11th Biennial IFC Conference on “Post-pandemic landscape for central bank statistics”

BIS Basel, 25-26 August 2022

Materiality of ESG factors in financial markets and financial statistics1

Patrick Slovik 2 and Farah Azman

1
This presentation was prepared for the conference. The views expressed are those of the authors and do not necessarily reflect the views of the BIS, the IFC or the central banks and other
institutions represented at the event.
2
Lead author

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Materiality of ESG Factors in Financial Markets and Financial
Statistics

Patrick Slovik and Farah Azman

Abstract

The study assesses the materiality of Environmental, Social and Governance (ESG) factors in financial
markets and financial statistics. The stocks of and flows in ESG financial assets have reached a
systemically-relevant share in the overall financial system. The study explores the implications of
materiality for ESG financial statistics while acknowledging that data gaps need to be addressed
amid considerable uncertainty. It outlines the necessity to differentiate between single-materiality
and double-materiality approaches and defines the concept of financial uncertainty in contrast to
financial risk and its implications for materiality.

Keywords: Climate-related financial risks; Double materiality; Environmental, social and governance
factors; ESG; Materiality; Sustainability; Sustainable finance; Uncertainty

JEL Classification: G11, G14, G21, M14, Q56

1
ESG Factors in Financial Markets

Sustainable finance evolved rapidly, both in terms of asset size and diversity of financial products.
Sustainable finance became increasingly linked with Environmental, Social and Governance
(ESG) criteria. The stocks of and flows in ESG financial assets reached a systemically-relevant share
across key markets and asset classes. Financial markets and institutions have a critical
financial intermediation role in sustainable finance.

ESG Factors in Debt Securities Markets

The market for sustainable-finance debt securities expanded at a fast pace during the last five years.
ESG debt securities issued during 2021 alone amounted to more than USD 1 trillion. The market
share of sustainable-finance debt securities in the overall global bond market increased to 11%. In
Europe, ESG bonds comprised 20% of all debt securities issued in the region in 2021, representing
a fourfold increase from a 5% share in 2017.

Global ESG Bonds Graph 1

Sources: S&P CIQ; Authors’ calculations.

Notwithstanding Europe's dominant position in sustainable finance, ESG debt securities issuance
recorded strong growth across all other key global regions. Sustainable-finance debt securities
issued in 2021 by European counterparties represented 55% of global ESG debt securities issued,
followed by the Asia-Pacific region with a 22% share, the North American region with a 15% share,
while the remaining regions collectively accounted for 8%.

Types of ESG Financial Instruments

ESG financial instruments evolved into several key types, reflecting the growing diversity of
sustainable-finance products. While the categories originally derive from the principles developed
for sustainable-finance bond markets (ICMA, 2020, 2021a, 2021b, 2021c), such categorisation can

2
also be applied to a broader set of sustainable finance products, with environmentally beneficial or
socially beneficial uses of proceeds.

Types of ESG Financial Instruments Table 1

Financial instruments where the proceeds are used

Green Financial Instruments
to fund environmentally beneficial projects.1

Financial instruments where the proceeds are used

Social Financial Instruments
to fund socially beneficial projects.2

Financial instruments to fund both environmentally

Sustainability Financial Instruments
and socially beneficial projects.

Financial instruments linked to the issuer achieving

Sustainability-Linked Financial Instruments
predefined sustainability targets.

Sources: Authors’ review based on ICMA (2020, 2021a, 2021b, 2021c).

Among ESG debt securities, green bonds had the largest market share of 56% in 2021. Social bonds
surged to 23% during the pandemic due to an increase in projects with socially beneficial use of
proceeds (Moody’s, 2021). Sustainability bonds, which combine characteristics of green and social
bonds, also gained market share, representing 15%. Sustainability-linked bonds, with returns linked
to achievements of predefined ESG targets, had a 6% market share.

Global ESG Bonds Breakdown in 2021 Graph 2

Sources: S&P CIQ; Authors’ calculations.

