Time horizons, systemic impacts, and investor mandates are just some considerations that may conflict with each other
As the sustainable investing movement continues to gain momentum, organizations the world over are redoubling their efforts to create a common yardstick for ESG performance. Part of that work involves determining what non-financial information should count as materially risky to an enterprise – though as noted in a recent company published by FTSE Russell, that’s much easier said than done.
“There are literally thousands of raw environmental, social and governance (ESG) indicators that can provide insights into the performance of companies,” said Arne Staal and David Harris of the London Stock Exchange Group. “For any one theme—health and safety, or biodiversity, say—there is a wide variety of potential measures.”
Beyond the question of relevance to a firm’s business or industry – the impacts of lithium mining will be less relevant for a clothing company than for an electric vehicle firm, for example – the two said investors must draw a line on how much of a direct bearing a certain factor must have on a firm’s bottom line to count as material.
On one hand, investors might let poor labour practices slide for a “white label” clothing manufacturer with no brand recognition, and therefore little-to-no reputational risk. On the other extreme, they may follow the principle of “double materiality” favoured by the EU and the Global Reporting Initiative (GRI), which looks for disclosures on social and environmental impact on top of the potential impact of sustainability factors on a company.
“The danger here is that [double materiality] can be perceived as lacking a focus on the concerns of investors,” they said.
The Sustainability Accounting Standards Board (SASB) in the U.S. avoids that by adopting the more investor-focused definition of materiality set out by the Securities and Exchange Commission. However, it ignores the fact that some non-issues today may in time break into the sphere of materiality in time, such as how companies’ aggressive tax-avoidance policies have recently emerged as key reputational and regulatory risks among investors.
Investors’ different time horizons must also be taken into account. “A day trader will not be concerned about the possible introduction of tighter labor laws in five years’ time,” they said. “A pension fund with obligations to beneficiaries decades into the future will be far more likely to be scan the horizon for structural changes in the economy and society.”
The scope of an investor’s mandate may also influence their view of materiality, the two added. While a stock-picking hedge fund may favour companies that minimize their tax exposure, a universal manager that owns listed companies across an economy will likely take the view that one company’s avoidance will eventually ripple out and create a performance drag on its other holdings.
To resolve the different conflicts, they proposed that materiality exists on a continuum that’s based on the time horizon over which it may impact enterprise value, as well as the degree of market consensus around this. In theory, all impacts on the society, the environment, or the economy can be seen as material to a given company as they can come back in the form of reputational impact, revocation or restrictions on licenses to operate, and shifting client demand, among other consequences.
“From this vantage point, … trying to reach consensus on the materiality or otherwise for every issue for every company is a fool’s errand,” they said. “Instead, it should be possible to reach consensus on an approach that recognizes the subjective and dynamic nature of materiality, and which gives companies, investors, regulators and other interested parties a framework in which to effectively communicate.”