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Firm-Specific ESG Adoption Pushes Leaders to Dig Deeper

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The rise of company-specific materiality assessments will force companies to undertake substantial organizational and behavioral adjustments, reduce their reliance on standardized measures, and incentivize investors to dig deeper into the inner workings of each portfolio company.

The emergence of ESG issues has generated a global reassessment of the so-called corporate social pact. It has upended the concept of shareholder primacy and raised questions about traditional methods of auditing and evaluating companies. Business externalities, intangibles, purpose, culture, values ​​and other qualitative factors – formerly referred to as non-financial – are now recognized as integral to the risk profile, financial health and the long-term value of a business. As a result, business leaders and boards are expected to address a growing list of ESG topics, including climate change, human capital management, pay equity, ethnic and gender diversity and justice, #MeToo, wealth gap, human rights, immigration, guns. control, domestic terrorism, voting rights, political contributions and more.

Alongside their impact on companies, ESG issues have a transformative effect on institutional investors and shareholders. Giant financial institutions such as
black rock,
State Street,
Avant-garde,
loyalty and many other asset owners and managers around the world are realizing the need to include ESG factors in their investment decisions and in the management of portfolio companies – and millennial investors and Gen Zers bring their personal environmental, social and political concerns into their selection of asset managers, their choice of asset classes and directly in their engagement with the businesses they own. ESG issues have become a mainstream concern for shareholder activists and have contributed to their growing success. Social media is further accelerating the process by which companies are linked to ESG issues in the news.

E and S against G

The transition to ESG engagement presents business leaders with significant new challenges. In particular, the monitoring of environmental and social policies cannot rely on the compliance methodology used for corporate governance. While governance can be assessed across different companies using a standardized checklist of best practices (although often with a comply or explain option), a prescriptive, one-size-fits-all approach doesn’t work for issues. environmental and social. E&S factors vary widely from company to company, depending on their industry, size, location, competitive position, and various other considerations. This variability problem is evident in the proliferation of competing global standards that have been developed to measure climate risk and assess responses to climate change across different industries and in different markets. the Sustainability Accounting Standards Board (SASB)’s 77 industry standards are a good example.

However, global standardization of I&O remains an important goal. Companies, investors, NGOs and regulators consider standardization essential to achieve comparability and ensure fair valuation of listed and private companies. An important step towards standardization is the recent creation of the IInternational Sustainability Standards Council
(ISSB) — a consolidation of the International Financial Reporting Standards Foundationthe Climate Disclosure Standards Council and the
Value Report Foundation (which in turn combines the SASB and the
International Integrated Information Council).

Despite pressure for standardization – and even if the ISSB achieves its goal of providing “a comprehensive global base of sustainability information” – tailored analysis of individual companies on E&S issues will continue to be necessary.

Think differently about materiality

Experts and regulators reflecting on the growing need for personalized treatment of E&S factors have suggested that the traditional concept of “financial materiality” should be supplemented with alternative definitions – such as “dual materiality”, “dynamic materiality” and “pre-financial materiality”. .” It is important to carefully consider whether the financial materiality standard is comprehensive enough to encompass ESG issues. If so, other definitions may confuse the materiality analysis rather than clarify it.

In a comment letter dated April 27, 2021 to Security and Exchange Commission on the theme of “Climate Change Disclosures”, Uber Technologies, Inc. recommended a broad approach to materiality that would not require redefinition. While endorsing an ISSB-style “harmonized climate change reporting framework” that “…not only would provide the standardization, comparability and reliability sought by investors and other stakeholders, but would allow…companies to streamline reporting and climate change communications,” Uber encouraged the Commission to consider requiring companies to conduct a company-specific materiality assessment to identify the ESG issues most relevant to their business.

Uber’s “Company-Specific Materiality Assessment” envisions a two-step analytical process that, in addition to determining what an average investor would want to know, asks additional questions:

  • What issues do we, the people running the company, think are strategically important?
  • What do our stakeholders want?
  • How do third-party standards apply to our business?
  • What are peer companies doing?
  • What does our corporate purpose statement, corporate values, culture, reputation, brand image and public image require?

These are important business questions whose answers are contextual and specific to each company. They are no exception to the traditional standard of financial materiality. In fact, they depend on it. A company’s determination of whether an ESG issue is material ultimately depends on whether the issue has an actual or potential financial impact on the company. Once financial materiality has been determined, the ESG issue is no longer theoretical; it is redefined as a business issue rooted in the specific business activities and circumstances.

While Uber’s business-specific materiality assessment relies on traditional financial criteria, the approach will require companies to undertake substantial organizational and behavioral adjustments in the long run. The ISSB standards will provide useful guidance to companies wishing to adopt reforms such as integrated reporting, holistic management, stakeholder engagement and greater board transparency as a means of achieving corporate governance. ESG integration.

The concept of firm-specific materiality assessment also has an impact on institutional investors. This will force them to dig deeper into the inner workings of individual portfolio companies and systematically engage with their managements – and further reduce their reliance on standardized metrics, regulatory guidance and wholesale recommendations from outside advisors. and service providers.