1
Environmentally beneficial uses of proceeds cover areas such as renewable energy, energy efficiency, green buildings,
pollution prevention, climate-change mitigation, biodiversity, clean transportation, or water management.
2
Socially beneficial uses of proceeds cover areas such as basic infrastructure, essential services, employment generation,
affordable housing, food security and sustainability, socioeconomic development, or inequality reduction.

3
ESG Factors in Mutual Funds and Exchange-Traded Funds

Sustainable-finance funds represent mutual funds and exchange-traded funds that integrated ESG
criteria into their investment strategies and portfolio selection processes (although the ESG
investment methodologies may vary among funds). Assets under management of global
sustainable-finance funds increased to over USD 2.7 trillion in 2021, representing about 7% of the
total global mutual fund and exchange-traded fund industry (Morningstar, 2022).

ESG Mutual Funds and Exchange-Traded Funds (ETFs) Graph 3

* Rest of the World category comprised funds domiciled in Asia, Japan, Australia, New Zealand, and Canada.
Sources: Morningstar; Authors’ calculations.

Europe has also been at the forefront of the ESG mutual fund and exchange-traded fund market.
Based on assets under management, more than 82% of such funds were domiciled in Europe,
followed by the United States at 13%, and the rest of the world at 5%. The number of ESG mutual
funds and exchange-traded funds expanded to close to 6,000 in 2021, a fourfold increase in the
total number of sustainable-finance funds during the last five years.

ESG Factors in Equity Markets and Investment Principles

Concerning ESG factors in equity markets, publicly listed companies have increasingly considered
ESG criteria, as reflected in their sustainability reports and disclosures. Out of the 500 largest listed
companies in the United States, represented in the S&P 500, more than 90% issued sustainability
reports or disclosures (G&A Institute, 2021). Thus, the considerations for ESG factors among listed
companies could also be viewed as systemically relevant.

The Principles for Responsible Investment, supported by the United Nations, with close to 4000
signatories, are a further illustration of the integration of ESG criteria into the investment process
and financial markets. The signatories of the principles committed to incorporating ESG issues into
investment analysis and decision-making. The assets under management of the signatories of the
principles amounted to over USD 100 trillion (PRI, 2021).

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Materiality of ESG Factors in Financial Institutions

The materiality of ESG factors arises from two distinct approaches. The first approach to materiality
reflects the impact of ESG factors on the entities' financial performance and risk profile. The second
approach to materiality reflects the impact of the entities' business activities on the environment
and stakeholders. These two approaches were utilised in various ESG-related frameworks with
varying terminologies. Double materiality refers to the blend of both approaches.

Different Terminologies of Materiality of ESG Factors Table 2

Impact of ESG Factors on Entity Impact of Entity on ESG Factors

Financial Materiality Non-Financial Materiality

Business Materiality Stakeholder Materiality

Outside-in Materiality Inside-out Materiality

Impact on Business Impact on Stakeholders

Impact on Entity Impact on Environment and Society

Double Materiality

Sources: Authors’ review based on ESG frameworks and sustainability reports.

Impact of ESG Factors on Financial Institutions

Outside-in materiality refers to the impact of external environmental and social factors on financial
institutions. The materiality approach is also referred to as financial materiality as it relates to the
impact on entities' financial performance and business value. Financially material ESG factors could
have implications for investors, regulators, and shareholders concerned with financial institutions'
performance, soundness, and enterprise valuation.

Impact of Financial Institutions on ESG Factors

Inside-out materiality refers to entities' impact through their business activities on sustainable
development goals. It is also referred to as environmental and social materiality, as financial
institutions' business affects environmental and socioeconomic factors. As business activities
impact wider stakeholders, such as the environment, employees, customers, and communities, this
approach is also known as stakeholder materiality.

