Materiality matters: Targeting the ESG issues that can impact performance
At Russell Investments, we believe that a sound awareness of ESG factors and a robust process can help to deliver strong investment returns and meet objectives over the long-term. So, we asked ourselves: Can materiality help to deliver strong performance?
Materiality and the Task Force on Climate-related Financial Disclosures (TCFD)
Formed in December 2015, in response to a call from the G20, the Financial Stability Board developed clear recommendations for voluntary climate-related financial disclosures. One of those recommendations is for companies to look at materiality. Philippe Désfosses, CEO of French pension scheme ERAFP and vice chair of Institutional Investors Group on Climate Change (IIGCC), said:
“The more companies report effectively on climate-related risks and opportunities, the easier it becomes for investors to allocate the substantial amounts of capital required to implement the Paris Agreement and to work on their own climate risk disclosure. There should be no resistance to the widespread adoption of the TCFD’s recommendations given how – in most G20 countries – companies already have legal obligations to disclose material risks in their routine financial filings, including those that are related to climate change.”
Not all ESG issues matter equally
The relevance of ESG issues varies industry to industry, company by company. For example, fuel efficiency has a bigger impact on the bottom line of an airline than it does for an investment bank. So, rather than adopt a one-size-fits-all approach, we have worked to develop a new ESG scoring methodology that is truly material to a company and its profitability.
Why? We have found that traditional ESG scores are composed of a large number of issues that are not material for every industry or company. Specifically, for two-thirds of all securities in the Russell Global Large Cap Index universe, less than 25% of the data items in the traditional score are considered material.1
So, to generate our new score, we have leveraged the “traditional” ESG scores from the data provider Sustainalytics alongside the industry-level materiality map developed by the Sustainability Accounting Standards Board (SASB). After doing this, we asked ourselves: Can this new score be used as an ESG signal for investment decision-making?
SASB and Sustainalytics: Who are they and what do they do?
Sustainalytics provides data for 145 sustainability categories divided into environmental (E), social (S) and governance (G) issues. Scores for these subcategories are then rolled up into aggregated E, S and G scores, which are further rolled up into an aggregated ESG score for each company. Sustainalytics acknowledges that not every subcategory is relevant to every industry. To reflect this, data is not provided for each industry in each category.
The mission of the SASB is to develop sustainability accounting standards that help companies disclose value-relevant information to investors via standardized filings. SASB use a six-step process before making a final determination that a sustainability issue is material.2 The SASB materiality map is the product of this, and explicitly identifies the material ESG issues to industry groups.
New material score methodology and findings
We used the materiality map released by the SASB to help us determine which of the 145 ESG issues from Sustainalytics data set could be deemed as material to companies’ bottom lines. Following this, we used a number of statistical techniques to help formulate and standardize what we have coined the new material ESG score.
By looking at the correlation between traditional ESG scores and the new material score, our research has indicated that there is indeed a meaningful difference between the two scores. We have found that there is a benefit to investors who differentiate between a company’s financially material ESG issues and non-financially material ESG issues.
So, does materiality matter? Yes.
Industry bodies actively promote and recommend that investors need to focus more on the material ESG issues that directly affect a company’s bottom line. At Russell Investments, we have been able to do just that by constructing a new ESG score that focuses solely on material issues.
Ultimately, our new score allows us to differentiate between companies in a way that the traditional score does not. We can now distinguish between companies who score high on ESG issues that are financially material to their business, from those who score high on issues that are not financial material to their business. In sum, our research suggests that the Russell Investments material ESG scores can provide insights beyond traditional ESG scores.
1 Source: Russell Investments research.
2 Source: ‘SASB’s Approach to Materiality for the Purpose of Standards Development’ Staff Bulletin No. SB002-07062017. July 2017.