Credit analysis: materiality assessment. When conducting our credit analysis, it is essential that we focus our efforts on the most material, environmental, social, and governance risks for the company. A materiality assessment helps us to do this, and it normally follows as assessments of impacts at a high level. Measuring them consistently, however, is more complex and usually requires a framework that is supplemental to the traditional accounting standards and reporting model. One of the most widely used frameworks is the Materiality Map produced by the Sustainability Accounting Standards Board, or SASB. This identifies the most material, environmental, social, and governance risks for each industry and sector. However, any materiality map or framework is just a starting point in our analysis. Analysts should try to determine the impact of these environmental, social, and governance risks on a company's business model and its value drivers, such as the impact on operating revenues, capital expenditure, profit margins, and risk appetite. These are all factors that are taken into consideration when undertaking any credit analysis. These are, however, just some of the many variables they need to consider. Let's look a little more closely at examples of how this may work in practice. As examples of revenues impact, a company may design a more environmentally friendly product leading to higher demand from the market and higher revenues, or a company may find that the production method for one of the components of its products is concerning to customers, for example, because they use inputs that are harmful to local biodiversity; this could cause a drop in demand and a drop in revenues. As an example of capital expenditure impact, a distribution company is expanding its fleet of trucks where the existing fleet uses diesel. The law is changing over the next five years to discourage polluting vehicles and the company therefore considers investing in electric vehicles. The price, however, is high compared to the diesel option so the company's capex may have to increase or its fleet ambitions scale back. Higher capex could reach financial covenants in the loan agreement that it has with its bank. Or alternatively, future revenue growth could be slower as a result of having a smaller fleet. As an example of profit margin impacts, a toy manufacturer is sourcing material and labor from a developing country. It is a socially responsible company, so it decides to pay higher-than-average amounts to have its products manufactured locally in addition to using measures that enhance the quality of life for its workers; production costs are higher and profit margins are lower than they would otherwise have been. Or a failure to meet minimum wage or other social obligations in the supply chain may have negative reputational impact leading to lower sales and profits in the long run. The examples described here are what is known as transmission mechanisms. This is where ESG risk drivers affect the economic and financial metrics, and if sufficiently material, impact the business's bottom line. In material circumstances, the company may suffer a loss and see its credit risk rise as a result.
