This quarter, our newsletter highlights our engagement with oil and gas companies, the Business Round Table statement and how hospitals are addressing social determinants of health.
In recent years, the practice of integrating environmental, social and governance (ESG) factors into the investment process has become increasingly prevalent. A confluence of important drivers has led to this recent mainstreaming of ESG integration within the investment sphere.
In particular, we think there are five key determinants to this rise in ESG: (1) greater appreciation of sustainability as an important part of corporate strategy and operations; (2) improved quality of corporate reporting on sustainability; (3) expanded availability of relevant analytical tools and metrics; (4) growing asset owner demand for sustainable investments; and (5) recent policies that clarify fiduciary duty for investors.
Simply put, companies, investment analysts and asset owners are all becoming increasingly sophisticated in their understanding of sustainability, which has resulted in a steady growth in assets allocated to sustainable investments. According to the US SIF, $8.72 trillion in assets was allocated to sustainable, responsible and impact investments in the United States in 2016, representing one-fifth of all assets under professional management. This indicates a 33 percent increase in these types of investments since 2014.
Yet some important questions need to be addressed if ESG integration is to go truly mainstream, one of the most pressing of which pertaining to the thoughtful prioritization of ESG factors. Today, ESG issues are so numerous that it has been difficult to discern which ones to target as part of investment research and analysis. To complicate matters further, companies tend to report on a vast array of ESG issues in order to accommodate as many of their stakeholders as possible.
Enter the Sustainability Accounting Standards Board (SASB), a San Francisco based non-profit organization that aims to assist investors as well as companies by helping determine which ESG factors matter most for reporting and analytical purposes across a range of industries. The core principle behind SASB’s approach revolves around materiality. As part of its financial disclosure guidelines dating back to the 1970s, the U.S. Supreme Court defines materiality as follows:
Information is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”1
From the sustainability perspective, the goal is to identify ESG factors that significantly change the “total mix” of information available to investment analysts. By telling them something they otherwise wouldn’t have been able to discern about the investment under consideration, these material ESG factors can have meaningful impact on the overall financial outcomes of the investment decision being made.
While materiality in ESG is a relatively recent concept, there is mounting evidence of its relevance.
First, materiality helps determine which ESG factors are most likely to be linked to stronger investment performance, therefore improving the signal to noise ratio in investment decision-making. According to a 2016 study by Harvard Business School professor George Serafeim and colleagues, “firms with strong ratings on material sustainability issues exhibit higher growth in accounting profitability compared to firms with poor ratings on the same issues.”2 Additionally, the study finds that a similar relationship is not present in firms with strong performance on immaterial sustainability issues (Figure 1). For the purpose of the study, accounting profitability is measured through return-on-sales (ROS), and ROS growth over time.
Second, materiality helps improve the effectiveness of any stakeholder engagement efforts. A separate 2016 study by Professor Serafeim and colleagues looks at 2,665 shareholder proposals that address ESG issues. The study finds that shareholder proposals on material ESG factors are associated with subsequent increases in company value, while proposals on immaterial factors are associated with subsequent declines in company value (Figure 2). Interestingly, the study also finds that the vast majority of proposals (58 percent) focus on immaterial ESG factors, which suggests notable inefficiencies in the engagement efforts conducted by many investors.3 For the purpose of the study, company value is measured through Tobin’s Q, a metric that reflects “the effectiveness with which a company turns a given book value into market value accrued to investors.”4
Lastly, a clear understanding of materiality helps companies as well as investment analysts streamline their decision-making process. This enables both stakeholders to direct their time and resources toward ESG issues that matter most, while deprioritizing those that are less relevant. As discussed in Putting ESG Materiality into Action, the focus on materiality has been critical in enabling our credit analysts to perform their investment research and analysis more effectively and efficiently. Our discussions with issuers point to the same benefits for company management teams, who often conduct careful materiality assessments with input from internal as well as external stakeholders in order to determine the most important areas on which to focus.
Overall, the ability to distinguish material ESG factors from the rest has proven to be critical in making ESG integration value-accretive for investors. By prioritizing ESG factors that truly matter and observing clear value from doing so, investors are better able to make the investment case for ESG integration and also to encourage greater focus on ESG factors in any stakeholder engagement efforts. This transforms ESG integration from a niche practice deployed in selected cases to a necessary component of intelligent long-term investing.
At bottom, we believe that the growing focus on materiality has had a catalytic impact on mainstreaming sustainable investing practices, helping to make sustainable investing and smart investing one and the same.
 TSC Indus. v. Northway, Inc., 426 U.S. 438, 449 (1976)
 Mozaffar Khan, George Serafeim and Aaron Yoon, “Corporate Sustainability: First Evidence of Materiality,” Harvard Business School, November 2016.
 Jody Grewal, George Serafeim and Aaron Yoon, “Shareholder Activism on Sustainability Issues,” Harvard Business School, August 2016.
 Lucian A. Bebchuk, Alma Cohen and Allen Ferrell, “The Long-Term Effects of Hedge Fund Activism,” National Bureau of Economic Research, 2015.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.