In the materiality multiverse madness: a call for policies that can really make a difference

I was humbled and honoured when Paul Clements-Hunt asked me to contribute to Riding the Dragon: The Future of the ESG Law Firm. You can read my contribution in this LinkedIn Article - and download the full report here.

In the materiality multiverse madness: a call for policies that can really make a difference

It is a truth universally acknowledged, that every policy maker working on the standardisation of ESG or sustainability information must provide a definition of materiality. This trend flourished over the recent years, originating a materiality multiverse rich in labels - single, double, financial, impact, context, sesqui. These - most of the time - conceptually intriguing and elegant proposals typically share a common limitation: they fall short of providing applicable practical and operational guidance. In other words, they leave decision makers on their own when it comes to gathering and assessing evidence to make sound and credible materiality judgements.

Not by chance, the words that Simon Zadek and Mira Merme wrote 20 years ago in their Redefining Materiality (2003) - the first public paper addressing materiality in the sustainability contextstill hold true: “Materiality is being redefined - through pressure on business from wider civil society, and through precedents established by company practice and, increasingly, regulation and litigation. But current experimentation in redefining materiality suffers from being ad hoc, often confused and confusing, and rarely credible. As a result, companies too often disclose information that is not used, incurring unnecessary costs without satisfying intended audiences.”?

This gap should be considered as a top priority for the legal ecosystem aiming at bringing clarity in the ESG Wild West. There are at least 2 key arguments in support of this.

The first argument regards ensuring the usability and comparability of the outcome of materiality assessments. Without clear boundaries and procedures on how materiality assessment should be conducted even agreeing on a shared definition of materiality would prove ineffective, as variations in the outcomes of the materiality assessment would be due to its operationalisation and determination process rather than reflecting the organisation’s own positioning, strategy, impacts, and dependencies.

Relevant academic literature explored this challenge, highlighting how even within the application of the same standard (GRI), the outcomes of two materiality assessments are de facto non-comparable due to significant divergences in the methodology and determination process.

The second argument, instead, concerns the nature and ultimate purpose of materiality assessments. The development of effective operational guidance on the application of the materiality definition should start from taking stock that transplanting materiality from the auditing and accounting domain to the sustainability field has substantially altered its characteristics and purpose.

A ‘traditional’ accounting materiality statement reads like this one: "Generally speaking, economic events are recognized and presented based on their relative importance or materiality. In the case of the financial statements for 2010, materiality was determined on the basis of 5% of consolidated EBITDA."

In accounting and auditing, materiality is the principle that guarantees disclosures free from significant misstatements and omissions, and it can be determined through a rather straightforward numerical test (e.g. more than x% of consolidated EBITDA), just like in the above example.?

In the ESG and sustainability domain materiality still holds its original purpose of ensuring disclosures free of misstatements and omissions, and in addition it is assigned further objectives related to corporate strategy, governance mechanisms and structure, risk management, and even budgeting.

For example, in the Exposure Draft of the European Sustainability Reporting Standards proposed by EFRAG and published in April 2022, paragraph 70 of ESRS 2 General, strategy, governance and materiality assessment disclosure requirements indicates that:

“Once identified, material sustainability impacts, risks and opportunities are considered by the undertaking to deploy prevention, mitigation, adaptation and other management measures. This may imply strategic decisions, governance consideration, the establishment of policies, targets, action plans and allocation of resources as well as the use of metrics to monitor the evolution of impacts, risks and opportunities over time. All of the above addressed by other ESRS disclosure requirements.”

This broader purpose of materiality assessments in the context of sustainability is not a recent shift in the concept, it has been indeed a part of the redefinition of materiality in the context of corporate sustainability since it was first proposed. Zadek and Merme, back in 2003, proposed that materiality assessment should be embedded within an appropriate corporate governance framework, including:

1. “An explicit process through which the tests are applied, which ensures that the required information is identified, assessed and made available to the Board.
2. A Board that collectively has the necessary competencies to be able to make sound decisions on the basis of the information provided.
3. An external assurance of the entire process that is inde- pendent, delivered by providers with adequate competencies, and based on standards designed specifically to handle the range and complexity of non-financial as well as financial, and qualitative as well as quantitative, information.”

Materiality and materiality assessments in accounting were never designed to achieve such a broad range of strategic, governance, and risk management goals - again, it is exclusively about ensuring that financial disclosures are free of significant misstatements and omissions.

Hence, policy makers working on materiality in sustainability should bear in mind that they’re dealing with a substantially different object than materiality in accounting. This is a key reason why simply providing a new definition of materiality is not sufficient - if materiality is attributed additional purposes related to strategy, governance, and risk management, proper workable guidance of how the materiality determination process can achieve these goals should be provided.

A good starting point could be to identify what elements of the materiality assessment process can be standardised. Those could be, for example:

1. Standardisation in the typology of evidence that can be used to demonstrate the materiality of a sustainability issue in materiality tests. The table below, extracted from the think Tank Organismo Italiano Business Reporting OIBR’s recent guidelines on Operationalising Materiality gives an example of how the standardisation of the typology of evidence might be structured.

