What is ESG Materiality?

Understanding materiality is a key part of business strategy, and with a growing emphasis on environmental, social and governance issues in the boardroom, assessing ESG materiality has become a corporate imperative.

The definition of materiality

Material issues are relevant in many contexts – legal, financial, regulatory, and accounting. Financial materiality is perhaps the most apparent, with its impact on the bottom line, but materiality is also found in a non-financial context, such as sustainability, governance issues, or corporate social responsibility. Any of which can also have a knock-on financial effect.  

Information or issues can be considered material if omitting, misstating or obscuring them could influence decision-making on related subjects.

Materiality encompasses all of those issues that organisations need to take into account when assessing their opportunities and risks. They are the issues they cannot afford to ignore.

Comprehensive materiality analysis allows businesses to: 

1. Report on non-financial issues
2. Make more robust decisions about where to invest
3. Assess new business opportunities
4. Weigh up potential risks
5. Enhance stakeholder engagement by offering insight into how the business functions
6. Stay on top of regulatory and legal developments

Ultimately, materiality analysis helps businesses to future proof.

Materiality does not have a one-size-fits-all definition. Each organisation will have a bespoke set of criteria for material issues. These depend on stakeholder priorities, the purpose of the organisation, and even the subjective viewpoint of its leaders. Nonetheless, it is possible to outline standard attributes when looking at a framework for materiality analysis. In 2016, the Corporate Reporting Dialogue Consortium released its Statement of the Common Principles of Materiality, which sets out foundational principles for standards development and business reporting. 

The importance of materiality to ESG

The concept of bespoke materiality is particularly apposite around ESG liability. Encompassing every environmental, social and governance factor affecting an organisation, ESG is a practically limitless topic.

Material ESG issues are those governance, sustainability or societal factors likely to affect the financial condition or operating performance of businesses within a specific sector. 

But not all ESG issues are created equal: within any business, industry, and even geography, their relative importance varies. Organisations need to focus on those elements of ESG that are financially material to the way they do business. Reduction of fuel consumption, for example, will have a more direct impact on a transport company’s financial position than on that of an accounting firm. Paper recycling is a large-scale undertaking for a print media organisation, while pesticide use is high on the list of environmental issues for farmers. Sustainability accounting should have ESG materiality at its core.

ESG investments have been shown to outperform the market, but largely when the business being invested in scores highly on material ESG issues. Research by Harvard University found the way a company handles material ESG factors is more likely to influence its performance than how it addresses immaterial ones. Meanwhile, investment in immaterial sustainability issues may lead to worse stock performance.

While ESG materiality is focused on the financially relevant, it is not solely about the bottom line. It can also help businesses understand how they are tracking against other targets – such as decreasing gender pay gap, increasing diversity, aligning with the UN’s Sustainable Development Goals, or growing community engagement. The ability to measure material ESG performance is essential for accurate sustainability reporting.

Assessing ESG materiality

A business’s ESG rating, which can be employed to predict investment returns and ESG performance, needs to incorporate ESG materiality, specific to that company and sector. There are a number of ways to perform materiality assessments. The SASB Materiality Map, for example, offers a sector-by-sector breakdown of how strongly 26 specific ESG issues impact on particular industries.  

For individual organisations looking for greater detail on their ESG materiality and liability, solutions such as alva’s ESG Intelligence offer a more precise scoring mechanism. It measures the materiality of any given issue by calculating the degree to which it is either adding to or detracting from a business’s overall ESG score when compared with the sector average impact of that issue. In this way, organisations can view their ESG materiality compared to their competition and the industry as a whole. 

This method of using ESG data to calculate a materiality score not only looks at the nature of the issue and its relevance to the business, but also incorporates the volume of coverage, the influence of the source and the prominence of the issue.

This makes it an extremely accurate representation of the material impact of the ESG issue for that company.

The value of ESG materiality

Tracking ESG materiality has the added benefit of providing a mechanism for surfacing new issues as they arise. While certain ESG factors will be standard within any industry, there is always the likelihood that additional ones will emerge – or that existing ones will gain more traction due to external influences. ESG is a fast-moving area, and new risks and opportunities are emerging all the time.

In the wake of the Black Lives Matter protests, businesses across the board were compelled to make public their racial equality and diversity policies, which previously were for internal consumption only. Those with an understanding of how important their position on these issues was to their stakeholders were able to react appropriately, and avoid the risk of reputational damage. 

Corporate governance isn’t limited to the business as a discrete entity. In today’s complex business landscape, companies can be held accountable for the behaviour of their suppliers, and so need a mechanism for surfacing activity in their value chain that might leave them open to ESG risk. Clothing retailers, for example, need complete transparency of where and how their stock is manufactured due to the industry’s history of exploitative employment practices. ESG materiality will vary throughout the supply chain, so a robust framework that can identify relevant issues along its length is vital for avoiding that risk.

Having a strong ESG profile isn’t about ticking standard environmental, social, and governance boxes. It’s about understanding which ESG issues matter to the business. And with ESG materiality presenting a moving target, reducing ESG risk and opening up associated opportunities requires a robust means of assessing it.