The rise of company-specific materiality assessments will require companies to undertake substantial organizational and behavioral adjustments, reduce their reliance on standardized metrics, and incent investors to dig more deeply into the inner workings of individual portfolio companies.
The emergence of ESG issues has generated a wholesale reevaluation of corporations’ so-called social compact. It has upended the concept of shareholder primacy and raised questions about traditional methods of auditing and evaluating companies. Corporate externalities, intangibles, purpose, culture, values and other qualitative factors — formerly characterized as non-financial — are now recognized as integral to a company’s risk profile, financial health and long-term value. Accordingly, corporate executives and boards of directors are expected to attend to an expanding list of ESG topics including climate change, human capital management, pay equity, gender and ethnic diversity and justice, #MeToo, the wealth gap, human rights, immigration, gun control, domestic terrorism, voting rights, political contributions and more.
Simultaneously with their impact on corporations, ESG issues are having a transformative effect on institutional investors and shareholders. Giant financial institutions such as BlackRock, State Street, Vanguard, Fidelity and many other asset owners and managers around the globe, are waking up to the need to include ESG factors in their investment decision-making and stewardship of portfolio companies — and millennial and Gen Z investors are bringing their personal concerns about the environment, society and politics into their selection of asset managers, their choice of asset classes and directly into their engagement with the companies they own. ESG issues have become a dominant focus for shareholder activists and have contributed to their growing record of success. Social media is further accelerating the process by which corporations are linked to ESG issues in the news.
E and S versus G
The transition to ESG engagement presents company managers with substantial new challenges. In particular, the monitoring of environmental and social policies cannot rely on the compliance methodology used for corporate governance. While governance can be evaluated across different companies using a standardized checklist of best practices (albeit often with a comply-or-explain option), a prescriptive, one-size-fits-all approach does not work for environmental and social issues. E and S factors vary widely at individual companies — depending on their industry, size, location, competitive standing and a variety of other considerations. This problem of variability is apparent in the proliferation of competing global standards that have been developed to measure climate risk and assess responses to climate change across different industries and in different markets. The Sustainability Accounting Standards Board (SASB)’s 77 industry standards are a case in point.
However, global E and S standardization remains an important goal. Companies, investors, NGOs and regulators deem standardization essential to achieve comparability and ensure fair valuation of both listed and private companies. An important move toward standardization is the recent creation of the International Sustainability Standards Board (ISSB) — a consolidation of the International Financial Reporting Standards Foundation, the Climate Disclosure Standards Board and the Value Reporting Foundation (which in turn combines SASB and the International Integrated Reporting Council).
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Despite the push for standardization — and even if ISSB does achieve its objective of providing “a comprehensive global baseline of sustainability disclosures” — bespoke analysis of individual companies on E and S issues will continue to be necessary.
Thinking differently about materiality
Experts and regulators pondering the growing need for customized treatment of E and S factors have suggested that the traditional concept of “financial materiality” should be supplemented with alternative definitions — such as “double materiality,” “dynamic materiality” and “pre-financial materiality.” It is important to carefully consider whether the financial materiality standard is sufficiently comprehensive to embrace ESG issues. If so, alternative definitions may confuse materiality analysis rather than clarifying it.
In an April 27, 2021, comment letter to the Securities and Exchange Commission on the subject of “Climate Change Disclosures,” Uber Technologies, Inc. recommended an expanded approach to materiality that would not require a redefinition. While endorsing an ISSB-type “harmonized climate change disclosure framework” that “... would not only provide the standardization, comparability and reliability sought by investors and other stakeholders, but would allow ... companies to streamline reporting and communications on climate change,” Uber encouraged the Commission to consider requiring that companies perform a company-specific materiality assessment to identify the ESG issues most relevant to their businesses.
Uber’s “company-specific materiality assessment” contemplates a two-step analytical process that, in addition to determining what an average investor would want to know, asks additional questions:
- What issues do we, the people running the business, think are strategically important
- What do our stakeholders want?
- To what degree are third-party standards applicable to our business?
- What are peer companies doing?
- What do our statement of corporate purpose, our company values, our culture, our reputation, our branding and our public image require?
These are important business questions whose answers are contextual and specific to individual companies. They in no way depart from the traditional standard of financial materiality. In fact, they rely on it. A company’s determination as to whether an ESG issue is material ultimately turns on whether the issue has an actual or potential financial impact on the business. Once the financial materiality determination has been made, the ESG issue is no longer theoretical; it is redefined as a business issue grounded in the company’s specific activities and circumstances.
While Uber’s company-specific materiality assessment rests on traditional financial criteria, the approach will over the long term require companies to undertake substantial organizational and behavioral adjustments. ISSB standards will provide helpful guidance for companies willing to adopt reforms such as integrated reporting, holistic management, stakeholder engagement and greater Board transparency as a means to achieve ESG integration.
The concept of company-specific materiality assessments also impacts institutional investors. It will require them to dig more deeply into the inner workings of individual portfolio companies and to engage with their managements systematically — and will further reduce their reliance on standardized metrics, regulatory guidelines and wholesale recommendations from outside advisors and service providers.