This article was written by Doe Tien Xuan, Head of Research, Public Equities; Liew Weylin, Portfolio Manager and Global Sustainability Lead, Public Equities; and Shang Thong Chie, Director of Enterprise Strategy at GIC. 

ESG factors are material to financial performance

Environmental, Social, and Governance (ESG) issues are now recognised as being important considerations for financial performance, and this correlation is underpinned by a growing set of research and data points:

• Firms with strong ratings on sustainability issues material to their sector tend to have significantly better performancethan firms with inferior ratings
• Their outperformance was more marked over longer time horizons.
• They show better downside protection during times of economic and social crisis.

For an investor focused on long-term risk-adjusted returns, it is thus important to correctly identify the ESG issues that are material to a company and to incorporate them into investment decision-making.

Challenges in assessing materiality

The growing demand for corporate disclosures on ESG risks and performance has led to a proliferation of ESG metrics and scores, with over 600 different company ESG ratings identified in 2018 by a recent landscaping study.While significant consolidationhas taken place in the ESG data provider space in the last two years, the volume of ESG data collected on listed companies remains immense. Another reviewrevealed that ESG data firms have amassed over 1,000 data points per issuer, and have translated these into 100 to 350 ESG metrics for clients to assess.

However, most of the ESG data collected are not material to the long-term financial performance of the company, while not all ESG issues are of equal importance to every industry. For example, one studycited that “for 66% of all securities in the Russell Global Large Cap Index Universe, less than 25% of the 100+ data items in the traditional (ESG) score are considered material.”

Even within a single sector, what is financially material could vary. For example, the Sustainability Accounting Standards Board (SASB)found that within the healthcare sector, ‘Greenhouse Gas Emissions’ matter more to healthcare distributors but less to other players such as biotechnology and pharmaceutical firms, or medical equipment manufacturers and suppliers. This is because healthcare distribution requires the transport of products which burns fossil fuels and exposes healthcare distributors to the risk of rising carbon and fuel prices. In contrast, ‘Product Quality & Safety’ is material to all within the healthcare sector.

The set of material factors will change over time as regulations increase and market externalities become more internalised. A company’s impact on biodiversity, for instance, may become more financially material across industries if regulators formally take action on nature-related risks. Being able to identify these trends early and monitor the relevant factors will help long-term investors pre-empt the negative impact on their portfolios, and facilitate timely engagement with companies.

Developing a materiality analysis framework

It helps to have a structured framework to provide comparability and specificity to analysis. While some investors have developed in-house approaches, SASB’s framework does provide a useful starting point. It helps investors and companies focus on ESG issues that are generally common and thus comparable within a sector, which are then tied back to fundamental drivers of economic value such as revenue, cost and balance sheet quality.

SASB’s standards cover 77 industries across 11 sectors (eg. Consumer Goods, Financials, Food & Beverage, Services, Technology & Communications), and organise the universe of sustainability risks and opportunities that companies might face into five broad sustainability dimensions: Environment; Social Capital; Human Capital; Business Model and Innovation; and Leadership and Governance. This allows SASB to narrow down the set of material sustainability metrics to the most financially material ones – a manageable 6 topics and 13 metrics per sector and company, on average.

Figure 1. Overview of SASB Standards

Adapting the SASB Standards for due diligence and active engagement

SASB’s industry-specific standards provide a useful framework for investment due diligence and corporate engagement. Taking the technology sector as a case study, cybersecurity and data governance are generally considered material factors for most companies in the technology business, and for companies that are in possession of sensitive customer information. Losses from cybersecurity breaches, liabilities from litigation and regulatory fines can have a debilitating impact on a company’s financials. In a McAfee report on the Hidden Costs of Cybercrime, monetary loss from cybercrime was approximately US$945 billion in 2020. IBM estimated the average total cost of a data breach to be US$4.24 million in 2021, an increase of 11.9% since 2015.

As an actual example, it was reportedthat Equifax’s cybersecurity incident of data breaches in 2017 resulted in them incurring over US$1.3 billion in related costs. Long-term investors should hence consider how the company is preparing itself to withstand or recover from future cybersecurity threats. SASB metrics that describe the company’s approach to cybersecurity risk management would be relevant for investors to include in their due diligence and asset valuation.

