To better manage risks and create forward-looking reports, ESG data must be materialized.
By Dinah A. Koehler, Deloitte Services LP and Eric Hespenheide, retired partner, Deloitte & Touche LLP
Part of the Business Trends series
In a series of blog posts over the past few months we have explored themes from The Responsible Enterprise, a chapter from Deloitte’s 2013 Business Trends. Prior posts have explored the increasing strategic importance of ESG (environmental, social, governance) issues and have examined the drivers fueling this trend.
In this fourth and final post we explore the issue of materiality.
Why Materiality Matters
Numerous external forces are converging to create increased awareness of ESG factors. These forces are challenging CFOs to reconsider a traditional reporting model that may not effectively meet today’s information needs. Today, 60 percent of CFOs at large global enterprises – with average annual revenue of at least $17 billion – believe that sustainability challenges will change financial reporting and auditing.
Of the 250 largest companies in the world (G250 companies), 95 percent now issue separate sustainability reports. Moving forward, it is likely there will be greater alignment of traditional financial reporting and reporting on ESG topics. The International Initiative for Integrated Reporting (IIRC) is proposing integrating the disclosure of standard financial information with ESG information to provide a more complete view of the commercial, social and environmental context within which a company operates.
Importantly, integrated reporting will likely require reporters to make valuation impacts of ESG information more explicit. In the context of how the “total mix” of information can influence an investor or others’ decisions, companies need to expand their view of how financial and non-financial information can be reported—which can be overwhelming.
Right now, there is often a disconnect between what ESG information companies disclose to their stakeholders and the data that actually drives management and investment decisions. Some think companies disclose too much information while others complain about too little information. Most agree that it is hard to know which information is business-critical for the long run.
For these reasons, there is increasing focus in the sustainability world on the principle of materiality as the essential filter for determining which ESG information will be useful to key decision makers. The Global Reporting Initiative (GRI) has placed materiality at the center of ESG reporting in its most recent G4 sustainability reporting guidelines.
A Crucial Challenge – Defining Materiality
Many corporate leaders, including sustainability managers, are focused on the concept of materiality beyond the traditional and well-understood financial statement materiality concept. These leaders recognize that the traditional interpretation of financial statement materiality does not adequately capture non-financial business drivers. GRI guidance encourages companies to consider what is material to stakeholders, but the guidance does not provide enough information on what that could mean for a company. Is it a visit to the emergency room because a child has an asthma attack precipitated by air pollution? Is it five such visits in a week, because the family lives next to a facility, which emits particulate matter that causes chronic infection of the lung? Is it fires in a Bangladesh clothing factory? Is it rainforest destruction? How many acres? And in what timeframe?
For many companies the problem is not a lack of ESG issues that stakeholders think are important. The challenge has been figuring out when and why these issues might become financially material to a company. This is particularly difficult for ESG issues because they are often related to externalities and are not properly priced in the marketplace. Thus, without a clear price signal, figuring out materiality is a more subjective rather than objective endeavor especially if you are only looking at it from a traditional financial statement standpoint. The costs of the externalities to others in the community, the supply chain, and in the broader ecosystem are real and can be quantified via health economics and environmental economics. This is knowledge that needs to be more integrated into corporate decision-making on the trade-off between total (social and environmental) costs and benefits of every product and technology being used and produced. Omission of this type of information means that it has zero value to the company.
The definition of materiality is not as big a hurdle as often stated in sustainability circles. According to SEC's SAB 99, reporters are directed to consider quantitative and qualitative factors – see Table 1. In short, materiality determination is not limited to financial (quantitative) information. If you read the definition carefully, you note that a matter is material if there is a substantial likelihood that the information will impact decisions of a reasonable person.
In other words, materiality is not 100 percent certain, even though it is often treated as such in quarterly reports. We know, based on voluminous academic work, that ESG issues can influence economic outcomes and economic decisions. The problem is that in most cases managers have a hard time assessing the likelihood of a material ESG event (e.g., accident, boycott, strike). Many managers assume it will not happen to their company, because they are managing to price, cost and traditional financials, and not to risks.
Table 1: Definitions of materiality
A matter is “material” if there is a substantial likelihood that a reasonable person …relying upon the report would have been changed or influenced by the inclusion or correction of the item … financial management and the auditor must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality.
Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic that information must have if it is to be useful.
IAASB Framework for the Preparation & Presentation of Financial Statements, paragraph 30.
Two Key Challenges to ESG Materiality
There are two primary challenges inherent to ESG issues:
- Casting a net wide enough outside of traditional financial performance metrics to include non-financial issues, such as ESG risks and opportunities. GRI provides over 400 metrics that might be relevant to the company and stakeholders and ultimately deemed financial material. That is a reasonably wide net.
- Establishing a robust filter that yields a smaller subset of issues that really matter to the company in a consistent way and ensuring that issues are not omitted just because they will or may occur in the future.
The second challenge – developing a credible and robust materiality filter is where more work needs to be done. Companies can tackle this by searching for key performance indicators that apply to their industry sector. The Sustainable Accounting Standards Board (SASB) is in the process of developing sector-specific materiality filters—initially on a voluntary basis. As another example, congressional fiat has made reporting on conflict minerals mandatory. Unfortunately a standardized, generally accepted short-list of ESG key performance indicators is missing.
The other way is to do the analysis required to assess the likelihood that an ESG issue can impact corporate strategy and create or destroy a firm’s value by impacting cash flows in a given time period. Is there a particular event that could occur in the near and medium term that can change a company’s valuation? Do stakeholders inside or outside the company play a role in precipitating or averting an ESG event? Does it matter how stakeholders perceive a company’s approach to an ESG issue, particularly one of great concern and high impact? We believe it does.
Deloitte has outlined a process for ESG materiality determination that is grounded in decision sciences. The keystone of the approach is a multi-stakeholder process that brings sustainability managers together with the CFO, controller and other stakeholders to discuss how the company builds value (today and in the future). As a result of the process, the information that is ultimately disclosed to shareholders and other stakeholders is more likely to be:
- Aligned with the business’s strategic objectives,
- Understood as part of the value proposition for various investment projects,
- Incorporated into the assessment of how various projects are evaluated, and
- Effectively communicated with a direct linkage to the business’s strategic objectives.
In short, this approach helps make ESG information more decision-relevant inside the company and positions the company to better manage its risks. Equally important, it focuses on helping companies identify and ultimately disclose forward looking information on those ESG and other non-financial issues (e.g., R&D or talent) that are most likely to impact a company’s value. Precisely the type of information investors need and are asking for.