In my previous post, I looked at the importance of purpose when developing an ESG policy. Here, I turn to the question of focus and the need for a demarcation of the limits of materiality.
The list of topics that potentially fall under the ESG banner is long, varied, and changing all the time. I have likened the field to a goat rodeo: “it’s where the action is because of – not despite – the fact that investors are dealing with incomplete data, with unknown and shifting relationships, with changing (and widely varying) client expectations, with difficult-to-interpret science.”
In an environment like that, investment firms cannot chase after every potentially interesting idea. Judgment is needed about where to focus. Just as no investment process pursues every financial concept, so it is not possible to embrace every aspect of ESG.
From the outside in; external indicators of materiality
What is regarded as material will depend, in part, on external considerations such as regulation and client priorities.
For example, the European Union taxonomy published earlier this year defines what is required before a product can be marketed within the EU as being a sustainable investment. The criteria underpinning this taxonomy have become, as a result, a natural starting point for decisions about what is, and is not, material in environmental terms. Another external marker is the UN Sustainable Development Goals, a list of 17 broad areas regarded as the most important in meeting global environmental, political, and economic challenges. Each SDG comes with associated development targets and indicators.
In most cases, an investment policy will be primarily concerned with financial materiality. Here, a key reference point is the Sustainable Accounting Standards Board’s materiality map. Unlike standard financial reporting, SASB takes a sector-by-sector approach, because materiality becomes a much more nuanced concept once we move beyond pure financials to the much more complex world of ESG.
The EU taxonomy, UN SDGs and SASB materiality map are just some of the external input that can be relevant in identifying what is to be treated as material within an investment process.
From the inside out; the horse before the cart
But, as I’ll go into in more depth in my next post, an ESG policy is most authentic and most likely to be effective when it starts from the inside, with the investment proposition of the firm. Faced with the pressure of a stream of legislation, transparency reports, RFPs, consultant questionnaires, and so on, it can be easy to forget that conversations about materiality are, first of all, about how ESG issues fit into the way the firm invests. How that is expressed to the outside world is the cart, not the horse.
Finally, as COVID-19 has dramatically reminded us, remember that materiality is dynamic in a fast-changing world. For that reason, it’s wise to see ESG policy as a work-in-progress, and to expect it to be that way for some time to come.
Materiality is the second of our three pillars of ESG policy. Click here to read about the first pillar, purpose, and click here to read about the third pillar, authenticity.