Materiality Matters
Targeting the ESG issues that impact
performance - the Material ESG Score

russellinvestments.com

Materiality matters
Targeting the ESG issues that impact performance – theMaterial ESG Score
Emily Steinbarth, Sr. Quantitative Research Analyst

In 2018, Russell Investments developed a new way to measure a company’s ESG(environmental, social and governance) score. Drawing on metrics developed by industry
leaders Sustainalytics, MSCI, and SASB (Sustainability Accounting Standards Board), ourMaterial ESG Score identifies and evaluates those issues that are financially important to acompany.
The material score can be used to differentiate between companies in a way that a traditional
aggregated ESG score does not facilitate. It allows us to distinguish between companies whoscore highly on ESG issues that are financially material to their business, from those whoscore highly on issues that are not financially material to their business. Our evidence
suggests that Russell Investments’ Material ESG Scores are better predictors of return
compared to traditional ESG scores.

Bottom line: Not all ESG issues matter equally
The relevance of ESG issues varies industry to industry, company by company. Forexample, 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 worked todevelop an ESG scoring system that is specific to a company and its profitability.
Why? Our research found that traditional ESG scores are composed of a large number ofissues that are not material. When we conducted our original research in 2018, 66% of all
securities in the Russell Global Large Cap Index universe had less than 25% of the data
items in the traditional ESG score that were considered material.
Financial materiality is not the only reason to look at ESG information. Double materiality,or going beyond financial materiality to consider broader environmental and stakeholder
materiality, is critically important. Rather than ignoring other issues, we think it’s time tomove beyond ambiguous “ESG” labeling toward more explicit and transparent terminology.
Our Material ESG Score is tailored to financial materiality – it’s explicit and transparent inthat endeavor. To measure materiality in the other direction – how is a company impacting
the world outside – we believe frameworks such as the European Union’s Principal
Adverse Impact indicators offer a useful starting point.

Rather thanadopt a onesize-fits-all
approach, weworked todevelop an ESG
scoring systemthat is specific to
a company andits profitability.

To generate our in-house Material ESG Score, we leveraged data from ESG data
providers alongside the industry-level materiality map developed by SASB. Since ouroriginal research in 2018, the concept of materiality in ESG has become much more widelyadopted across the industry. Here we summarise our original research as well as
developments that have taken place in the years since we first released our score.

Russell Investments / Materiality Matters – targeting the ESG issues that impact performance/1Russell Investments’ Material ESG Score
methodology
Identifying which ESG sub-categories are material, and which
are not
Traditional ESG scores are constructed for a variety of financial and non-financial uses.
This means that a company may receive an ESG score based upon issues that are notfinancially material. So, to help us identify which of the many sub-categories feeding into
off-the-shelf ESG scores are indeed material, we used the SASB materiality map as aguide. For example, feeding into an overall ESG score is performance on a variety of subcategories such as labour practices, emissions, water and waste management, businessethics and so on. Those subcategories that are not identified as material are not included
in our overall score for each industry.

Constructing the material scores
To construct the scores, we first standardise the underlying subcategory data. Then, weaggregate the scores of the sub-categories that are material before calculating the final
material scores and scaling them into a range between 0-10, where higher scores
represent stronger outcomes.

At Russell
Investments, webelieve that asoundawareness ofESG factors anda robust process
can help deliver
stronginvestment
returns andmeet objectives
over the longterm.

Materiality and company performance
At Russell Investments, we believe that a sound awareness of ESG factors and a robust
process can help deliver strong investment returns and meet objectives over the longterm. In light of this, the next obvious question is: can materiality help to deliver strong
performance?

Kahn, Serafeim, and Yoon (2016)
A 2016 study by Khan, Serafeim, and Yoon (KSY) showed that companies with strong
performance on material ESG topics outperform companies with poor performance onmaterial topics. Exhibit 1 shows the relative returns of companies that had highperformance in material issues and low performance in immaterial issues. Highperformance on material issues led to higher alphas1 than low performance (quadrant 1vs. 2 and quadrant 4 vs. 3).
Interestingly, after controlling for high performance in material issues, a portfolio ofcompanies scoring low on immaterial issues generated higher alpha than the portfolio ofhigh performance on immaterial issues. In other words, spending resources on immaterial
issues appears to have been value-detracting.
The purpose of our original research was to see if we could replicate this finding using a
new data set, time horizon, and mapping.

