Dynamic ESG Materiality
ESG* Materiality is not constant! Some examples from war

Conducting fundamental ESG risk research and ESG scoring quickly makes you realise that ESG Materiality is core to understand, including its dynamics. It is a challenging subject, representing a problem in too simple ESG research and ESG scoring methodologies. Approaches are differing with regards to the the dynamics. The SASB approach is rather stale with its standardised activity-based approach, while the stakeholder interview approach is more dynamic and adjusted to the specific company and their stakeholders. But are they both too stale really? Working directly with global megatrends and their sub-trends can capture some of the dynamic. As a practicing ESG analyst, having participated in building an ESG research methodology and ESG score system, I think all of them must be considered and be well understood. But in addition to this, you need to keep a finger on the pulse! (In this article, ESG risk also includes ESG opportunities).

ESG Materiality is about highlighting the most important factors that really can make a difference in the ESG risk profile of a company. All ESG factors are relevant for all companies, but they carry different weights in different companies’ ESG risk. ESG Materiality is rather stable, as the activities of companies are and as the stakeholder group composition is. But it is far from fixed, and it is important to understand this to fully grasp the concept of ESG Materiality. This really matters when it swings.

Stakeholders may change their perception of what is important to them, and this will have an impact on how they will behave in relation to a company. It can be triggered by a multitude and sometimes surprising events. This has impact on the business and its outlook.

Let us have a look at some actual situations impacting ESG Materiality.

A war and its effects on ESG Materiality

As we have seen with the Russian war on Ukraine, stakeholders have strongly focused on certain elements having forced large global companies taking important strategic choices. Examples here are companies announcing new store openings, office openings, etc. in Russia after the start of the war. Huge protests and boycott threats in social media by consumers and other stakeholder groups have forced some of these powerful global companies to change course of action. They have been targeting the companies directly, and investment funds financing them. We have seen many companies pulling out of Russia after pressure, despite high direct costs.

Is this just a one-time ESG Materiality focus blip? Not if we’re on a “reverse globalisation” trend bringing more geopolitical instability and polarisation.

Reverse globalisation to impact ESG Materiality – Who do you deal with and the inherent risk?

The world has been on a course of protectionism and polarisation since some years back linked to geopolitical tensions to a large degree. Stakeholders are influenced by this, and the rise of social media power to each keyboard globally has been a game changer. As we have seen with the Russian war on Ukraine, massive costs through likely write downs will hit companies. While the ESG country risk exposure for companies has been focussed on anti-corruption, exposure to unworthy working conditions, human rights breaches, and non-respect of environmental standards as a counterweight to the emerging market growth opportunities, we are now seeing an increased focus on the exposure to non-democratic state governances. This kind of governances can lead to wars, sanctions, etc., leading to problems for exposed companies as stakeholders like clients and financing sources, care about this. The ESG Materiality of this factor has grown for companies with relevant activities. Companies with direct relationship to consumers may also be more exposed to this factor.

Ethical boundaries may change too? – Defence sector

We have seen other topics emerging from the Russian aggression, where stakeholders argue for changing the borders for what is ethical. Many investors have mandates prohibiting investments in the defence industry, at least in companies producing controversial weapons. Voices have raised the question whether the non-controversial weapons should be classified as ethical investments as they are required to defend against aggressors and keep peace in the world. For this example, as defence sector companies not really are in lack of clients or capital, the ESG Materiality for the companies in the sector will not change for this reason, but there will be an increased scrutiny on who they sell weapons to. Any company selling to non-democratic state governances will notice the increased ESG Materiality on that point, as it will impact on the stakeholders’ relationship with the company. This can lead to more difficulties to recruit, to find good suppliers, etc.

For the asset managers having invested for the first time in the defence sector recently, it was only possible when their investment strategy permitted it. It is not so that the asset managers have changed their values-based (or ethical) screening. This is nothing asset managers can change unilaterally overnight. Only asset owners can do this, either by choosing another fund or having the mandate’s investment strategy changed. The timing may simply be good with regards to increasing sales and profits ahead? The mechanisms at work here is focus on profits and performance rather than ethics. As it should be really to respect the fiduciary duty.

Food security to impact ESG Materiality – A growing front in-between biodiesel and food?

Another issue rising from the Russian war on Ukraine is food security. Using arable land for other than food is impacting the food supply and security negatively for all as the trade for agricultural products is global. It works against the SDG number 2 (End hunger, achieve food security and improved nutrition and promote sustainable agriculture), and some stakeholders may not appreciate this. Biodiesel raw material production is an issue if it uses arable land.  This is being accentuated by the seriously reduced production capacity of Ukraine and the dwarfed export from Russia. These two countries are very important exporters of wheat and other grains for food use. In that context, how sustainable is biodiesel and other biofuels when they come from fields where food could be cultivated? Here some biodiesel companies are very vocal about supporting SDGs, but they omit the negative impact on SDG 2. Questions will continue to be raised on this topic, but now with more power. Here ESG Materiality is changing, and a company in the biodiesel value chain, may be considered to have relevant risks, whereas earlier most only saw opportunities? The provenance of the raw materials is core. It can lead to less sales growth through less subsidies or less access to raw materials among other elements.

Practical implications for an ESG research and ESG research score provider

As ESG Materiality changes, we as an ESG research and ESG score provider, must take this into account in our work. How do we do this? We can dig deeper in the most material factors, with the above example of Russia’s war, to understand the risk of a company’s country exposure. Can they lose all business, local assets, etc. if a new Putin clone reveals him or herself elsewhere?

Practically, we can increase weight on metrics in the scoring model and even include new metrics. What is sure is that we need to keep the finger on the pulse of ESG Materiality and ensure the right questions are asked to the companies if they are not showing they understand and try to mitigate all ESG Material risks.

Conclusion – Dynamic ESG Materiality

There are many other elements that are moving the ESG Materiality of course. And all stakeholders have their say. Biodiversity and supply chain are other examples where we see increased focus nowadays.

With regards to ESG Materiality and the practical implementation in ESG research and ESG scores, it will differ between providers. As will ESG scores. They always will, this is about assessment of risk, and it has never been a science. When the focus of investors changes from the ESG score to the underlying fundamental ESG research, they will notice that the differences are smaller.

The main point here is to understand ESG Materiality and its dynamics, particularly if you do ESG research and ESG scoring. Without this base, your ESG research and ESG scores may soon be less relevant than they were yesterday.