RobecoSAM’s research focuses on the link between sustainability and financial materiality. But what is financial materiality, exactly? Christopher Greenwald, Head of Sustainability Investing Research explains how RobecoSAM determines the financial relevance of the sustainability criteria that are incorporated into the Corporate Sustainability Assessment.
How do you define financial materiality, and why is this important for RobecoSAM’s CSA methodology?
We consider any intangible factor that can have an impact on a company’s core business value – namely growth, profitability, capital efficiency and risk exposure – to be financially material. Factors such as a company’s ability to innovate, attract and retain talent, or anticipate regulatory changes matter from an investor’s point of view because they have significant impacts on a company’s competitive position and long-term financial performance.
As an asset manager, we have always focused on identifying financially relevant sustainability factors. For this reason, we have put considerable effort into developing and updating our materiality framework so that our analysts focus on those factors that are most relevant to the companies’ financial performance. This helps us ensure that we integrate financially material sustainability factors into our investment process in a structured manner. Because these factors are relatively under-researched by most investors, our integration of financially material sustainability factors in the investment process allows us to make unique and better-informed investment decisions for the long-term.
There has been much discussion about the materiality of sustainability. What makes your framework different?
Our financial materiality framework draws upon more than 20 years of experience in integrating sustainability into the investment process. What sets us apart is that our approach focuses on the intersection between sustainability and business performance. Specifically, we focus on identifying the most important intangible factors that relate to companies’ ability to create long-term value. For instance, lowering energy consumption in manufacturing processes results in significant cost-saving opportunities and has a direct impact on a company’s bottom line. This focus on the most financially relevant sustainability factors is essential, given our mission to create long-term attractive returns for our clients through Sustainability Investing strategies. However, we have also found that a focus on the link between sustainability and business performance is also a key priority for the leading companies in sustainability, which are working toward much more sophisticated models to understand the pay-offs of their sustainability investments in financial terms.
So how do you determine which information is financially material?
We begin with a top-down industry and mega-trend analysis. For each of the 60 industries we assess, we ask ourselves which are the key sources of value creation for that industry, and which long-term trends are likely to have an impact on these industry drivers.
Once we have identified material factors for each industry, we prioritize them according to their expected magnitude and the likelihood of their impact on growth, profitability, capital efficiency and risk. This results in a materiality matrix for each industry, which maps the relative importance of each material factor against each other and provides us with a visualization of the most important factors for each industry (See Figure 1).
Figure 1: Financial Materiality matrix for pharmaceuticals industry
How is this information used in your company analysis?
Once we have identified and prioritized the material sustainability issues for each industry, our analysis shifts to the company level and evaluates how well company management is addressing each of these factors. Based on this analysis, we adjust the assumptions of the return on invested capital and the weighted average cost of capital in order to obtain a fair value that balances short-term financial projections with the consideration of long term sustainability factors.
Essentially, we are determining which companies are most likely to remain competitive in a rapidly changing business environment and are therefore best positioned to continue to create value in a sustainable way.
Although the materiality framework focuses on industry-specific criteria, have you identified any sustainability criteria or factors that are significant across all industries?
Yes. A variety of sustainability factors are relevant to companies across a wide range of industries. These include innovation management, human capital management, supply chain management, environmental management and corporate governance. But we tailor the questions in these criteria to the specific characteristics of each industry.
How do you ensure that your research and CSA remain up to date?
Our Sustainability Investing Research Analysts work with our Quantitative Analysts to test the financial materiality of the criteria and questions included in the CSA. Our quantitative research identifies which intangible factors have demonstrated the clearest correlations to past financial performance. Results are fed back into the CSA methodology development process, and help determine adjustments to the CSA questions and criteria to ensure that they remains focused on financially material factors.
In turn, the CSA itself serves as an engagement tool by making companies aware of which sustainability criteria and topics RobecoSAM and investors consider to be financially relevant to business performance.