Materiality matters

Targeting the ESG issues that can

impact performance – the material ESG score

Russell Investments // Materiality matters: Introducing a new ESG metric FEBRUARY 2018
Contents
Introduction ................................................................. 1
Chapter 1: Data and Score Methodology .................... 3
Chapter 2: Characteristics of the ESG Scores ............ 6
Chapter 3: To what extent do material
ESG scores differ? ...................................11
Chapter 4: Results for the material ESG score ..........14
Chapter 5: Coverage and Robustness .......................19
Chapter 6: Conclusions ..............................................20
References .................................................................21
Appendix 1: Literature on Financial Performance
of ESG Investing ....................................22
Appendix 2: SASB Materiality Map Sample ...............25
Appendix 3: Why SASB?............................................26
Appendix 4: SASB to Sustainalytics Mapping ............27
 Materiality matters
Targeting the ESG issues that can impact performance
– the material ESG score

Emily Steinbarth, Quantitative Analyst

ABSTRACT

Russell Investments has developed a new way to measure a company’s ESG

(environmental, social and governance) score. Drawing from the metrics
developed by industry leaders Sustainalytics and SASB (Sustainability Accounting
Standards Board), our new material ESG scores are designed to identify and
evaluate 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 research suggests that the Russell Investments’
material ESG scores are better predictors of investment return compared to
“traditional” ESG scores.

Introduction
Not all ESG issues matter equally
In assessing the relationship between a company’s performance on environmental, social and
governance (ESG) issues with financial performance, not all ESG issues matter equally. For example,
fuel efficiency has a bigger impact on the bottom line of an airline, than it does for an investment bank.
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. In addition to the academic literature (summarized
in the appendix), the concept is also being applied in practice. Rather than adopt a one-sized-fits-all
approach, industry groups such as the Task Force on Climate-Related Financial Disclosures (TCFD)
and sustainability reporting organizations 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 manager research analysts identify ESG issues that
are relevant to the success of a given strategy when evaluating the ESG awareness of asset
managers.
Our work follows a recent study by Khan, Serafeim and Yoon (2016)1, where the authors present
evidence that investment in sustainability issues can lead to financial outperformance, but only when
the investment is in sustainability issues that are financially material to the firm. In contrast to this, they
find that investment in immaterial sustainability issues does not lead to better financial performance,
and may in fact detract from performance.

1
From here on referred to as KSY (2016)

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p1
 Applying the notion of ‘materiality’ from financial accounting
The notion of materiality used in this study is borrowed from financial accounting. The Financial
Accounting Standards Board defines materiality as: “information which would be considered decision-
relevant to an investor”. As the airline versus the investment bank example above highlights, decision-
relevant issues depend on the company’s business and also varies with industry.
In this study, we leverage the work of the Sustainability Accounting Standards Board (SASB) to
determine what is a material ESG issue in each industry. As outlined in their mission statement:
“SASB sets industry-specific standards for corporate sustainability disclosure, with a view towards
ensuring that disclosure is material, comparable and decision-useful for investors”.
In this study, we have used the SASB materiality map that explicitly identifies the material ESG issues
to industry groups. The map is included in Appendix 1.

Mapping Sustainalytics data with SASB guidance

We seek to build on this evidence by differentiating between firm performance on material and
immaterial ESG issues within “traditional” ESG scores, such as those created by data provider
Sustainalytics. In this study, we map performance on ESG sub-issues provided by Sustainalytics to an
industry-level materiality map developed by SASB.
This allows us to separate the subcomponents of a “traditional” ESG score into two buckets:
• Material
• Immaterial
In doing so, we take a combined signal that was designed for a wide range of financial and non-
financial purposes, and strip it down for our more specific goal: improving the quality of the ESG signal
used for portfolio construction. The outcome of this exercise is a signal of firm characteristics on purely
material sustainability issues.

Building a new ESG metric

Our study adds to the field by applying these principles to a specific task: building a new ESG metric.
We extend the techniques established by others to a new sustainability dataset and a new expanded
universe. Going further, we seek to understand how these scores differ from “traditional” ESG scores.
As with other investment signals, we want to know how incorporating these scores is likely to impact
investment performance.
We can further break this question down into two components.
1. Correlation – that is, correlation with other known drivers of returns, or factors.
2. The alpha component, or rather, the information not captured by our factors.
Specifically, we analyse how material ESG scores are correlated with known factor exposures, show
that the correlations differ from “traditional” ESG scores, and provide high-level return profiles for the
new scores over the short history where we have data available. We find that a high percentage of the
underlying signals feeding into the traditional score are not considered material. While we do not
believe our limited data history is sufficient for making claims about long-term performance, we find
evidence that material ESG scores are better predictors of return compared to “traditional” ESG scores,
even after adjusting for known drivers of equity returns (such as factor exposures).
In the rest of this paper, we describe the underlying data and methodology used to construct the
Material ESG scores, summarise the new scores, compare these to other ESG metrics, and finally
provide a sector-level case study to illustrate how the new scores can work in practice. An analysis of
related literature can be found in the appendix.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p2
 Chapter 1: Data and Score Methodology

Sustainalytics data
The Sustainalytics data set provides sustainability data at the company-level for over 140 sustainability
categories. These are divided into environmental (E), social (S) and governance (G) issues. Scores for
these subcategories are then rolled up into aggregated E, S and G scores which are further rolled up
into an aggregated ESG score for each company. Sustainalytics acknowledges that not every
subcategory is relevant to every industry. To reflect this, data is not provided for each industry in each
category. Additionally, even where subcategory scores do exist, the weight matrix used to roll up
subcategories into an aggregate score varies by peer group. Sustainalytics ESG scores are
constructed for a variety of financial and non-financial uses and reflecting this, these weightings do not
necessarily focus on financial materiality.

SASB materiality guidance

To identify what subcategories are financially material we use materiality guidance from SASB. The
mission of the SASB is to develop sustainability accounting standards that help companies disclose
value-relevant information to investors via standardized filings with the U.S. Securities and Exchange
Commission (SEC) such as a 10-K2. The Board engages in a six-step process, described in the figure
below, before making a final determination that a sustainability issue is material. This detailed process
and the resulting materiality map represent precisely the work that we look to leverage in our study. The
explicitness of linking industries to specific sustainability issues mean that SASB’s work can be more
directly applied to this exercise compared to other sustainability reporting organizations. 3

Step 1: Mapping Sustainability Subcategories

This first step in our process, mapping sustainability subcategories to SASB materiality, closely follows
the process outlined by KSY (2016) in their study on materiality. We start by comparing the list of all
145 subcategories available from Sustainalytics to the 30 material sustainability issues identified by
SASB. Construction of new Material ESG scores based on SASB materiality involves the following
steps:
1. Identify ESG issue materiality for each industry
This is performed using the SASB Materiality Map in Appendix 2
2. Map SASB ESG issues to related categories in the Sustainalytics data set
See SASB to Sustainalytics Map in Appendix 4
3. Aggregate the material ESG issues into a single score per company. This process is described
below.

