Materiality matters: why don't companies have to disclose sustainability risk?

Materiality matters: why don't companies have to disclose sustainability risk?

ShutterstockRon and Joe

Given that disclosure of financial risk always has been a difficult mandate for publicly-traded companies, requesting the voluntarily disclosure of sustainability risks may seem like a nearly Sisyphean task.   

Currently, the Securities and Exchange Commission, under rule 405, requires disclosure of anything considered “material” through annual or quarterly filings.

The Financial Accounting Standards Board defines materiality as “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”

Accountants often rely on what is known as the 5 percent rule, meaning that if something could affect the company’s net income by 5 percent, it is material. The SEC has stated that this should just be used as a rule of thumb.

However, with the exception of some mandates on climate change and conflict minerals sourced from the eastern Democratic Republic of the Congo, sustainability disclosures largely have been omitted by SEC regulation.

Although more companies are disclosing sustainability information, there are few standards and the reporting is often vague and subjective. 

The casual reader of SEC annual filings might find the concept of materiality — or the mandatory disclosure of anything vital to the investment making decision — and large-scale sustainability issues, such as fossil fuel use, climate change or massive droughts, as slightly paradoxical.    

For example, for a company in the food and beverage industry, future profitability is directly linked to climate change and natural disasters, which would make those potential events material. Yet, under current SEC regulations, these factors are not deemed as material.

According to Michael Muyot, president of the sustainability analytics firm CRD Analytics, companies “will keep doing it [not disclosing sustainability information] as long as they can get away with it. I don’t know if they don’t think it’s not material.”

“It’s just that it’s so fragmented within the large corporation that there’s no central strategic accountability," he added. "They’ll keep doing it, especially in B2B because the penalties aren't there."

Enforcing disclosure

This leaves sustainability non-profit accounting boards such as the Global Reporting Initiative (GRI), the Sustainable Accounting Standards Board (SASB) and the International Integrative Reporting Council to ask companies — at least in the U.S. — to voluntarily disclose information.

SASB was formed in 2012 with a mission to “develop and disseminate sustainability accounting standards that help public corporations disclose material, decision-useful information to investors.”

The organization specifically focuses on sustainability disclosure on SEC annual and quarterly public filings known as a 10-Ks and 10-Qs. According to Doug Park, SASB’s director of legal policy and outreach, working with companies to disclose this information on its 10-Ks provides a way to hold companies accountable for the accuracy of their disclosures.

“The company has to sign a certification saying that the information in the 10-K or 10-Q report is accurate and complete and does not misstate anything,” Park said.

“The company has to make these certifications under the Sarbanes-Oxley Act. And the penalty for making inaccurate or incomplete or misleading statements are civil penalties — in terms of fines — as well as potential criminal liability."

While the SEC has few requirements about sustainability reporting, the SEC did propose guidelines for companies to disclose climate change information in 2010. It seems few companies actually have followed through, and it is rather left up mostly to the companies themselves to determine what event or damage from climate change is material.

According to a 2014 report by the sustainability non-profit Ceres, “41 percent of S&P 500 companies failed to address climate change in their 2013 filing.”

Ceres also scored the quality of the companies' climate change disclosures in their 10-Ks. The organization scored the quality of disclosures in 2013 as lower than in 2011 even though the number of companies that disclosed information increased.

“I think you can only go so far with voluntary [disclosure]. Then you’re relying completely on the carrot and that could take anywhere from five to 10 years,” said Muyot. “I think the combination of both the carrot and the stick — with the regulatory stock exchange listing requirements and direct investor shareholder return reward — can be done in less than five years.”

In several countries outside the U.S., regulatory agencies mandate more disclosure of sustainability information by companies. In South Africa, the Johannesburg Stock Exchange requires all listed companies to adhere to a strict set of guidelines for sustainability disclosure.

“Regulation around the world is playing an increasing role in driving behavior change and disclosure,” said Kristen Sullivan, a partner at Deloitte and Touche LLP and head of Sustainability Reporting, Assurance and Compliance Services in the U.S. “An example would be the passage of the EU directive back early last year in 2014 that will mandate non-financial disclosure.”

In 2014, the European Union issued a directive that requires sustainability reporting for companies with over 500 employees. In 2017, over 7,000 companies in Europe will report “on environmental, social and employee-related, human rights, anti-corruption and bribery matters.”

Although the U.S. does not have mandatory disclosure policies like the EU, voluntary disclosure is becoming more prevalent. However, there is little enforcement to ensure that the information that companies are reporting on is accurate and has quality.  

“In the last three to four years the numbers of companies that have been disclosing information about sustainability and sustainability efforts has been increasing,” said Park.

According to a Reuters article, “Comments by SEC Chairman Mary Jo White and Commissioner Daniel M. Gallagher indicate that the Commission does not view sustainability reporting as a priority.”

In regards to ensuring that these standards will be upheld, Muyot said, “It’s a challenge. But it’s kind of just like with sports; a $10,000 fine to LeBron James doesn't mean anything. The fine and the penalty has to actually hurt.”

The risk of stranded assets

Some companies have been under increasing pressure to disclose sustainability information from investors in part due to increasing concerns over the risk of stranded assets.

According to the Smith School of Enterprise and the Environment at the University at Oxford, “Stranded assets are assets that have suffered from unanticipated or premature write-downs, devaluations, or conversion to liabilities and they can be caused by a variety of risks.”

The risk of assets being stranded is a particular concern for energy companies involved with fossil fuels such as oil and coal. These companies hold substantial fuel reserves, but with evolving federal regulations to meet climate change and environmental goals these reserves will become unburnable.   

A study by the University College London Institute for Sustainable Resources stated that up to 80 percent of coal reserves could become unusable by 2050.

“Companies have known this for a while; they are just trying to get as much out of these assets as they can. But I think the writing is on the wall,” said Muyot.