What is Materiality?
In This Post:
Materiality is the cornerstone of Sustainability and ESG...but you would never know it.
Shareholder vs. Stakeholder materiality.
Double materiality is the future...but can we get a better name for it?
What is Materiality?
When we hear about sustainability and ESG, it is so easy to be drawn in by science-fictionesque innovations, silver-bullet solutions, industry-wide campaigns, and celebrity-backed start-ups. We get it, who doesn’t get just a little curious when talk turns to cloud-seeding, kelp forests, mars colonies, cow burps, carbon-free oil, or net-zero aviation? These stories grab headlines…but these stories are not the foundation of sustainability and ESG, rather they are the leading edge of hopeful thinking (or ‘hopium’ more critically).
The core issue of corporate Sustainability and ESG programs and reporting is much more mundane: Materiality.
Materiality is not a new concept, but it is one that has long been left to the less-publicized and less-celebrated dealings of technicians and service providers. But through it all, there is no progress on sustainability without materiality. No other modern institution is as capable of leading or responding to change as is the company…and determinations of materiality are what will define the types of change companies act on. So what exactly is materiality?
In its simplest form, materiality refers to identifying the issues which are important to achieving the desired outcomes. If ESG and Sustainability can help us craft a better world, then understanding materiality is critically important.
In a more complicated view however, you can see that concepts of materiality can get tripped up in trying to come to terms with:
The ‘how’ of identifying issues;
The hierarchy of importance;
‘Whose’ desired outcomes?
As it stands, there are two broad conceptualizations of materiality, that of Shareholder Materiality and that of Stakeholder Materiality, as well as an emergent hybrid conceptualization under the unfortunate name of Double (or Dual) Materiality. Let’s explore.
Shareholder Materiality
The fundamental concept of materiality has grown from the financial industry wherein materiality refers to something being important enough to be included in financial statements, and defined by the Auditing Standards Board of the American Institute of Certified Public Accountants along the lines of: “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion of correction of the item.”
To paraphrase, an item is material if its omission from a financial report could alter a reasonable individual’s financial decision-making process. As an investor, knowing if your company’s cash position is being held in cryptocurrencies or in a Government/Treasury Money Market Fund would influence how I perceive the risk level of investing in your company, and so this information is material. Knowing changes to your corporate cafeteria menu much less so.
So how does this relate to ESG and Sustainability?
When ESG and Sustainability were just starting to gain a foothold in the early 2000s, the most common criticism was that a focus on environmental, social, and governance issues beyond what is directly and immediately relevant to revenue generation and/or operational costs was a distraction from the primary objective of a business, that of profit generation. The thought was that these elements were not material to corporate performance as measured by shareholder value (i.e. the 'desired outcomes').
The counter-argument was that many ESG and Sustainability issues are in fact important to longer-term financial performance. Issues such as employee engagement and retention, access to water for critical infrastructure, climate risk exposure, board diversity and independence, and so on. Being the new disruptor to the financial systems, the onus was on proponents of ESG and Sustainability to prove their point, and this set off decades of research (still ongoing today) trying to pinpoint which issues influence corporate financial performance and across what timelines. Sufficient evidence can move an issue into being considered material whereas a lack of convincing evidence leaves an issue to be disregarded as being immaterial.
Ultimately shareholder materiality seeks to answer one question: Which issues present a risk or opportunity to corporate financial performance?
The sum of this research is effectively reflected in the materiality frameworks developed by financial industry interests to assist companies in determining what they should be addressing and reporting on. Issues beyond the recommendations of these frameworks are still largely considered to be immaterial and hence distractions for corporate management.
SASB (Sustainability Accounting Standards Board) is the most well-established such framework and has been diligent in driving reporting on material ESG issues to a level similar to GAAP accounting standards. (Please note that SASB has merged into the Value Reporting Foundation, although the framework is still commonly referred to as the SASB standards.)
What is most interesting to note upon reviewing the SASB standards is just how few issues are actually considered to be material. Popular commentary would have us believe ESG and Sustainability frameworks are pushing companies to address every imaginable progressive (or ‘woke’, ascribing to a more critical perspective) cause currently trending. But the leading shareholder materiality frameworks demonstrate anything but! According to SASB materiality maps, Amazon Inc., for example, need only disclose on five out of 26 possible issues…and these five recommended disclosure areas do not include labor practices.
To summarize, shareholder materiality is an identification of which ESG and Sustainability issues represent a clear risk or opportunity for corporate financial performance. To address anything else would be a distraction and, worse, perhaps a breach of fiduciary duty.
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Stakeholder Materiality
In contrast, where shareholder materiality is concerned with the effects of issues on corporate performance, stakeholder materiality is concerned with the effects of corporations on issues. The term stakeholder materiality is not seen in print quite as often as it readily goes under the pseudonym of ‘impact’.