Step 2: Score Construction

The distribution of raw Sustainalytics subcategory scores is not the same across the subcategories as
shown in figure 2 over page.
This suggests that to fix the aggregation distortions coming from scale differences, standardization is
required prior to aggregating into an overall ESG score.

2
Form 10-K are annual reports required by the SEC, providing a comprehensive summary of a company’s financial performance
3
For more discussion on other providers such as the Global Reporting Initiative or Integrated Reporting, see Appendix 3.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p3
 Figure 1: SASB research methodology

Source: ‘SASB’s Approach to Materiality for the Purpose of Standards Development’ Staff Bulletin No. SB002-07062017. July 2017
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. Forms 10-K and
20-F are mandatory filings with the SEC. Form 20-F is the primary disclosure document required of foreign private issuers listing
equity shares on exchanges in the United States.

Figure 2: Sustainability subcategory scores – box and whisker plots

Sustainability Subcategory Scores - Box and Whisker plots

Environmental Issues Social Issues Governance Issues

Source: Russell Investments, Sustainalytics. Data as of June 30, 2017

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p4
 Step 2 continued: The score construction process involves three steps:

1. Calculate the standardized subcategory score by z-scoring4 the raw Sustainalytics subcategory
scores:
raw Sustainalytics score-Average(raw Sustainalytics score)
Subcatogory Score=
Standardized(raw Sustainalytics score)

Scores are standardized cross-sectionally at a given point in time for a given subcategory. There
are 145 Sustainalytics subcategories.

2. Aggregate subcategories at the material issue level. Material issues are the categories identified by
SASB and include, for example, categories such as Fuel Management and Supply Chain
Management. In total, there are 30 issues. A material issue may be based on one or several of the
Sustainalytics subcategories mentioned above. Suppose there are n subcategories related to a
given material issue, the material issue score is the average subcategory score:

n
1
Material Issue Score= ∑ Subcategory Scorei
n
i∈Material Issue

The subcategory scores can be very industry specific so a subcategory is only used when a score
is available (i.e. no substitution logic is applied).

3. Calculate the final material ESG score. Suppose there are m material sustainability issues for a
given industry, the material ESG score for companies in that industry will be the average of the m
issue scores:
m
1
Material ESG Score= ∑ Material Issue Scorej
m
j ∈ Industry

This final score is standardized and finally, scaled up so that it ranges between 0 and 10.
Note: A SASB Issue is always relevant to the industry (by definition of the materiality matrix) so
substitution logic is applied if a score is null. Specifically, if a company has no SASB issue score for
a material issue, the average score for that sector is used.

4
Z-scoring is a statistical measurement of a score relationship to the mean in a group of scores. Standardized scores are also known as z-scores
and help in comparing different scores by converting them to standard scores.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p5
 Chapter 2: Characteristics of the ESG scores
At the company level, the material ESG score is discrete and ranges from zero to ten. The distribution
of scores is approximately normal with a mean, median and mode of roughly five. For the Russell
Global Indexes Developed Large Cap Index (RGI Global Large Cap), the cap-weighted index average
is also five. The histogram for all securities in the coverage universe as well as summary statistics for
the RGI Global Large Cap Index are provided for reference in Figure 3 below.

Figure 3: Material ESG score distribution and summary statistics

600

500

400
Name
Count 300

200

100

0
0 1 2 3 4 5 6 7 8 9 10
Score

RGI GLOBAL LARGE CAP MATERIAL ESG SCORE

Count 3399
Mean 4.87
St Dev 2.39
Min 0
Max 10
Mode 5
Median 5
Skew5 0.28
Kurtosis6 -0.43
Cap weighted Average 5.58
Cap weighted Coverage 96%
Source: Russell Investments, as of June 30th, 2017.

To what extent do these new material ESG scores resemble the original generic ESG scores?
While our goal is to build a different ESG signal, an obvious question is to what extent these new
material ESG scores resemble the original generic ESG scores. In Figure 4 we report the correlation
between our new score and Sustainalytics ESG scores. While we have no specific correlation threshold
in mind, a very low or negative correlation with existing scores would be surprising, if not outright
concerning, given the data used to construct our scores is a subset of the data used for the
Sustainalytics scores. A very high correlation would suggest there is little to be gained by rebuilding the
scores in the manner proposed here. At roughly 65% correlation, the new scores meet these criteria in
that they are positively correlated, but meaningfully different from the existing scores.
In addition to considering how the scores are correlated with a “traditional” ESG score, we are also
interested in how these scores may be related to other signals. To the extent that we believe certain
factor exposures drive equity returns, these correlations are informative to answering the question of
how incorporating these scores is likely to impact investment performance.7 In Figure 5 we report
correlations between the Material ESG scores and Russell Investments Factor Scores8 for the RGI
Global Large Cap universe over time.

5
Skew is the term used to describe asymmetry from the normal distribution in a set of statistical data.
6
Kurtosis is a statistical measure that is used to describe the distribution or skewness of observed data around the mean.
7
Barber, Bennett, Gvozdeva (2015)
8
Russell Investments Factor Scores are a proprietary measure of a company’s exposure to a particular factor exposure.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p6
 Figure 4: Correlations of Sustainalytics ESG Scores and new Material ESG Score
1
0.9
0.8
0.7
0.6
Correlation 0.5
0.4
0.3
0.2
0.1
0

Rank Correlation Pearson Correlation

Source: Russell Investments, Sustainalytics

Figure 5: Correlations of Material ESG Score and Russell Factor Scores

0.3

0.2

0.1
Correlation 0

-0.1

-0.2

-0.3

Growth LowVol Momentum Quality Size Value

Source: Russell Investments

Correlation analysis
The largest correlation in terms of magnitude is a negative correlation to the size factor, or in other
words, the scores display a large cap bias. This is consistent with the cap bias we identified in Ross,
Song and Pearce (2014). Other relationships are quite modest. Scores are positively correlated with
both value and quality. Momentum, low volatility and growth exposures are either inconsistent or close
to zero over time. To help understand how these new material scores will be expected to perform
relative to the Sustainalytics scores, below we report the correlations of both Material ESG and
Sustainalytics scores.
Factors are separated into two charts for readability. Figure 6 below presents the factors where
correlations are consistently higher for the Material score. Compared to the Sustainalytics ESG scores,
the negative correlation to the size factor is smaller in magnitude. In other words, the new ESG Score
exhibits less of a large cap bias than the Sustainalytics ESG score. Correlation with quality is higher for
the Material ESG score and a negative correlation to growth associated with the Sustainalytics score is
eliminated. Meanwhile, Figure 7 presents factors where there is either no distinguishable change in the
exposure (value and momentum) or the exposure is reduced, as is the case for low volatility.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p7
 Figure 6: Comparison of Russell Factor Score correlations with Sustainalytics and Material
ESG Scores

