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ESG Focus: Materiality Matters – Part 1

ESG Focus | Mar 16 2021

The story below has been republished to rephrase First Sentier's investment approach vis a vis the United Nations’ 17 SDGs, see first sentence under Targeting UN Sustainability Goals. The original story was published on 10 March 2021.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: Materiality Matters – Part 1

The highly coveted "sustainability premium" is the holy grail of ESG investors globally, and determining materiality is the key to attaining this. First Sentier shares some of its preferred metrics.

-Materiality meets “social licence” and outcomes
-Certain SDG indicators – the low-hanging fruit – come first
-Grappling with the materiality of social themes in the supply chains of emerging economies 

By Sarah Mills

It is early days yet for ESG but we at FNArena are always trying to determine the more material ESG metrics to investors.

We also like to follow the money trail: where, why and when institutions are allocating their funds.

Speaking to these issues, First Sentier Investors has published a paper and held a webinar titled Navigating Investment in a Post-Covid World.

The paper discusses material indicators for broad sustainability, renewable energy, biodiversity, modern slavery, mental health and gender.

It also provides an interesting insight into the focus and approach of fund managers in the ESG investment space, as well as insightful information on the link between materiality and the social theme.

Part 1 of this series examines First Sentier’s approach to materiality and the challenges of investing in emerging economies.

Part 2 will examine materiality in mental health, gender and modern slavery.

Part 3 will examine the environmental materiality: biodiversity, climate change, water, and oceans. 

Where materiality meets outcomes

First Sentier says it focuses on both materiality and on a company’s “social licence to operate” when allocating funds.

Or, as First Sentier responsible investment specialist Kate Turner puts it: “the space where materiality intersects with outcomes.”

The social licence premise is that a company has a “right” to do business so long as they accept the basic rights of others to receive a living wage, breathe clean air, and drink fresh water, for example. 

Social licence is becoming an increasingly material factor, and a sustainability issue, as the threat of regulation looms.

“We only invest where management operates the business effectively and in the interests of all stakeholders,” says Turner.

“Those that don’t look after their customers, employees, suppliers and larger community are unlikely to be rewarding long-term investments,” she asserts, noting corporate failures are often indicators of low sustainability in these areas.

Social issues are also becoming increasingly material as funds pivot to invest in emerging economies with a clear growth path (as opposed to developed economies with ageing populations but reasonable working conditions).

This is particularly important given that raising standards and sustainability in emerging economies is also a focus of the UN's Social Developemnt Goals (SDG), meaning a large proportion of institutional funding will be funnelled into these economies – another revenue source for shareholders.

Given this is the case, investors are grappling with understanding the materiality of social outcomes to a company’s longevity in these regions.

As an example, FSSA Investment Managers investment analyst Angus Sandison notes that the crippling of many large Indian corporations over the past few years, in particular, can be sheeted back to “social” themes. 

Not only did direct investors in these companies suffer, but those with supply chain exposures to these organisations were also burnt. 

So institutional focus on supply-chain management is intensifying globally.

Targeting UN Sustainability Goals

When making investment decisions, First Sentier is conscious of the United Nations’ 17 SDGs, which contain 169 targets and 231 unique indicators. In this manner, the institution seeks to make its efforts more focused

The fund has chosen a handful of SDGs and then focuses on the targets and indicators upon which it feels it can have the greatest influence.

Using gender as an example, Turner notes that institutions have minimal influence over SDG indicator 5.1.1, which refers to legal frameworks to prevent sex discrimination; but it can wield strong and immediate influence on indicator 5.2.1, which relates to the percentage of women in management.

In this manner, the institution ensures its efforts are both focused and incentivised. 

It rates a company according to both its negative and positive contributions to the chosen indicators.

“Every institution is likely to have its own starting points [for ESG investment],” says Turner.

“It’s about seeking real world outcomes with targets and indicators.”

For First Sentier, biodiversity; modern slavery; mental health; green energy and infrastructure; electrification; decarbonisation and progression to net zero are key areas of interest and areas in which the materiality-outcomes nexus features strongly.

It views biodiversity as mutually dependent with climate change themes.

Low hanging fruit on the SDG chart

First Sentier believes it can immediately influence the following SDG target indicators.

SDG 5: Achieve gender equality and empower all women and girls Indicator
 Proportion of women in managerial positions

SDG 8: Decent Work
Indicator 8.7.1: Proportion and number of children aged 5-17 years engaged in child labour, by sex and age (this is difficult for them to directly measure but they are working towards it)

SDG 7: Affordable and Clean Energy
Indicator 7.2.1: Renewable energy share in the total final energy consumption.

SDG 8: Decent Work
Indicator 8.7.1: Proportion and number of children aged 5-17 years engaged in child labour, by sex and age (this is difficult for them to directly measure but they are working towards it).

Indicator 8.8.1: Frequency rates of fatal and non-fatal occupational injuries, by sex and migrant status (particularly in the fund’s diversified infrastructure fund portfolio)

SDG 12: Responsible Consumption and Production
Indicator 12.6.1: Number of companies publishing sustainability reports.

Given the ease of measurement, the number of women on boards is a key metric for institutions globally. 

Norges Bank Investment Management, for example, has advised it will vote against the nomination committees of companies without at least two women on the board, unless they have clear plans and targets.

Last year, the investor voted against the committees of 16 European and US companies will all-male boards.

Of course, being on the board doesn't guarantee a voice, but it is a start.

