Measuring ESG risk in an ever-changing environment
Environmental Finance: What are material ESG issues?
Adam Fleck: ESG covers a wide range of topics and potential issues that a company can face. But not every industry faces the same issues. The oil and gas industry, for example, faces more environmental issues than other industries.
Material ESG issues, or MEIs, organise the thematic topics that can impact a company’s enterprise value. Morningstar Sustainalytics has identified 22 MEIs that businesses could face, but only some issues are material to some companies. At Morningstar Sustainalytics, we spend a lot of time estimating how exposed specific industries are to those 22 MEIs. Each can present a unique risk to a company and requires specific oversight and management.
EF: How important is it to understand MEIs?
AF: The MEIs are the building blocks behind our ESG Risk Ratings, which are a cumulative tally of how exposed companies are to those issues and how well we think they’re managing them. However, it is important to note that they are a measure of risk.
If you think about ‘double materiality’, a common term in ESG, there are two ways that ESG issues can affect a company and its stakeholders. Firstly, there are the material outward-in-facing risks that can plague a business. For example, a highly pollutive company may be at greater risk of the developments that a more sustainable world might entail, such as carbon taxes or consumer backlashes. Such risks differ from inward-out risks, which could impact key stakeholders amid ongoing developments in society and the environment. We view these risks and the MEIs that help us draw conclusions similar to any other potential risks companies face.
EF: How can mismanagement of MEIs affect a business?
AF: Our Risk Rating measures unmanaged ESG risk because companies that don’t address these risks are likely to see negative effects on their future cash flows and, ultimately, their enterprise value. Poor management of ESG issues can lead to consumer backlash, a lack of preparedness for new regulation, or poor decisions resulting from sub-optimal governance practices.
Poor management of MEIs can also lead to idiosyncratic events, such as a data breach or health and safety issues.These types of issues are measured through our Events Research and our Controversy Research, which are additive to our Risk Ratings. We are trying to recognise if companies are walking the walk they say they will.
EF: How important is reliable, timely and complete ESG data?
AF: The evolution of ESG data over the last several years is welcome, but we are always looking for comparable, consistent and contextualised data - the ‘three Cs’. Having those ‘three Cs’ allows us to see how different companies are operating and the trends of that data over time. This is where regulation comes in, and groups like ISSB can help standardise what companies are reporting so investors can start to ask deeper, tougher questions.
Indeed, companies that disclose more environmental and social data in a timely, comparable fashion because they are mandated to or because they feel like it’s helpful to investors will help investors make better decisions, allowing them to better price material risks or opportunities.
EF: What is Morningstar Sustainalytics doing to help investors?
AF: Morningstar Sustainalytics provides Risk Ratings on thousands of companies. We aim to provide consistent, comparable, and transparent measurement of companies’ exposure and management to those MEIs. We don’t take our position in the industry lightly.
We have 250 indicators across those 22 MEIs to support our research and help investors. Morningstar Sustainalytics also advocates for greater data disclosure and management of ESG issues because it can help companies perform better and have a real impact on stakeholders.
ESG data is not as fast-moving as daily stock price movements. We usually get annual or quarterly updates, but companies are in the news every day. That’s how our Events and Controversies Research can help us tell whether companies are really sticking by their policies and governance or not.
Learn more about how investors can consider and incorporate material ESG risks into their approach by downloading Fundamentals of ESG Materiality the latest e-book from Morningstar Sustainalytics.