Stakeholder materiality has come to the fore lately along with the growing interest in stakeholder capitalism, wherein it is held that companies should not be operated for the benefit of shareholders but rather for the benefit of all stakeholders (including shareholders). It's this sense that companies have significant impacts, both positive and negative, beyond a myopic focus on profit, and they should take responsibility for these impacts.
Under a traditional shareholder materiality framework, if Company Y contributes significantly to climate change but the effects of climate change are not of any consequence to the company’s continued performance, then climate change is not a material issue for this firm. Under a stakeholder materiality framework, if Company Y contributes significantly to climate change then climate change is a material issue for it to address as the consequences of climate change are felt by stakeholders even if they do not pose any meaningful consequences to the company itself.
The most common stakeholder framework is that of the Global Reporting Initiative (GRI) and the associated UN Sustainable Development Goals (SDGs). These frameworks set out to establish common language, metrics, and a system for companies to report their impacts on issues identified as being important to stakeholders through a lens of sustainability.
Note that the starting point of these frameworks is not about corporate performance but rather about what is important to stakeholders relative to sustainability. In this sense, Amazon Inc. should certainly report on its labor practices as it is the second largest employer in the USA and hence carries significant weight throughout the broader employment standards landscape.
If shareholder materiality is about the effects of issues on corporate performance then stakeholder materiality is about the effects of corporations on issues, regardless of concerns with profitability. Perhaps not surprisingly, the stakeholder materiality framework has not been able to displace the shareholder materiality framework within financial markets, although it does continue to gain favor in consumer markets.
But What about Double Materiality?
Double materiality, in our view, is the direction markets are moving, but is nonetheless an unfortunate term.
Double materiality is pretty much just what it sounds like. In this, companies should address and report on issues that meet shareholder materiality thresholds and stakeholder materiality thresholds. In this sense, double materiality means addressing issues which present meaningful risks or opportunities to corporate performance as well as issues to which the company has a meaningful impact. You can imagine this as both inward and outward materiality.
We say this is the direction markets are moving not because of a moral imperative we happen to agree with, but rather due to market signals we are observing. Consumers and investors are now fully internalizing their stakeholder materiality concerns into their purchasing and investment decision-making processes. This has the effect of transforming a formerly non-financial stakeholder concern into a financially material market signal. The line between stakeholder and shareholder is blurring.
In the early 2000s when shareholder materiality research was being formalized, only a slim minority of stakeholder concerns were internalized into market transactions while the vast minority existed outside of the market. As an example, at the turn of the millennium, many people were concerned with biodiversity conservation (I like to refer to this as the National Geographic effect rolling over from the 1990s).
This level of concern, however, was predominantly displayed by people supporting NGOs, pushing elected officials to bolster sustainable development and associated foreign aid programs, and perhaps dabbling in eco-tourism. Within all of this, only a small share of people acted on these concerns within their market transactions, as in modifying their purchasing or investment decisions. In effect, stakeholder concerns were acted out in the social and political spheres and much less so in the economic sphere.
Now fast-forward to today and things have completely changed. Today, stakeholder concerns fully inform purchasing and investment decisions. ESG-oriented funds have been witnessing record inflows of investment capital over the last three years while consumers have made it clear that their concerns will inform their purchasing decisions, consider that:
93% of global consumers report that their views on sustainability inform their purchasing decisions, with 51% saying sustainability is even more important to them now than it was only 12-months ago;
Half of consumers have paid a sustainability and/or socially responsible premium for products…on average reaching up 59% more. (see link above)
From 2015 to 2021, consumer packaged goods which were sustainability-marketed grew 2.7X faster than products not marketed as sustainable. And in 2021, one out of every two new products introduced had a sustainability benefit.
The long-ago belief that stakeholder concerns were not market dynamics may once have been true, but no longer holds. With consumers and investors acting on their concerns and internalizing them into their market-based decision-making, stakeholder concerns are quickly formalizing as market dynamics.
Issues of stakeholder materiality are now impacting companies' revenues and access to capital, and so stakeholder materiality is becoming shareholder materiality.
As such, it is easy to understand the foundation for a move to double materiality, however we still do not like this term. Double materiality implies that there are two distinct forms of materiality which should both be addressed. History has shown us time and again that when we create distinctions we also create opportunities for exclusion.
We prefer to think that there are not two distinct forms of materiality. Rather, stakeholder concerns have become market dynamics which influence shareholder concerns, and so the formerly distinct identities of shareholder and stakeholder materiality are now merging into a singular comprehensively integrated understanding of materiality. (At Motive, we refer to this as dynamic materiality, which we will explore in a future newsletter as this one is already getting far too long!).
