Three influential reporting initiatives are each betting their future on the all-important materiality principle -- the idea that companies should focus their strategy and reporting on the most relevant sustainability challenges and opportunities.
The problem for companies is that each initiative is putting forward a potentially incompatible definition of materiality.
The three organizations -- the International Integrated Reporting Council (IIRC), the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI) -- diverge in their approaches based on which stakeholder group they focus their initiative on.
Here’s the lineup.
• The IIRC, which is betting that investors will broaden their analytical horizons, proposes a framework that seeks to integrate financial and nonfinancial reporting by taking a broader and longer-term view on how value is created.
• The SASB, meanwhile, is betting that regulators will broaden their interpretations of materiality and is creating standards on how publicly-listed U.S. companies should disclose material sustainability issues for investors in mandatory filings to the Securities and Exchange Commission (SEC), such as the Form 10-K and 20-F.
• And the GRI, the traditional authority for sustainability reporters, is betting that stakeholders should have an equal say in sustainability reporting, since reports are used by multiple audiences.
Given these potentially mixed messages, what is a company to do? Reporters thinking they must complete three separate reports can take heart: There are three (ok, maybe four) fairly straightforward paths, and an opportunity to shape the future of reporting.
Multiple materiality meanings
While the materiality principle is suffering from a “one word, three definitions” syndrome, the most significant difference is between the approach of both the IIRC and SASB, which ultimately look at materiality through the lens of what is meaningful to investors, and the approach of the GRI, which looks at materiality in terms of what is relevant to investors and other stakeholders.
More specifically, the IIRC frames materiality in terms of what will influence assessments made by the primary intended users of integrated reports, which it defines as the “providers of financial capital.” The SASB also presents materiality in terms of what will influence investors’ assessments, but it frames materiality in terms of existing U.S. federal securities law and previous judgments of the U.S. Supreme Court.
By contrast, the GRI frames materiality as a combination of two dimensions: issues that will have a significant financial impact on the organization and its future success (i.e. issues that are relevant to investors) and issues that will influence the assessments of other stakeholders. This two-by-two model of materiality has become common in the sustainability reporting field over the past seven to 10 years.
Both the SASB and the IIRC provide guidance that attempts to broaden the range of issues considered material and narrow the gap with the approaches to materiality commonly used in sustainability reporting and in the GRI.
For example, the IIRC is based on the notion that there are six types of capital that companies should consider: financial, manufactured, intellectual, human, social and relationship, and natural. The IIRC makes the case that financial returns are “dependent on interrelationships between various types of capital in which other stakeholders have an interest,” and that investors are “likely to align over time with the interests of stakeholders because both are focused on the creation of value in the short, medium, and long term.”
Further, the IIRC’s “stakeholder responsiveness principle” states that nonfinancial stakeholders are a valuable source of insights into what might be of material significance to the providers of financial capital: “An understanding of the perspectives of relevant stakeholders is critical to [the materiality] assessment because stakeholders have the potential to affect the organization’s ability to create value over time.”
SASB makes a similar logical leap, suggesting that a wider range of sources should be used in defining what is material, and that a longer-term perspective on three capitals (for SASB, these are environmental, social and human) will result in a greater disclosure of sustainability issues in the Form 10-K.
However -- and this point is key -- for both SASB and IIRC, the level of materiality ascribed to an issue that is important to nonfinancial stakeholders is entirely contingent on how much it influences decisions and assessments made by the providers of financial capital. In other words, the priorities of stakeholders only matter to the extent they also matter to investors. By contrast, for the GRI, the opinions of stakeholders have value in their own right, regardless of investors.
Materiality definitions and disclosures
The IIRC, SASB, and GRI define materiality in three different ways:
• IIRC: “An integrated report should provide concise information that is material to assessing the organization’s ability to create value [for the providers of financial capital] in the short, medium, and long term.”
• SASB: “[Material issues are matters that] either individually or in the aggregate, are important to the fair representation of an entity’s financial condition and operational performance … [information that is] necessary for a reasonable investor to make informed investment decisions.
“Presenting a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having substantially altered the total mix of information made available.”
• GRI: “The report should cover aspects that: a) reflect the organization’s significant economic, environmental, or social impacts [in terms of whether they positively or negatively influence the organization’s ability to deliver its vision and strategy], and b) substantially influence the assessments and decisions of stakeholders.”
Furthermore, both the GRI and the IIRC require that companies disclose information about their materiality process and review the analysis annually in accordance with the reporting cycle.
• GRI: “The process by which the relative priority of aspects was determined should be explained, [and companies should] explain how the organization has implemented the Reporting Principles for Defining Report Content.”
• IIRC: “The materiality determination process is required to be disclosed in an integrated report, including the process and criteria used, the key personnel involved, and the role played by key governance bodies.”
As a result, companies applying both the IIRC and GRI guidelines could be in a position of having to undertake not only two different materiality assessments, but also two different disclosures about how they conducted their materiality process.
Three approaches to reporting
Given the materiality muddle, what is a company to do? We see three primary options, which we express here with reference to the IIRC and GRI, rather than SASB. (We’ve done this not out of disregard to SASB, but because, in simplest terms, SASB is mainly about an increase in disclosures made in the existing Form 10-K, whereas the IIRC and GRI bring more sweeping implications for report structure and content.)
