Is an obsession with financial materiality failing our economy?

Ridhima Sharma
Is an obsession with financial materiality failing our economy?

Interest in responsible investing has grown significantly over the last decade and this has created a boom in new investing strategies. Incorporation of environmental, social and governance (ESG) factors into investment and ownership decisions is increasingly at the forefront of this proliferation of new approaches.

As a result, there are now a number of service providers offering ESG rating and scoring systems to help fund managers analyse company's ESG credentials. However, there remains a lack of consensus on which ESG issues should be taken into account.

One increasing trend among responsible investors - and ESG rating service providers offering them a service - is to focus solely on financial materiality. This is the set of factors influencing a company's financial performance, such as revenue growth and profitability. Whilst increased appetite to assess financial risks and opportunities that arise from ESG factors is encouraging, there are also significant problems in failing to look beyond financial materiality.

The Principles for Responsible Investment (PRI), an industry body which supports the development of responsible investment globally, now counts over 2,000 signatories and sets out six principles that guide best practice in the industry. The PRI claims that by implementing the principles, "signatories contribute to developing a more sustainable global financial system." Applying the principles may also "better align investors with broader objectives of society." This commendable ambition seems difficult to achieve when investors are only focussing on financial materiality. Financial materiality is only one aspect of what is material for businesses, and focussing on purely financial areas of materiality does nothing to discourage short-termism. Other stakeholders and wider society should likewise be taken into account.

Investors should not operate in isolation from society. Whilst the primary goal of the financial sector is to help investors save, manage money and raise capital, the impact of the sector on society is much broader. Investment managers have a fiduciary duty to their clients; however the sector also needs to be aware of its license to operate and its wider purpose. The question of the purpose of finance was recently discussed at the World Economic Forum in Davos. Christine Lagarde, the head of the International Monetary Fund (IMF) argued that the financial sector should, like any sector, have a purpose. "It can't just be single-mindedly the pursuit of profit, it has to be multifaceted and it has to take into account multiple stakeholders" according to Lagarde. 

Certain ESG issues may indeed not be financially material at a company level. However, ignoring them altogether has serious consequences and creates so-called externalities. These are consequences of a business activity which affect other third parties more widely, without their choice, whether good or bad.

For example, paying the living wage may see a company's costs increase, but the wider societal benefits of the living wage are difficult to measure through a company's profitability metrics. Yet paying a living wage goes a long way in building a fairer and sustainable global economy, creating good jobs and reducing economic inequalities. Similarly, environmental issues may not be financially material for a business with a small office footprint; we believe that this should not stop investors from questioning a company's environmental management and should not halt a company from switching to renewable power or from innovating to further reduce its footprint. A closed view that focuses solely on financial materiality may have the unintended consequences of saying to business these vital issues lack importance.

Trust in the financial sector is also at a low level. According to the Edelman Trust Barometer, only 46 percent of the general public in the UK trusts the financial services sector to do the right thing.  Short-termism and a focus on financial materiality only is unlikely to change that.  

EdenTree agrees that financial materiality is one of the aspects that responsible investors should take into account when making investment decisions. Nonetheless, we do not shy away from looking at the broader picture. With our long-standing heritage in responsible and sustainable investment we continue to be committed to our "profit with principles" approach. We will continue to encourage companies to do the right things and go the extra mile in their ambitions to be good corporate citizens; even if the impact on a company's bottom line may - in the near term - not be visible.

Esmé van Herwijnen, Responsible Investment Analyst at EdenTree Investment Management