In the End
Materiality is about determining what matters. There are historical distinctions to shareholder and stakeholder materiality, however, with evolving consumer and investor decision-making patterns, these two formerly distinct typologies are merging into what is now being called double materiality. We firmly believe there is one more step in the works as double materiality evolves into a more integrated understanding, but this is largely academic and will not present any significant changes to actionability.
The concept of materiality is not as popularly discussed as its degree of importance would suggest. No other modern institution is as capable of leading or responding to change as is the company…and determinations of materiality are what will define the types of change companies act on. Understanding materiality and how it is evolving is critically important to ESG and Sustainability.
What This Means for CSOs: Materiality is at the root of everything you do--it is the answer to “what should we focus on?”. Unfortunately, there is no clear-cut assessment of materiality. Even the definition employed by accountants for financial materiality is one based predominantly on judgment and reasoning rather than on rules and categories.
Most importantly, this means one of the most critical elements of your job is actually the materiality assessment process. We see quite a few ‘cookie-cutter’ approaches to materiality assessments in ESG and Sustainability reports which have been promoted by certain frameworks (and we will definitely be exploring these in future posts!), but these all serve to simply jump through the assessment process as if it were a compliance nuisance rather than a fundamental component of success.
No other individual has as much power in determining what is material to your company as you do. The concept is vague and markets and stakeholders are waiting for you to take the lead:
Develop a materiality assessment process that works for your organization;
SASB, GRI, and other frameworks can be used as starting blocks but should not be relied upon as complete processes;
Confidently present what you consider to material to you organization and why;
Build-out your ESG/Sustainability program from here.
Acknowledge that markets and social landscapes evolve and so too should consideration of materiality.
Out In The World
A Quick Review of Recent News
Bank of America
Bank of America has developed one of the better materiality assessment processes we have reviewed to date. We would consider making a few alterations, but this is not important as the Bank of America:
Has provided full transparency to their process;
Has taken full ownership of their process;
Has provided descriptions and definitions to all elements of their process;
Has incorporated channels to update and modify their process as necessary over time.
We say that any little disagreements we may have are not important because no materiality assessment process will ever satisfy everyone. The objective should be to develop a process that works for the company and satisfies most of the concerns of most interested stakeholders--and Bank of America has done just that.
What This Means for CSOs: The Bank of America approach may not be best-suited for you, but it is a great example of how they started with a foundation based in leading frameworks and built-out a process that works for them and helps them stay focused on what matters. You can lean on existing frameworks and the work of other companies, but you need not be beholden to it.
Double Materiality is Happening
Investors and regulators continue to debate exactly which ESG disclosures are material and which are not. However markets appear to be leaving these debates behind. Some companies may try to hide behind traditional definitions of financial materiality to justify limited ESG disclosures, however, as ESG considerations become mainstream criteria and impact investment allocations, they will likely fall within the traditional definition of financial materiality itself. The practical definition of materiality may very well change even if the regulatory definition does not.
What This Means for CSOs: Perhaps not surprising, markets are moving faster than regulations. You need to develop a materiality assessment process that works for you and allows you to identify exactly what you should be focused on and why. The financial definition of materiality should be viewed as a baseline and not fully prescriptive--if you determine that you should be focusing on an issue which would formerly have been considered stakeholder materiality instead of shareholder materiality, then so be it.
Why Is It So Important?
The ESG Mirage in Bloomberg is not new, having been published in late 2021, and we have discussed this article before, but it perfectly summarizes why clarity around materiality is important. In this piece, the authors demonstrate how MSCI ESG ratings--the foundations of the majority of ESG mutual funds and ETFs, which are receiving record inflows--have very little to do with the impacts of companies on the planet and all to do with risks to the companies’ bottom lines. It was broadly received as a ‘gothcha’ moment in ESG across social media but really was a case study in different understandings of materiality. MSCI products operate with a perspective of shareholder materiality whereas many newcomers to ESG investment products are bringing a perspective of stakeholder materiality…and MSCI marketing did very little to ever correct this situation as demand was skyrocketing. Both sides approached the same products but from different understandings of materiality and just like that a PR-crisis emerged for the ESG industry itself.
What This Means for CSOs: Transparency matters. You should develop a materiality assessment process that works for you and focus on the issues that are deemed important throughout this process. Be sure to describe and define your process so as to ensure there are no misunderstandings. If you explain what you are focusing on and why and a stakeholder disagrees with you, this will result in a discussion; if instead you black-box your process and a stakeholder disagrees with you, this will result in accusations of greenwashing, ignorance, or corruption.
In the end, there is no one approach to materiality. There is a legal definition, but this is remarkably open to interpretation so as to serve as a baseline conceptualization at best. ESG and Sustainability succeed based on materiality, and the opportunity to define what this means for you is at hand. We are focused on this space and will have more to say in our next edition, in the meantime, please connect with us on Twitter and LinkedIn, or from our website to continue this discussion.