Pharma's ESG Equation: Materiality and Strategy are Key

Molly Podolefsky, PhD, Managing Director of Environmental, Social, and Governance, Stern Investor Relations

The greatest challenge pharmaceutical and biotechnology leaders face in launching environmental, social, and governance (ESG) programs is deciding where to focus. Pharmaceutical executives make tough decisions with value at risk every day. So, what makes ESG different? While the newness of the focus on ESG, political polarization, and regulatory uncertainty add complexity, the biggest barrier remains the sheer number of choices executives face in launching a program. The emergence of global reporting frameworks has narrowed the focus some, but even leading frameworks, such as the Sustainable Accounting Standards Board and Global Reporting Initiative, often disagree on the set of issues relevant to a given industry or type of company.

From supply chain traceability to data privacy, executives must select a handful of issues out of dozens to address in an ESG program. Each issue, in turn, can be described through a variety of key performance indicators (KPIs) and metrics, each of which might be tracked and reported or monitored but not disclosed. Beyond reporting, there are countless actions companies might take to improve sustainability performance over time. The dimensionality of ESG keeps many companies from taking the first step, but kicking ESG down the road is not a winning strategy in the face of increasing market and regulatory pressure.

The next questions become: how can companies get unstuck, and where to begin? Thankfully, over the past five years, the sustainability reporting industry has begun to coalesce around best practices that solve most, if not all, of these problems. The answer to the choice problem lies in identifying issues that pose material risks and opportunities to a company and developing a strategy to address those issues efficiently and effectively.

Many are tempted to move straight into information gathering and reporting without having laid the foundation for a credible ESG program. The result is a set of disparate actions and disclosures that lack focus and purpose, waste valuable time and energy, and leave the company vulnerable to accusations of greenwashing.

Two foundational practices—materiality and strategy—enable executives to escape the inertia of too many choices to launch robust, successful ESG programs. They are the building blocks of a successful ESG program. With these in place, executives can confidently approach the ESG choice problem to maximize value creation through ESG.

Materiality

Reporting without materiality is like setting out on a trip without knowing the destination. Companies that collect data and report on issues without determining materiality waste valuable time and resources pursuing issues that are misaligned with business objectives (meanwhile, higher priority risks and opportunities go unaddressed).

Before we dive into what materiality means for ESG, it is helpful to consider the term’s origins. In a legal sense, material facts are those that have a “legitimate and effective influence or bearing on the outcome of a case.”¹ From a financial accounting perspective, since the 1940s, the Securities and Exchange Commission (SEC) has defined material information as “matters as to which an average prudent investor ought reasonably to be informed before purchasing the security registered.”²

It is widely agreed that ESG materiality should encompass the set of issues associated with risks and opportunities that could significantly impact a company’s long-term success and viability. Whether ESG materiality should extend to significant outward impacts the company has on society and the environment, referred to as “double materiality,” is debated. Public dialogue and divisions within the SEC on its forthcoming rulemaking on climate and carbon emissions disclosure by public companies highlight this tension.^3,4 Many argue that small emitters should not have to measure and disclose Scope 3 emissions, which pose no material risk from a business perspective.

Executives do not have to take a position on double materiality to conduct an impactful materiality assessment of their business. Through a materiality assessment, companies gain a holistic understanding of the sustainability issues they face, eliminating blind spots and mitigating sources of bias. A comprehensive business-oriented materiality assessment leverages the perspectives of a wide array of internal and external stakeholders to identify and prioritize sustainability issues likely to significantly impact the company’s long-term success. In most cases, if the company has significant negative environmental or social impacts, its actions pose risks to its success, which will be identified through a full business-oriented materiality assessment.

As an example, for pharma companies with energy-intensive commercial drug production processes, investor input to a business-oriented ESG materiality assessment will identify emissions as a material issue. This is because more stringent regulations, a carbon tax, or other elements of the transition to a low-carbon economy could lower risk-adjusted returns to investors. Similarly, human rights and research ethics will be identified as material issues for companies conducting clinical trials in developing countries, because failure to manage these risks exposes the companies to legal liability, regulatory action, and reputational damage. Companies may choose to manage and report on issues outside the scope of materiality, referring to these issues as “relevant” but not material. Indeed, as companies get larger, their ESG programs often mature to address a wider range of material and relevant sustainability issues.

Materiality addresses the problem of too many ESG issues by identifying a tractable set of material issues a company should address and providing a strong, credible business case for managing them. Executives armed with a rigorous ESG materiality assessment can defend their ESG programs from a business perspective while relieving pressure from investors and the market to become more sustainable.

Materiality also provides executives with a credible, research-based basis for defending their decision not to address sustainability issues that are not material to their companies.

Strategy

With a credible set of material ESG issues in hand, pharma executives must decide which aspects to address, what actions they will take and when, and which targets and metrics they will disclose to the public at different points on their ESG journey. Returning to the travel metaphor, after identifying a set of material issues as the destination, companies still need a strategy to get there efficiently while creating value along the way.

