Sustainable investors and sustainability-oriented issuers face an asset class data gap.Sustainability standards setters have designed frameworks for public equities because to date, most ESG data and analysis have focused on equities.Between increasingly extreme weather patterns raising awareness of the climate crisis and the pandemic and criminal justice challenges heightening focus on social issues and the Biden administration’s focus on climate and racial justice, the capital markets broadly are mobilizing toward a more sustainable economy.Since less than 20% of asset owner allocations, according to FCLTCompass, are to equities and over 80% are to other asset classes, the time has come for a concept of materiality that spans asset classes and the capital structure.
Let’s start with first principles. The materiality concept is the universally accepted accounting principle that all material matters are to be disclosed.Financial statement items are considered material if they could influence an investor’s decisions.The same holds true for non-financial information, such as environmental, social, and governance (ESG) issues.
Sustainability Accounting Standards Board (SASB), the most widely acceptable sustainability standards, outlines how material sustainability issues vary across 77 industries in its Materiality Map.Specifically, SASB standards drive 13 areas that affect the income statement and balance sheet.The increasingly widespread adoption of SASB by companies and investors has deepened and broadened understanding of sustainability risks and opportunities in corporate boardrooms and executive suites and at large asset managers and asset owners.Many credit and private markets investors use SASB to inform their processes given the industry-specific insights. At the same time, beyond public equity markets, SASB is not enough.
SASB standards were developed with public equities in mind, and public equities have led other asset classes in the prevalence of ESG integration.The dominance of long-term growth prospects as a contributor to company valuation is apparent to investors, investment bankers, and business school students alike.In discounted cash flow analysis, the most common approach to valuation, the value of cash flows during the near-term 5-10-year forecast horizon is typically dwarfed by the value of cash flows beyond that horizon, or the terminal value.Terminal value’s potential for substantial contribution to valuation is what makes ESG integration essential.
Given that SASB standards were developed with public equities in mind, SASB standards naturally have an equities bias.More broadly, an equities bias is prevalent across nearly 600 ESG frameworks.To illustrate equities bias, standards that impact intangible assets—patents, brands, client relationships, skilled workers and organizational processes—factor heavily into ESG frameworks.This makes good intuitive sense: intangibles are mispriced by even the savviest investors.For example, overvaluing dot-coms led to the dot-com bubble and subsequent crash.Twenty years later, the investment community may be undervaluing intangibles at traditional car makers like Ford (NYSE: F) and General Motors (NYSE: GM) and overvaluing them at Tesla (NASDAQ: TSLA).At the same time, the focus of ESG frameworks on intangibles gives ESG frameworks at equities bias: intangible assets generate most corporate growth and represent 90% of the market value of the S&P500, but are less relevant to other asset classes, such as fixed income.Alongside SASB’s industry-specific materiality maps, a more generalized notion of materiality is necessary, or at a minimum different lenses that institutional investors can apply to SASB for different asset classes.
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Double And Dynamic Materiality Also Have Equity Biases
Double materiality.Introduced by the EU Commission through the Non-Binding Guidelines on Non-Financial Reporting Update (NFRD), double materiality describes issues that are material from both financial and non-financial perspectives.Said differently, information that is material to social or environmental objectives can have financial consequences over time.For example, diversity, equity, and inclusion (DEI) is a human and civil rights issue that can increase enterprise value by improving a company’s talent pool and the quality of its decisions while reducing the likelihood of discriminatory lawsuits.DEI is an issue that primarily affects the talent pool—an intangible asset that is considered an expense according to accounting standards. With this focus on intangibles comes an equities bias.
Dynamic materiality.The basic idea of dynamic materiality is that what investors consider to be the material environmental, social, and governance (ESG) issues changes over time.As University of Oxford Saïd Business School Professor and BCG Senior Advisor Bob Eccles explains, “this can happen slowly, as with climate change and gender diversity, or most quickly, as with plastics in the oceans.The process of dynamic materiality is as follows: growth in evidence of why an issue should be material leads to escalating stakeholder activism, which puts pressure on companies to address this issue lest they lose customers and truly engaged employees. Investors who understand the profitability implications also become more active in their engagement with the company on this issue. And then, voila, it is material!”