We also believe that, as the keepers of the sustainability reporting key, companies have the opportunity to shape the direction of this discussion, either through their own intervention in the debate, or by the power of example.
Here are three possible approaches:
1. Spread your risk: Use both IIRC and GRI. Companies could choose to apply both the IIRC and GRI materiality principles separately. They would apply the former to their financial and/or integrated reports, and the latter to their sustainability reports. Companies would disclose both methodologies and clearly describe the differences between them.
2. Follow the money: Use IIRC, not GRI. Companies could choose to apply the IIRC framework, including the materiality principle, and use that analysis to shape their financial and sustainability reporting. Under the conditions of the G4 GRI Sustainability Reporting Guidelines, this would likely prevent companies from stating “in accordance” with the GRI Guidelines (either at the “core” or “comprehensive” levels), but would instead allow companies to use the lower statement that “this report contains standard disclosures from the GRI Sustainability Reporting Guidelines.”
3. Follow the heat: Use GRI, not IIRC. Companies could choose to continue using the GRI materiality principle for sustainability reporting and not seek to apply the IIRC or attempt an integrated report. Rather, companies would continue to publish separate financial and sustainability reports, though they could, of course, use the SASB outputs to increase sustainability disclosures in their Form 10-K.
A final option: Make your own dinner (a blend of the GRI and IIRC)
Companies could choose to develop a unique materiality model that is consistent with both the IIRC framework and the GRI guidelines, and companies could use their own model to influence the future direction of reporting.
While the GRI has a fairly precise description of how to apply the materiality principle, the IIRC allows for more flexibility, provided the process used is disclosed in the report. With that in mind, we offer two different materiality models that incorporate key features of the IIRC materiality principle yet seem (to us) to be consistent with the GRI materiality principle.
One of these approaches builds on the standard two-by-two model, while the other uses a spider chart to incorporate a wider range of factors while avoiding the presentation of business and stakeholder concerns as starkly opposing each other.
Two-by-two model: This model is consistent with the one used in the GRI guidelines but applies key concepts contained in the IIRC framework to alter the criteria used for each axis.
• The axis traditionally referred to as “importance to business” would be based on the company’s business model and renamed “impact on ability to deliver company strategy.” These criteria would vary according to the company’s business model, but would likely include aspects such as deepening customer relationships; succeeding in growth markets; reducing operational costs; and creating innovative products, services and technologies.
• The axis traditionally referred to as “importance to stakeholders” would be based on the IIRC framework’s six capitals, and renamed “impact on ability to create value.”
Issues would then be ranked according to their impact on two things: the ability to deliver company strategy and the ability to create value. In order to apply the stakeholder inclusiveness/responsiveness principle, the materiality process would consider stakeholder perspectives when ranking the issues.
Per the graphic below, additional criteria could also be included, such as the company’s ability to influence the issue (which could be illustrated by larger or smaller bubbles on the materiality matrix), and changes in value creation over time (which could be represented by arrows).
The spider’s web: This model radically departs from all existing materiality approaches, though it does incorporate key concepts from both the GRI guidelines and the IIRC framework. In essence, it creates an output that does not implicitly suggest that stakeholder, business or investor expectations oppose each other.
Specifically, this approach uses a four-sided spider chart to allow for additional factors to be included in the determination of materiality:
• Ability to deliver company strategy, which is similar to the traditional “importance to business” axis
• Ability to capture stakeholder expectations, which is similar to the traditional “importance to stakeholders” axis
• Impact on value creation for the IIRC’s six capitals
• Potential to cause disruption (positive or negative) to the social and environmental system, which is the sustainability context principle contained in the GRI guidelines
IIRC’s six capitals
1. Financial: Funds for production of goods and provision of services
2. Manufactured: Physical objects available for production of goods and provision of services
3. Intellectual: Knowledge-based intangibles, such as intellectual property or brand value
4. Human: People’s competencies, capabilities and experience
5. Social and relationship: Relationships with and between communities, stakeholders and networks
6. Natural: Renewable and nonrenewable environmental resources that provide goods and services
So really, what now?
We’ve been involved in enough of these and other initiatives to know that the real power often resides not inside them but outside them: What really matters is how companies adopt or change each approach and how credible the resulting reports are for their users.
If the past 20 years of corporate responsibility have taught us anything, it’s that we’re all better off when companies create approaches that work in the real world. That’s what we’d like to see now: companies innovating in ways that run with the spirit of these initiatives but that bring a heavy dose of practical reality to the cause of better reporting for all stakeholders. And we believe that this practical reality demands an approach to materiality that is flexible and broad enough to satisfy a variety of reporting needs.
One could argue that we’ve just further complicated matters by offering five potential materiality models (oops!). But that’s not what we’re trying to do. Rather, our ideal is one model that meets both the needs of investors and broader stakeholder groups. And we actually think this is possible because while the information needs of these different groups vary, the fundamental principle of materiality does not, and it must be possible to develop one materiality model that acts as the common jumping-off point for the selection of report content for different types of report users and even for different reports.
For that reason, we’re all for blending.