How CEOs Can Better Understand ESG Materiality and Long-Term Value Creation
Social and environmental ESG data can be difficult to measure. ESG surveys can feel repetitive and the rating audits, challenging and time consuming. It’s tempting for CEOs both new and those experienced in the ESG marketplace to take a passive approach to ESG reporting. When addressing ESG data, evaluating what is material to your financial performance and therefore where to prioritize focus to drive the biggest impact is key to producing long-term value creation.
No ESG measure is created equal. Nor is there a “one size fits all” approach to incorporating ESG data and strategies into your portfolio.
It’s imperative for all CEOs to understand how ESG materiality affects your company’s reputation and bottom line. The first key to successful ESG reporting is to make material ESG issues central to your strategy and operations, then continually track and measure. Since ESG is data driven and relationship-oriented, a powerful story can emerge from your ESG strategy planning. Beyond your bottom line, the results can enhance your company culture and sense of purpose.
In order to help your company stand out to investors, we’ve mapped out why it’s important for you to understand ESG materiality. We’ve also underlined best practices on how a strategic, differentiated approach can take your material ESG data to a whole new level of value creation.
Identify your company’s material ESG pillars
ESG includes three pillars: environment, social responsibility, and governance. Material ESG issues refer to the specific pillars likely to affect the financial condition or operating performance of your company and the businesses within your sector. In other words, some ESG issues materially matter more depending on the enterprise and industry. For instance, energy efficiency has a bigger impact on the carbon footprint metrics and bottom line for data centers at Microsoft, Apple, and Salesforce, than it does for Wells Fargo and Bank of the West’s financial data centers. These days many startups are tech-driven and rely on data clouds. Universal material pillars for the tech industry’s ESG risk tend to include data privacy, clean energy, and water pollution in its supply chain. In most industries, only about five or six industry-unique issues are identified as disclosure topics that inform corporate ESG reporting.
ESG scoring methodology is designed to be material to companies. It’s not static given ESG data functionally changes over time. Various statistical techniques for materiality mapping continually formulate and standardize new material ESG scores per industry in order to enhance ratings and provide transparency into fund, index and company ESG performance. Companies can quickly compute an industry material assessment using MSCI’s ESG Industry Materiality Map orSASB’s Materiality Map, which offer a sector-by-sector breakdown of how strongly 26 specific ESG issues impact particular industries.
Other ESG criteria will be unique only to your company. For instance, regulatory fraud will weigh heavier for Volkswagen’s ESG score than Ford, due to its emissions scandal. Just as natural disaster liabilities and problematic governance will impact cost advantage and ESG scores for Pacific Gas & Electric Company’s role in California’s wildfires. Therefore, companies need to strategically analyze which material ESG specifically matters most to their bottom line and their industry.
ESG materiality and financial performance are strongly correlated
Material ESG scores are important because investors consider them a predictor of returns. According to George Serafeim, Faculty Chair at Harvard Business School, “In analyzing the performance of more than 2,000 U.S. companies over 21 years, we found that those firms that improved on material ESG issues significantly outperformed their competitors. Interestingly, companies that outperformed on immaterial ESG issues slightly underperformed their competitors. This suggests that investors are becoming sophisticated enough to tell the difference between greenwashing and value creation.”
Low performance on material issues is costly, even if your company performs well on all other ESG issues. Therefore, to appeal to investors, companies should continually and strategically mitigate their material risk. For example, if you are a carbon-neutral footwear company, like ESG top performer Allbirds, you’ll need to examine every aspect of future water supply and cost effectiveness of organically sourced “thirsty” cotton materials suited to its customer values and brand reputation. Be prepared to know for certain if the palm oil in your products incentivizes deforestation in poor farming communities, or if your inefficient combustion engines will have a dirty image in the age of electrification. If material, ESG efforts will undoubtedly contribute to your company’s long-term value creation.
Aim for a differentiated material ESG strategy that stands out
A differentiated ESG brand strategy connected to societal and environmental needs will help you boldly go above and beyond your competitors to see real financial dividends. Afterall, investors have an eye for innovation, competitiveness, and disruption. No better example demonstrates this than Tesla’s ambitious disruption of electric cars. Some critics refer to it as Tesla’s “sustaining innovation,” which established a new tier of auto industry standards in emissions reduction.
As Harvard Business School’s George Serafeim lays out, “The strategic challenge for corporate leaders is to be foresighted about the ESG themes that are emerging as important industry drivers—to identify them before their competitors do (and in some cases ahead of SASB too). This requires leaders to conceptualize the various actors in the system, their incentives, and the interventions that could drive change.”
Wynn Resorts ESG reporting recently embraced their commitment to gender diversity by increasing the number of women on their board from one to four. Wynn is now in the top 40 S&P 500 companies in terms of its 36% female board representation. Other distinctive ESG best practices include Airbnb’s peer-to-peer network and “circular economy” business model which reuses existing assets. Or Google’s unconventional ability to recruit, retain and reward employee loyalty and leadership. Salesforce’s competitive advantage in hiring and stakeholder engagement also established itself as a leading ESG champion. In all five cases, the ESG practices were tied to significant return on capital and market valuation.
Performing better and more differentiated than your competitors isn’t an easy task. Companies are more likely to increasingly engage in identical ESG activities, and mimic rivals. Other times your ESG differentiation may create new problems, like Airbnb’s impact on neighborhoods, increasing the cost of living.
When formulating an ESG strategy, target your material ESG issues first for financial benefits. Then collect, measure, and monitor your data. If done correctly using best practices and cutting edge software, your ESG data will offer real value, and your ESG strategy will drive better investment outcomes. Finally, disclose your most material challenges transparently, then communicate your superior performance to stakeholders to reap further rewards.
CEOs from high ESG performing companies all recognize that ESG data generates more value by analytically scrutinizing every business practice and business model to understand which issues are most material in terms of ESG risk. One of the exciting aspects we love about ESG analysis is that it requires competitive operational changes that inherently increase innovation. Good.Lab’s ESG consultants specialize in improving competitive advantage and know how to help CEOs become foresighted about ESG themes emerging as important industry drivers.
Wherever you are at in your ESG journey, our experienced ESG consultants and fractional CSOs at Good.Lab can help your company materially focus. If further along the journey, we can leverage your collected ESG data for deeper improvements. Good.Lab’s fractional talent enhances the analytical rigor in ESG data using winning roadmaps that combine ESG materiality with authentic purpose. To learn more about our fractional ESG services, contact us today.
Disclaimer: Good.Lab does not provide tax, legal, or accounting advice through this website. Our goal is to provide timely, research-informed material prepared by subject-matter experts and is for informational purposes only. All external references are linked directly in the text to trusted third-party sources.
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