2. Standardisation in the governance of the materiality determination process, with step-by-step guidance describing the different phases of the analysis and the various organisational bodies and levels that should be involved;

3. Standardisation in the disclosure of the outcomes and of the process itself, so auditors, market authorities, and other interested stakeholders can easily find information on what issues an organisation identified as material and how it came to such conclusions.

While 2 and 3 have been addressed more extensively by policies and voluntary frameworks and standards so far, an important policy gap still exists on the standardisation of the typology of evidence and related materiality test. Not by chance, the EFRAG Sustainability Reporting Board asks the following crucial question in the EFRAG SRB 15 August 2022 Agenda Paper 05.01 “Approach to materiality assessment in ESRS”.

At page 12, paragraph 37 (b) the document asks:

“Is the quantitative element of materiality assessment equally important in impact and financial materiality? For example, some consider that disclosure about workforce is to be provided irrespective of materiality consideration (e.g. if an undertaking has only 15 employees the disclosure about gender gap would be equally important than for an undertaking with 15.000 employees; having only one child exposed to child labor in the value chain out of thousands of workers involved would be material). Other consider that materiality should be assessed per each DRs and for some of them undertaking shall be able to conclude that the info is not material.”

It is clear from this interrogative that the number of employees is not the correct test to determine the materiality of workforce disclosures. The real unasked and unaddressed question here is: “what is a good materiality test for workforce disclosures? What kind of evidence should be used to demonstrate materiality of this matter or lack thereof?”

Until the standardisation of materiality evidence and test is not addressed by policy makers, practitioners, auditors, and market authorities will be left with an unbridgeable gap between the conceptual definition of materiality and its operationalisation.?

A second vital element policy makers should consider is the role of data and technology. A recent report prepared by the EFRAG Task Force on reporting on sustainability-related risks and opportunities and their linkage to business models analyses the role that technology and data play in ensuring good quality disclosures. See figure below:

This analysis illustrates how different technological solutions can enable the qualitative characteristics of good disclosures. As it emerges from the visualization, some technologies have broader applications than others, a finding that can be helpful in informing implementation and investment decisions for report preparers.

More importantly, it is clear that technology should be considered holistically in the entire disclosure journey, from preparation to consumption.

The landmark US SEC proposal on Climate-related financial disclosures also recognises the crucial role of technology:

“We recognize that determining the likely future impacts on a registrant’s business may be difficult for some registrants. Commenters have noted that the science of climate modelling has progressed in recent years and enabled the development of various software tools and that climate consulting firms are available to assist registrants in making this determination.”

To provide a more concrete example of how technology and data can help identify those companies that have a credible plan to deliver on stated Net Zero or other ESG goals, consider this case based on Datamaran’s analysis of disclosures. Datamaran is a SaaS solution used by the C-suite to determine current and emerging material ESG risks and opportunities in a data-driven and credible way leveraging AI.?

This is a climate-related disclosure identified by Datamaran in the sustainability report of a large pharmaceutical company:

[Company X] has long acknowledged the significant risks posed by climate change, including potential adverse impacts on human health, frequency of severe weather events impacting personnel and operations, and the potential disruption of value chains critical to providing medicines and vaccines to patients.

If the US implements a federal carbon pricing scheme aligned with World Bank recommendations, the cost to Company X could range from approximately $28 million to $73 million annually by 2030 based on current scope 1 and 2 emissions.

Climate change presents risks to our operations and those of our suppliers, including the potential for property damage, business interruption, and/or loss of stored product as a result of more frequent and severe weather events and water availability challenges. The potential loss that could reasonably be expected is challenging to quantify and predict given the number of variables but could range from $20 million to $400 million based on facility and product values.

The same company, includes the following disclosure in their 10-K filing:

Climate change presents risks to our operations, including the potential for additional regulatory requirements and associated costs, the potential for more frequent and severe weather events, and water availability challenges that may impact our facilities and those of our suppliers.?

Based on our reviews, we do not believe these potential risks are material to our operations at this time.

Inconsistencies like this one are a sign of potential greenwashing, and can lead to liability risks for the organisation as the US SEC itself clarified (sample letter from US SEC). Technology is key to identify those and other inconsistencies that can poke holes in the credibility of a company’s stated commitments and goals.

As stakeholder pressure, financial market interest, and regulatory scrutiny mount, there are other likely liabilities and exposures for companies that do not have credible or actionable plans in place to address the evolving materiality considerations associated with broad ESG. The key drivers are:

• Increased legal and compliance risks and associated costs;
• Reduced and less favorable options to access capital and funding;
• Losing touch with the demands and expectations of the next generation of consumers, talents, and decision makers;
• Failing to recognise that best practices that once drove competitive advantage are now quickly becoming hygienic essentials as regulation and policy are raising the bar at an accelerating pace.

Stakeholders have been asking for long enough for reliable, material, consistent, timely, and comparable information on sustainability matters. These requests are now top of the policy agenda, and that is going to profoundly change sustainability accounting. Will those changes bring a more sustainable society? The question will remain most likely open as we try to address the broader sustainable development challenge - at the very least a more transparent and comprehensive information ecosystem will be established, which hopefully will inspire more responsible and sustainable decision making.