
How ESG issues become financially material to corporations and their investors
This working paper advances a framework that illustrates how environment, social and governance (‘ESG’) issues become financially material and impact on company and industry valuation. The framework comprises five stages of the pathways to materiality.
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OVERVIEW
This paper advances a framework to illustrate how environment, social and governance (‘ESG’) issues become financially material. This is important due to exponential growth over the past decade with respect to companies measuring and reporting on ESG issues and the number of investors committing to integrate ESG issues. The proposition that ESG issues are or will become financially material is one gaining acceptance among investors, companies and regulators.
A challenge for investors and stakeholders has been the lack of a standard materiality framework comparing companies’ performance on issues deemed material by individual firms. The framework advanced in this paper emerges from the experience of the Sustainability Accounting Standards Board in devising standards that classify 2,000 ‘industry-ESG issue pairs’ as financially material or not. This is applied across 77 industries in 10 sectors. The paper provides specific examples involving different companies to illustrate how materiality of an ESG issue arises. From these standards and examples, the framework segments the most common pathways to materiality into five stages.
The first stage, status quo, relates to society’s tolerance of misalignment between its interests and the interests of a company whose actions negatively impact society. Such tolerance can be due to societal norms on the issue in question or lack of information about the level of misalignment. The second stage, catalyst, is where the misalignment expands due to a company’s behaviour moving away from what is considered socially acceptable or where societal norms about acceptable conduct move away from the company’s practices.
The third stage, stakeholder reaction, is where civil society, the media or other stakeholders react to the expanding misalignment and engage the company directly, appeal to politicians for regulation or appeal to the public for boycotts. Such actions can lead to investigations, future regulation and reputation and brand damage, which all impact on company value. This is the first evidence that an issue can be financially material. The paper discusses how and when this affects the company, its peers and the entire industry.
The fourth stage, company and industry reaction, relates to how a company and industry respond to stakeholder reaction, the paper discussing when a company and industry is likely to address the misalignment and to what extent. The fifth and final stage, regulation and innovation, relates to how misalignment can be lessened through regulation that changes business practices on certain issues or through innovation that disrupts an industry forcing firms to improve their performance on certain issues. In both instances, the materiality of those issues is increased.
The paper discusses how this framework provides a theory of change for actors that prioritise social progress such as ‘impact first investors’ better enabling them to create change in company behaviour. The paper discusses how the framework provides a theory of action for those actors that prioritise economic outcomes like ‘return first investors’ enabling them to better understand which issues will become financially material. Overall, the important question becomes not only whether an issue is material, but how an issue becomes material.
KEY INSIGHTS
- Over the past decade great progress has been made in understanding the materiality of environment, social and governance (‘ESG’) issues along with increasing mainstream acceptance of the proposition that to properly integrate ESG issues into a company or industry analysis, one must focus on material factors.
- Conferring the status of financial materiality on any ESG issue significantly elevates the importance of the issue within corporate management because companies are compelled to manage and disclose financially material issues to investors.
- Mainstream acceptance of the materiality of ESG issues has been accelerated by studies demonstrating their materiality and the release of industry-based standards by the Sustainability Accounting Standards Board that enable comparison of firms with respect to ESG issues.
- Misalignment of corporate behaviour with societal needs and how that misalignment is perceived by society is a critical initial condition for materiality. When society has easier access to information about the misalignment and more influence over politicians, ESG issues related to that misalignment are more likely to become financially material.
- Financial materiality of ESG issues is something that evolves over time, varying from sector to sector, proportionate to stakeholder pressure on those issues. While stakeholder pressure around the #MeToo movement accumulated quickly, causing firms to focus on sexual harassment in the workplace, the issues of climate change and global warming had been pursued by activists over decades with little success in engaging oil and gas companies.
- Where stakeholder pressure does not bring about change in company behaviour, increased regulation will make an ESG issue material. In the absence of such regulation, innovation can be the impetus that makes an issue material by developing a competitive advantage that forces competitors to improve their performance on those issues.
- For impact first investors, who prioritise social progress, understanding how issues become financially material can be a powerful framework for changing company behaviour because companies will act on those issues that they consider to be financially material.
- For return first investors, who prioritise economic outcomes, understanding how issues become financially material, in particular, the social context within which they arise, better enables them to predict which issues are likely to become financially material and need proactive management.
- The response of a company to a material issue will usually depend on the costs involved and the position of peers in the industry. However, companies that improve their performance and disclosure on material ESG issues enable market efficiency and more informative stock prices and, in addition, outperform competitors whose performance on those issues is poor.
- This report contains a collection of case studies about how issues became material for certain companies in certain industries. It also contains tables presenting the different and evolving stages of financial materiality as well as the development of material issues in four industries. The report also contains a list of references for studies of ESG issues as well as materials related to the various case studies in the report.
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