Materiality – The Starting Point for any ESG strategy
This overview focuses on materiality, continuing the series of posts on the five key elements of successful ESG integration launched by the ESG Advisory Team in Dec 2020..
Establishing which ESG factors are material to a company is essential to identifying sustainability-related risks and opportunities, integrating them in a company’s strategy and risk management processes, and communicating with stakeholders. Views on the relative importance of particular ESG issues are not always consistent. Traditionally, investors have been drawn to information linked to the financial state of a company, while non-financial stakeholders (the wider community, NGOs, regulators) were more focused on the external impact of business activities. This divergence in focus is reflected in the dominant ESG frameworks, SASB and GRI.
The Global Reporting Initiative, aiming to improve corporate transparency and accountability, focuses on a wider audience. According to GRI, material ESG factors ‘reflect the organisation’s significant economic, environmental, and social impacts; or substantively influence the assessments and decisions of stakeholders’. A topic can be considered material if it falls under either or both of those elements. SASB, developed in consultation with the leading asset managers, focuses on financial value with factors that are ‘reasonably likely to have material impacts on the financial condition or operating performance of companies in an industry’’.
The regulatory view presented in the Non-Financial Reporting Directive encompasses both perspectives. Under the NFRD, companies are required to disclose information necessary to understand the financial position of a company as well as the impact of its activities (on the environment or society). This view is similar to the approach that is increasingly adopted by many investors seeking to integrate the external company impact into their decision-making. One factor driving this change is the growing demand for impact investment products (global impact investing market estimated at $715 billion in 2020). Additionally, the lines between financial and stakeholder materiality are often blurred.
Climate change has been leading the ESG conversation in recent years, with investors increasingly demanding transparent information on companies’ transition strategies. Transitional and physical risks stemming from climate change pose a material threat to companies in many industries, from the fossil fuels industry facing increasing regulation and a shift towards renewables to real estate assets endangered by extreme weather events. In this context, companies with negative environmental impacts (such as high emissions rates) are also more likely to be exposed to climate-related transitional risks that will affect their bottom line.
Despite ample scientific evidence and stakeholder demands, effective integration and disclosure of climate considerations remain a challenge to most. According to a 2020 report, 42.2% of companies did not provide sufficient information on climate-related risks, with only 8.9% providing long and short-term horizon information required by the TCFD. Recent research by the European Financial Reporting Advisory Group similarly indicates a lack of reporting on strategy resilience to climate risks.
Companies experience similar problems when integrating and reporting on key social factors – diversity and inclusion, health and safety, labour practices. Corporate missteps in these areas have been subject to stakeholder scrutiny in the past few years, which only intensified since the start of the pandemic. Consequences of inaction can include lawsuits – last year shareholders at several large US tech companies pursued legal action against them for their failure to address board diversity. Human rights and environmental concerns in global supply chains is another topic attracting stakeholder attention. This is signified by the upcoming regulatory action in the UK and the EU as well as large companies such as Nike and Airbus demanding greater transparency from their suppliers.
Climate change (alongside other environmental issues such as biodiversity, waste, and water), diversity, labour practices, and other sector-specific ESG issues will continue to be crucial to business success during the transition to sustainable economy. Considering the full spectrum of relevant issues, including external impacts on non-financial stakeholders, will allow companies to take advantage of the transition opportunities, manage risks and provide the market with relevant reporting. Our upcoming paper, ‘ESG Reporting – A moving but business-critical feast’, will aid companies on this journey by providing deeper insight on materiality in reporting, including suggestions and views from ESG specialists of leading asset manager firms.
By Dr. Elena Zharikova and Andrew Archer – ESG Advisory
 Global Impact Investing Network 2020 Survey
 https://www.whitecase.com/publications/alert/increased-human-rights-supply-chain-scrutiny-uk-and-eu-legislative-proposals; https://www.cdp.net/en/articles/media/24-percent-jump-in-companies-asking-their-suppliers-for-environmental-transparency