Defining Materiality and Sustainability

“Materiality” has long been defined as that financial information which might harm or benefit a shareholder. Simple stuff.

In the modern and complicated world of corporate governance today, however, that’s changing. As regulators, activists, and consumers increasingly pressure companies to address sustainability issues, a concurrent push is happening to have companies assess the materiality of sustainability as well. Now one proposal from Harvard University challenges the ubiquitous assumption that shareholder interests alone should guide materiality disclosures, making the case to consider a broader universe of stakeholders.

“The guts of reporting—whether it’s financial, integrated, or sustainability—is materiality,” says Robert Eccles, a professor of management practice at Harvard Business School. “Companies report on what is material so there is not a bunch of noise. But what’s material depends upon who your audience is. If the only audience you care about is short-term investors, then what’s material is short-term earnings. If you care about employees, reporting on human capital is material.”

Eccles’ proposal: To improve corporations’ public disclosures, boards should publish an annual “Statement of Significant Audiences and Materiality” that identifies key stakeholders for purposes of material disclosures. While this description would almost certainly include shareholders, it could also include, for example, employees, suppliers, customers, non-governmental organizations, trade groups, government agencies, and environmental groups.

The board can ultimately decide which, if any, environmental, social, and governance issues are material. “All we are asking for is transparency about the board’s view of its role,” Eccles says.

A modest proposal, perhaps, but one that will require plenty of persuasion. CEOs and CFOs of publicly listed corporations traditionally position shareholders as the owners of the corporation, and directors espouse a fiduciary duty to them. That view is so entrenched that many assume the approach is codified by law. Multiple people have told Eccles that his idea will never succeed because “the lawyers will never let you do it”—thanks to that narrow view of fiduciary duty.

“Companies report on what is material so there is not a bunch of noise. But what’s material depends upon who your audience is.”
Robert Eccles, Professor of Management Practice, Harvard Business School

Eccles begs to differ. Drawing on principles of limited liability, separate corporate personhood, and the primacy of directors’ duty to the corporation, he argues that “the shareholders don’t actually own the corporation. They own shares in the corporation. The corporation owns itself.” And under the legal doctrine known as the Business Judgment Rule, directors can take into account the interests of other stakeholders if they are in the best interest of the corporation, too.

To prove his assertion, Eccles (and co-author Tim Youmans, a researcher at Harvard Business School), worked with the United Nation’s Global Compact and the American Bar Association’s Task Force on Sustainable Development to gather 26 legal memos from around the world, including every G-20 country. The consensus: There is no legal impediment to issuing a materiality statement.

“You have companies that say they only want to report what’s material,” Eccles says. “I’m OK with that, but you have to give some basis for how you determined that. This is an easy first step. It’s a single page, it is values-neutral, and if you want to say the only significant audience is shareholders, you can.”

How This Might Work

The logistics of the plan still need to be worked out. Would the one-page document be an addition to Form 10-K or other Securities and Exchange Commission filings? To what degree could it be driven by shareholder initiatives? (After convincing those same shareholders that the plan isn’t intended to undermine their influence.) What’s the best way to win support from directors and corporate leadership?

One potential strategy is to leverage the audit function, both internal and external. “The key minds we have to change are not executives, but boards,” Youmans says. “Within boards, the target for doing that is the audit committee.”

“Let’s be honest, CEOs say all the right things about the importance of good governance, but they really would prefer to just be left alone to do what they want,” Eccles says. “Internal audit and external auditors are a route into the board. I would think this is important for auditors because materiality, in the U.S. context with Regulation S-K, says materiality goes in the 10-K. But it doesn’t tell you it has to be financial information, quantitative or qualitative.”

WHAT IS MATERIALITY?

The Global Reporting Initiative, International Integrated Reporting Council, and Sustainability Accounting Standards Board each have their own approach to defining materiality.
GRI: “The report should cover aspects that: a) reflect the organization’s significant economic, environmental, or social impacts, and b) substantially influence the assessment and decisions of stakeholders.”
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 decisions.”
IIRC: “An integrated report should provide concise information that is material to assessing the organization’s ability to create value in the short, medium, and long term.”
The Global Environmental Management Initiative suggests the following steps when conducting a materiality assessment:
• Define goals and scope. How will the assessment be used? What requirements must be met?
• Identify appropriate resources. Are internal resources sufficient and capable to meet the company’s needs? Will the company need to hire an experienced sustainability consultant to provide external support and credibility?
• Identify potential material issues. What internal and external data is already available to assess materiality? Are there critical gaps in existing knowledge? Seek to identify a robust list of potential material aspects.
• Identify and engage priority stakeholders. Who are the most important and relevant internal and external stakeholders to engage? What methods will be used to collect data?
• Rank and prioritize stakeholder concerns. How important is the issue to organization? To stakeholders? What is the organization’s ability to influence the issue? A variety of methods may be considered by the company to prioritize results.
• Apply the assessment results. How will the results be communicated internally and externally? How will results inform the company’s sustainability strategy and corporate planning processes?
Source: Global Environmental Management Initiative.

If Eccles’ idea catches on (admittedly, a big if), that could help companies better navigate the various reporting standards that complicate the sustainability reporting landscape. Right now companies have three main models to choose from, and they don’t align perfectly. The International Integrated Reporting Council (IIRC) and Sustainability Accounting Standards Board both define materiality as what is meaningful to investors; the Global Reporting Initiative’s sustainability reporting guidelines look at materiality in terms of both investors and other stakeholders.

Unrelated to the proposal by Eccles and Youmans, in early September the Global Environmental Management Initiative (GEMI) published a new “Quick Guide on Materiality,” designed to help corporations understand materiality and its relationship to sustainability and what factors to consider when undertaking a materiality assessment.

"It’s critical that any organization undertaking a materiality assessment understand the different approaches, tools, definitions, and best practices," says Dan Daggett, executive director of sustainability for Sealed Air and GEMI’s vice chairman. The GEMI guide uses Sealed Air as one case study in disclosure, as well as other examples from Carnival, FedEx, Smithfield Foods, and Union Pacific.

Some suggestions from the GEMI report on how to assess materiality:

Define goals and scope. How will the sustainability assessment be used? What requirements must be met?

Identify potential material issues. What internal and external data is already available to assess materiality? Are there critical gaps in existing knowledge?

Identify and engage priority stakeholders. Who are the most important and relevant internal and external stakeholders to engage? What methods will be used to collect data?

Rank and prioritize stakeholder concerns, and assess how the company uses the assessment for business planning purposes.

In Daggett’s view, corporate sustainability efforts have evolved in the last 10 years from “random acts of good things” to taking “a more strategic look at integrating with the business.” That more rigorous look includes identifying new revenue streams, cost savings, and new ways to control risk. His company’s materiality assessment, a process that will be repeated at regular intervals, is a tool for identifying stakeholders and better engaging with them.

Beyond company walls, it remains to be seen how sustainability reporting evolves, and whether the goal of fully merging it with financial reporting (one of SASB’s goals is to integrate its reporting with SEC filings) will ever come to pass. “I think most of the sustainability world is holding that a bit at arm’s-length, because we aren’t really sure we want full integrated reports,” Daggett says. “There are certainly some companies that do that today, but I don’t expect all this to happen overnight. There will be a transformation over time.”

“There is regulated materiality from the SEC, and there are concerns by some sustainability professionals that if we put something out in a sustainability report and say it is material to our organization because it has a social impact—does that automatically mean that you have to include this in the 10-K filing?” one sustainability advocate said. “That’s to be determined.”