add to the difficulty that asset owners and managers face in selecting an ESG data provider (find out more details later in this chapter).
Performing a materiality analysis
A materiality analysis is a method used to pinpoint and prioritize the issues that are most important to an organization’s value chain and its stakeholders. After identifying these issues, they are typically analyzed using two different lenses. For direct environmental issues or working with sustainable suppliers, the organization needs to evaluate the capacity for each issue to positively or negatively impact growth, cost, or trust. They then need to determine how important each issue is to their stakeholders. The final result gives a picture of which issues should be prioritized according to their importance to the company’s success and stakeholders’ expectations.
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.
Applying weights to materiality measures
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.
Furthermore, not all weightings have the same importance to every industry (see Chapter 14 for 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.
Understanding Why ESG Is Important
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.
Global sustainability challenges
The year 2020 marked the start of the “decade of delivery” for the 17 Sustainable Development Goals (SDGs; see Chapter 1 for 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.
