Traditional ESG assessments have been criticised for focusing mainly on how climate and social issues affect a company’s operations but not its net impact.
The Double Materiality framework on the other hand distinguishes between "how you do it" (operational performance) and “what you do" (product impact).
Operational performance focuses on a company's adherence to sustainability principles, while product impact assesses the positive or negative contributions of its core products and services to sustainability challenges.
Incorporating Double Materiality assessments helps investors and stakeholders identify companies excelling in performance and product impact, ultimately contributing to sustainability.
In our inaugural webinar for the Rize Global Sustainable Infrastructure UCITS ETF, we introduced the concept of ‘Double Materiality’. In this blog post, we delve deeper into Double Materiality and its integration into the Foxberry SMS Global Sustainable Infrastructure USD Net Total Return Index. We’ll explain how it addresses the challenges inherent in traditional ESG investing and illustrate its practical application in real-world scenarios. Join us as we explore the evolution of Double Materiality analysis and its emerging significance in the landscape of sustainable investing.
In recent years, ESG considerations have gained significant standing in the corporate and investment spheres, reflecting a growing concern for sustainability challenges and how companies impact the planet and its people. ESG criteria, aimed at evaluating companies based on their environmental, social and governance practices, have played a crucial role in defining corporate responsibility and accountability. More recently, however, ESG has experienced a backlash. Leaving politics aside, one key constructive criticism that was raised is that this ESG assessment predominantly focuses on how climate and social issues affect the company’s operations – in other words, providing only an “outside-in” perspective. While this perspective is useful in acknowledging and managing such risks, it tends to fall short of addressing how an organisation can create positive change for the planet and society at large (i.e. the “inside-out” perspective).
In other words, ESG tends to emphasise “how you do it” but lacks a comprehensive view including “what you do”, which accounts for the net impact of a company’s and/or products and services on society.
- “How You Do It” (Outside-In Perspective): This perspective focuses on how external environmental and social issues affect a company’s operations. It’s about how a company manages its operations and processes in response to these challenges. For example, it includes how a company reduces its carbon footprint, ensures fair labour practices, or implements ethical governance. This approach is primarily risk-focused, evaluating how external factors influence the company’s sustainability.
- “What You Do” (Inside-Out Perspective): In contrast, the “what you do” approach looks at the impact a company’s actual products or services have on society and the environment. It’s about the inherent nature of the business itself and its contribution (positive or negative) to sustainability challenges. For instance, a company producing renewable energy contributes positively to environmental sustainability (what it does), regardless of its internal operational practices (how it does it). This perspective assesses the net impact of a company’s core activities on the world.
To effectively tackle these challenges, our team at Sustainable Market Strategies (SMS) employs the “Double Materiality” concept, presenting a more encompassing and nuanced approach to sustainability evaluation. This means our assessment doesn’t just consider the impact of external risks on a company’s operations; it also recognises the significant potential for a company’s products and services to drive positive environmental and social change. This dual-focus approach allows us to provide a more complete picture of a company’s overall sustainability impact.
Diving deeper into the concept of Double Materiality, one must consider its two distinct components: Operational Performance and Product Impact.
Operational performance focuses on a company’s ability to run its business in alignment with robust sustainability principles. This aspect centres on how well a company manages its “material” ESG risks. It addresses concerns related to environmental impacts, labour practices and ethical governance, depending on the industry the company operates in.
For instance, greenhouse gas emissions may be a particularly relevant metric for a cement producer, whereas it may not be as relevant of a metric for a software company. Conversely, a key metric for that software company may be data privacy, which may not be as relevant to the cement producer. Operational performance examines the company’s compliance with ESG standards.
Examination of a company’s operational performance has potential for effective engagement. After identifying areas of weakness, engagement strategies can be tailored to target areas where a company’s operational performance falls short of sustainability standards. Investors can influence the company to change specific practices to improve its operational sustainability.
Product impact focuses on the impact of a company’s products and services on sustainability and society.
When considering the impact of a company’s products and services, it can be challenging when a company’s core product or service offering is misaligned with sustainability goals (see the example with tobacco company Philip Morris below). For these companies, opportunities for improvement are limited as the company is unlikely to change its core product or service offering. However, this can help investors identify areas of exclusions for their portfolios.
The following examples illustrate the importance of considering both aspects of Double Materiality: operational performance and product impact.
- Operational Performance: Schneider Electric demonstrates leadership, notably through its substantial renewable energy use and sustainable procurement policies.
- Product Impact: Schneider Electric’s main activity is to produce energy efficiency solutions through digital energy management. The company’s products are essential in our cities and infrastructure to make the transition to a lower carbon economy.
Schneider Electric excels in both aspects of Double Materiality.
- Operational Performance: Philip Morris receives high praise from ESG rating agencies for its exemplary operational performance, including robust sustainability practices and effective management of ESG risks.
- Product Impact: The company’s core product, cigarettes, is widely recognised as harmful to health.
Philip Morris is strong operationally, but the company’s core products offset some of this impact.
- Operational Performance: JinkoSolar Holding is involved in operational controversies related to its Labor Rights, Governance and Environment impacts. The most severe controversy involves the alleged employment of Uyghurs and other ethnic minorities implicated in forced labor practices at their Xinyuan, China, manufacturing plants.
- Product Impact: JinkoSolar is one of the world’s largest manufacturers of photovoltaic (PV) solar components like wafers and solar modules. The products they make are undoubtedly positive for the environment.
While JinkoSolar’s products have a positive impact on the energy transition, the impact is mitigated by the company’s record when it comes to human and labor rights in its operations. Engaging with companies embroiled in controversies can, in some instances, convince them to better their operational practices.
- Operational Performance: The company’s transparency is limited, lacking details on risk information from suppliers, and manufacturing is outsourced with a vague Supplier Code of Conduct.
- Product Impact: Monster Beverage’s energy drinks have poor nutritional value, high sugar content and synthetic caffeine, contributing to adverse health effects like high blood pressure and obesity.
Monster Beverage has challenges in both product and operations. It’s important to note that overall improvement is difficult because even with engagement strategies, focusing solely on operational enhancements won’t resolve the fundamental health concerns associated with their products.
The matrix chart below provides a visual representation, positioning these companies based on their operational performance (horizontal axis) and their impact (vertical axis).
Using a Double Materiality framework aids in the comprehensive evaluation of a company’s overall contribution to sustainability and society, effectively distinguishing between those excelling in both operational performance and product impact and those that may fall short in one or both dimensions. It is possible for companies to shift towards the right by improving operational performance thanks to engagement strategies, but impact remains relatively stable.
By evaluating a company’s operational performance and product impact, investors and stakeholders gain a more comprehensive view of its sustainability contributions and challenges. This approach opens the door for effective engagement and ensuring that investments genuinely contribute to the betterment of the planet and society. Incorporating Double Materiality assessments is a vital step in the evolution of sustainability considerations and standards.
This Featured Article has been produced by Sustainable Market Strategies. Rize ETF Ltd make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability or suitability of the information contained in this article.