0.35
0.25
Correlation

0.15
0.05
-0.05
-0.15
-0.25
-0.35

Growth Quality Size Growth Quality Size

Source: Russell Investments, Sustainalytics

Digging deeper into ways in which the scores change under the new methodology, Figure 8 shows
scatter plots with Material ESG scores on the x-axis versus Sustainalytics scores on the y-axis
(organized by sector). Where points fall on a diagonal 45-degree line, the two methodologies led to the
same scores. For illustrative purposes, we highlight some notable clusters of scores that do not fall on
the diagonal and hence where the two methodologies are in the most disagreement.
The highlighted cluster in consumer discretionary, for example, includes a group of automobile
manufacturers where our material ESG score is higher than the data provider’s score. This represents
an industry where SASB and Sustainalytics disagree on what criteria matter, an example we will dig
into deeper in the case study section of the paper.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p8
 Figure 7: Comparison of Russell Factor Score correlations with Sustainalytics and Material
ESG Scores
0.3
0.2
0.1
Correlation 0
-0.1
-0.2
-0.3

LowVol Momentum Value LowVol Momentum Value

Source: Russell Investments, Sustainalytics

Financials and real estate sectors

In the financials and real estate sectors, we see vertical clusters on Figure 8 where the material ESG
score is the same and the Sustainalytics score differs. These represent key differences – Sustainalytics
is differentiating between these companies and the material ESG score is not. This means that
Sustainalytics is differentiating between companies on sustainability issues deemed not material and
this is precisely the type of information that a Material ESG score looks to strip out from the signal. In
the case of insurance companies, the data provider considers discrimination, employee incidents and
financial inclusion as material to the industry.
While SASB includes these categories for other industries in the financial sector like lending, materiality
in the insurance industry instead focuses on the impact of the environment on assets and operations,
systemic risk management, lifecycle impacts of products and services, fair marketing and customer
welfare.
Carbon and Green House Gas (GHG) Emissions
In utilities, the traditional score considers carbon emissions equally material for electric and gas utilities.
Operations of electric utilities generate considerably higher carbon emissions relative to gas utilities –
approximately six times as much on average – and SASB chooses to focus instead on downstream
impacts of a gas utilities’ operations rather than their own carbon emissions (Scope 1)9.
In information technology, while both consider issues like data privacy and security, diversity and
inclusion, and development and retention material, Sustainalytics again includes GHG emissions and
disclosure whereas SASB focuses on resource management. These examples are consistent with the
trends we saw in general, including finding that the “traditional” ESG score considers GHG emissions
material to far more companies than our material scores.
Disclosures
We also observe that companies are heavily penalized in the traditional scores for failure to provide
disclosures, even in areas the new scores are considered immaterial. We explore these nuances
further in the sector case study that follows.
In each case, one could argue for the data provider’s approach of including more categories captures a
wider range of issues. While this is certainly true, the key objective of our work is to focus on the
sustainability issues that are considered most important to the firm’s business. We seek to avoid
including less material issues that can obscure changes in material characteristics thereby eroding the
descriptive value of the signal.

9
The Greenhouse Gas Protocol (GHG Protocol) defines Scope 1 as all direct emissions - emissions from sources that are owned or
controlled by the reporting entity.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance /p9
 Figure 8: Sector scatter plots of Sustainalytics vs Material ESG scores

Source: Russell Investments. Data as of June 30, 2017. Colors represent industries within sectors. To facilitate
comparison, all scores are z-scored. GIC refers to the sectors identified by Global Industry Classifications.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 10
 Chapter 3: To what extent do material ESG scores differ?
It is reasonable to ask to what extent does all this work really matter? Can we measure how much the
materiality scores differ from the existing generic framework?
There is a difference and the difference is large
In Figure 9 below, we report the number of material issues compared to the immaterial issues
constituting the “traditional” ESG score.
Where the blue line is above the orange line, there are more immaterial than material pieces of
information feeding into the score. Often there are far more. In other words, immateriality appears to
dominate the “traditional” ESG score. The grey line represents the percent of data items that are
material for a given security. The dotted red line represents a threshold for 25% of items being material.
For all securities under the red line, less than 25% of the issues considered in the “traditional” ESG
score were material.
The main takeaway here is that the ESG scores we currently use are composed of a very large number
of issues that are not material10. Specifically, for 66% of all securities in the RGI Global Large Cap
universe, less than 25% of the data items in the “traditional” ESG score were material.

Figure 9: Material vs Immaterial Issues in a “Traditional” ESG Score, RGI Global Large Cap
Universe
80% 80
70% 70
60% 60
% Issues 50% 50 Issue
Material Tally
40% 40
30% 30
20% 20
10% 10
0% 0
Securities
Percent of Issues that are material 25% Issues Material
Non-material Issues Material Issues
Source: Russell Investments. Data as of June 30, 2017.

Do these differences matter for investment performance?

Returns
The next natural question is – to what extent do these differences matter from a return standpoint? A
major limitation for drawing conclusions about the investment performance of the new scores is limited
data history that impedes testing over full market cycles. The underlying subcomponents used to build
the new scores are available from December 2011. That is considerably less history than we need to
draw robust conclusions about investment performance. For this reason, we stop short of advocating
adoption of the scores based on historical performance. As referenced above, our work closely follows
a methodology laid out in Khan, Serafeim, and Yoon (KSY) in 2016. Their study uses data with a longer
history: 1991 – 2013. Our findings can serve as a rough out-of-sample test of their work.
Khan, Serafeim, and Yoon (2016)
KSY (2016) use the historical MSCI KLD 400 Social Index (MSCI KLD) dataset that has a longer history
than other sustainability datasets. The MSCI KLD dataset’s historical coverage is limited to the US. It
assigns binary strength or concern flags to various sustainability issues including community
engagement, governance structure, workforce diversity, and water stress, among others. The authors
use these flags to build a material and immaterial score for each company. For their analysis, the

10
As defined by SASB (Sustainability Accounting Standards Board) Materiality Map. See Appendix 2.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 11
 authors focus on change in these scores rather than levels in an attempt to isolate the unexpected level
of sustainability outcomes. Changes in scores are regressed against changes in other firm
characteristics that may be correlated with ESG scores such as size and value, to further isolate the
sustainability signal. The residuals of the changes in both the material and immaterial scores that are
not explained by the other characteristics, are used to construct high and low Material and Immaterial
indexes based on quintiles. For example, a company with a (residual) material score in the top quintile
will be included in the High Material index. A company with a (residual) material score in the bottom
quintile will be included in the Low Material index.
Robust testing
Returns for the Material and Immaterial indexes are regressed on a Fama-French (Mkt-Rf, SMB, HML)11
plus momentum (UMD) factor model 12. The authors present various specifications and robustness
checks, but here we summarize their findings to the most relevant for our purposes: the difference in
alphas13 generated by high and low performance on material and immaterial issues as displayed in Figure
10.

Figure 10: Differences in the four-factor alphas of high and low portfolios formed on the
basis of material and immaterial Sustainability issues (Khan, Serafeim, and Yoon, 2016), US
Large Cap Universe, 1991 - 2013

Differences in four-factor alphas (High – Low Quintile Performance)

Material Sustainability Issues 4.98%**

Immaterial Sustainability Issues 0.71%

Source: Russell Investments. Alphas refer to portfolio returns regressed on 4-factor models including Mkt-Rf, SMB, HML,
and UMD. ***, **, * refer to significance at the 1%, 5%, and 10% levels respectively.