However, there are several limitations to using SASB Standards:

• Lack of readily available data as not all companies disclose SASB-recommended metrics. Notwithstanding, as the number of companies reporting on SASB Standards is growing rapidly (it rose by 50% to around 1,000 companies in 2021), this issue may diminish over time. Even where standardised disclosures are available, the conclusions that can be drawn from the data would differ based on each company’s operating context, geography, and growth stage, among other variables.
• Bottom-up analysis remains critical in identifying financially material metrics, as not all of SASB’s metrics may be material. For example, GIC’s Futures Unit conducted cross-sectional regression analyses to quantify the extent of financial materiality for certain SASB metrics. The studyidentified just a handful of metrics that had measurable positive correlations with equity returns. For those metrics, the linkage to returns was strong – every 10% of improvement in score was correlated with higher annualised returns in the future (controlling for company-level variables such as sector, valuation, size and profitability) ranging from 2.2 to 6.0 percentage points. That said, company-level analysis is still required to determine if the performance on the material metric is causal to the improvement in returns, or vice versa. On the other hand, metrics that did not show an impact on returns over the time horizon of the analysis could still be important for companies to track and disclose, and to demonstrate ESG effort so as to secure a social license to operate over the longer term.
• Potential need to augment SASB’s standards with additional, forward-looking analysis, notably when examining sectors that are evolving fast, or are at the cusp of being disrupted. For example, when assessing a company’s cyber resilience in the technology sector, investors could examine the company’s track record in taking remedial action on breaches, the speed and frequency of their disclosures on cybersecurity incidents, the existence of a Chief Information Security Officer, and the number of layers between that C-level executive and the board.

GIC’s approach to materiality

We seek to assess the strength of a company’s sustainability practices on factors that are financially material to that company. This is grounded in our belief that companies with strong sustainability practices offer prospects of better risk-adjusted returns over the long term, and that this relationship will strengthen over time as market externalities get priced in through the actions of regulators, businesses and consumers. We integrate sustainability into our investment processesin a way that recognises the diversity of the industries and markets in which we operate, and the trade-offs between different sustainability objectives that may arise in the shorter term.

In practice, GIC has used SASB as a reference to guide investment analysis, but deep research into each sector and company is still required. Some of the steps taken by the investment teams include:

• Validate each set of metrics with internal research and analysts’ perspectives, and capture these in engagement guides that investment groups across GIC may use.
• Sector-focused workshops with external industry specialists may be conducted to expose analysts to issues on the ground, and to enhance appreciation of the materiality of the factors considered and how they should be incorporated into asset valuation.
• Where possible, data acquired on material ESG metrics are also used in portfolio reporting and analytics as part of ongoing investment monitoring.
• For material indicators where data gaps are evident, or where data is not readily available, analysts would leverage their regular meetings with company management to better understand how those issues are being managed, and insights gained would inform the assumptions in their financial models.

The focus on materiality has enhanced our investment teams’ underwriting of opportunities and portfolio companies, and enriched our portfolio managers’ dialogues with company management. By considering where companies are leading or lagging on material metrics against peers in the sector, we can customise our engagement agenda for each company. An understanding of drivers material to a company’s performance, such as exposure to green revenue or dependency on external voluntary carbon credits, also helps our teams identify opportunities for potential investment.

For example, we have, on occasion, advised companies on how disclosures of targeted, material metrics could amplify their stakeholder communications. In the case of a European specialty chemicals company, which is a supplier to the industrial and consumer sectors, we encouraged the company to enhance its reporting of the full product life cycle carbon footprint of its innovative, low carbon products and carbon-efficient operations. This benefited the company through its wider recognition as a provider of effective solutions in the global effort to reduce carbon emissions.

A structured approach to materiality assessment allows our investment teams to identify and evaluate the ESG issues most relevant to a company in a more targeted way, enabling them to go beyond superficial, ‘check-the-box-type’ discussions on ESG with their investee companies. In addition, being aware of upcoming regulatory requirements or regulatory direction, and hence identifying factors that could become material over time, can help investment teams make better pre-emptive risk assessments of companies. All these allow us to better manage longer-term portfolio risks, as well as engage and support companies in their transition towards more sustainable outcomes.

Conclusion

Integrating the concept of ESG materiality into every stage of the investment process is a practical way to ensure potential ESG risks are factored into investment valuations, and to equip investors and company leaders to take pre-emptive steps on gaps in material ESG areas to avoid long-term impairment losses.

However, it is important to undertake bottom-up research and assessment, and adjust the material indicators to each company’s sector and specific context, as a one-size-fits-all approach will dilute impact. This makes implementation challenging, particularly with regards to scale and comparison across sectors. Notwithstanding, a structured materiality framework helps to provide a constructive platform for both parties to engage on ESG issues that could affect long-term investment value.

While this will be an ongoing journey for all asset owners and managers, we can benefit from working together to sharpen the set of material indicators companies should monitor and disclose, based on the sustainability risks and opportunities most relevant to each industry and sector, and accelerate the adoption of a materiality framework by the industry.

Please click on “Save As PDF” for the full article, including Appendix A and the list of references.