Incorporating ESG into Credit Decisions: What is Materiality?

What is materiality, and why is it important when incorporating ESG into credit decisions? Catherine Bealin, Financial Trainer at the GICP explains all.

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Investors and lenders considering providing finance are increasingly incorporating ESG considerations into their financial analysis and risk assessments.

The assessment of ESG risks and opportunities complements existing investment and credit analysis techniques, providing a more robust and extensive assessment of material information to improve
decision-making.

Incorporating ESG into analysis does not require a fundamentally new approach. Instead, we systemically include or overlay material ESG factors to complement traditional decision-making processes such as a credit analyst’s review of a corporate borrower.

So how do we define material? Materiality is an accounting concept which describes factors that are likely to have a significant impact on key metrics, operations and risk. ESG factors can have a positive or a negative effect on financial performance, both in terms of the likelihood of an outcome and the potential magnitude of impact. In fact, they can have a combination of both.

To determine the credit risk presented by ESG factors we need to consider two components. First, how material the effects may be. And second, whether they are sufficiently large enough to change the credit profile or influence the credit decision.

So how might this play out in real life?
Well, let’s say we have a logistics company poised to expand and ready to add vans to its fleet, which to date have been powered by diesel. Knowing that regulations are set to change, to discourage highly polluting vehicles, the company considers adding EV. This decision could be more expensive in the near term, affecting their cap ex and funding requirements, but impactful over the longer period in terms of growth, preparedness and competitiveness.

In another example, imagine a bank that’s decided to go green, turning down loans to fossil fuel companies. This type of decision is an example of negative screening, a decision that limits a segment of the market. It’s a bold move for the bank which might limit its current business model and earnings potential, but it positions the bank as a leader in sustainable finance for the future.

In these ways, ESG factors have tangible impacts on financial and economic metrics. This is also known as a transmission mechanism. This means that ESG risk drivers can transmit or affect economic and financial metrics, directly and indirectly, at a micro or macro level.

So how do we begin to assess material ESG factors and transmission mechanisms in a way that is consistent and objective for application in a credit process? Well, one way to start is with a supplemental framework to guide our analysis.

SASB – The Sustainability Accounting Standards Board – has developed a materiality index via a map and finder tool. The map identifies how 26 material ESG issues manifest across 77 industries. The finder allows the user to look up a company or an industry and compare them side by side. The map and finder are interactive and are available on the SASB website.

Let’s have a look at this…
As an example, for the commercial banking industry, the materiality finder identifies 5 factors as highly material, including data security, access and affordability, product design and lifecycle management, business ethics and systemic risk management.

Looking at the alcoholic beverage subsector of the food and beverage industry, we see 6 different factors that are highly material to companies in this space – water and wastewater management, energy management, selling practices and product labeling, product design and lifecycle management, supply chain management, and materials sourcing and efficiency.

An analyst would then deep dive into the framework factors themselves. For example, if we look at the details for energy management, we see that this category refers to a company’s use and management of energy sources, and it comprises metrics for measuring or reporting on energy intensity and efficiency, energy mix and grid reliance. A credit analyst can then review these metrics and associated data in the same manner as they would do for a financial analysis.

For example, as water and wastewater management is a material factor for companies in the beverage industry those companies often report on water usage ratios – hectoliter of water per hectoliter of output. This material metric might be disclosed in a company’s annual report or sustainability report, often with notes around year-to-year changes and progress towards a goal set by the company. In order to achieve that goal, perhaps a ratio they’ve set for a few years out, it is important to understand how the company is going about achieving this progress (or lack of). In other words, what operational changes in the production process or investments in R&D for example, are required in order to improve water efficiency in their operations. In addition to evaluating the change in this metric, an analyst would also compare one company’s ratio to its competition or in some cases even a metric potentially set by the industry itself.

In this way, a relevant ESG issue with a quantifiable metric allows an analyst to identify and focus on the most material issues for a company or industry, to extract key metrics and performance indicators, potentially including baseline and goal objectives, to research what is happening across an industry, and then to overlay this information with their standard financial analysis. Analysts can easily integrate ESG into the credit decision making process, making the overall analysis more robust.