The positive sign on the spread between high and low alphas suggests firms in the top quintile of
sustainability characteristics outperformed low sustainability on both material and immaterial issues. With
an annualized difference in alphas of 4.98%, the spread was considerably larger for material sustainability
issues than immaterial issues at 0.71%.
To further differentiate between performance on material and immaterial issues, the indices are double
sorted into four buckets: firms that were high performers in both material and immaterial categories, high
in one category and low in the other, or low performers in both. The authors isolate the relative
performance of companies that had high investment in material issues and low investment in immaterial
issues, as represented by quadrant 1 in Figure 11 below.

11
The Fama-French Three Factor Model is an asset pricing model that expands on the capital asset pricing model (CAPM) by adding size (SMB)
and value (HML) factors to the market risk (Mkt-Rf) factor in CAPM. Source: Investopedia.com
12
Momentum (UMD) is an additional factor and, when added to the three factor Fama-French model, is referred to the four-factor alphas used in the
research.
13
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 can impact performance / p 12
 Figure 11: Mapping of performance of both material and immaterial categories. Double-
sorted alphas14 and differences in four-factor alphas (Khan, Serafeim, and Yoon, 2016), US
Large Cap Universe, 1991 – 2013
Four-factor alphas Annualized Difference in
(1991-2013) alpha alphas 3 4
Low Material High Material
High High
1 – High Material, 6.01% Immaterial Immaterial
Low Immaterial

2 – Low Material, -2.90% 8.90%***

Low Immaterial
2 1
3 – Low Material, 0.60% 5.41%*** Low Material High Material
High Immaterial Low Low
Immaterial Immaterial
4 – High Material, 1.96% 4.05%***
High Immaterial
Source: Russell Investments. Alphas refer to portfolio returns regressed on 4-factor models including Mkt-Rf, SMB, HML,
and UMD10,11. ***, **, * refer to significance at the 1%, 5%, and 10% levels respectively. Annualized alpha measures the
fund’s value added relative to a benchmark, smoothed over a stated period.

High performance on material issues led to higher alphas than low performance (quadrant 1 vs 2 and
quadrant 4 vs 3). Interestingly, after controlling for high performance in material issues, a portfolio of firms
scoring low on immaterial issues generated higher alpha than the portfolio of high performance on
immaterial issues. In other words, spending resources on immaterial issues appears to have been value
detracting. This further suggests that differentiating between material and immaterial issues matters from an
investment perspective.

14
Double-sorted alphas refers to the mapping of the material and immaterial categories as high/low material and high/low immaterial as is shown in
the four scenarios illustrated in Figure 11.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 13
 Chapter 4: Results for the material ESG score
Here we extend the scores’ analysis to the period December 2012 – June 2017 on a wider universe:
the Russell Global Indexes Large Cap Index. Following the same methodology as KSY (2016) we
report results for our sample in Figure 12 below.

Figure 12: Differences in the four-factor alphas of high and low portfolios formed on the
basis of material and immaterial Sustainability issues (RGI Global Large Cap, Dec 2012-
June 2017).
Differences in four-factor alphas (High – Low Quintile Performance)

Material Sustainability Issues 1.19%**

Immaterial Sustainability Issues 0.30%
Traditional ESG Score 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.

Material issues are the most promising signal

Consistent with KSY (2016), we find 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.
This suggests that we can improve conviction by focusing on material characteristics, consistent with
our goal of reducing noise and improving the information content of the signal. Again, these results
have already controlled for differences in known return contributors such as firm size, value, and
momentum. A higher spread and higher significance is supportive of the thesis that material
sustainability issues provide a more robust investment signal than immaterial issues or the “traditional”
ESG score.

Low performance on material issues is especially costly

Following the methodology of KSY (2016), we go one step further to isolate high performance on only
material issues. We consider the same four double-sorted buckets that capture firms that are high
performers in both categories, a high performer in one and low performer in the other or a low
performer in both. Our analysis is performed on the RGI Global Large Cap universe over the period
Dec 2012 – June 2017, results for which are presented in Figure 13 below.

Figure 13: Double-sorted alphas and differences in four-factor alphas (RGI Global Large
Cap, Dec 2012-June 2017)
Double-sorted buckets Annualized Difference in
alpha alphas

1 - High Material, Low Immaterial -1.18%

2 - Low Material, Low Immaterial -4.60% 1.22%*
3 - Low Material, High Immaterial -3.38% 2.20%*
4 - High Material, High Immaterial -0.95% -0.23%
Source: Russell Investments. Alphas refer to portfolio returns regressed on 4-factor models including Mkt-Rf, SMB, HML,
and UMD. ***, **, * refer to significance at the 1%, 5%, and 10% levels respectively.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 14
 The first thing we notice is that alphas for all buckets are negative. This is not entirely surprising given
we know the returns of any strategy are generally well explained by the standard factors that we’ve
controlled for here. 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. Specifically, for firms with low immaterial performance, a high material performer had a 1.22%
annualized improvement in alpha relative to a low material performer. For firms with high immaterial
performance, a high relative to low material performer had a 2.20% annualized performance
improvement in alpha.
High performance on immaterial issues has a small but positive impact on alpha
We do not replicate the Khan et al. finding that high performance on immaterial issues is costly
(quadrant 1 minus quadrant 4 is negative not positive) although the difference between these buckets is
not statistically significant. Moving from low performance to high performance on immaterial issues has
a small but positive impact on alpha of 0.23%.
On the one hand, we know from the results that material issues are still a better signal than immaterial
issues. We are also cautious to avoid drawing too many conclusions from quadrants 1 and 2 (high
performance in one category, low performance in the other) because these buckets tend to have very
few companies. As pointed out in the analysis sections above, performance on material and immaterial
issues is positively correlated. This means that there are more firms that are high performers on both
material and immaterial issues than there are firms that are high in one category and low in the other. In
fact, being a top quintile performer in one category and bottom in another is relatively rare: less than 20
names on average are represented in these off-diagonal buckets.
Should material ESG scores be treated as alpha signals?
While these findings are interesting, we do not necessarily have high conviction in their robustness and
would not advocate, at this stage, that material ESG scores should be treated as alpha signals.
Similarly, generating significant positive four-factor alphas is not necessarily the standard we would set
to evaluate these scores. Our goal here is to provide a framework that is consistent with previous
studies in order to leverage their longer history on results we found informative.
The robustness of our results is undermined by limited data history and an inability to replicate the
results across a sufficient number of dimensions: regions, portfolio construction techniques, cut-offs
and so on. However, we did gain valuable takeaways, most notably that material ESG performance
appears to be a better signal than standard or immaterial ESG performance and that low performance
on material issues is especially costly.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 15
 Material ESG Scores in action: Case Study – Tesla and Volkswagen AG
To provide a deeper understanding of how the material ESG scores works in practice, below we
present a case of how the inclusion of materiality impacts the ESG score for a comparison between
Tesla and Volkswagen.
Firstly, we identify the relevant mapping of SASB to Sustainalytics subcategories that reflects the five
categories identified as financially material.