Each organization will approach sustainability differently, but an effective strategy should be grounded in a company’s mission and values, guided by its principles, in support of its vision, and in harmony with business objectives.

For example, a company’s mission reflects its sense of purpose and contribution to the greater good, while vision captures its aspiration toward an ideal future state. A pharma organization's mission might be to cure ovarian cancer, and its vision is a future where effective and affordable ovarian cancer treatments are available to all women.

Best practice suggests every company should articulate the set of principles it will follow in shaping its ESG program. Principles often relate to a organization’s business model and help define the balance between a public company’s mission to do good and its responsibility to maximize profit for shareholders. Principles help a company ensure its ESG program is authentic, providing a rubric to use in judging whether new key performance indicators, metrics, actions, and disclosures are aligned with its mission and values and whether they will support its vision in alignment with business objectives.

The following illustrative set of ESG principles* reveals how these principles serve as tools to help executives narrow the choice problem:

• Our company will only undertake ESG initiatives and actions associated with demonstrated risks and opportunities facing our business.
• We will apply an environmental justice lens to our decision-making process when deciding on new ESG policies, programs, and initiatives to undertake.
• While prioritizing cost-effective solutions, we will undertake all reasonable actions needed to attain net zero by 2028.
• As a global pharma company, all our ESG KPIs, and metrics will be applied, tracked, reported, and disclosed uniformly, enterprise-wide, regardless of country or region.
• In every ESG decision-making process, we will prioritize options that create the most ancillary social and environmental benefits.
• We value transparency and trust above all else and will apply a more-is-better approach to disclosure. Withholding information only when doing so would jeopardize critical business advantages or privileged information.
• We aim neither to be an ESG leader nor a laggard within our industry and will generally undertake disclosures and actions the majority of our peers have adopted.
• Though environmental issues are not material to our business, we will track and disclose metrics and take actions to address environmental issues in harmony with our core value to do no harm.

Once pharma executives have defined their values, mission, vision, principles, and alignment with business objectives, they should capture these elements in a succinct strategy statement that can be shared externally to help define and control the company’s ESG narrative.

Leveraging an ESG strategy statement as a guide and assessing the company’s level of ambition, pharma executives must create the final element of ESG strategy—a roadmap charting the company’s path toward improved sustainability across a three- to five-year planning horizon. The process of arranging actions, programs, policies, and disclosures to be undertaken across several years helps companies assess whether their plans are realistic or in need of calibration to match the reality of funding and resource constraints. In accordance with best practices, a company’s board of directors and executive leadership team should review and approve its ESG strategy and roadmap according to a formal, agreed-upon process.

Where materiality shrinks our initial ESG choice problem to a tractable set of material issues, strategy reduces the dimensionality of how we manage, track, and report on those issues. Pharma leaders equipped with research-based, board-approved ESG strategies and roadmaps position themselves for long-term success. Materiality and strategy help executives ensure their efforts to satisfy public and regulatory sustainability demands serve their broader business goals and responsibilities as corporate leaders.

Optimal outcome

Materiality and strategy transform a thorny choice problem into something disarmingly simple. A research-based approach to materiality zeroes in on the set of material ESG issues tied to value creation for a company. A strategy helps narrow the set of actions available to address these issues, measure progress, and disclose transparently.

Combined, materiality and strategy prepare ESG executives to promote and defend a company’s approach to ESG, avoiding the pitfalls of greenwashing through a research-based methodology, and reducing the dimensionality of ESG to arrive at an optimal, business-aligned outcome benefitting society and the planet.

References

1. MATERIAL Definition & Legal Meaning. The Law Dictionary. https://thelawdictionary.org/material/
2. Corporate Governance Update: “Materiality” in America and Abroad.” Harvard Law School Forum on Corporate Governance. May 1, 2021. https://corpgov.law.harvard.edu/2021/05/01/corporate-governance-update-materiality-in-america-and-abroad/
3. Hupart, J. H.; Gates, M.; Weld, W. F.; et al. What Public Comments on the SEC’s Proposed Climate-Related Rules Reveal—and the Impact They May Have on the Proposed Rules.” Mintz. July 20, 2022. https://www.mintz.com/insights-center/viewpoints/2301/2022-07-20-what-public-comments-secs-proposed-climate-related-rules
4. Peirce, H. M. We Are Not the Securities and Environment Commission - At Least Not Yet. U.S. Securities and Exchange Commission. March 21, 2022. https://www.sec.gov/news/statement/peirce-climate-disclosure-20220321

*The set of ESG principles represents the wide variety of principles companies may employ to guide program development. Several of these illustrative principles conflict with one another and are not meant to be taken as the set of principles guiding any single company’s ESG approach.

Molly Podolefsky, PhD, is the managing director of environmental, social, and governance for Stern Investor Relations.