Blog: Financial materiality: Understanding the financial performance of ESG strategies – JD Supra

As ESG factors gain in importance, the question of financial materiality is one that regulatory, legal & corporate professionals need to consider

As environmental, social & governance (ESG) factors become increasingly important in investment decisions, the question of ESG factors’ financial materiality informs the discussion from both a legal and financial perspective. Legally, ESG factors that are misleading or inaccurately reported could be a basis for liability.

Materiality is a measure of the relative financial importance of a factor among a company’s ESG considerations. The Sustainability Accounting Standards Board defines material issues as those “that are reasonably likely to impact the financial condition or operating performance of a company and therefore are most important to an investor.”

It has been empirically validated that companies with higher ESG scores tend to do better than companies with lower ESG scores in terms of stock performance and underlying financial metrics. And there is much logic behind this finding. The integration of ESG factors reduces risk and increases efficiencies in various ways. For example, companies with higher ESG scores are less likely to be subject to monetary fines or reputational damage as a result of environmental shortcomings, such as through improper waste management, excessive land use, or the release of air pollutants. Further, companies with higher S scores tend to be equal opportunity employers with enhanced workers’ rights, which results in increased employee satisfaction.

Over the last 10 years, various meta-studies have empirically validated that ESG performance is correlated with financial performance. For example, one of the largest of these meta-studies combined the findings of more than 2,000 empirical studies, in which 90% showed either positive or neutral correlations between ESG factors and financial performance. Also, the Center for Sustainable Business at NYU Stern and Rockefeller Asset Management found in their analysis that not only did ESG drive positive financial performance in 58% of cases (with 13% of cases showing neutral financial performance, 21% showing mixed performance, and 8% showing negative performance), but efforts to decarbonize business operations were also strongly correlated with financial performance.

The financial materiality of ESG is not only present in equity investing; it also plays an increasingly important role in the credit decisions of fixed-income investors. To reflect this growing importance, the 2021 statement released by the UN Principles for Responsible Investment, which was signed by more than 180 investors and 25 credit rating agencies, committed to incorporating ESG into credit ratings “in a systematic and transparent way.”

In addition, ESG factors are influencing assessments of country-level performances as well. To provide more clarity for investors, the World Bank launched its first sovereign ESG database, which enables investors to understand ESG performance on a country-level by incorporating ESG data related to all 17 sustainable development goals.

It all starts with good governance

When evaluating empirical research, good governance influences materiality the most. For example, a global apparel company with a good anti-corruption framework (governance factor) may result in a lesser likelihood of encountering child labor in the company’s supply chain (social factor).

Research indicates that the governance category has the clearest link to financial performance, as factors such as anti-bribery and anti-corruption programs, executive pay, or board diversity show the strongest forms of correlation. This also holds for fixed-income investors, as business ethics, transparency in executive pay, and board diversity are more important in preventing corporate bankruptcy than are environmental and social factors.

How to integrate ESG?

What makes the integration of ESG such a dynamic and emerging field is that investors have various strategies to choose from.

The Global Sustainable Investment Alliance defines sustainable investment as one that “considers [ESG] factors in portfolio selection and management” and divides ESG investing into the following common strategies:

  • ESG integration (using ESG data next to financial data)
  • Corporate engagement and shareholder action (investor activism to focus on ESG)
  • Norms-based screening (screening against minimum standards)
  • Exclusionary screening (negative screening)
  • Best in class (positive screening)
  • Thematic investing (clean energy, social trends, low carbon, etc.)
  • Impact investing (generating financial return next to social or environmental return)

The popularity of these strategies varies by region; however, the most common approaches by far are: ESG integration, exclusionary screening, and corporate engagement/shareholder action. These account for roughly 85% of all sustainable assets.

The active integration of ESG factors which is defined as “explicit and systematic inclusion of ESG data in analysis and investment decisions” is also the best-performing strategy alongside traditional financial analysis. A key element of performance superiority lies in managing against downside risk, particularly during social or economic crises. These factors explain why ESG integration is becoming the most popular strategy, according to the NYU Stern and Rockefeller Asset Management report.

The shrinking world of unsustainable investing?

At the beginning of 2021, 35% of all managed assets worldwide were considered sustainable assets. With an annual growth rate of 15% over the last two years, the market will soon be reaching a point where the term sustainable investing will slowly account for the majority of total global managed assets.

The UK stewardship code from 2020, which sets high governance standards for institutional investors, has been adapted in various western regions. The code requires their growing list of signatories to disclose the use of ESG factors in the investment process, paving the way for further acceleration of ESG in investment management.

With the proposed rules to disclose greenhouse gas emissions in corporate reporting in the United States and in Europe via the Sustainable Finance Disclosure regulation, the importance of ESG-type investments will continue to increase and influence advisor and client interests. A recent survey by the Investment Advisor Association found that nearly 51% of advisers consider ESG or sustainability to be one of the “hottest” compliance topics for 2022.

Consumer demand — along with the standardization of reporting frameworks, regulatory requirements, and financial performance — will ensure that ESG factors become fully integrated into the investment process. The correlation between financial performance and active ESG integration will soon become so visible that the fiduciary duty of asset managers can only be fulfilled with full consideration of ESG factors.

Perhaps it is time to name the shrinking pie of investing without ESG, and call it unsustainable investing.

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