To illustrate, COVID-19 went from almost non-existent as an ESG issue in mid-January to over 60% of total information volume on SASB issues three months later, as tracked by Truvalue Labs.According to Truvalue Labs data, among ESG categories, employee health and safety and labor practices represent a disproportionate share of volume.These increasingly important ESG issues relate to intangible assets and introduce an equities bias.
Toward A More Universal Concept of Materiality
Factors that include intangible assets are just one example.Market share and asset impairment matter more for public equity investors and less for fixed income investors, while contingent liabilities and cost of capital matter more for credit investors.Naturally, value drivers differ by asset class and with them the ESG issues that are material to those value drivers.
Intuitively, we note that fixed income investing is more focused on mitigating risk.And research indicates a number of differences between material corporate debt and equity ESG issues:
·Governance.Since bonds are often secured, corporate governance (G) scores are less relevant to bond yields.
·Environmental and social.New research by Halling, Yu, and Zechner suggests that materiality varies across bond ratings: the relationship between strong environmental (E) and social (S) scores and lower new issue spreads is only significant for bonds rated BBB or below and for those that do not have a rating.
·Actively do good vs. do no harm.“Actively do good” aspects of ES matter more than the “do no harm” in terms of bond yields.The same research indicates that higher product-related E and S scores are associated with a lower cost of debt.By contrast, higher environment, community, and human rights scores are actually linked to a higher cost of debt, although the results are statistically insignificant. It therefore seems that the “actively do good” aspects of ES matter more than the “do no harm” for bond yields.The opposite is true for equities.Analysis of MSCI All Country World Index (ACWI)
·Labor markets.During expansions, when there are tighter labor markets, strong employee relations reduce new issue bond yields, perhaps by facilitating recruiting and retaining top talent.There is also no relationship between corporate social responsibility (CSR) activities as a proxy forsocial capital and bond spreads.By contrast, during downturns, when there is labor market slack, employee relations scores are insignificant, and high-CSR firms are able to raise more debt at better ratings, lower spreads, and longer maturities.This may suggest that materiality for fixed income could vary across market cycles.If true, this increases complexity for corporate issuers, which tend to access fixed income markets more regularly than they access equity markets.
UNPRI and others have put together useful guides by asset class, like theFixed Income Investor Guide, that note examples of ESG criteria analyzed for corporate issuers, such as biodiversity, demographics, and audit practices.At the same time, there is the need for a tool that could narrow the list of SASB standards to those relevant to a particular asset class.For unsecured corporate credit, this could mean focusing on ESG issues that affect credit investors more and layering in time horizon.For secured corporate credit, it would mean focusing more on ESG issues that affect the collateral than on those affecting the issuer, as well as considering whether green and social bond issuers are collecting a premium for ESG-friendly purposes, lowering their overall cost of funds, while at the same time issuing regular corporate debt for less ESG-friendly activities.For a handful of distinct asset classes, like sovereign bonds and municipal bonds, it would mean supplementing SASB with a handful of additional standards.
The Road Ahead
This short piece represents musings about the road ahead for sustainability standards trailblazers like SASB as the transition to a sustainable economy accelerates and investors across asset classes seek outside input in adjusting their investment processes.My good friend Robert Eccles and I are researching how materiality, both in terms of the concept itself and particular issues, varies across asset classes. We look forward to hearing from practitioners and researchers across the capital structure and to collaborating with those who are interested to distill a handful of practical and evidence-based guidelines for ESG investing by asset class.
Note: this article would not have been possible without the thought partnership of University of Oxford Saïd Business School Professor and BCG Senior Advisor Robert Eccles, Bracebridge Capital Managing Director Charlotte Hamill, and Director of Capital Markets Integration&Head of Private Investments Initiatives at SASB Jeff Cohen.