1

Alpha measures the difference between a portfolio’s actual return and expected performance, given its level of risk

Russell Investments / Materiality Matters – targeting the ESG issues that impact performance/2Exhibit 1: Bucket companies according to performance on material andimmaterial categories(Kahn, Serafeim, and Yoon, 2016) U.S. Large Cap Universe, 1991-2013

FOUR FACTOR ALPHAS 2(1991-2013)

ANNUALISEDALPHAHigh Material, Low Immaterial

6.01%

Low Material, Low Immaterial-2.9%

8.90%***

Low Material, High Immaterial

0.60%

5.41%***High Material, High Immaterial

1.96%

4.05%***

DIFFERENCE IN
ALPHAS

Source: Khan, Serafeim, and Yoon (2016) and Russell Investments. Alphas refer to portfolio returns regressedon four-factor models including Mkt-Rf, SMB, HML, and UMD. ***, **, * refer to significance at the 1%, 5%, and10% levels respectively.

Can our material score be used to impact
performance?
The study by Khan, Serafeim, and Yoon had many important implications for our researchand 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 toinconclusive results, even though it may be a valid signal for a subset of the universe.
In an effort to evaluate whether our scores could indeed be used as a return indicator, weback-tested them between December 2012 and June 2017 on a wider universe than Khan,
Serafeim, and Yoon used - the Russell Global Large Cap Index. This test found that2

Annualised alpha measures the fund’s value-added relative to a benchmark, smoothed over a stated period. The Four-factor model used in the research refers to acombination of the Fama-French Model [adds size (SMB) and value (HML) factors to the market risk (Mkt-RF) factor in the capital asset pricing model (CAPMI)] plus
momentum *UMD).

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material issues are indeed a promising signal for informing investment decisions based on
ESG performance. Investors could potentially gain an additional 22 basis points (versus
using the traditional ESG score) by refining the signal to those that have higher material
ESG characteristics.

Exhibit 2: Material and Immaterial ESG Issues(RGI Global LC, Dec 2012 – June 2017)
ANNUALISED DIFFERENCES IN FOUR FACTOR ALPHAS (HIGH – LOW QUINTILES)
Material ESG Issues

1.19%**

Immaterial ESG Issues

0.30%

Traditional ESG Scores

0.97%*

Source: Russell Investments. Alphas refer to high minus low portfolio returns regressed on four - factor models
including Mkt-Rf, SMB, HML, and UMD. ***, **, * refer to significance at the 1%, 5%, and 10% levels
respectively.

Consistent with Khan, Serafeim, and Yoon, we found that the difference between high andlow 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 inalphas is statistically significant for material issues, but not for immaterial issues.

Enhancing the Material ESG Score
Following our original research, the industry adopted the concept of materiality more
widely. Our data provider overhauled their methodology, and the Sustainalytics AccountingStandards Board updated the Materiality Map. Following these developments, we released
a major update to our Material ESG Score in 2019. In addition to incorporating new data,
we took the opportunity to make several important enhancements including:1
The addition of a corporate governance score for all companies

2
More explicit emphasis on forward-looking information where available, and3
Addition of MSCI data as an input to the model

Russell Investments / Materiality Matters – targeting the ESG issues that impact performance/4Summary of data changes: Sustainalytics released
their own score enhancement
Although we use multiple providers for ESG data, the data feeding into the first release of
our Material ESG Score was all sourced from Sustainalytics. Shortly after we released ourMaterial ESG Score, Sustainalytics released an enhancement of their own, called the Risk
Rating, representing a major overhaul to the way Sustainalytics scores and evaluatescompanies. The new scores:a)

