"Materiality: a day late and a dollar short", Andras Ferencz summarises Dr. Todd Cort and Professor Rodney Irwin’s visit to Lancaster University Management School on 17th March 2017.
When a company is assessing its future liabilities, or an investor is deliberating a crucial decision, risk assessment takes center stage. But evaluating risks, i.e. defining what is material, isn’t a clean-cut matter. How do you tell whether climate change is more important for a company than a child labor issue that had been detected in its supply chain? And how do you quantify these issues?
One way businesses try to address these matters is through their mandatory financial reporting, and through their sustainability disclosures. Reports are described by Investopedia as “[publications] that public corporations must provide to shareholders to describe their operations and financial conditions,” while disclosures are defined as an integral part of financial reports containing additional information.
Mandatory reporting came about as a response to the stock market crash of 1929. In 1934, five years after the Black Tuesday, the Securities and Exchange Commission (SEC) was formed with the mission “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” In the same vein, following the recent mortgage crisis, new efforts surfaced to put more stringent protocols in place regarding not only mandatory reporting, but additional sustainability disclosures as well. A recent case in point is The Task Force on Climate-related Financial Disclosures (TCFD), an organization spearheaded by Michael Bloomberg to create guidelines for better sustainability reporting. TFCD states that “The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values.” In other words, when things fall through in the economy, the development of better financial risk assessment and reporting protocols becomes inevitable.
But like exercise and a healthy diet, reporting is not only laborious, but there is no one right way to do it. Reporting requirements are set in place by the SEC in the U.S., and the Transparency Directive in the EU. And while these regulations and regulators tell companies what to do, there isn’t one clear guideline on how to do it. Accountants are intimately familiar with various financial reporting frameworks, but when it comes to sustainability, or the ESG (Environmental, Social and Governance) disclosure frameworks (e.g. GRI, IR, SASB), things get a bit fuzzy. That is because defining what risks are important to a company and to its stakeholders, and finding a standardized reporting framework that works across borders and industries, are impossibly complicated undertakings.
How you decide what is material, and how you define materiality, vary depending on who you talk to. For example, the SASB framework uses the U.S. supreme court’s definition of materiality, but the GRI framework and the IR framework both use different terminologies. This is problematic, as it can shift responsibilities away from companies at a time when environmentally and socially conscious production needs to become the norm. In other words, rather than allowing companies to pass the hot seat, a standardized and accurate sustainability reporting framework needs to be established so that companies would be urged to accurately and truthfully assess their potential risks.
To illustrate the complexities of sustainability reporting, Lancaster University Management School and The Pentland Centre for Sustainability in Business recently hosted a workshop titled Materiality: Stakeholder to Business. The workshop featured Dr. Todd Cort, faculty member at the Yale School of Management and Yale School of Forestry and Environmental Studies, and Professor Rodney Irwin, Managing Director at the World Business Council for Sustainable Development (WBCSD) and Honorary Pentland Centre Teaching Fellow.
Dr. Cort kicked off the workshop by guiding his audience through the structuring of a classic multi-stakeholder materiality matrix, a tool that helps companies identify issues that can affect the success of their future operation. Dr. Cort explained that while identifying material issues is intuitive, “it’s frustrating to put down on paper.” He illustrated that balancing between nuance and generality, or distinguishing between risk and opportunity, eventually unfurls a semantic conundrum. As a result, when the criteria established to identify material issues isn’t sufficiently objective, a company’s upper management can just arbitrarily rearrange the matrix to fit their own preferences. Dr. Cort referred to this inherent weakness in the matrix as the “Ouija board approach,” where “the strongest hand pushes the issues around the board.” In other words, what some might define as a material issue for the company and for the stakeholders, a senior executive may consider trifling. Following that line of thought, Dr. Cort concluded the first half of the workshop by asking the rhetorical question as to why anyone would even bother refining the matrix’s criteria until these subjective and perception-based issues could be better objectified. He suggested that the key importance in these materiality matrixes, despite their thorny nature, is that when they are sophisticated enough, they can offer the benefit of “[identifying] issues that we might not have found in our normal risk assessment.”
Professor Irwin picked up the baton and continued the second half by further expounding on the bewildering complexity of materiality. “It’s a highly divisive concept,” he said, and explained that "there is no universally agreed definition of materiality as applied to sustainability. There are a plethora of approaches for stakeholders, accountants and non-accountants. There are approaches on pretty much everything but these are not universally applied."
And to illustrate the gravity and complexity of the issue, Professor Irwin reminded his audience that while there are about 15,000 companies listed in the United States, only 500-600 of them produce a sustainability report apart from, or within, their mandatory financial reporting.
While he noted that the task of assessing environmental and societal risks is “a mixture between art and science,” he went on to suggest an astute solution. The classic multi-stakeholder materiality matrix essentially says that the way to define what is material is to identify potential risks, see how likely they are to occur, and evaluate what impact they might have on the company. But when you look at a model that puts potential risks on the two axes of ‘likelihood’ and ‘impact’, you end up focusing on the obstacles instead of the road. “You tend to focus on what could go wrong; and not on opportunity,” said Professor Irwin, thus clarifying why this narrative wouldn’t gel with executives and investors. In other words, no one likes to hear bad news. But when instead of gauging the likelihood of a risk, you examine the resiliency of a company, then you insinuate a more suitable question into the matrix, namely, “If this were to happen, could you deal with it?” Professor Irwin underscored his point by referring to a previous work experience which revealed that when approaching sustainability reporting through the lens of resiliency, senior management was 75% more likely to agree that an issue was important. “That is the way of getting sustainability into business consciousness: through resilience,” he concluded.
In the end, a business’s goal is to not end up a day late and a dollar short. If the road to attracting investors and updating business models leads through better risk assessment, then companies need to buckle down and swallow this bitter medicine called sustainability reporting. A positive example, Professor Irwin reminded his audience, is the Danish company Novozymes. The company enthusiastically states on its website how their “reporting ambition is to provide a report that connects the company’s business model, strategy, targets and performance through integrated financial and sustainability data.” While Novozymes employs a multi-stakeholder approach in determining what is important (the approach that Dr. Cort previously presented as problematic), Professor Irwin did commend the company for looking at materiality “through the lens of what the recipient of that information will consider to be important.”
Ultimately, businesses seek to survive, and they can only do so by turning a profit. So, evidently, the most compelling way to convince businesses to experiment and adopt sustainability frameworks, is to present a profitable case to them for the often tedious task of reporting. Professor Irwin readily pointed to a 2015 study, titled Corporate Sustainability: First Evidence on Materiality, which, according to the professor, “confirms that firms that perform well on material sustainability factors enjoy enhanced accounting and marketing returns over firms that perform poorly in these factors.” So let us hope that with the help and research of such competent experts as Dr. Cort and Professor Irwin, we can get more companies on board. Because for a better future, we need all hands on deck.