Let’s talk Materiality!

— Arvind Sharma

Over the past few years, the term of materiality has gained much traction in the sustainability domain. While it has been around for quite some time, and has been the backbone of financial reporting for several decades. Its relevance and importance has dramatically improved in much recent times.

In accounting terms, materiality refers to the estimated effect that a given piece of information may have on a Company’s value.  Simply put, anything is important if it has potential to affect perception of your company and thereby impact your business. The concept of materiality made inroads into non-financial performance reporting with the Global Reporting Initiative’s sustainability reporting guidelines, way back in the year 2000. It brought with it fundamental challenges for organizations in prioritizing issues in terms of identifying and preparing for global sustainability trends and challenges; responding to stakeholder expectations and developing a roadmap to address the prioritized issues. These challenges are faced by the organizations that are beginning their sustainability journey and also those that are looking to refresh or expand upon current strategies and initiatives. In a nutshell struggling to tell their own story.

The recently released GRI G4 guidelines simplified the definition of materiality by stating materiality as the topics that have a direct or indirect impact on an organization’s ability to create, preserve or erode economic, environmental and social value for itself, its stakeholders and society at large. It is no longer limited to the impacts on the organization itself but includes the impact on all the stakeholders.This expansive view of materiality includes economic, environmental and social values and takes into account the stakeholder perspective. The International Initiative for Integrated Reporting (IIRC) is proposing integrating the disclosure of standard financial information with sustainability information to provide a more complete view of the commercial, social and environmental context within which a company operates.

Why is it important?

With increased awareness on environmental and social factors, investor community, from socially responsible investors to mainstream pension funds, to stock analysts, and the regulatory agencies, all are concerned with the risk factors facing companies with regard to the availability of natural resources, risk associated with safety and procurement, and credit risk due to altered insurance policies as an after effect of regular extreme weather events. Sustainability issues have made their way into the risk registers of the companies, taking a leap from just the mention of extreme weather events and fire to granular description of risks related to water availability, product safety, consumer perception, and compliance.

The Securities and Exchange Commission requires disclosure of material issues in the Form 10-K, 20-F and other filings in use by investors. There are a few institutional investors who consider material issues pertinent. And, then there are environmental activists who have been pointing out the lack of reporting of material issues, particularly extractive industries like forestry and mining, as well as water-intensive industries, such as chemicals, food and beverage, and pulp and paper. These forces are challenging the company’s top executives to reconsider a traditional reporting model that may not effectively meet today’s information needs.

Defining Materiality – a challenge

Conducting a materiality assessment to identify key opportunities and risks is an analytical process that involves three main questions:

Do you have an overview of your value chain? And its social and environmental impacts?

Who are your stakeholders?

How are key stakeholders and/or financial performance affected by the topic?

A well-defined materiality assessment is a crucial component of organizations’ business strategy. It can also serve as a tool to build confidence with interested stakeholders and drive clarity of vision.

Many corporate leaders, including chief sustainability officers, are focused on the concept of materiality beyond the traditional and well-understood financial statement materiality concept. Investors and other stakeholders ask whether the information is business-critical, and the lack of benchmark ESG (environmental, social, governance) metrics even within an industry raises the question as to whether ESG information can help them make better decisions. The challenge is to figure out when and why these issues might become financially material to a company.

Follow the leaders

Materiality is widely referred to as a guiding principle of sustainability reporting. A recent survey by KPMG International shows that about 79% of global 250 companies identify issues that are material to them. Among these, companies in the mining, construction, pharmaceuticals and telecommunications sectors have articulated the process of defining materiality in their sustainability reports. BHP Billiton for example, identifies its sustainability focus area through three step materiality process – identify issues through the review of internal risk registers and enquiries from its key stakeholders; rate the significance of issues based on impact on BHP and importance to its stakeholder and finally review the issues and seek feedback from both internal and external stakeholders.

Larsen and Toubro conducts extensive stakeholder surveys and uses the results to update its materiality framework and expand the scope of reporting. Glencore’s approach to materiality incorporates international and sector specific standards and guidelines. Glencore determines material issues based on their potential risk to compliance, reputation, relationship with stakeholders and financial performance.  Vodafone uses a ‘materiality matrix’ to map the issues that its stakeholders are most concerned about against those that have the biggest financial or operational impact on our business. They apply the materiality principle to each key issue to identify and prioritize the most significant sub-topics.

Most of the proactive organizations are using materiality as a tool to build confidence with interested stakeholders and drive clarity of vision.

Linking materiality with business strategy

Getting to a more strategic view of materiality depends on the maturity of an organization’s sustainability program and its goals, its measurement system, and whether the organization wants to understand the impact of ESG performance on its valuation. A robust materiality assessment should account for:

• Business context and objectives
• Goals and targets
• Business strategy
• Risks
• Policies, processes and programs
• Level of control or influence an organization has over a current or future issue
• Stakeholder relevance, perception and influence
• Broader industry trends and initiatives
• Major reporting efforts

Materiality as a principle has been well ingrained by the following reporting standards and initiatives. While there are some differences in the way it is defined, the foundations remains much the same. Let’s take a look at how they look and deal with materiality:

The Global Reporting Initiative (GRI)-GRI was launched in 1999 and has produced several iterations of a voluntary sustainability reporting framework for disclosure on key areas of economic, environmental, social, and governance performance. The latest generation guidelines (GRI G4) puts much greater emphasis on materiality determination as part of the disclosure process.

The International Integrated Reporting Council (IIRC) – IIRC founded in 2010, has developed a framework for integrated reporting that demonstrates the linkages between an organization’s strategy, governance, and financial performance and the social, environmental, and economic context within which it operates in a clear, concise, consistent, and comparable format.

The Sustainability Accounting Standards Board (SASB) – SASB, launched in 2011, collaborates with regulatory and accounting organizations (for example, the SEC, Center for Audit Quality, PCAOB) to aid in the development and dissemination of a set of industry-specific sustainability reporting standards for disclosure in standard filings such as Form 10-K. The SASB plans to identify which sustainability issues are material for industries to establish a minimum disclosure standard that is concise, comparable within an industry, and relevant to all 35,000 publicly listed companies in the United States.

The Global Initiative for Sustainability Ratings (GISR)– GSIR was launched in June 2011 to design and implement a global sustainability ratings standard and to move existing sustainability ratings toward a core set of principles, processes, and performance. Fostering convergence and harmonization across ratings will enhance the quality and comparability of material information needed to move markets toward more sustainable outcomes. The group is developing this framework at present.

In the end, understanding materiality and defining it rightly can go a long way for an organization in pursuit of sustainability. After all, materiality lies at the very foundation of any sustainability reporting exercise. Thus its importance and relevance cannot really be overstated.

—-

The author is one of the leading experts on sustainability and climate change with over 20 years experience in sustainability advisory.