Focus on financial materiality – this was good. The focus on materiality aligned withthe approach we took in originally developing our Material ESG Score in 2017. Thisdevelopment begged the question: do we even still need our own scores? This iswhere our analysis started, asking did the new Risk Rating from Sustainalytics
capture the same things as our Material ESG Score. Our analysis concluded theanswer was no, the Risk Rating was not the same as our Material ESG Score. In fact,
the correlation between the new Risk Rating and our Material ESG Score at the time
was only -0.17. Why were the scores so different? The answer was right in the name:the new Risk Rating focused on risk.

b)

Focus on risk – while there is nothing wrong with taking a risk-based approach to ESG
integration, our approach to thinking about ESG from a materiality standpoint is not
only about risk but also opportunities.

c)

New data items from Sustainalytics that align with the SASB framework – compared
to when we initially mapped the Sustainalytics data set to the SASB mapping, newdata became available that better aligned with the SASB indicators, which wasencouraging. Some examples of alignment we found include the following topics:

Exhibit 3
MATERIALITY TOPIC

INDICATORSAVAILABLE IN 2017

INDICATORSAVAILABLE IN 2019

Competitive behavior

03

Systemic risk management

05

Data privacy & security

14

Summary of methodology enhancements
The update brought on by changes in the underlying data gave us the opportunity toincorporate several improvements that were identified since releasing the Material ESG
Scores two years before. The methodology enhancements included:1

Incorporation of a corporate governance scorea.

We found our original materiality score based on the SASB framework to beweak on corporate governance. SASB themselves acknowledged that they
intentionally did not seek to fully represent the "G" aspect of "ESG" in theirframework since this was an area that has already been covered
extensively by other frameworks. Our solution was to supplement the SASB
framework with an additional pillar of corporate governance for allcompanies.

b.

For the governance metric, we use a comprehensive corporate governanceassessment from Sustainalytics that includes board and management
quality, board structure, shareholder rights, renumeration, audit andfinancial reporting, and stakeholder governance.

c.

Reflecting our belief that good corporate governance is important
regardless of industry, the issues feeding into the final Material ESG Score
are now those identified by SASB (which vary by industry) plus corporate
governance (which is a pillar for all companies).

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2

Replacing Systainalytics assessments with raw environmental data,
where availablea.

Moving to a model where raw data can be used from a variety of providers
allows us to capture unfiltered data, with a quicker time from disclosure toincorporation in the scoreb.

One of the fundamental shortfalls with ESG data is data quality. In this newmodel, we are not beholden to one provider for all metrics but can source
data from a variety of providersc.

For this release both carbon emission data and water usage data will be
moved to MSCI, where available

Addition of a forward-looking adjustment

3a.

One of the major criticisms with the current state of ESG data is the focus
on backward-looking information. A natural area to seek enhancement isaddressing the question of what, if anything, can we do to make ourassessment more forward-looking.

b.

What drives a forward-looking view on a company's future sustainability
varies by industry. Fortunately, our framework is already built to beindustry-specific.

c.

We identified 3 pillars where forward-looking information is most relevant,and where data is available, and incorporated a forward-looking score tothese pillars.

So, does materiality matter? Yes.
Russell Investments’ Material ESG Scores are better predictorsof returnUltimately, our in-house score allows us to differentiate between companies in a way thatthe traditional score does not facilitate. It allows us to clearly 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 research suggests that the Russell Investments Material ESG Scores can provide
insights beyond traditional ESG scores.
Push beyond a one-size fits all approach Financial materiality is not the only reason to lookat ESG information. Double materiality or going beyond financial materiality to consider
broader environmental and stakeholder materiality, is critically important. Rather thanrecommending ignoring other issues, we think it’s time to move beyond ambiguous “ESG”
labeling toward more explicit and transparent terminology. Our Material ESG Score is
tailored to financial materiality – it’s explicit and transparent in that endeavor.

Ongoing research to ensure robustness and risk management
We continue to use the Material ESG Score in the Russell Investments’ Decarbonisation
Strategy as part of our ongoing integration of the score. The Russell Investments’ Material
ESG Score represented a strong development in our understanding of ESG performancedrivers and continues to provide an excellent framework for incorporating our latest
thinking on how to measure the ESG performance of the companies in which we invest.

Russell Investments / Materiality Matters – targeting the ESG issues that impact performance/6Additional authors
Scott Bennett

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