ESG Investing For Dummies. Brendan Bradley

while consistency across ESG scores is needed, you also need heterogeneity of methodologies so that investors can decide what is more compelling for their ESG-related objectives. Moreover, in 2020 the EU Technical Expert Group (TEG) on Sustainable Finance published a taxonomy report for sustainable finance that aims to improve the coverage of disclosed data. Perhaps there will be a convergence of ratings, as seen in the credit ratings space since the 1960s, with agencies in that area keen to apply their current domain expertise to an ESG offering. There is also an increasing demand for real-time reporting around ESG issues to understand immediately what ESG-related risks investors have in their portfolios.

      

Clearly there is an ongoing race to provide a “single point of truth” platform for ESG data. An increasing number of providers are producing thousands of metrics and scores, either within their platforms or over an application programming interface (API). This further supports the use of AI, as it enables continuous, real-time, big data ESG harvesting and analytics. This should lead to the creation of stronger ESG investment signals, through sustainable ratings, that facilitate the creation of more forward-looking analysis rather than largely backward-looking corporate disclosure. The result could be the realization of transparent performance attribution analysis that correctly determines the premium on ESG investments. Whichever way, greater data quality and integrity are required.

      

You can visit www.researchaffiliates.com/en_us/publications/articles/what-a-difference-an-esg-ratings-provider-makes.html to review how different service providers apply their ratings. The physical scores or rankings offered by service providers are proprietary, but more of the ratings agencies are now providing indicative scores on their websites without the requirement to be a subscriber. One example is www.sustainalytics.com/esg-ratings/.

Exploring the “Personality” of an ESG Company

      In principle, many companies would argue that they are ESG-compliant because they have paid lip service to some of the major environmental, social, and governance issues that are the flavor of the month. However, ticking the box and engaging in a true analysis of the ESG factors that your company faces, and what they can do to mitigate those factors, are two very different issues. Moreover, some firms deliberately undertake greenwashing (see Chapter 6) to mislead stakeholders as to their real ESG credentials. This section highlights what the true characteristics of an ESG-focused company should be and how companies define the material factors to their issues to achieve such characteristics.

      Determining material ESG factors

Materiality is a concept within accounting that relates to the significance of an amount or discrepancy. The purpose of an audit of financial statements is to enable an auditor to state an opinion on whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework.

      

Likewise, financially material ESG factors represent a significant impact, either positive or negative, on a company’s business model, such as revenue growth, margins, and risk. The material factors differ from one sector to another, including supply chain management, environmental policy, worker health and safety, and corporate governance. For sustainability to translate into financial performance, it must have an influence on either the amount of cash flow generated or the cost of external financing to the company.

      Many firms consider ESG factors such as renewable energy, community relations, and political contributions to be material indicators that they are being good corporate citizens and following an ESG strategy. However, there is a difference between “doing good” and “doing well.” From an investment perspective, these factors may not be financially material to the company’s bottom line, so they don’t score highly in terms of investment-grade aspects that will impact their share price. Therefore, a company needs to consider which ESG issues present real financial risk or opportunity. This analysis should include stakeholder engagement to agree on the priority issues that need to be addressed. For example, an airline company could focus on energy efficiency, customer satisfaction, and executive compensation as core ESG factors that make a difference, but there isn’t always consensus as to what constitutes financially material ESG factors.

      

It’s not surprising that a critical part of ESG scoring is determined by material factors that affect a company’s financial performance, but data providers typically take their own view on materiality issues. This proprietary approach doesn’t allow full transparency, and any differences 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.

      

However, companies voluntarily self-report information that they consider materially relevant. Moreover, companies also tend to overreport areas of positive impact and underreport areas of negative impact. As such, for investors performing cross-company or cross-industry comparisons, it can be difficult to find or develop consistent data sets or methodologies that allow a true assessment of materiality (see Chapter 12 for more information). Further moves toward mandatory reporting, and clarity on what should be reported and how, should improve this issue in the future.

      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