Materiality of indicators

It is notable that First Sentier points out that one of its targets is, at present, difficult to measure. 

The SDG indicators, are tiered as I, II and III.

Tier 1 indicators are those with an established methology and regular global data production across at least 50% of countries.

Tier II indicators have an established methodology but no regular data production.

Tier III indicators have no internationally established methodology or available standards. Which means, of course, they are, at present, ineffectual.

Given the SDGs are constantly under review and it is proposed that if no progress is made against improving measurement of Tier III indicators, those indicators will be dropped.

So investors seeking impact need to ensure their corporate investments are focused on Tier 1 indicators, particularly given they are measurable and can be used to demonstrate success, which should attract institutional funding.

Tier II indicators are generally considered satisfactory at present, but not overly material.

For example, only 34% of gender-related indicators sit in Tier 1, which means the balance is not really material.

A potential guide to greenwashing is the corporate promotion of Tier III indicators.

Tracking progress towards the SDGs

First Sentier also rewards corporate progress against SDG timelines to ensure progress towards, and accountability against, long-term ambitions.

While most SDGs are long-term goals; they include many shorter-term milestones, such as 2023, 2025, 2030, and so on.

“It’s about ensuring management teams are aligned and accountable [over the timeline],” says First Sentier.

The institution also attempts to assess how a corporation’s present actions will affect future outcomes; and then which tools are available to institutions to ensure progress.

Supply chains and the China problem

As noted above, there is a general shift to diversifying manufacturing operations out of China, in particular, and this will have serious implications for global supply chains.

This reflects in part on the nation’s continued state-sponsored human rights incursions, growing militarism, and expansion ambitions in South-East Asia.

These include the enslavement of ethnic minorities such as the Uighurs; and the murder and extraction of organs from dissidents and religious dissenters such as the Falun Gong (which has earned China a reputation as the global organ superhighway).

As mentioned in previous articles, slavery has broad economic implications; but when labour (not to mention organs) is sourced from ethnic minorities and dissidents, combined with expansionary military policies, it becomes a matter of geopolitical security.

It echoes of the rise of Hitler in Germany in the 1930s in which the nation subsumed and enslaved surrounding sovereign nations.

Many recall that that resulted in an extremely “material” war, in which vast amounts of capital were destroyed and the world order was rewritten.

In the ensuing chaos, communism extended its influence to create the Soviet bloc; China raised the bamboo curtain; the atomic bomb was dropped; and the Cold War created an uneasy balance of power that lasted nearly 40 years.

It also reflects a shift in focus to latent opportunity in lagging economies.

Investing in emerging economies

The United States has expressed a clear preference for corporations with onshore operations, and may regulate to this effect. 

Corporations meanwhile, are considering their options in India, and Latin America.

But investing in emerging economies is increasingly a risk issue for investors as growth in developed economies tapers off and geopolitical tensions rise.

Weaknesses in supply chains due to slavery and poor treatment of staff and the resulting affects on quality control and secure supply are all material issues.

Sandison points to other risks of investing in India, and uses the generic pharma industry as an example.

“India is well known for its generic drug making industry, and is often dubbed ‘the world’s pharmacy’,” says Sandison. 

“In our expectations, a lot of these companies have failed to meet international expectations in terms of quality control.” 

“They are truly global corporations but meeting India’s manufacturing standards did not necessarily translate to those desired by the US/Europe.”

“As you can imagine, the consequences (for human health and shareholders), of poor quality control is devastating in pharmaceuticals.”

Sandison says this is indicative of the general mismatch between Indian and Western manufacturing standards that occur in other Indian industries; and pose high risks for investors in the region.

Sussing out sustainability in India

“As a general comment on India; there is a long-standing phrase in India about family businesses: ‘the first generation builds it, the second generation grows it and the third generation destroys it’,” says Sandison.

“Hence, when investing in India, we have always paid attention to management changes, the corporate culture, and the morale of various stakeholders. 

“Perhaps more than any of the other markets in which we invest, India is where we wish to spend the most time on the ground – getting to visit businesses, speaking to management teams and network with the promoters.

“What we typically look for are companies where sustainability and stewardship is part of the DNA. “

“A good indicator for this is where we find companies which have successful transitioned to a professional management team whilst maintaining the crucial stability offered by a family’s ownership and influence.”

“It is a fine balance but can lead to great outcomes if achieved.”

As an example, Sandison points to Godrej Consumer, a 122-year-old Indian consumer goods business. 

“We have regular caIls with Nisa Godrej, the chairperson, and have seen our conviction increase as the company has demonstrated its responsiveness and willingness to be a leader around sustainability matters,” says Sandison. 

“After expressing to us their desire to become leaders in environmentally friendly packaging solutions, we introduced Godrej to an innovative biodegradable packaging company in late 2018. 

“By the time we met management again in May 2019, the company had commissioned a pilot study of alternative biodegradable packaging, signed up to the Plastic Pact and were increasingly using refillable containers, which lowered prices for customers and generated higher margins for the company. 

“There are plenty of challenges ahead for Godrej, but the company's transparency, awareness and willingness to learn helps us build confidence in their ability to navigate the various business and sustainability challenges India faces.”

Social materiality

The next instalment in this series examines First Sentier’s approach to defining materiality and extracting the “sustainability premium” – as Blackrock’s Larry Fink describes it – for the social themes of gender, mental health, and modern slavery.

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