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An analysis of financial materiality in the wake of the “woke” and ESG debate

Natalie Runyon  Director / ESG content & Advisory Services / Thomson Reuters Institute

· 6 minute read

Natalie Runyon  Director / ESG content & Advisory Services / Thomson Reuters Institute

· 6 minute read

The debate over the impact of ESG has become more charged with accusations by some critics that some companies are becoming "woke" enterprises

The woke debate — a click-bait framing of the anti-environmental, social and governance (ESG) movement — is typically framed as one of value in terms of financial materiality, and values in terms of a focus on the right thing to do.

More specifically, the value approach of ESG issues focuses on analyzing risks and opportunities through an expanded lens; and the values is based on understanding the importance of issues falling underneath the ESG label based on varying perspectives of stakeholders, which include board members, investors, employees, clients and customers, community organizations, and regulators among others.

The politicization of ESG has worsened this dynamic. Under these conditions, the debate around wokeness is frame as an either/or choice, meaning the value lens is either right and the values approach is wrong or vice versa. But what if the answer is both?

ESG is about financial value and organizational values

Central to making this case is the definition of materiality. In financial terms, what is material is seen narrowly through the lens of investors and lenders. More specifically, a material fact is “a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote,” or “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available,” according to the Harvard Law School Forum on Corporate Governance. In the U.S. context, the perspective of the reasonable investor is key.

Yet, institutional investors continue to have an acute interest in ESG, and firms and funds with interest in ESG are “adamant that issues such as climate change and human capital management are financially material, albeit non-traditional, issues.”

Laurence D. Fink, the CEO of BlackRock — the world’s largest asset manager with more than $9 trillion assets under management — is known for being a champion of ESG through “urg[ing] corporate leaders to assess the societal impact of their businesses, embrace diversity and consider how climate change could affect long-term growth.” In addition, broadly speaking, the Securities and Exchange Commission and the International Sustainability Standards Board “both support a materiality assessment based on the potential effect on the company’s enterprise value, according to a PwC report.

Making the case for the financial materiality of ESG

The value lens examines issues under the ESG moniker as financially material. The values lens analyzes a broader range of issues based on a broad set of stakeholders beyond what is typically found on financial statements, such as assets, liabilities, equity, sources of revenue, and expenses. Many aspects of ESG show up on the balance sheet as intangible assets, which are defined as non-monetary assets that cannot be seen or touched, such as goodwill, brand equity, intellectual properties, licensing, customer lists, and research & development.

Customers lists and brand equity (defined as “the commercial value that derives from consumer perception of the brand name of a particular product or service, rather than from the product or service itself”) as intangible assets involve two key stakeholder groups — consumers and customers, respectively. As intangible assets on the balance sheet, it is easy to understand their financial materiality.

Perhaps the most questioned areas of ESG in the determination of financial materiality are the factors related to “S” or social sphere, which includes areas of human capital management such as employee engagement, diversity, equity & inclusion (DEI), and organizational culture. The main reason for the debate is that these items don’t directly show up on financial statements, though they are key influencers in organizational performance and financial returns.

Indeed, human capital is a critical operational mechanism for a company’s operations. Goodwill — an accounting term defining the value of the business that exceeds its assets minus the liabilities and represents the non-physical assets, such as the value created by a solid customer base, brand recognition, or excellence of management — is one of the areas within financial statements in which human capital will create outcomes.

In addition, positive outcomes from the human capital elements of the “S” are correlated to positive financial measures, further emphasizing the financial materiality of human capital. That said, the body of research is correlation-focused rather than causation-focused. Positive human capital results are not 100% the direct cause of positive financial measures.

Regardless, it is hard to argue with the strong body of research that shows how positive employee trends lead to strong financial performance. More specifically, the following human capital factors of ESG are financially material:

      • Employee engagement, satisfaction & experience — Companies with an engaged workforce are 21% more profitable, according to Gallup’s State of the American Workplace study. In addition, organizations that score in the top 25% on employee experience report nearly 3-times the return on assets and double return on sales, according to this IBM / Work Human study. Finally, according to Bain & Company, “ESG leaders have higher employee satisfaction, and companies with the most satisfied employees grow faster and are more profitable.”
      • Organizational culture — Companies with strong cultures have seen a fourfold increase in revenue growth. In addition, organizations with inclusive cultures are twice as likely to meet or exceed financial targets, three-times more likely to be high performing, and eight-times more likely to achieve better business outcomes, according to a report from Deloitte.
      • Employee well-being — Stock values for a portfolio of companies that received high scores in a corporate health and wellness self-assessment appreciated by 235% compared with S&P 500 Index increase of 159% over a six-year simulation period.
      • DEI — Companies in the top quartile for racial and ethnic diversity are 35% more likely to have financial returns above their respective national industry medians, and those companies in the top quartile for gender diversity are 15% more likely to have financial returns above their respective national industry medians.

The aforementioned body of data proves major elements of the “S” are financially material. Therefore, the social aspect of ESG has value and values relevance. Moving forward, it will be necessary to ignore the politicized headlines around ESG and get back to doing the work of business. Indeed, when the term ESG is no longer needed, it will mean that ESG is normalized into business and is now just that, business.

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