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Materiality of ESG Factors in Financial Statistics

Developing sustainable finance statistics requires distinguishing between the two approaches to
materiality. The duality of the materiality of ESG factors necessitates separate sets of methodologies
also for statistical purposes. The first set focuses on the impact of sustainability factors on financial
institutions (outside-in materiality). The second set focuses on the impact of financial institutions
on sustainability factors (inside-out materiality).

Measuring Sustainability Factors of Financial Exposures

The first set of statistical methods ascribes to measuring, modelling, or pricing sustainability risks
of the financial institutions' exposures. It broadly relates to financial materiality and requires
measuring and disclosing material information to assess the risk profile, financial performance, and
valuation of financial institutions. Such approaches require granular and forward-looking statistics
and assessments on the sustainability of financial institutions' exposures. 3

Measuring Sustainability Factors of Business Transition

The second set of statistical approaches relates to the transition of business models of financial
institutions towards sustainability. It broadly relates to stakeholder materiality and requires
measuring and disclosing information relevant to a wider group of stakeholders on the external
impact of business activities of financial institutions. Such approaches require measuring the
transition of financial institutions and financial systems towards sustainability.

Materiality of ESG Factors in Financial Ratings

The dichotomy of materiality was also evident in the approaches of rating agencies. Credit ratings
integrate material implications of ESG factors on the likelihood of default of borrowers on their
financial obligations in given time horizons.4 Creditworthiness materiality is thus similar to financial
materiality. In contrast, ESG ratings reflect wider spectrums of ESG factors addressing the impacts
on broader groups of stakeholders, i.e. the environment and society.5

3
Along these lines, the International Conference on Statistics for Sustainable Finance identified pressing data gaps in the
lack of granular firm-level data and the absence of forward-looking data on future sustainability paths of firm-level
counterparties (IFC, 2022).
4
For instance, S&P Global Ratings reported 550 credit rating actions driven primarily by ESG factors during 2021 (S&P,
2022a). In addition to integrating ESG factors in credit ratings, S&P Global Ratings also conducts separate ESG evaluations.
Most credit and ESG rating agencies practice the duality of approaches to materiality.
5
The dichotomy of materiality, when not properly recognised, may result in identifications of improper causal hypotheses
in research studies. Such as testing causal relationships between inside-out ESG factors (particularly present in ESG ratings)
and entities' financial performance (impacted particularly by outside-in ESG factors).

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Uncertainty of ESG Factors

The manner in which environmental risks translate into financial risks over time remains an area of
significant uncertainty (EBA, 2022). Subject to considerable uncertainty, climate-related financial
risks cannot be accurately measured (Chenet et al., 2019). While there is high confidence in the
severity of climate-related hazards, how they will interact with future socioeconomic developments
that determine the scale of exposures and vulnerabilities remains uncertain (OECD, 2021).

Financial Risk and Financial Uncertainty

Financial risk relates to stochastic positive or negative outcomes with determinable likelihoods
(Knight, 1921). In contrast, financial uncertainty corresponds to outcomes with indeterminate
probabilities (Knight, 1921; Keynes, 1937; Lawson, 1985). While financial risks are determinable
based on available information, knowledge, and experience, financial uncertainty occurs due to a
lack of adequate information, knowledge, and experience at the time (Slovik, 2010).

Financial Risk and Financial Uncertainty Table 3

Financial Risk Financial Uncertainty

Potential for adverse outcomes with Potential for adverse outcomes with
determinate likelihoods of occurrence. indeterminate likelihoods of occurrence.

Determinate due to available information, Indeterminate due to unavailable information,

knowledge, and experience at the time. knowledge, and experience at the time.

Predictable through conventional risk Not predictable through conventional risk

management approaches. management approaches.

Sources: Author's review based on Knight (1921), Keynes (1937), Lawson (1985), and Slovik (2010).

Financial Uncertainty and Materiality

Financial risk and financial uncertainty represent two distinct concepts with different implications
for the decision-making of financial institutions and financial authorities. In decision-making under
risk, potential stochastic positive or negative outcomes and their probabilities are determinable. In
decision-making under uncertainty, these probabilities are indeterminable with adequate precision,
which often occurs due to structural shifts and a lack of historical precedence.

