustainability Standards Board (ISSB) has helped manifest this single materiality approach by identifying material ESG issues by sector, helping investors to focus on specific, financially relevant risks and opportunities. The fact that the ISSB has acquired and absorbed formerly used reporting frameworks, including the Task Force on Climate-related Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB), is yet another indicator of the evolving landscape of sustainability reporting focusing on materiality.
The EU’s current Corporate Sustainability Reporting Directive (CSRD) and the European Sustainability Reporting Standards (ESRS) add an extra challenge by asking companies to assess and report on two distinct but related aspects of sustainability performance: how ESG influences the company’s financial performance (financial materiality) and how the company’s operations, products or services impact people and the environment (impact materiality). This dual consideration of materiality, central to the EU’s Sustainable Finance framework, is also fully integrated into the related Sustainable Finance Disclosure Regulation (SFDR) for investors. The approach poses a practical and strategic dilemma for investors by requiring consideration of both financial performance and sustainability impact in investments. On the positive side, double materiality reporting can highlight upcoming areas or topics of future regulation and serve as early risk/opportunity indicators.
While some may view the current headwinds as a major setback, it is essential for long-term oriented investors to consider the broader context in which companies operate. Whether this context refers to supply chain disruptions due to changing regulatory environments or geopolitical risks, they are all real-world forces shaping market dynamics as also reported in the findings of the World Economic Forum’s (WEF) annual Global Risks Perception Survey. It is first and foremost about taking a holistic view to understand the material spectrum of externalities that can influence the long-term financial performance of a company (outside-in perspective) followed by how externalities affect society and the environment (inside-out perspective).
Even though adopting a double materiality lens arguably adds significant challenges to corporate sustainability reporting, in the end the resulting data output interlinks and aligns with investors’ regulatory frameworks so companies can benefit if they deliver both types of information. And even though the fine-tuning of these regulatory frameworks is currently underway, their emergence is the product of a long-term journey that has taken decades in establishing itself and is unlikely to become undone in a world that is only increasing in complexity and interconnectedness.
Julia Wittenburg
is responsible for the stewardship activities of Bank J. Safra Sarasin and has held positions at PJT Partners and BlackRock. She regularly presents on corporate governance topics and is a member of the advisory ESG Committee of a Swiss-listed technology company.