Materiality Matters: Targeting the ESG Issues that Impact Performance

Emily Steinbarth is a Quantitative Analyst and Scott Bennett is Director of Equity Strategy and Research at Russell Investments. This post is based on a Russell Investments publication by Ms. Steinbarth and Mr. Bennett Related research from the Program on Corporate Governance includes Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

In our paper, Materiality Matters: Targeting the ESG issues that impact performance, we develop a new measure—the material environmental, social and governance (ESG) score. Drawing from the metrics developed by Sustainalytics and SASB (Sustainability Accounting Standards Board), our new material ESG score identifies and evaluates only those issues that are financially important to a company. The new material score allows us to differentiate between companies in a way that the traditional aggregated ESG score does not facilitate.

We can now distinguish between companies who score highly on ESG issues that are financially material to their business, from those who score highly on issues that are not financially material to their business. Our evidence suggests that the Russell Investments’ material ESG scores are better predictors of return compared to traditional ESG scores.

Existing research and literature review

We are not alone in seeking a connection between sustainability and materiality, and our research builds on a growing library of literature on the topic. To pay homage to this, we feature an appendix in our paper comprised of a literature review, providing analysis of the large body of research on the financial performance of ESG investing. Our focus for the literature study is financial in that we survey only the evidence on ESG investment performance. This is not meant to imply that this is the most important dimension of ESG investing. Rather, our goal is to focus on answering one specific question: what is the link between ESG and investment performance? One strand of the literature that we build on suggests focusing on sustainability issues that are material to an industry is an important part of linking ESG performance to financial performance.

Industry bodies and Russell Investments aligned

In addition to academic research into the connection between industry-relative ESG performance and financial performance, this question is also being addressed by practitioners. Rather than adopt a one-size-fits-all approach, industry groups such as the Task Force on Climate-Related Financial Disclosures (TCFD) and sustainability reporting organisations expend considerable resources developing standards that are specific to business lines. ESG data providers weight subcategories differently based on their relevance to different industries. At Russell Investments, our investment manager research analysts identify ESG issues that are relevant to the success of a given strategy when evaluating the ESG awareness of asset managers. 

Not all ESG issues matter equally

The relevance of ESG issues varies industry to industry, company by company. For example, fuel efficiency has a bigger impact on the bottom line of an airline than it does for an investment bank. So, rather than adopt a one-size-fits-all approach, we have worked to develop a new ESG scoring framework that is specific or truly material to a company and their profitability.

Why? We have found that traditional ESG scores are composed of a large number of issues that are not material for every industry or company. Specifically, for two-thirds of all securities in the Russell Global Large Cap Index universe, less than 25% of the data items in the traditional score are considered material.

Our paper follows a recent study by Khan, Serafeim and Yoon (2016), where the authors present evidence that investment in sustainability issues leads to financial outperformance, but only when the investment is in sustainability issues that are financially material to the firm. In contrast, they find that investment in immaterial sustainability issues does not lead to better financial performance, and may in fact detract from performance.

New material score methodology

We used the materiality map released by the SASB to help us determine which of the 145 ESG issues from Sustainalytics’ data set could be deemed as material to companies’ bottom lines. Following this, we used a number of statistical techniques to help formulate and standardise what we have coined ‘the new material ESG score’.

Score analysis

To what extent these new material ESG scores resemble the original, generic ESG scores?

By looking at the correlation between traditional ESG scores and the new material score, our research has indicated that there is indeed a meaningful difference between the two scores. At roughly 65% correlation, our new material scores are indeed positively correlated—but, meaningfully different—from the traditional scores. This suggests that the Russell Investments scores offer something different from the traditional scoring approach. But is different better? Next, we looked at performance of the scores, which suggested the answer is yes. We have found that there is a benefit to investors who differentiate between a company’s financially material ESG issues and non-financially material issues. 

Results for the material ESG score

As referenced above, our work closely follows a methodology laid out in Khan, Serafeim, and Yoon (KSY, 2016). Their study uses the historical MSCI KLD [1] dataset that has a longer history than other sustainability datasets (199–2013). However, the KLD dataset’s historical coverage is limited to the United States. We extended the scores’ analysis on a wider universe—the Russell Global Large Cap Index—to the period December 2012–June 2017. Using the same methodology as KSY (2016) we report results for our sample in the chart below.

Differences in four-factor alphas (High–Low Quintiles)
Material Sustainability Issues 1.19%
Immaterial Sustainability Issues 0.30%
Standard ESG Score 0.97%

Source: Russell Investments. Alphas refer to high minus low portfolio returns regressed on four-factor models.

High and low performance

The study by Khan, Serafeim, and Yoon has many important implications for our research and indicates that spending resources on immaterial issues is potentially value detracting. Going back to our original example, learning that fuel efficiency is a poor signal for future outperformance of an investment bank does not imply that the same is true for an airline. This explains why using fuel efficiency as a signal across a universe could lead to inconclusive results, even though it may be a valid signal for a subset of the universe.

Consistent with KSY, we found that the difference between high and low performers on material issues is larger than immaterial issues or the traditional scores. This suggests that material issues are the most promising signal among those we consider here for informing investment decisions based on ESG performance. The difference in alphas is statistically significant for material issues, but not for immaterial issues. We however, have gone one step further by isolating high performance on only material issues. The key takeaway for us from these results is that low performance on material issues is especially costly. This appears to be true even if the firm is a high performer on other ESG issues.

So, does materiality matter? Yes.

Industry bodies actively promote and recommend that companies need to focus more on the material ESG issues that directly affect their bottom line. Here, we align the way we evaluate companies with this broader industry movement and construct a new ESG score that focuses solely on material issues. Overall, we have reached conclusions consistent with existing literature in this field. That is, when measuring sustainability performance, the separation of material issues from immaterial issues matters.

Ultimately, our new score allows us to differentiate between companies in a way that the traditional score does not facilitate. We can now distinguish between companies who score highly on ESG issues that are financially material to their business, from those who score highly on issues that are not financial material to their business. Our research suggests that the Russell Investments material ESG scores can provide insights beyond traditional ESG scores.

Our goal was to confirm whether we could improve the information content of a standard ESG score for the tailored purpose of making investment decisions. Our analysis demonstrates this is possible. Specifically, we found that a high percentage of the underlying signals feeding into the standard score are not considered material to the firm’s business; we observe correlations with factors that are modestly improved; and finally, our material ESG scores appear to be a predictor of returns when compared to the standard score, even after adjusting for known factor exposures. Our results up to this point are encouraging, and we remain confident.

Further research

Our study uncovered several potential areas for further research. We studied a global universe, but given regional differences in ESG integration and our inability to fully replicate a prior study’s results from the United States, it is interesting to consider to what extent, if any, there should be a regional component to expectations for ESG investing. As noted above, there are many reasons to integrate ESG into an investment process.

While our study has largely focused on financial materiality, opportunities exist for developing cleaner signals based on other ESG-related goals, such as alignment with the UN Sustainable Development Goals (SDGs). Rather than mapping industries to key issues based on financial materiality, we could also focus on mapping industries to the SDGs that are relevant to their business line.


1KLD criteria were created by a company called KLD Research & Analytics Inc., a former social-responsible investing firm and pioneer in providing investment products like performance benchmarking, consulting services, and compliance evaluations to the financial world. In the late 2000s, KLD became a part of the Morgan Stanley Capital International (MSCI) RiskMetrics Group, where its methods in evaluating companies’ ESG performance continue to influence investment decisions.(go back)

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