Numerous external forces are converging to create increased awareness of environmental, social and governance (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 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 [PDF]. Moving forward, there likely 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 [PDF].
Importantly, integrated reporting likely will require reporters to make valuation impacts of ESG information more explicit.
Right now, often a disconnect exists between what ESG information companies disclose to their stakeholders and the data that actually drives management and investment decisions. Most agree that it is hard to know which information is business-critical for the long run.
For these reasons, focus is increasing 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 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 lungs? Is it a fire in a Bangladesh clothing factory? Is it rainforest destruction? If so, how many acres and in what timeframe?
For many companies, the problem is not a lack of ESG issues that are important to stakeholders, but when and why these issues might become financially material. 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, supply chain and 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. Omitting this 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. In short, materiality determination is not limited to financial (quantitative) information. A matter is material if it is substantially likely that the information will affect 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, such as a boycott or 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.
Two key challenges to ESG materiality
There are two primary challenges inherent to ESG issues:
1. Casting a net wide enough outside of traditional financial performance metrics to include nonfinancial issues, such as ESG risks and opportunities. GRI provides more than 400 metrics that might be relevant to the company and stakeholders and ultimately deemed financial material. That is a reasonably wide net.
2. 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 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 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 affect corporate strategy and create or destroy a firm's value by impacting cash flows in a given time period. Could a particular event 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 approach's keystone 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 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
• Effectively communicated with a direct linkage to the business's strategic objectives.
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 most likely to affect a company's value, such as R&D or talent. This is precisely the type of information investors need and are asking for.
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