Figure 14 SASB/Sustainalytics category mapping for the automotive industry15

SASB Issue Sustainalytics subcategories
Waste and E.1.3.2 E.3.1.16
hazardous Hazardous Hazardous
materials Waste Products
management Management
Labor relations S.1.1.1 S.1.5.1
Working Percentage of
Conditions Temporary
Policy Workers
Lifecycle E.3.1.1. E.3.1.2 Clean E3.1.3 Fleet E.3.1.4 Fleet E.3.1.6 Eco- S.2.2.4 Fair S.1.6.2.1
impacts of Sustainable Technology Emissions Efficiency Design Trade Health
products and Products & Revenue Products and Safety
services services
Management
Systems
Product quality E.3.2 Product S.3.3. E.3.1.16 E.3.1.7
and safety & service Customer Hazardous Product
incidents Incidents Products Stewardship
Programs
Materials S.2.1.3 Conflict S.2.1.3.1 E.2.2
sourcing Minerals Policy Conflict Environmental
Minerals Supply Chain
Programs incidents
Source: Russell Investments. The letters/numbers preceding the subcategory names above are reference numbers used by Sustainalytics for
categorizing the subcategories.

15
All Sustainalytics subcategories are weighted scores.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 16
 We then take the Sustainalytics scores for each of the subcategories.

Figure 15 Sustainalytics subcategory scores for the identified material ESG criteria
Tesla Volkswagen
Subcategory Subcategory
Sustainalytics Subcategory Description Score Score
S.1.1.1 Working Conditions Policy * *
S.1.5.1 Percentage of Temporary Workers * *
E.3.1.1 Sustainable Products & Services 3.20 1.25

E.3.1.15 Sustainable Financial Services * *

E.3.1.2 Clean Technology Revenues * *
E.3.1.3 Fleet Emissions 3.70 0.76

E.3.1.4 Fleet Efficiency 3.08 0.83

E.3.1.6 Eco-Design * *
S.1.6.2.1 Health and Safety Management System * *
S.2.2.4 Fair Trade Products * *
E.3.1.16 Hazardous Products * *

E.3.1.7 Product Stewardship Programmes * *

E.3.2 Product & Service Incidents 1.65 -2.09

S.3.3 Customer Incidents -0.83 -2.06

E.2.2 Environmental Supply Chain Incidents 0.66 0.66

S.2.1.3 Conflict Minerals Policy -0.02 1.48
S.2.1.3.1 Conflict Minerals Programs 1.35 -0.23

All subcategory scores are weighted. *no reporting available so default to industry standard
Source: Russell Investments analysis as of December 31, 2017.

The material issue score is then calculated based on the average subcategory score:

𝒏
𝟏
𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑰𝒔𝒔𝒖𝒆 𝑺𝒄𝒐𝒓𝒆 = ∑ 𝑺𝒖𝒃𝒄𝒂𝒕𝒆𝒈𝒐𝒓𝒚 𝑺𝒄𝒐𝒓𝒆𝒊
𝒏
𝒊∈𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑰𝒔𝒔𝒖𝒆

To calculate the final material ESG score. Given there are eight material sustainability issues for the
automotive industry, the material ESG score for companies in that industry will be the average of the
eight issue scores:
𝒎
𝟏
𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑬𝑺𝑮 𝑺𝒄𝒐𝒓𝒆 = ∑ 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑰𝒔𝒔𝒖𝒆 𝑺𝒄𝒐𝒓𝒆𝒋
𝒎
𝒋 ∈ 𝑰𝒏𝒅𝒖𝒔𝒕𝒓𝒚

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 17
 The material ESG score is then standardized and rescaled to range from 0 (worst) to 10 (best). The
table below shows the variation from the Material score to the “traditional” ESG score (measure out of
100).

Figure 16 Comparison of Tesla and Volkswagen AG scores using the material ESG score
vs the “traditional” ESG score
Tesla Volkswagen

Material ESG Score 10/10 3/10

“Traditional” ESG Score 55/100 61/100
Data as of December 31, 2017.

Score commentary
As a leader in vehicle efficiency and clean vehicle technology, Tesla scores well above average on the
issues of lifecycle impacts of products and services. Their lowest score was in the Material ESG
subcategories related to product quality and safety where they received relatively lower scores due to
consumer safety concerns surrounding self-driving functionality. The material ESG score differs
meaningfully from the traditional score in which Tesla is significantly penalized for weak reporting of its
own inhouse (corporate operations) carbon emissions. This is not identified as a material issue to the
company’s growth and hence does not impact the material ESG score.
When reviewing the material score for Volkswagen AG, the company’s past action in cheating on
vehicle emission testing leads to a well below average score on the issue relating to product quality
such as product and service incidents. Concerns still exist that the company will be unable to meet its
emission targets in the EU which would result in further legal risk to the company. Sustainalytics reports
and overall negative view on the company’s governance and ability to meet emissions standards but
continues to award high scores on (immaterial) issues like diversity, employee turnover and other
human capital issues. Thus, Volkswagen AG’s resulting traditional score is still higher than Tesla who
was penalized for weak reporting on their inhouse emissions.
The result
The material vs “traditional” ESG scores led to very different rankings. Whereas, the material ESG
score picked up that Tesla has a much stronger performance on the material issues of fleet emissions
and product quality and safety relative to Volkswagen, the traditional score awards a lower ESG score
to Tesla based on lower performance in issues that SASB did not consider material to the sustainability
of companies in the automotive industry.16

16
Any stock commentary is for illustrative purposes only and is not a recommendation to purchase or sell any security. The case study is provided
for discussion purposes only. Individual security results will vary based on individual circumstances and market events. There is no guarantee that
all firms will experience the same results.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 18
 Chapter 5: Coverage and robustness
As outlined in the score methodology chapter above, our approach involves applying substitution logic 17
to a material issue score when no data is available from Sustainalytics for that issue. It is not
uncommon in ESG data for substitution logic to be applied to achieve high coverage for an index.
However, we want to know what level of substitution logic we are relying on here. In the case of our
new material ESG scores, we report the index coverage and percent use of estimation (i.e. substitution
logic) for the RGI Global Large Cap index in the figure below.

Figure 17: Material ESG Scores: Percent of RGI Global Large Cap Index using substitution
logic

100%
90%
80%
93% of index has
70%
less than 50% of
60% SASB issues using 96% of index has
Cap Weight fill logic a Material ESG
50% 18% of index
of Index Score. 0.25%
40% using no fill
uses all fill logic
logic
30% (no SASB issues
scores)
20%
10%
0%
0% 10% 25% 50% 75% 99% 100%
% of Material SASB Issues Estimated
Cap weight of companies Cumulative Coverage

Source: Russell Investments. Data as of June 30, 2017.

Fill logic is utilized when there is no underlying data available for the company. Our Fill logic approach is to use industry
averages as data estimates.

