It’s official. The long-predicted era of the integration of ESG (environmental, social and governance) factors into mainstream investing has arrived. For decades, ESG has slowly built momentum: Sustainable investing enthusiasts have watched the number of PRI signatories increase, read the tea leaves of ESG data being added to mainstream investor research sources, and hailed any other whiff of investor interest in sustainability.
In the U.S., the reality has lagged that of Europe and Asia and has been particularly slow to catch up with the prophesies—but now real change has arrived. Of the 788 proxy proposals in 2018, 43 percent were related to environmental and social issues and 36 percent to governance. According to the 2018 Edelman Trust Barometer Special Report: Institutional Investors, 66 percent of U.S. investors said that their firm altered its voting or engagement policy to be more attentive to ESG risks in the last year alone.
Perhaps it is no coincidence that ESG has achieved this level of mainstream acceptance in the same era that the concept of materiality has become the bedrock philosophy of the corporate sustainability and the sustainability reporting fields. The gospel of materiality preaches that a company’s sustainability strategy, as well as its reporting, should focus on those issues that affect stakeholder decision making, i.e., issues that have the ability to profoundly impact the health of the company’s business, industry and/or issues on which a company has the ability to profoundly impact society.
Similar to the concept of ESG, the concept of materiality is not new, but it has been popularized in recent years following a decision by the Global Reporting Initiative (GRI), the globally-dominant sustainability reporting standard, to make a materiality analysis mandatory in all GRI-aligned reports. As it stands, 75 percent of the world’s largest sustainability reporters rely on the GRI framework and governments, and stock exchanges commonly refer to GRI in their mandates and guidance. In the years since GRI codified materiality, more and more companies have undergone the exercise of conducting a materiality analysis—formally engaging with internal and external stakeholders to identify and refine those issues that are uniquely material to the company.
Challenge in ESG Data
This maturation process in sustainability reporting was likely necessary for investors to uncover ESG as a worthwhile area of study, no less implement it as an overlay in mainstream investments. We know from recent studies conducted over the past several years, including a 2015 study from Harvard Business School, that companies that make investments based on a sustainability strategy rooted in materiality outperform peers in terms of risk-adjusted stock price performance, sales growth and profit margin expansion. Importantly, companies that make sustainability investments without regard to materiality do not enjoy such benefits. For investors to make real judgments based on ESG, they must have information related to material issues and moreover, understand that the company in question acts in a way that is guided by materiality.
We are, however, still in the early innings of ESG integration. The lack of quality and uniformity in sustainability reporting is one of the largest barriers to the successful application of ESG in mainstream investing. U.S. companies are particularly guilty. In October 2018, institutional investors representing more than $5 trillion in assets rightly called on the U.S. Securities and Exchange Commission to step in to provide guidance to companies on creating more useful and comparable ESG data.
Investors’ frustration is understandable. The financial worth of ESG is proven, but the lack of comparable and uniform data presents a challenge. ESG raters (e.g., MSCI, Sustainalytics) have taken this to heart, providing comparable tools and processes around each industry’s material issues. This is of course helpful, but imperfect, given that each rater has its own methodology for valuation (they have not reached the harmony achieved between credit rating agencies), and only approximates materiality at the industry rather than the company level.
The Opportunity for Businesses
In the 2018 Edelman Trust Barometer Special Report: Institutional Investors, global investors indicated their No. 1 source for ESG information was a company’s ESG report and U.S. investors’ No. 1 source was a company’s website. Based on investor interviews conducted by Ceres, we know savvy investors are headed to these sources because that’s where the best information is, but they would prefer to see ESG information ultimately also appear in proxy statements, 10-Ks and annual reports, which they more routinely reference. These preferences put the onus on companies—and give them the opportunity—to demonstrate how they communicate and act on material issues and to articulate how that focus and investment contributes to their long-term business strategy.
As investors, governments, stock exchanges and others continue to assess how to infuse ESG as an overlay into the totality of mainstream investing, there are clear steps that all companies can take to prepare themselves for an increasing number of questions from and conversations with investors on this subject.
- Conduct a Materiality Analysis - Done improperly, materiality can become a box-checking exercise—because isn’t every issue important? But done well, with careful consideration to those ESG issues that present real financial risk and opportunity, it is a revealing exercise in stakeholder engagement that can set a company free to prioritize the ESG issues that will make a difference financially and societally.
- Develop a Materiality-Driven Strategy - Make materiality core to your strategy. Once material issues are identified, companies must refocus their resources and time and allocate capital to address these topics. This includes a clear roadmap to address each issue, ideally complete with qualitative or quantitative goals to drive action and accountability.
- Create Materiality-Driven Reporting - Report on your ESG performance with a focus on material issues. This can be accomplished in a standalone ESG report or through other corporate channels. Make sure to align your reporting to the ESG issues investors will care most about and continue updating them through varied means, whether during earnings, at a conference, or in one-on-one meetings. Reporting should be honest about the challenges faced and forthright about the company’s current stage of sustainability development. Greenwashing still exists and long-term does no favors for an ESG valuation.
- Operationalize Materiality-Driven Stakeholder Engagement - Disclosure is important, but it is equally important to engage in a year-round dialogue with key stakeholders on ESG performance and progress. The report can be the basis for the conversation, but a year-round stakeholder communications approach is critical to both allow stakeholders to gain an appreciation of current efforts and to calibrate priorities for future efforts.
Andrea Helisek is vice president, Business + Social Purpose, New York.