In view of climate-related financial uncertainty, conventional risk management approaches and

estimation techniques might not be sufficient to determine the financial implications of climate-
related hazards with satisfactory precision. As a result, reliance on financial materiality (outside-in
materiality) alone might not be sufficient. In view of financial uncertainty, a double-materiality
approach offers preferred policy options in lieu of a single-materiality approach.

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Reference:
BaFin. (2020). Guidance Notice on Dealing with Sustainability Risks. The Federal Financial Supervisory
Authority.

BCBS. (2022). Principles for the effective management and supervision of climate-related financial
risks. Bank for International Settlements.

Chenet, H., Ryan-Collins, J., & van Lerven, F. (2019). Climate-related financial policy in a world of
radical uncertainty: Towards a precautionary approach. UCL Institute for Innovation and Public
Purpose, Working Paper Series No. 13, 2019.

Christophers, B. (2017). Climate change and financial instability: Risk disclosure and the problematics
of neoliberal governance. Annals of the American Association of Geographers, Volume 107, Issue 5,
2017.

Davidson, P. (1991). Is probability theory relevant for uncertainty? A post Keynesian perspective.
Journal of Economic Perspectives, Volume 5, No. 1, 1991.

EBA. (2022). The role of environmental risks in the prudential framework. Discussion Paper,
EBA/DP/2022/02. European Banking Authority.

EC. (2019). Guidelines on non-financial reporting: Supplement on reporting climate-related

information (2019/C 209/01). European Commission.

Fehr. M, Schlitzer. C, & Triebskorn (2022). The Bundesbank Sustainable Finance Data Hub. IFC
Bulletin, Volume 56, 2022. Bank of International Settlements.

Freiberg, D., Roger, J., & Serafeim, G. (2019). How ESG Issue Become Financially Material to
Corporations and Their Investors. Harvard Business School Working Paper, No. 20-056, 2019.

FSB. (2021). FSB Roadmap for Addressing Climate-Related Financial Risk. Financial Stability Board.

Grisey, L. (2022). The NGFS Progress Report on Bridging Data Gaps and Beyond. IFC Bulletin, Volume
56, 2022. Bank of International Settlements.

GRI. (2021). GRI Standards 1: Foundation. Global Reporting Initiative.

GRI & SASB. (2021). A Practical Guide to Sustainability Reporting Using GRI and SASB Standard.
Global Reporting Initiative and Sustainability Accounting Standards Board.

G&A Institute. (2021). Sustainability Reporting in Focus. Governance & Accountability Institute.

Hache, F., & Spash, C. L. (2021). Nature, life & relations – optimised. Green Finance Observatory,
Policy Report, No. 04 2021.

ICMA. (2020). Sustainability-Linked Bond Principles: Voluntary Process Guidelines. International

Capital Market Association.

ICMA. (2021a). Green Bond Principles: Voluntary Process Guidelines for Issuing Green Bonds.
International Capital Market Association.

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ICMA. (2021b). Social Bond Principles: Voluntary Process Guidelines for Issuing Social Bonds.
International Capital Market Association.

ICMA. (2021c). Sustainability Bond Guidelines. International Capital Market Association.

IFC. (2022). Proceedings of the International Conference on Statistics for Sustainable Finance. IFC
Bulletin, Volume 56, 2022. Bank of International Settlements.

IFRS. (2020). Consultation Paper on Sustainability Reporting. International Financial Reporting

Standards Foundation.

IIF. (2022). Climate and Capital: Views from the Institute of International Finance. Institute of
International Finance.

Keynes, J. M. (1937). The General Theory of Employment. The Quarterly Journal of Economics,
Volume 51, Issue 2, 1937.

Knight, F. H. (1921). Risk, Uncertainty and Profit. Houghton Mifflin Company.

