How to be an effective Organization that leads in understanding the evolving nature of financial materiality of ESG issues?

I come from banking and financial services sector and this is my view on helping anyone from within my sector to understand what they need to understand when they are collecting, reporting , disclosing and explaining about ESG findings and issues.

This will help you build ESG strategy and consensus. I found the emerging framework discussion in this paper quite helpful in drawing a picture for you.

The core principle you will learn and perhaps will get better is - in engaging with others when it comes to ‘How ESG Issues become Financially Material ?'

But first thing first - Negativity is counter-productive. I have read umpteen number of write ups on how the investment world is moving away from ESG , how it has not delivered, how it makes you feel lost among all the changes your organisation needs to go through and many more.

I completely disagree with this narrative.

A general lack of awareness, risk aversion, short term-ism and lacking positive engagement with core advocates of policy change – is perhaps the reason why you may want to brush off ESG before it has been given a chance to create its root system to flourish and really create sustainable ways of doing business.

but if you are willing to take some measures of change, perhaps your journey should start from this point.

You need to understand and teach your entire organization about two things-

1.      Materiality

2.      Externality

Any investor takes note of an issue and labels it 'Important' if its materiality is high. Because its significant hence they will raise their concern. Society takes note of an issue and raises an alarm when business crosses its threshold of what is perceived as 'tolerable cost of doing business' and is not anymore 'just doing business'.

Regulators and governing bodies create regulation when the guard rails start failing. The concern raised is not addressed by industry because the companies have not yet been held responsible for an “externality” because society either does not have information on the magnitude of the issue or has not internalized the information regarding the magnitude of the misalignment or even worse information is withheld from public eye.

And, ESG is that place where both externality and Materiality will be given a dashboard and help you build a long term vision for the organisation and business, it will help you build a very collaborative journey of sustainability so that you are not where you have tragically meandered off to - the unsustainable path. No business wants to be on path of creating adverse impact on natural resources and climate. but since we are here - ESG does provide a place of harmony or rather something that can lead to harmony.

How?

There are clear ESG materiality Pathways. And what is that? 

It is a Framework for shifting the perception of materiality as a “state of being” to a “process of becoming” material over time. We are tuned to looking at point in time data but spend little time and energy on what brings in change - the catalyst.

So instead of point in time snapshot your organisation should become bold and ambitious to develop a rhythm of knowing when an ESG issue will put you on a materiality path that perhaps you did not aspire for but find yourself in the making! May be this will help you stop putting blames on previous executives or unfair regulatory demands but be more in control of ‘your affairs’ both internal and external.

Thus far you have been collecting gigantic amount of ESG data, so what works?

1. To properly integrate ESG issues into a company or industry analysis, one must focus on material factors

When an ESG issue is noted/reported- understand the issue through the lens of Misalignment. Misalignment is defined here as gap of expectation between what society thinks is right Vs what the business thinks is right. There is always a local and cultural context into the misalignment (and perhaps that's why globalisation has hurt us more- we have lifted, shifted one strategy into all locations). Generally, minor misalignments exist - there is less friction and one is well within the means of tolerance - that there is no significant price and valuation effect on the business (read - materiality manifestation). But as the corporate behavior linked to strategy linked to business purpose deviates from this ‘status Quo’ an issue starts showing its head. And at this stage it may or may not be material because this all depends upon the materiality of the impact of widening of this misalignment and the associated catalyst that will change the status quo.

Below illustration shows stages of ‘forming’ of an ESG issue into a materiality ESG issue that seeks attention

The opportunity lies not only in actively managing issues that are already financially material but monitoring and proactively managing the issues that are becoming financially material

Clearly we need an internal and an external guidance on how to predict which issues are likely to become financially material by understanding the social context within which they are operating. No business can exist in isolation.

using SASB standards, studies have shown that firms improving their performance on material ESG issues in the future outperform competitors with declining performance on material ESG issues, and more disclosure on material ESG issues is associated with more informative stock prices and other capital market proxies for capital formation and efficiency

(Source )

Important things to note -

1. internally resources are allocated to issues that are material

2. there is more likeliness of an issue becoming material if the stakeholders can get information about the misalignment between societal and business interests

3. Issues are more likely to become financially material when media and NGOs have more power and politicians are more responsive to this power.

4. New norms are set for industry behavior - when an issue becomes material and the company is unable to address it and the issue tends to spread in the industry sector.

5. Issues are more likely to become financially material when companies lack ability to self-regulate and address the issues of misalignment

6. Instances where changes in societal expectations drive increased misalignment, if a company’s performance is close to its peers, the whole industry could be indicted by stakeholders (e.g. fossil fuel industry right now)

   see below illustration to put oil and gas sector through this framework:

Another example of serious misalignment , if you look at the recent report of forest 500. when we look at top 500 companies that are responsible for market driven deforestation (in this report), there is complete misalignment from 'well within tolerance' level that the society expects.

A paradigm - ESG becomes really important if the firm at fault is clearly misaligned with industry norms and its performance on the focal ESG issue can be identified as an outlier, which leads to the company being singled out by stakeholders and the issue may become material only for the that company and not the whole industry and this can be addressed. However in absence of ESG – its not easy to know if this misalignment is at one company level or has become a industry wide practice.

Convergence vs divergence – In context of stakeholder activism, if we can successfully influence an entire industry, potentially through shaming the whole industry or inspiring successful self-regulation, a convergence of practices could occur (e.g. SBTi was born from such common thought process of self-regulation and reducing misalignment of purpose). If the activism results in a convergence of practices, the issue becomes an industry norm and stakeholders may assume a certain standard of compliance/performance on the issue in question and with regulatory performance within guard rails soon one could achieve status quo where the misalignment is well within accepted limits and information is well regulated and disclosed to the society.

Now one key aspect is that stakeholder response and the subsequent continuous pressure sets the path and tone of materiality. The non market players (NMP) play a huge role in this (include your self in it!) As does the regulatory framework. An absence of NMP, media scrutiny and regulation leads to further misalignment and increase in materiality of the ESG issue with no recourse to adaptation/mitigation but only loss. Read about AGM resolution to know more about such impacts and how this fits in to the larger narrative of ESG. I wrote about AGM earlier.

What stakeholder reaction brings to the table – is recognition of an issue and how can the company attempt to respond and regain public trust. Hugely important.

From a cost perspective, for a company tracking back from a misalignment that is becoming material -  voluntarily change towards status quo is cheaper to action as compared to awaiting a regulation to kick in !

Here it matters what strategy the business, boards and executives come up with to accept or deny the misalignment. E.g. some fossil fuel companies has been denying and funding this narrative that fossil fuels have nothing to do with climate change ☹ (read here about Exxon)

I recently attended 'Sustainability Live : Net Zero', and in a room full of so many sustainability officers there was no dialogue and discourse on informing the attendees on how crucial it is to build ESG strategy with clarity on 'becoming material' in order to be truly sustainable in the long term!

I know its long post but I want the reader to find some long term value in why this is important.

Thank You for your time.