Over the last three years, there has been a growing number of voices which have stressed the importance of incorporating sustainability in the investment process. In 2014, the Law Commission recommended that both trustees and their financial advisers “bear in mind that ESG and ethical factors may, in any given case, be material to the performance of an investment” and the UN PRI in its 2015 report on fiduciary duty in the 21st century noted that “failure to consider long-term investment value drivers, which include environmental, social and governance issues in investment practice, is a failure of fiduciary duty”. Proponents like these have resulted in the subject of sustainability gaining greater traction with investors, with the US SIF (The Forum for Sustainable and Responsible Investment) reporting that $8.10 trillion in US-domiciled assets at the beginning of 2016 were being held by organisations that apply various ESG criteria in their investment analysis and portfolio selection.
Critical to the prominence of sustainability in investors’ minds has been the growing body of evidence emerging over recent years indicating that companies that engage with sustainability in their decision-making perform better over the long-term than those that do not. However despite this and the proliferation of sustainability products, there still remains a degree of imprecision as to what exactly constitute ‘material’ sustainability factors. Recognising the complexity of the concept, the Global Reporting Initiative has sought to help companies understand how different stakeholders approach materiality, noting that for investors it is “any factor which might have a present or future impact on companies’ value drivers, competitive position, and thus on long-term shareholder value creation.”
Grewal et al., in their 2016 working paper on Shareholder Activism on Sustainability Issues, shed some light on a number of interrelated issues around the question of materiality and provide evidence which links this to ESG performance. Specifically they note:
A growing number of investors are engaging companies on non-traditional ESG issues in addition to traditional topics such as executive compensation and shareholder rights.
Fifty-eight percent of shareholder proposals studied were filed on immaterial ESG issues (filtered using guidance from SASB) suggesting that a significant number of shareholders are unaware of materiality, or are pursuing objectives other than enhancing firm value.
Shareholder activism was effective in improving company performance on the focal ESG issue regardless of its financial materiality.
Even though they rarely receive majority support, proposals filed on immaterial ESG issues are accompanied by larger and faster increases in firms’ ESG performance on the issue relative to material issues due to: addressing agency problems, the firm’s inability to differentiate which issues are material and attempts by the firm to divert attention from poor performance on material sustainability issues.
Proposals on immaterial issues are associated with subsequent declines in firm value and conversely, those on material issues are associated with subsequent increases in firm value. This suggests that pressure on companies to address ESG issues that are not financially material for the firm but relevant to other non-investor stakeholders destroys financial value.
If the evidence is correct and failure to distinguish between material and immaterial factors is destroying value, then the drive by investors towards integrating ESG practices may lose its impetus, by failing to translate into increased profitability for companies. At the Thinking Ahead Institute (TAI), we believe that, using a foundation of sustainability beliefs, it is critical for investors to be able to make this distinction and to then use this to understand how these factors can affect risk management and portfolio construction. The TAI sustainability portfolio construction working group was set up to do just this and we will report on progress throughout the coming year.