Figure 14 presents several key findings:

• Coverage for the Material ESG scores for the RGI Global Large Cap universe is 96%.
• Very few companies have a Material ESG score based entirely on estimation (0.25% of the index).
• Most companies have substitution logic applied for at least one of the SASB issues that make up their
SASB ESG score (80% of the index).
• Roughly 60% of the index has substitution logic applied. At most, 25% of these are SASB issues. By
using a <50% substitution logic threshold, 93% of the index is covered.
By filling with averages, our substitution logic by design pushes companies with missing data closer to
the center of the distribution. The center of the distribution represents a lower conviction in a company’s
ESG signal on either the high or low side. In other words, we are less likely to tilt towards or away from
a company based on the ESG signal in the center of the distribution and by extension based on an
ESG signal that is predominantly estimated.
This fact, taken together with coverage rates that are at least in line with industry-standard ESG data
practices, suggest neither coverage nor reliance on substitution logic are reasons for not adopting the
methodology.

17
Substitution is a fundamental concept in logic. To apply a substitution to an expression means to consistently replace its variable, or
placeholder, symbols by other expressions. The resulting expression is called a substitution instance of the original expression.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 19
 Chapter 6: Conclusions
Industry bodies and Russell Investments aligned
Industry bodies such as the Task Force on Climate-related Financial Disclosures (TCFD) and the
United-Nations backed Principles for Responsible Investment (PRI) actively promote and recommend
that companies need to focus more on the material ESG issues that directly affect their bottom line.
With the help of SASB’s industry-level material map and data from Sustainalytics, we have been able to
do just that, and construct a new ESG score that focuses solely on material issues.

How do we build an ESG score that is tailor made for informing investment decisions?
“Traditional” ESG scores contain both financially material and immaterial issues. This is not surprising
given ESG scores are designed for a broad range of purposes. There are a multitude of reasons why
ESG criteria are considered by investors, many of which are non-financial. Our focus here on financial
criteria is not meant to imply that this is the only or most important dimension of ESG investing. Instead
our goal is narrower: how do we build an ESG score that is tailormade for informing investment
decisions?
We seek to pull out the information that is material to a firm’s performance and eliminate the
nonmaterial data feeding into the signal. This supports existing literature by constructing a new score,
examining the correlation with other known drivers of equity returns, analysing the commonality with
generic ESG scores, and providing a high-level return analysis over the available history.
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.

Ensuring robustness and risk management

We believe that the Russell Investments’ material ESG score represents a strong development in our
understanding of ESG performance drivers.
Today, the scores are being used and measured in our research databases to help us chart further
progress.
We are in the early stages of development and further research is required to integrate the Russell
Investments’ material ESG score throughout our investment process.

Further research
Our study uncovered several potential areas for further research. Here 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.

The material ESG score and returns

Our goal was to confirm whether we could improve the information content of a “traditional” 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 traditional 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 traditional score, even after adjusting for known factor exposures. Our results up to
this point are encouraging, and we remain confident.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 20
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Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 21
 Appendix 1: Literature on financial performance of ESG investing
are non-financial. Our focus for this literature study however is financial in that we surveyed the
evidence on ESG investment performance. This is not meant to imply that this is the only or most
important dimension of ESG investing. Rather our goal is to focus in on answering one specific
question: what is the link between ESG and investment performance? The literature addressing the
investment performance of ESG investing is extensive. The theoretical basis for arguing that ESG
detracts from performance is largely connected to screening. The argument starts by assuming that
investors maximize expected risk-adjusted returns. Absent an ESG constraint, investors will select an
optimal unconstrained portfolio, P*, that maximises the expected return for a given level of risk. Adding
an ESG constraint, such as constraining the portfolio to not hold any tobacco stocks for example,
means that the remaining portfolios are (weakly) inferior to P*. After all, not holding tobacco was always
an option in the unconstrained world and so P* is at least as good, if not better, as everything in a
constrained subset.
In contrast, theoretical justifications for why ESG incorporation is return-enhancing can be based on
market efficiency18. Relative to financial data, proponents argue that ESG data is less widely available
and comparative analysis of firms is challenged by a lack of standardized, comparable data. Whereas
the market is largely efficient with respect to financial data, proponents argue that market inefficiencies
may still exist for ESG information based on these limitations19. Other arguments linking ESG
incorporation to financial performance are based on lower costs of capital observed for high ESG
firms20 and firm investment in ESG issues as a signal for long-term orientation as opposed to short-
termism21. Both of these characteristics have been shown to in turn lead to higher financial
performance22.

Cleaner conclusions
When it comes to summarizing literature on the value of ESG investing, the key is to be specific about
what type of ESG investing we are talking about. When all of the different categories of ESG strategies
are taken together, the literature on financial performance of ESG is mixed. By clearly distinguishing
what category of ESG is being employed however, cleaner conclusions can be made.
ESG-related investing and the corresponding literature can be categorized into several groups:
Category Description Example
Values-based Screening securities involved in certain activities Weapons exclusion
screening based on a religious, moral or family view. list
(traditional SRI23)
ESG Integration Systematic and explicit inclusion of data related Portfolio composed of
to stewardship of the environment (E), workforce companies with high
and communities (S), and/or long-term ESG characteristics
shareholder interests (G) as one factor in an
investment process.
Impact Investing Targeted investment in companies, assets or Direct investment in
projects that meet specific “E” or “S” objectives, sustainable
typically implemented via private investment. agriculture project
Pure-play or Investment in specific themes such as renewable Renewable Energy
Sustainability energy, typically without broad market exposure. Index
themed investing

While a deep dive into the academic literature on impact investing and pure-play investing is outside
the scope of this paper, we focus on two of the categories: screening and ESG integration. We have
chosen to focus on these two because they have dominated both the literature and largest share of
ESG-related assets under management.

18
Hamilton and Jo (1993)
19
Borgers, Derwall, Koedijk and Horst (2013), Bebchuk, Cohen, and Wang (2010)
20
Cheng, Ioannis, and Serafeim (2017)
21
Benabou & Tirole (2009)
22
Lamont, Polk & Saa-Requejo (2001), Flammer & Pratime (2016)
23
SRI refers to social, responsible investing

