Financial Materiality of ESG Metrics

Recently, a congressman asked us to help explain how Environmental, Social and Governance (ESG) metrics can be financially material to a company’s performance. We turned to our network of industry professionals for their favorite resources and have compiled them below. We will continue to update this page over time with new resources as they become available.

We thank our friends at Calvert Research and Management, FCLTGlobal, Nordea Asset Management, Russell Investments, Vert Asset Management, and Boston University for the following content.

Overview of ESG risk to financial performance

The Sustainability Accounting Standards Board (SASB) offers the SASB Materiality Map, an interactive tool that identifies and compares 26 sustainability-related business issues and the issue’s respective materiality across industry and sector.

The Task Force on Climate-related Financial Disclosures (TCFD) publishes recommendations for more effective climate-related disclosure and emphasizes three key benefits of better disclosure: improved risk assessment, capital allocation, and strategic planning.

S&P Global provides analysis of the financial and social consequences of climate change in their report “Understanding Climate Risk at the Asset Level: The Interplay of Transition and Physical Risks.”

“Almost 60% of companies in the S&P 500® (market capitalization of $18.0 trillion) and more than 40% of companies in the S&P Global 1200 (market capitalization $27.3 trillion) hold assets at high risk of physical climate change impacts. Wildfires, water stress, heatwaves and hurricane (or typhoons) linked to increasing global average temperatures represent the greatest drivers of physical risk.”

Individual investor opinions

Larry Fink, Chairman and CEO of multinational investment management corporation BlackRock, published an open letter to CEOs in 2020. In this letter titled “A Fundamental Reshaping of Finance,” Fink stresses the urgent need for sustainable investing, improved disclosure, and reallocation of capital.

Sarah Adams, Chief Sustainability Officer of Vert Asset Management, captured the significance of ESG metrics and disclosure in the following quote:

“Generally speaking, more information available to investors along the investment value chain is important for all types of decision-makers from the mutual fund investor, the energy procurement specialist, the regulator, the corporate strategist to the product developer. Markets do not work without information. Simply put, decision-makers require more information and some of this information is climate-related.”

Recent organization reports

The Basel Committee on Banking Supervision (BCBS) established the Task Force on Climate-related Financial Risks (TFCR) with the intention of “enhancing global financial stability by undertaking the… initial initiatives on climate-related financial risks”. The 2020 report “Climate-related financial risks: a survey on current initiatives,” published by The Bank for International Settlements, summarizes Basel Committee members’ responses to a questionnaire regarding these initiatives.

The Inevitable Policy Response (IPR), commissioned by The United Nations Principles for Responsible Investment (UN-PRI), prepares investors for portfolio risks associated with the highly probable policy changes in response to climate change. In March 2021, the IPR released the executive summary of their policy forecast: Preparing financial markets for climate-related policy and regulatory risks.

Morgan Stanley Capital International (MSCI) addressed climate-related financial impacts by creating the quantitative model Climate Value-at-Risk (Climate VaR), “designed to provide a forward-looking and return-based valuation assessment to measure climate related risks and opportunities in an investment portfolio.”

In The World Economic Forum’s Global Risks Report 2021, climate action failure was identified as “the most impactful and second most likely long-term risk,” posing a critical threat to global economic and geopolitical stability. See Figure II below from the Global Risks Perception Survey 2020 detailing risk and impact.

WEF GRPS 2020 Figure II

Examples of climate-related financial risk

  • In 2012, Hurricane Sandy resulted in over $6o million1 in economic damages.
  • In 2015, Volkswagen was caught hiding exorbitant levels of toxic diesel emissions, leading to almost $35 billion in fine and settlement costs and affected cash outflows projected through 2021.
  • In January 2019, Pacific Gas and Electric Company (PG&E) filed for bankruptcy after California wildfires presented the utility company with an estimated $30 billion in liabilities.
    • Management consulting company Oliver Wyman shared additional industry insights into the PG&E bankruptcy.
  • In October 2019, Typhoon Hagibis in Japan contributed to the flooding and destruction of a third of a bullet train fleet, worth around $300 million.
  • Multinational insurance company Munich Re published a report in 2017 detailing financial losses caused by a particularly unprecedented hurricane season. The following passages expose the financial vulnerabilities posed by climate risk and the ineffectiveness of previous financial models and status quo operations that ignore the threat of a changing climate.
    • “Hurricane Harvey demonstrated once again that floods not only account for a significant proportion of total losses from tropical cyclones, but can actually make up the bulk of such losses. Up until now, these have only played a minor role for the insurance industry in the USA because the risk – where applicable – was covered by the federally run NFIP (National Flood Insurance Program) … If the insurance industry is to expand flood insurance in the USA and tap into the new business potential this will bring, it will need to include flooding in its hurricane models.” (p. 13)
    • “Looking further into the future, insured losses from large wildfires in the American West are expected to continue to increase in frequency and severity. This increase is primarily being driven by continued construction of new homes and businesses within the wildland-urban interface and the rising values of both real and personal property. However, the influence of climate factors on this peril is becoming harder to ignore.” (p. 46)
    • “Both overall and insured losses from natural disasters in 2017 were significantly higher than the corresponding averages for the last ten years, which, after adjustment for inflation, amount to US$ 170bn and US$ 49bn respectively.” (p. 51)

Additional academic work

Reimagining Capitalism in a World on Fire, a book by Harvard Business School Professor Rebecca Henderson, provides a multitude of examples of how companies are identifying and responding to physical threats from climate events in their supply chain.

“Decarbonization will be expensive. But unchecked climate change will cost billions of dollars more. Current estimates suggest that climate change could cost the US economy as much as 10 percent of GDP by the end of the century and destabilize the world’s food supply.” (p. 222 sourced from Matthew E. Kahn et al. “Long-term Macroeconomic Effects of Climate Change: A Cross-Analysis,” NBER Working Paper no. w26167 Cambridge, MA: National Bureau of Economic Research, 2019)

“Mandating Disclosure of Climate Related Financial Risk”, a report published by the Institute for Policy Integrity and the Environmental Defense Fund, details how markets are not sufficiently driving disclosure and what actions the SEC can take under existing legislative authority.

Madison Condon, a contributing author to this report, provides deeper analysis on this topic of mispricing climate risks in her paper “Market Myopia’s Climate Bubble.“

 

1 All financial amounts are reported in equivalent USD currency.

Know of another great resource demonstrating the financial materiality of ESG metrics that we should add to this list?  If so, please email the IMAP’s Executive Director, Susan Murphy.