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May 24, 2023, Shunsuke Managi, President and CEO, and Keely Alexander Ryuta, Director and Chief Researcher, co-authored a paper entitled "How ESG Assessments Considering Financial Materiality Can Help Investors Understand Financial ESG Risks and How They Reflect in Stock Returns" The paper examines how ESG assessments that consider financial materiality can help investors understand financial ESG risks and how they are reflected in stock returns.
The research results were published in Corporate Social Responsibility and Environmental Management (2022 Impact Factor: 9.8), a top journal in the field of environmental economics and environmental management.
Do investors incorporate financial materiality? Remapping the environmental information in corporate sustainability reporting
https://onlinelibrary.wiley.com/doi/10.1002/csr.2524
This report will explain the contents of the above paper.
summary
This study examines how integrating accounting metrics (financial materiality*, see below) published by the U.S. Sustainability Accounting Standards Board (SASB) into a company's environmental score assessment can help investors understand a company's environmental risk. The SASB's Sustainability Accounting Standards Board (SASB) is the U.S. Sustainability Accounting Standards Board.
Although companies are increasingly disclosing environmental information as sustainable investments increase, the financial impact of corporate environmental initiatives has not been fully considered.
This study reveals how incorporating financial materiality in a company's environmental score evaluation changes investors' evaluation of the company.
Background and Objectives
The importance of assessing environmental, social, and corporate governance (ESG) information is increasing with the rise of sustainable investing.
On the other hand, companies have diverse business characteristics, and the importance of each ESG item differs according to differences in business characteristics. However, the importance of most ESG items was determined by the company's own and stakeholders' perspectives, without considering differences in business characteristics. Some of them are not essential for shareholders, and neither profitability nor risk can be predicted, which may prevent proper understanding of ESG risks in the capital market.
An ESG assessment from a shareholder perspective is essential for investors to distinguish between companies that are performing well on both financial and ESG fronts and to further identify ESG risks in the capital markets.
Among these challenges,Financial Materialityis attracting a lot of attention.
Materiality means "critical issues" that a company prioritizes.
Financial materiality is a criterion for evaluating the impact of issues related to ESG items (environmental and social issues) on a company's finances.
The authors wondered if incorporating financial materiality into the environmental score (E-score) assessment might make it easier for shareholders to make sustainable investment decisions.
Therefore, the purpose of this study was to clarify the following
How does integrating financial materiality into the environmental score assessment help investors understand the financial environmental risks?
How the integration of financial materiality and environmental score assessments is reflected in stock returns.
method
To address the above issues, the authors used information on financial materiality published by the U.S. Sustainability Accounting Standards Board (SASB) in 2018 to identify the financial materiality of each company's environmental information and reassessed the environmental score according to the status of its efforts to address environmental issues.
Data from 1766 U.S. listed companies (10,084 companies in total) from 2011 to 2020 were used in the analysis to analyze the relationship between environmental measures and stock price returns related to financial materiality in ESG investments.
We tested the impact of incorporating financial materiality on stock price earnings by comparing earnings when grouped according to a stakeholder-oriented environmental score rating (Refinitiv E score) versus when grouped according to an environmental score rating weighted by SASB's financial materiality. The impact of the inclusion of financial materiality on stock price earnings was examined by comparing the earnings of the two groups.
result
The analysis yielded the following results
- Investors consider companies that are reluctant to take environmental measures related to financial materiality to be high-risk stocks and seek stock returns commensurate with that risk (Table 1).
- Since shareholders and stakeholders have different perspectives in assessing environmental risks and making investment decisions, it is important to consider both perspectives (Table 2).
About 1.
Table 1 shows monthly excess returns based on SASB's financial materiality indexnote 1The magnitude of the For the highest Market Value quintile, the lowest SASB-based E-score excess return is 1.72% per month, while the highest E-score excess return is 1.09% per month. Meanwhile, in the lower quintile of market capitalization, the lowest SASB-based E-score excess return is 0.77% per month, while the highest E-score excess return is 0.70% per month.
This shows that investors seek excess returns for firms with low measures of financial materiality (SASB-based E score of 1 (worst)), and that the larger the firm (market value), the more return they are willing to pay for the risk. The larger the market value, the more return is demanded for the risk.
Table 1.Estimation of excess returns based on SASB
About 2.
GRS Test*2shows that the difference in the magnitude of investment returns relative to the magnitude of environmental risk observed for 1. is important only for SASB-based (shareholder perspective) E-score portfolios and not for Refinitive E-score (stakeholder perspective) portfolios (Table 2). (Table 2). This means that investors consider financial materiality-related environmental risks, i.e., shareholder-related environmental risks, rather than broader stakeholder-related environmental risks, in their investment decisions.
The different views of SASB-based and Refinitive-based E-score portfolios illustrate the importance of considering both perspectives.
Table 2.GRS test results
discussion
By incorporating environmental risk factors related to financial materiality into investment decisions, this research has enabled the prediction of excess returns and the proper evaluation of a company's environmental measures.
By aligning financial and environmental metrics, this approach promotes a more comprehensive understanding of sustainability and encourages companies to prioritize economic and environmental considerations.
These findings contribute to the debate on the role of ESG factors in investment strategies and underscore the importance of financial materiality considerations in achieving a sustainable and resilient economy.
1 Excess return: The difference between the return on risk-free assets (safe assets) and the return on risk-free assets (safe assets). A positive value indicates good investment performance, while a negative value indicates poor investment performance.
2 In financial economics, one of the statistical hypothesis tests to examine the validity of multi-factor asset pricing models.
[Explanatory note
Xie, J., Tanaka, Y., Keeley, A. R., Fujii, H., & Managi, S. (2023). Remapping the Environmental Information in Corporate Sustainability Reporting. Responsibility and Environmental Management, 30(4).
https://onlinelibrary.wiley.com/doi/10.1002/csr.2524
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