Would you be worried if your doctor – during a routine examination – confessed that she wasn’t an expert in legal matters, and that she couldn’t do your tax return? Given that this lack of knowledge shouldn’t affect her medical diagnosis, I’d expect not. Whilst lawyers and tax accountants have their place, (thankfully) they are not always important.
So should we worry if a software company fails to disclose its record on environmental spills, given that handling hazardous or polluting materials is not part of its business activity? How harshly should we treat a fast growing organisation of 1,000 software engineers working in a rented office space for not knowing how much water they use? Should, for example, they be held to the same standard as a global integrated oil company with 70,000 employees and hundreds of high impact operating sites across the world? We think not in this context.
Yet this is how ESG screens are often used. Different companies, in different industries, in different regions, at different stages of maturity are held to the same standards across a generic set of metrics. Remarkably, academic research shows that ESG screens work despite this. Even though the things that matter most are systematically deemphasised and the things that matter least are systematically overemphasised, they still work.
But we believe these generic screens underplay the value of ESG. Which brings me to ‘materiality’. Within our sustainable investment process, we focus on materiality from start to finish. We develop KPI’s for each company based on material factors, and track them. We consider ESG screen data but re-weight the ESG factors (at a subsector level) by materiality to make the data more applicable. We give allowances for size (i.e. a company’s ability to dedicate resources to internal ESG analysis) and region (i.e. local regulations, listing requirements and cultural awareness) and do additional bottom up due diligence – focusing on material factors – where disclosure is light.
I’m sure this makes intuitive sense to all of our smart Sustainability Soapbox readers but is there any evidence that it works? Yes.
The above study suggests it works very well indeed. In fact focusing on immaterial factors appears to be a performance drag. We believe that there are three key reasons that the analysis of material sustainability factors is a source of investment alpha:
- These factors have a direct impact on company performance
- These factors are often ignored or overly discounted during traditional fundamental analysis
- ‘Traditional’ fundamental analysts have lost interest in ESG analysis, as immaterial factors in ESG screens tend to drive decision making thus making them cynical and leaving alpha on the table for those who appreciate how to leverage the data wisely.
So remember, each ESG metric has its place, but only in the right context. Focus on what’s important. The truth is in the nuance.
1 Friede, Busch, Bassen (ESG & Corporate Financial Performance: Mapping the global landscape). September 2016
2 Khan, M.,Serafeim, G., and Aaron Yoon, 2015. ‘Corporate Sustainability: First evidence on materiality.’ Harvard Business School