In order to identify which ESG matters for your firm or the firm in which you're investing, we need to map specific pathways from ESG factors to the profits and loss statement of that organization and those in that organization supply chain. We then need to understand which of those pathways matter for your stakeholders such that they might mobilize for action that could impact the profits and losses of your company. We also need to look ahead, look ahead to future stakeholder risks and opportunities. Let's proceed through those four steps in turn. First, while ESG factors may impact revenues and costs, the specific factors that have the largest material impact differ dramatically across industries. Retailers like Walmart consume large quantities of electricity and produce large quantities of waste. Uber and Lyft consume less electricity and produce less waste, but they're heavily dependent upon regulatory permission to operate. In an effort to pressure companies to disclose material data on their ESG performance to investors in a more systematic manner, the Sustainability Accounting Standards Board, which is an industry group of investors and corporates interested in ESG reporting, have worked to map out the most material ESG factors for each of several dozen industry groups and suggest in their trademark's Materiality Map the Disclosure Standards for each factor in each industry that a reasonable investor would want to know about. A reasonable investor is an investor who invests primarily for economic reasons with a variety of investment horizons from short term to long term and investment strategies from income generation to asset valuation. The definition of materiality follows the US Supreme Court definition in US securities law as presenting a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. Three tests determined potential sector-specific materiality. Evidence of interest, the way they do this is they use a keyword-based heatmap to determine which general sustainability issues are most important to investors and key stakeholders in that industry. Second is financial impact, which pertains to the likely impact of management decisions on future valuations. Third is forward-looking impact, which identifies the issues not previously captured that could prove systematically disruptive in the future. Along the columns of the SASB Materiality Map, SASB has divided the economy into distinct sectors and within each sector a set of related industries. Each row of the Materiality Map corresponds to a distinct category of environmental, social, or governance risks. Let's take a look at a comparison between e-commerce retailers like Amazon and brick-and-mortar stores like Walmart. For the former, energy management, customer privacy, data security, employee engagement, diversity, equity, and inclusion, product design, and lifecycle management are all material. For the latter, all of these are material except for customer privacy and labor practices are also material. Next, let's compare fuel cells and batteries to solar technology. For the former, energy management, employee health and safety, product design and lifecycle management, and material sourcing and efficiency are all material. For the latter, the same factors of material except for employee health and safety, but also waste and wastewater management, hazardous waste, and ecological impacts. Finally, let's look at the comparison between EMS or ODM electronic manufacturers and integrated semiconductor producers. They both face risks from waste and wastewater, hazardous waste, employee health and safety, product design, lifecycle management, and material sourcing or efficiency, but semiconductor manufacturers also face material risks from their GHG emissions, energy management, employee engagement, diversity, equity, and inclusion. For each of these ESG factors, SASB provides guidelines as to recommend the data that can be disclosed and/or monitored over time to assess performance. The second step, as you assess your company's ESG risks and opportunities, keep in mind that those factors extend beyond your operations into the upstream activities from which you source supplies and materials and the downstream activities in which your products are consumed. In the past, it might have been possible to claim that you don't have any responsibility for what your suppliers or customers do. But given the nature of ESG impacts, such distinctions are really hard to defend. Imagine if we only evaluated an oil company on the carbon emissions it produces to make oil, not the carbon emitted when its oil is actually consumed. In addition to the logical inconsistency and just focusing on the activities of the focal company, activists know that strategically it can be easier to hold some firms like Walmart or Home Depot or Apple responsible for a problem than the thousands of suppliers from which their companies source their product. To differentiate between these various elements of the supply chain, we refer to scope 1, 2, and 3 impacts. Scope 1 impacts are those direct impacts associated with a focal company's operations, what are the ESG factors resulting from its production. Scope 2 impacts are the indirect impacts associated with its operations, most notably the impact of the electricity source. Scope 3 impacts are the most broad, the indirect impacts associated with both upstream suppliers and downstream users of the product. For Apple, scope 1 impacts are those limited to Apple's own facilities and employees, scope 2 encompasses the electricity consumed by Apple, and scope 3 includes the activities of Foxconn as well as the customers who own iPhones or MacBooks. For Tesla, scope 1 impacts are limited to Tesla's battery and automobile manufacturing facilities, scope 2 impacts encompass the electricity of those facilities consume, and scope 3 impacts include the suppliers, including the minds that supply its factories and the driving and eventual vehicle disposal practices of its customers. The third step is to take into account the issues that stakeholders care about the most. As we discussed, these hypothetical pathways require the active engagement and actions of stakeholders. Such engagement and action or mobilization is costly to these stakeholders. So critical next step in the evaluation of risks and opportunities is to assess what's called stakeholder issue salience. In short, what are your stakeholders care about? Which ESG issues are top of mind for them? Data on stakeholder priorities across issues can come from a range of sources. You can talk to them in person, you can conduct surveys, you can log conversations, or you can monitor their discourse on regular and social media. When a potentially material issue rises and prominence among stakeholders, it's more likely to actually impact revenues, costs, and efficiencies sooner rather than later. See in this visual the example of Wells Fargo throughout the period where the customer fraud allegations were growing from a rumor to an SEC action. You can see in a stacked area graph counting the distribution of news stories from the data provider true value labs facts that company that the number of stories around selling practices and business ethics rose from 228 in the second quarter of 2016 to 488 in the third quarter of that year. That spike in stakeholder interests or salience as reported in the media should have been a red flag to management and to investors in Wells Fargo that this issue above all else was top of mind for Wells Fargo stakeholders. Constructing similar visual and quantitative representations of your stakeholders priorities can be a useful input into corporate resource allocation decisions as well as investor strategies based on ESG factors. In the final step, we need to look ahead and understand how the external stakeholder environment might change next year or in the coming years. What new technologies could shift customer and supplier behavior? Are politicians actively investigating or debating new policies that are not top of mind to stakeholders yet but could still have impacts down the road? Are competitors experimenting with different approaches to these ESG issues? Are any of those efforts even if small and scale showing growth and performance impacts that could allow one or more of your competitors a first-mover advantage to which you and other firms will have to catch up? Are employees mobilizing, setting off a risk of employee defection or protest or any civil society organizations ramping up their efforts on issues material to an organization? While more difficult to measure and quantify, such a forward-looking exercise still seeks to identify early signals or triggers for more concerted investigation and risk management on ESG factors that, while not yet material, could become so in the medium to long term. Pulling these four steps together, every firm, investor, and board should be able to identify potentially material ESG factors for their business and in the supply chain to that business, they should assess the salience of those ESG factors to their stakeholders in the present and in the future, they should organize that information in a way that turns ESG from ideology to economics and the resulting data into a strategic or investor tool for realizing value.
