Embedding environmental, social and governance (ESG) principles into the investment process continues to attract all types of investors for many reasons. Institutional investors correctly recognize there are business risks associated with ignoring ESG. There are a long list of such risks that could hit the bottom line, some sooner, some later, and many have the potential to severely damage a brand’s image and destroy customer loyalty. At the same time, ESG offers real opportunities for companies that “get it right” – opportunities to reduce costs, attract a better, more engaged workforce (which boosts productivity), gain better insights into what customers want, and so on. Many individual investors and their financial advisors are also now realizing the risks and opportunities that ESG factors represent.
Similarly, some investors—again, both institutional and individual—are motivated to support environmental and/or social justice goals through their investing. In other words, they want their investment choices to have a positive impact. They want to use their capital to help bring about change. Sometimes that means they want funds to divest from companies engaged in business activities that are harmful to the environment, such as oil and gas or coal companies that continue to deal in fossil fuels. It might also mean bringing pressure on companies to achieve certain goals or force changes in senior management or at the board level.
ESG skepticism caused by conflicting definitions?
While the reasoning is sound, the ability to achieve the risk reduction, improved profitability, or changes in business practices through ESG-based investing can be difficult to prove, at least in the short run. In particular, reducing risk means reducing the likelihood that something bad will happen, but that rarely makes headlines. A recent opinion piece from Bloomberg says that “investors are growing more skeptical of ESG investing, wondering whether it actually furthers environmental or social justice aims.”
We can understand the frustration—change often comes more slowly than we might like. But there is more to it than that. We believe the skepticism is due in part to greenwashing, which the SEC’s proposed rules should help to address. But part of it is due to the different ways that ESG ratings firms define the very purpose of their scores, the scores that many funds, as well as investment advisors, rely on to evaluate the sustainability profile of their holdings.
Given this concern about ESG’s effectiveness, we believe it is an appropriate time to talk about the concept of double materiality in the sustainable investing space. A recent article published by the Harvard Law School Forum on Corporate Governance discusses the concept of “double materiality”, which gets at this issue of whether ESG is about the risks these issues present to a company’s financial health, or whether it is more about using an ESG lens to examine a company’s impact on others. In our view, it’s both.
Reporting standards define materiality
As the Harvard Law School article points out, the most widely used reporting standard for sustainability, the Global Reporting Initiative (GRI), asks companies to disclose ESG topics they see as material, and how those topics were selected. The initiative’s GRI 101 standard states that this assessment of materiality should “reflect the reporting organization’s significant economic, environmental, and social impacts” on stakeholders. This is an outward-looking approach—it looks at how a company’s practices affect others (the environment, its employees, customers, and suppliers, etc.).
The article then notes that the well-known, widely embraced set of ESG reporting standards published by the Sustainability Accounting Standards Board (SASB) defines materiality as factors that could affect the reporting company’s financial performance and enterprise value, and could therefore influence investment or lending decisions. This is inward-looking, i.e., it asks, what is the potential impact on the company?
Look both ways: Inward and outward
These two approaches—one focusing outward, the other inward—are complementary. This is consistent with the concept of “double materiality” applied in the European Union’s Non-Financial Reporting Directive. It also gets at one of the (many) reasons ESG scores for a given company that are provided by different vendors can differ significantly. If one vendor uses a more inward-facing approach and another adopts an outward-facing point of view, they are almost guaranteed to reach different conclusions.
Consider ESG ratings for a property & casualty insurance company, focusing on “E” for this example. The company has worked to reduce its carbon footprint and discloses a good deal of information about this, more so than many of its peers. However, a fairly high percentage of the company’s policies cover homeowners in states at high risk for wildfires and/or hurricanes. An ESG vendor with an outward focus would probably give the company a strong rating for the “E” component of its ESG score. A vendor with an inward focus would look at the risk that climate change represents to this insurer and would likely give this insurer a low “E” score. Neither one is wrong, but investors get mixed signals from the two scores, and relying on one or the other misses important information. That’s frustrating.
We believe the materiality focus that affects vendors’ ESG scores is under-appreciated. OWL ESG’s Consensus Scores by definition incorporate both views, inward and outward, because these Scores are a blend of inputs from hundreds of ESG data vendors. To learn more about our Consensus Score’s, contact us.