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 22
 SRI screening
The first category to achieve widespread adoption was values-based SRI screening. This refers to
excluding a group of companies from the investable universe because they are involved in products
that the investor considers incongruous with their values. Common examples of SRI screens include
tobacco, weapons or alcohol manufacturers. While the investor may have views on whether the
excluded securities are going to add or detract from performance, financial performance is not the
primary objective of the strategy24.
Unlike other forms of ESG-related information, involvement in the commonly screened SRI industries
such as tobacco, alcohol or gambling is common knowledge, making it difficult to claim a market
inefficiency exists. While the theoretical argument against ESG investing still holds (constrained
universe is weakly inferior to the unconstrained universe), it is more difficult to see how the arguments
in favor of ESG investing outlined above (i.e. market inefficiencies, long-termism and low cost of
capital) apply to this category. This is echoed in investor surveys, which find that negative screening is
perceived by investors to be the most detrimental to performance25.
The academic research on SRI value-based screening is mixed with weak consensus on the side of
underperformance. Geczy, Stambaugh, Levin (2005) show that the SRI constraint is costly and that the
size of the impact depends on the investor’s investment philosophy. They find the constraint ranges
from costing a passive strategy a few basis points to a cost of 30 bps per month or more for investors
who invest in factor exposures or believe in persistence of fund manager skills. Kahn, Lekander and
Leimkuhler (1997) find negative returns from tobacco divesture and similarly, Hong and Kacperczyk
(2009) find that a portfolio that goes long sin stocks (alcohol, gambling, and tobacco) and short a group
of comparable stocks generates positive and significant returns over the period 1965-2006 even after
adjusting for a Fama-French plus momentum model. Renneboog, Horst, Zhang (2007) find SRI funds
exhibit benchmark-like performance in US and UK regions but underperformed in Europe and Asia. In
contrast, there are many other studies that suggest SRI screens have no impact on performance.
D’Antonio, Johnsen and Hutton (1997) review research on the financial performance of socially
screened equity portfolios finding that they performed as well as traditional investments over the period
1990-1996. Hamilton and Jo (1993) similarly found there was no statistically significant difference in
performance of SRI screened mutual funds established in 1985 or earlier versus conventional mutual
funds over the same period. It is also worth noting that research examining fund performance is subject
to uncontrolled differences in manager skill even though these studies are prevalent and contribute to
the formation of investor opinion and consensus on the topic of SRI performance.

ESG integration
ESG integration is a broader category than SRI screening. Specifically, it refers to explicit and
systematic inclusion of ESG data into the investment process. Unlike SRI, which is characterized by
implementation via exclusion lists, ESG integration is not characterized by one type of implementation.
Instead it may include identifying positive opportunities, using ESG data as part of financial analysis,
tilting towards companies with higher ESG characteristics or avoiding companies with weak
sustainability performance. The academic evidence on this topic is again mixed, but unlike SRI, the
consensus does not point to underperformance. In terms of investor perception, ESG integration is
cited as the most beneficial26, whereas survey evidence suggests negative screening is considered the
most detrimental to performance.
Busch and Bassen (2015) provide a meta-analysis of over 2000 empirical studies and show that
roughly 90% of the studies included in their paper show a non-negative relationship between ESG
criteria and corporate financial performance, with the majority reporting positive findings. Renneboog et
al (2008) argue that risk-adjusted returns of companies with good sustainability performance will only
be persistently higher than those of companies with poor sustainability when the financial market
doesn’t price this information efficiently. Derwal et al (2005) provide evidence to address this question,
building equity portfolios based on an eco-efficiency dataset and finding that high-ranked portfolios
significantly outperform low ranked portfolios over 1995-2003. Additionally, the outperformance they
observe cannot be explained by other characteristics commonly linked to performance such as factors.

24
Amel-Zadeh and Serafeim (2017)
25
Amel-Zadeh and Serafeim (2017)
26
Amel-Zadeh and Serafeim (2017)

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 23
 Cheng, Ioannou, and Serafeim (2017) show that firms with voluntary integration of social and
environmental concerns in their companies’ operations and interaction with stakeholders faced
significantly lower capital constraints over the period 2002 to 2009. Their study leverages connections
between capital constraints and subsequent stock price outperformance from authors such as Lamont,
Polk and Saa-Requejo (2001).
The recent Khan, Serafeim and Yoon (KSY) study in 2016 suggests that a potential cause of
differences in financial performance of ESG investing is a lack of differentiating between companies
investing in sustainability issues that are material to a company’s business versus issues that are
nonmaterial. Their results show that firms with strong performance on material sustainability topics
outperform firms with poor performance on material topics, consistent with a view that material
investments are shareholder value-enhancing. They also show that firm performance on immaterial
issues does not lead to higher performance, which taken together suggests financial performance of an
ESG strategy may depend on the materiality of the underlying ESG signals.
This study has many important implications for our research here. 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.
To summarize, ESG investing is a broad category that covers many different investment styles and
implementations. The literature on the topic is extensive and meta-studies are available that aggregate
this body of work. A shortcoming that we see in the existing literature is that findings are aggregated
regardless of the approach used without distinguishing between the many different objectives and
implementations. Here we have separated findings into the distinct categories of ESG investing. In
general, this is part of a broader effort to be more explicit about what we mean when we say ESG. This
is useful not only in addressing investor expectations about ESG27 but also in drawing cleaner
conclusions from the literature. We also have found in the literature several promising areas for future
research. One of these is the recent work on materiality by KSY (2016) and this paper focuses on
building out our understanding of that topic.

27
As we can see from investor surveys, perceptions about ESG investing vary considerably by the ESG approach adopted.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 24
 Appendix 2: SASB Materiality Map Sample

Source: http://materiality.sasb.org. Above samples as of December 31, 2017. The SASB mapping is subject to change over time on the basis of SASB review of industry analysis.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 25
 Appendix 3: Why SASB?
In this paper, we leverage the standard setting work by SASB to identify materiality by
industry. SASB is not the only organization engaged in building a sustainability reporting
framework and a quick word is warranted on why our study leverages SASB work rather
than another framework such as the Global Reporting Initiative (GRI) or Integrated
Reporting (IR). For our study, the most relevant frameworks were SASB and GRI which
both develop sustainable reporting standards with a focus on materiality. Our intention is
not to make a judgement on the relative superiority of one reporting framework over the
other. One consideration was practical: The Materiality Map produced by SASB allows us
to translate insights on materiality to every company in our universe in a systematic way.
To our knowledge, a comparable industry-level mapping is not readily available from GRI.
Again, this is not necessarily a shortcoming of the framework, but for our purposes made
SASB a more practical choice. The second consideration was methodological: each
framework adopts its own definition of materiality and the SASB definition was modestly
better aligned with our purpose.
SASB: Adopts the U.S. Supreme Court definition of information that presents “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.”
GRI: Information that “may reasonably be considered important for reflecting the
organization’s economic, environmental and social impacts, or influencing the
decisions of stakeholders.”
Our goal was to build an ESG signal for investment decision making. SASB’s focus on
shareholder materiality is most aligned with this purpose. This is not to say that the GRI
definition which serves all stakeholders, not just shareholders, is less valid, and indeed in
many other uses may be more appropriate. SASB and GRI themselves highlight the
distinction in a recent jointly authored op-ed (Mohin & Rogers, 2017):
“Established in 1997, GRI developed the first corporate sustainability reporting
framework. Today, GRI’s standards are used by the majority of companies reporting
sustainability information. The standards are designed to provide information to a wide
variety of global stakeholders ranging from civil society to investors. Consequently, the
GRI standards include a very broad scope of disclosure. Typically, companies use them
to develop and design their sustainability or corporate responsibility reports…
Investors have their own unique needs, different from those of suppliers, customers,
communities, interest groups and other stakeholders. They demand reliable and
comparable sustainability information with clear links to financial performance. Focused
on this need, SASB standards identify the subset of sustainability issues that are
reasonably likely to be material to investors. In order to preserve a focus on financial
materiality as well as to attain comparability among peers, SASB standards are industry
specific.
As you can see, GRI and SASB are intended to meet the unique needs of different
audiences. The GRI standards are designed to provide information to a wide variety of
stakeholders and consequently, include a very broad array of topics. SASB’s are
designed to provide information to investors and consequently, focus on the subset of
sustainability issues that are financially material.”
Hence the rationale for using SASB materiality as the starting point for this study is
summarised by this alignment in purpose and the practically of the Materiality Map.

Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 26
 Appendix 4: SASB to Sustainalytics Mapping
The below table is an extract of the mapping undertaken by our research demonstrating how each of the 145 Sustainalytics subcategories have been mapped to the 30 issues
identified by SASB framework as financially material.

SASB Issue Sustainalytics Subcategories

Environment
GHG emissions E.1.9 Carbon Intensity-Weighted Score E.1.10 Carbon Intensity Trend-Weighted Score
Air quality E.1.3.3 Air Emissions Programmes-Weighted Score E.1.7.2 HCFCs Phase Out-Weighted Score
Energy management E.3.1.17 Energy Mix-Weighted Score E.1.11 Renewable Energy Use-Weighted Score E.3.1.14 Share of Green Buildings-Weighted Score E.3.1.13 Green Buildings Investments-Weighted Score
Fuel management E.1.2.4 Oil Spill Disclosure & Performance-Weighted Score
Water and wastewater management E.1.3.4 Water Management Programmes-Weighted Score E.1.2.7 Water Intensity-Weighted Score E.1.2 Environmental Management System-Weighted Score
Waste and hazardous materials management E.1.3.2 Hazardous Waste Management-Weighted Score E.3.1.16 Hazardous Products-Weighted Score
Biodiversity impacts E.1.2.1 Biodiversity Programmes-Weighted Score E.1.2.8 Forest Certifications-Weighted Score E.2.1.3 Sustainable Agriculture Programmes-Weighted Score E.2.1.4 Sustainable Aquaculture Programmes-Weighted Score
Social Capital
Human rights and community relations S.4.2.2 Community Involvement Programmes-Weighted Score S.4.2.1 Human Rights Policy-Weighted Score S.4.2.11 Community Development Programmes-Weighted Score S.4.3 Society & Community Incidents-Weighted Score
Access and affordability S.4.2.6 Equitable Pricing and Availability-Weighted Score S.4.2.3 Financial Inclusion-Weighted Score S.4.2.4 Access to Medicine Programme-Weighted Score S.4.2.12 Digital Divide Programmes-Weighted Score
Customer welfare S.3.3 Customer Incidents-Weighted Score S.3.1.11 Customer Eco-Efficiency Programmes-Weighted Score G.1.4.6 Clinical Trial Standards-Weighted Score S.4.2.10 Access to Basic Services-Weighted Score
Data security and customer privacy S.3.1.3 Data Privacy Policy-Weighted Score
Fair disclosure and labeling S.3.1.9 Product Health Statement-Weighted Score S.1.6.4 Health & Safety Certifications-Weighted Score S.3.1.2 Advertising Ethics Policy-Weighted Score S.3.1.12 Drug Promotion Standards-Weighted Score
Fair marketing and advertising S.3.1.2 Advertising Ethics Policy-Weighted Score S.3.1.12 Drug Promotion Standards-Weighted Score S.3.1.1 Responsible Marketing Policy-Weighted Score
Human Capital
Labor relations S.1.1.1 Working Conditions Policy-Weighted Score S.1.5.1 Percentage of Temporary Workers-Weighted Score
Fair labor practices S.1.4 Collective Bargaining Agreements-Weighted Score S.1.1 Freedom of Association Policy-Weighted Score
Employee health, safety and wellbeing S.1.6.4 Health & Safety Certifications-Weighted Score S.1.7 Employee Incidents-Weighted Score S.1.6.6 Employee Fatalities-Weighted Score
Diversity and inclusion S.1.3 Diversity Programmes-Weighted Score S.1.2 Discrimination Policy-Weighted Score G.2.7 Gender Diversity of Board-Weighted Score
Compensation and benefits G.2.12 Compensation Committee Independence-Weighted Score G.2.3 Board Remuneration Disclosure-Weighted Score
Recruitment, development and retention S.1.5 Employee Turnover Rate-Weighted Score S.1.6.1 Employee Training-Weighted Score
Business Model and Innovation
Lifecycle impacts of products and services E.3.1.1 Sustainable Products & Services-Weighted Score E.3.1.2 Clean Technology Revenues-Weighted Score E.3.1.3 Fleet Emissions-Weighted Score E.3.1.4 Fleet Efficiency-Weighted Score
Environmental, social impacts on assets & operations E.1.2.3 Sustainability Impact Assessments-Weighted Score E.2.1 Green Procurement Policy-Weighted Score
Product packaging E.2.1.7 Recycled Material Use-Weighted Score
Product quality and safety E.3.2 Product & Service Incidents-Weighted Score S.3.3 Customer Incidents-Weighted Score E.3.1.7 Product Stewardship Programmes-Weighted Score E.3.1.16 Hazardous Products-Weighted Score
Leadership and Governance
Systemic risk management
Accident and safety management S.1.6.2.1 Health and Safety Management System-Weighted Score E.1.2.4 Oil Spill Disclosure & Performance-Weighted Score E.1.4 Environmental Fines & Penalties-Weighted Score E.1.12 Operations Incidents-Weighted Score
Business ethics and transparency of payments G.1.5 Business Ethics Incidents-Weighted Score G.1.1 Bribery & Corruption Policy-Weighted Score G.1.1.1 Bribery & Corruption Programmes-Weighted Score G.1.2 Whistleblower Programmes-Weighted Score
Competitive behavior
Regulatory capture and political influence G.2.10 Audit Committee Independence-Weighted Score G.2.11 Non-Audit to Audit Fee Ratio-Weighted Score G.3.1 Political Involvement Policy-Weighted Score G.3.2 Lobbying and Political Expenses-Weighted Score
Materials sourcing S.2.1 Scope of Social Supplier Standards-Weighted Score S.2.1.1 Quality of Social Supplier Standards-Weighted Score S.2.1.3 Conflict Minerals Policy-Weighted Score S.2.1.3.1 Conflict Minerals Programmes-Weighted Score
Supply chain management E.2.2 Environmental Supply Chain Incidents-Weighted Score S.2.2.2.1 Supply Chain Management-Weighted Score S.2.2 Supply Chain Monitoring-Weighted Score S.2.2.1 Supply Chain Audits-Weighted Score

Source: Russell Investments, SASB, Sustainalytics. As of July 30, 2017

Russell Investments // Targeting the ESG issues that impact performance / p 27

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First used: March 2018. Revised: June 2018 AI-26649-06-21

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Russell Investments // Materiality matters: Targeting the ESG issues that can impact performance / p 28