The new sustainability language: materiality and risk
The new sustainability language: materiality and risk
"Materiality” is becoming part of the fabric of sustainable business.
For the uninitiated, materiality is an accounting or auditing term that refers to the estimated effect that a given piece of information may have on a company’s value—its current or future stock price, for example. If a CEO has been diagnosed with a terminal disease; if a company is being investigated for bribery by a government agency; if its profit or loss needs to be restated by a significant amount—all are examples of something that is “material,” from an investor or stakeholder point of view.
So, when does sustainability become a materiality issue?
This is a question that is rising up through investor communities, from so-called socially responsible investors, to mainstream pension funds and university endowments, to Wall Street stock analysts, and the regulatory agencies that oversee publicly traded companies. All are concerned with the risk factors facing companies in a world of constraints related to the availability of energy, water, and other resources; where the toxicity of products or manufacturing processes present risks all the way up the supply chain; and where climate shifts can disrupt the availability of raw materials and threaten the well-being of employees and customers.
And it’s increasingly part of the job of sustainability executives in the world’s largest companies. For them, understanding “materiality” and “risk” means learning a new language and translating it into their companies’ far-flung operations.
This is hardly new stuff. For years, environmental activists have been pointing out the lack of reporting of material issues in some sectors, particularly extractive industries like forestry and mining, as well as water-intensive industries, such as chemicals, food and beverage, and pulp and paper. (GreenBiz has reported on these issues for more than a decade; see this story from 2000 and another from 2003, for example.) Concerns have existed for years about the financial impact of climate change on the insurance industry; see this GreenBiz story from 2005, among many others.
What’s new in all this is the growing clarity of what sustainability materiality looks like across a range of sectors, and the growing role sustainability executives are now playing in bringing materiality issues to light, both internally and externally.
This was driven home last week with the publication by Ceres, Oxfam, and Calvert Investments of a guide for companies and investors “on disclosure and management of climate impacts.” The report (download here), prepared by the consultancy David Gardiner & Associates, is one of the best overviews I’ve seen of the tangible risks companies could face in coming years as the threat and impact of climate change grow. As the report puts it: “Virtually every sector of the economy faces risks from the short- and long-term physical effects of climate change—impacts across the entire business value chain, from raw materials through to the end users.”
Please understand: this is not necessarily about reducing a company's “carbon footprint”—its activities and actions that contribute to global climate change. It’s about doing business in a world in which climate change impacts become all too real, from worker health and safety risks to disruptions in transportation routes to radically fluctuating commodity prices.
The Ceres report covers seven sectors, from agriculture and apparel to mining and tourism. For each, it outlines how climate change could cause short- and long-term physical impacts, and what effects those impacts might have on each sector’s “value chain”—the various processes involved to produce and sell goods and services, from raw materials to customer use.
Take the apparel industry, one not often associated with climate risks. Among the real-world climate risks in that sector are “once-in-a-century” floods in Pakistan and Australia in 2010, which ravaged cotton crops and raised prices for VF Corporation, which owns brands such as North Face, Lee, and Wrangler; and lower revenue by athletic apparel maker Armour, resulting from reduced outerwear sales in some markets, due to “the impact of unseasonably warm weather” in 2011-2012.
The report offers a series of “key questions” for each sector. For the apparel industry, they include understanding how climate change could impact the value chain, building resilience into company operations, and working with suppliers to develop drought-resistant crops and address potential water conflicts in local communities.
In many companies, issues of materiality are falling to sustainability executives, some of whom are finding themselves far afield from their traditional roles of sustainability reporting and promoting energy-efficiency and waste-reduction initiatives.
Along the way, sustainability execs are finding common cause with their company's chief financial officer. CFOs, in turn, are beginning to grasp the relevance of sustainability, as Ernst & Young reported last year. This was bolstered by guidance issued in 2010 by the U.S. Securities & Exchange Commission regarding companies’ responsibility to disclose material risks related to climate change. The guidance notes that a company’s CEO and CFO must certify that the company has installed “controls and procedures” enabling it to discharge its climate change disclosure responsibilities. “In other words,” says E&Y, “sustainability has found its way into the realm of controllership and financial risk management.”
In a few companies, primarily European ones, sustainability departments are key to developing robust reporting mechanisms that help both the company and its stakeholders understand how climate and other environmental issues present material risks.
BASF, the German chemical giant, is often cited as a leader in this regard. In 2010 it conducted an extensive stakeholder and corporate survey together with the sustainability consultancy Five Winds International. More than 300 people from around the globe participated in the project, which led to the creation of a materiality matrix identifying 44 issues representing “the most important emerging issues on both global and regional levels for North America, Europe, South America, and Asia.”
More companies are likely to conduct similar exercises as stakeholders and, especially, shareholders ratchet up their interest in sustainability materiality. Among the many initiatives in this arena is something called the Sustainability Accounting Standards Board, quietly formed over the past year, modeled after the Financial Accounting Standards Board, the designated organization for establishing standards of "generally accepted accounting principles" that govern the preparation of financial reports by the private sector, nonprofits, and nongovernmental entities.
Just as FASB established the concept of materiality for financial reporting, SASB is looking to establish “an understanding of material sustainability risks and opportunities facing companies, and create industry-based key performance indicators suitable for disclosure in standard filings such as the Form 10-K.” SASB already is engaged in determining key materiality issues for as many as 70 industries, a process that will take several years. (Disclosure: I am a member of SASB’s Advisory Council.)
SASB has its work cut out for it, not the least of which is harmonizing its efforts with the alphabet soup of other global nonprofits that have trod some of the same ground: GRI, CDP, GISR, UNEP, ISO, and others.
It's the growing force of such efforts that make some kind of materiality standard inevitable, and companies will find themselves roiled by yet another round of self-examination and external reporting, pushing sustainability ever higher up the ranks of corporate strategy.