Lawson, T. (1988). Probability and uncertainty in economic analysis. Journal of Post Keynesian
Economics, Volume 11, Issue 1, 1988.
Lawson, T. (1985). Uncertainty and Economic Analysis. The Economic Journal, Volume 95, Issue 380,
1985.

Morningstar (2022). Global Sustainable Fund Report Q2 2022. Morningstar Direct.

Moody’s. (2022). Sustainable bonds to hit record $1.35 trillion in 2022. ESG Solutions. Moody’s.

NGFS. (2022). Progress report on bridging data gaps. Technical Document. Network for Greening the
Financial System.

OECD. (2021). Managing Climate Risks, Facing up to Losses and Damages. OECD Publishing.

PRI. (2022). PRI Signatory Update. PRI Association.

Sabbah, G. (2022). Statistical data needs on sustainable finance for central banks. IFC Bulletin, Volume
56, 2022. Bank of International Settlements.

Schmieder C., Artman M., Quang P., Esham E., Izzati N., Seyhun O., Kling L., Nefzi D., Peronaci R.,
Schlitzer C., Tissot B., Triebskon E., & Yang H. (2022). Progress, challenges and recent innovations in
sustainable finance statistics. IFC Bulletin, Volume 56, 2022. Bank of International Settlements.

Slovik, P. (2010). Market uncertainty and market instability. IFC Bulletin, Volume 34, 2010. Bank of
International Settlements.

S&P. (2022a). ESG in Credit Ratings Newsletter. S&P Global Ratings.

S&P. (2022b). Materiality Mapping: Providing insights into the relative materiality of ESG factors. ESG
Research. S&P Global Ratings.

UN. (1992). Rio Declaration on Environment and Development. United Nations Conference on
Environment and Development. United Nations General Assembly.

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11th Biennial IFC Conference on Post-Pandemic Landscape for Central Bank Statistics

Materiality of ESG Factors in Financial Markets

and Financial Statistics

Patrick Slovik and Farah Azman

Abstract
The study assesses the materiality of Environmental, Social and Governance (ESG) factors in
financial markets and financial statistics. The stocks of and flows in ESG financial assets have
reached a systemically-relevant share in the overall financial system. The study explores the
implications of materiality for ESG financial statistics while acknowledging that data gaps need to
be addressed amid considerable uncertainty. It outlines the necessity to differentiate between
single-materiality and double-materiality approaches and defines the concept of financial
uncertainty in contrast to financial risk and its implications for materiality.

1
ESG Factors in Financial Markets: Debt Securities Market

■ Sustainable finance evolved rapidly in terms of asset size and diversity of financial products. ESG financial
assets reached a systemically-relevant share across most key markets and asset classes.
■ ESG debt securities issued during 2021 alone amounted to more than USD 1 trillion. The market share of
sustainable-finance debt securities in the overall global bond market increased to 11%.

Global ESG Bonds

Annual Global ESG Bond Issuance Market Share of ESG Bonds

USD billion Per cent

1,200 12%

1,000 10%

800 8%

600 6%
400 4%
200 2%
0 0%
2017 2018 2019 2020 2021 2017 2018 2019 2020 2021

Sources: S&P CIQ; Authors' calculations.

2
ESG Factors in Financial Markets: Types of Financial Instruments

■ ESG financial instruments evolved into several key categories, reflecting the growing diversity of
sustainable-finance instruments.
■ Green bonds had a market share of 56%, followed by social bonds at 23%, sustainability bonds at 15%, and
sustainability-linked bonds at 6%.

Global ESG Bonds Breakdown in 2021

ESG Bond Types ESG Bond Issuers

Per cent Per cent

6% 11%

15%
15%
37%

23% 56%
16%

21%

Green Bonds Social Bonds Non-Financial Corporates Government Agencies

Sustainability Bonds Sustainability-Linked Bonds International Organisations Financial Institutions
Governments

Sources: S&P CIQ; Authors' calculations.

