ESG integration in financial materiality
ESG integration in financial materiality refers to the importance of ESG elements in influencing a company’s financial performance, whether positively or negatively. Unlike traditional financial analysis, which focuses largely on accounting indicators, ESG analysis broadens the scope to include externalities such as environmental, social and governance standards, that influence a company’s long-term sustainability and profitability.
Incorporating financially material ESG factors helps investors assess the full spectrum of risks and opportunities that a company faces. This approach aligns with the principles of sustainable investing, where long-term value creation is emphasised, and companies are expected to not only generate returns but also operate responsibly within societal and environmental frameworks.
The EU’s Corporate Sustainability Reporting Directive (CSRD) framework, in particular, underscores the concept of double materiality, recognising a company’s impact on ESG issues, as well as ESG issues that are material to the company and stakeholders.
Risk Management
A key benefit of incorporating ESG into financial materiality is the enhanced ability to identify risks that may not be immediately apparent but can significantly affect long-term financial performance. For instance, physical climate related risks like extreme weather can disrupt operations, supply chains, and market demand. By assessing these risks through an ESG lens, companies gain a proactive perspective on potential future challenges, allowing for more robust risk management and strategic planning.
A survey conducted by Morningstar shows that asset owners are increasingly recognising ESG as material. 45% of assets under management (AUM) in Europe in 2024 incorporate ESG factors, up from 36% in 2022. Key material topics include climate transition readiness, labour practices and business ethics.¹
As such, businesses that incorporate ESG factors in their operations and reporting are often more attractive to investors and provide reassurance to stakeholders.
ESG screening in investments decision making
To optimise risk-adjusted returns, investors can apply screening processes to construct portfolios of companies or assets that exhibit desirable ESG characteristics. This strategy enables investors to align portfolios with specific ESG standards that they believe contribute to under or outperformance. Negative screening, in particular, is a commonly used lever, allowing investors to exclude companies that do not meet certain ESG criteria.²
Addressing externalities
Originating from economist Arthur Pigou’s work in 1920 who suggested that governments tax polluters an amount equivalent to the cost of the harm to others³, externalities refer to the costs imposed on the environment and society that are not reflected in the prices charged by companies. Negative externalities can be environmental, such as pollution or resource depletion leading to environmental degradation; or social such as paying employees below living wage, pushing the cost of supporting employees to society.⁴ Positive externalities, however, such as engaging in reforestation projects or community programs, can provide broader environmental and societal benefits that can enhance a company’s reputation and long-term value.
To manage negative externalities, governments often use policies like carbon pricing and regulations to internalise environmental and social costs. The EU’s Carbon Border Adjustment Mechanism (CBAM), set to take effect in 2026, will impose costs on imports of carbon intensive goods entering the EU, and encourage cleaner production practices in non-EU countries.⁵ Investors who recognise the financial impacts of externalities can better assess the full spectrum of risks and opportunities within their portfolios.
The integration of ESG in financial materiality enables companies and investors to better anticipate risks, attract investment, and address societal costs. It is not only a pathway to sustainable returns but also a driver of long-term resilience, positioning companies to meet evolving market demands and societal expectations.
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Author: Maria Serrano, Consultant, Simply Sustainable
References:
https://newsroom.morningstar.com/newsroom/news-archive/press-release-details/2024
https://www.unpri.org/introductory-guides-to-responsible-investment
https://www.imf.org/external/pubs/ft/fandd/basics/38-externalities.htm
https://taxation-customs.ec.europa.eu/carbon-border-adjustment-mechanism_en