3
ESG Factors in Financial Markets: Mutual Funds and Exchange-Traded Funds

■ Sustainable-finance funds represent mutual funds and exchange-traded funds that integrated ESG criteria
into their investment strategies and portfolio selection processes.
■ Assets under management of global sustainable-finance funds increased to over USD 2.7 trillion,
representing about 7% of the total global mutual funds and ETFs.

ESG Mutual Funds and Exchange-Traded Funds (ETFs)

Global ESG Mutual Funds and ETFs Regional Distribution of ESG Mutual Funds and ETFs

USD billion Per cent

5%
3,000
13%

2,000

1,000

82%
0
2017 2018 2019 2020 2021
Europe United States Rest of the World*

*Rest of the World category comprised funds domiciled in Asia, Japan, Australia, New Zealand, and Canada
Sources: Morningstar; Authors' calculations.

4
 ESG Factors in Financial Markets: Equity Markets and Investment Principles

ESG Factors in Equity Markets

■ Publicly listed companies have increasingly considered ESG criteria, as reflected in their sustainability
reports and disclosures.
■ Out of the 500 largest listed companies in the United States, represented in the S&P 500, more than 90%
issued sustainability reports.

ESG Factors in Investment Principles

■ The signatories of the Principles for Responsible Investment committed to incorporating ESG issues into
investment analyses and decision-making.
■ Assets under management of the signatories amounted to over USD 100 trillion, a further illustration of
the ESG integration into financial markets.

5
Materiality of ESG Factors

■ Materiality of ESG factors arises from two divergent approaches. The first approach to materiality reflects
the impact of ESG factors on the entities' financial performance and risk profile.
■ The second approach to materiality reflects the external impact of the entities' business activities on the
ESG factors. The blend of both approaches is referred to as double materiality.

Different Terminologies of Materiality of ESG Factors

Impact of ESG Factors on Entity Impact of Entity on ESG Factors

Financial Materiality Non-Financial Materiality

Business Materiality Stakeholder Materiality

Outside-in Materiality Inside-out Materiality

Impact on Business Impact on Stakeholders

Impact on Entity Impact on Environment and Society

Double Materiality

Sources: Authors' review based on ESG frameworks and sustainability reports.

6
 Materiality of ESG Factors in Financial Statistics

■ The duality of materiality of ESG factors necessitates separate sets of methodologies for developing
sustainable-finance statistics, differentiating between single materiality and double materiality.

Measuring Sustainability Factors of Financial Exposures

■ The first approach focuses on the impact of sustainability factors on financial institutions (outside-in
approach), requiring data to evaluate financial risks and performance of financial institutions.

Measuring Sustainability Factors of Business Transition

■ The second approach focuses on the impact of financial institutions on sustainability factors (inside-out
approach), requiring data on sustainability transformation and impact of financial institutions.

Materiality of ESG Factors in Financial Ratings

■ The dichotomy of materiality was also evident in the approaches of rating agencies. Credit ratings reflect
material ESG factors on the default likelihood. ESG ratings reflect wider materiality spectrums.

7
Uncertainty of ESG Factors

■ Estimating financial implications of sustainability vulnerabilities remains subject to considerable uncertainty.

As a result, reliance on financial materiality alone might not be sufficient.
■ In view of considerable financial uncertainty of sustainability vulnerabilities, a double-materiality approach
might offer preferred policy options in lieu of a single-materiality approach.

Financial Risk and Financial Uncertainty

Financial Risk Financial Uncertainty

Potential for adverse outcomes with a determinate Potential for adverse outcomes with indeterminate
likelihoods of occurrence. likelihoods of occurrence.

Determinate due to available information, Indeterminate due to unavailable information,

knowledge, and experience at the time. knowledge, and experience at the time.

Predictable through conventional risk Not predictable through conventional risk

management approaches. management approaches.

Sources: Authors' review based on Knight (1921), Keynes (1937), Lawson (1985), and Slovik (2010).