Tuesday, June 7, 2016

Materiality: Talking heads, talking numbers and talking finance...

Part II on the GRI Global Conference 2016
Materiality had some sober moments at the GRI Global Conference in Amsterdam this May. It was evident that established reporters are asking more pertinent questions about the value of the materiality determination process. Some are starting to do it less frequently (for example every three years, not annually). This raises three important questions:

  1. The frequency or timeliness of the materiality determination processes;
  2. The level at which the process is conducted - for example from local community engagement to global "expert" stakeholder panels; and
  3. The extent to which reporters build in a forward-looking dimension and ask stakeholders about "actual" versus "potential" significance.
On the time dimension, RobecoSAM noted during the Sustainalytics Master Class that the time horizon it applies for specific issues is typically three to five years. Applicable time frame is influenced by both the industry sector and the issue context involved. In the case of an issue such as climate change, significant events can range from very long term to very short term developments.

The Conference featured findings from the first report of the Financial Stability Board (FSB)'s Task Force on Climate-Related Financial Disclosures. The report states that climate risks can result in disruptive events, and that such cases require a timely update of climate-related disclosures. At the same time its recommendations expect longer term, forward-looking information that is backed up by scenario analysis. The implies adequate research. Note that international reporting standards typically recommend five tests for applying the principle of materiality (see Materialitytracker for a comparative overview). They imply not only stakeholder engagement but also a fair amount of desk research. In its materiality methodology the Sustainability Accounting Standards Board (SASB) has described it as examining evidence of interest, evidence of financial impact and consideration of forward-looking impact (including possible systemic disruption).

With respect to time frames in the context of specific industry sectors, ABN AMRO noted that private banks (working with family money) would tend to think longer term, corporate banks would tend to focus more medium term and retail banks more short term. Compared to other financial subsectors, retail banking is more regulated and exposed in offering products of relatively small amounts at high interest rates to for example households. Being more regulated and exposed to consumer pressure also leaves retail banking or consumer finance with topics such as affordability and privacy as highly material issues according to the sector standards of SASB. On the other hand, SASB does not list business ethics as a material topic for consumer finance, but rather for commercial banking, investment banking and asset management among seven subsectors of the "financials" sector category.

For leading reporters the prioritization of stakeholder groups are becoming more refined. This includes being more focused in targeting certain business unit leads, rating agencies and investors for engagement. Experts on global stakeholder panels can provide valuable advice to multinationals, often free of charge mind you, but after years of operation some of those "critical friends`' can become too "friendly". Some business managers express the sentiment that much of the materiality determination process boils down to common sense or gut feeling, and that there is little need for doing an extensive process every 1-3 years. For some simply going through the materiality process annually becomes a "tick the box procedure" that risks no longer being strategic.

Some exclude from the materiality determination process discussion of topics seen to be "universally material" - topics such as governance and ethics noted Deloitte in its Materiality Master Class. Describing its approach, RobecoSAM explained that some "cross-cutting topics" are evaluated irrespective of their position on its industry sector materiality matrix. These are topics such as corporate governance, codes of conduct and reputational risk (assessed through media analysis).

The special status of some topics brings to mind an issue raised by the online hub Materialitytracker, namely level of aggregation and the level of specificity at which material topics are defined. Materialitytracker identifies the key material topics reported across sectors by the DJSI Industry Leaders since three years. Some define material topics at the level of "Aspects" (as per GRI G4), listing topics such as "governance". Others go to a deeper (in some cases indicator) level and prefer to be more specific in defining topics - for example "director remuneration" and "scope 3 emissions" - i.e. subthemes of "governance" and "climate".

From pre-financial to financial

In the most recent edition of Defining What Matters (2016), the GRI and RobecoSAM differentiates their definitions of materiality as being about "reporting materiality" versus "financial materiality". A graphic in the report (see below) illustrates that the list of topics that represent "reporting materiality" and "financial materiality" overlaps but that neither fully encapsulates the other. Traditionally, certainly in financial accounting, the assumption is that"materiality" is about content that goes into a report. The question then becomes: Which report?

Sustainability reporting materiality versus financial materiality
(from Defining What Matters, GRI and RobecoSAM 2016)
During a session presentation of their study (covering the three sectors mining, metals and utilities) at the Global Conference, GRI's Alyson Slater posed a question about possible differences between what is reported to be material versus what the sustainability rater finds to be material. Why did some participants expect any difference between what reports from a particular sector disclose to be material versus what RobecoSAM in its analysis of that very same group of reporting companies may found to be most material. I argued it depends which report you are looking at. If it were a sustainability report, its content may be highly material in the eyes of diverse stakeholders. However, if it were an integrated report, the content may more specifically be "financially material" in the eyes of the providers of financial capital. RobecoSAM is quick to point out that its sectoral materiality matrices reflect the views of RobecoSAM as investor (asset manager). Its focus on "financial materiality" or what I would call "integrated materiality" therefore resembles the content one would expect in an integrated report as defined by the <IR> Framework of the International Integrated Reporting Council (IIRC). 

The Sustainalytics Master Class included a panel discussion with RobecoSAM, ABN AMRO , E&Y and an academic from City University London. Sustainalytics highlighted the findings by Harvard researchers Khan, Serafeim and Yoon (2015) that firms with good performance on material sustainability issues significantly outperform firms with poor performance on those issues. This is based on their examination of the stock performance since the 1970s of 2307 firms from the MSCI KLD dataset and cross-referencing sector-based material topics as identified by SASB in the USA. They conclude that investments in sustainability issues are indeed shareholder-value enhancing.

In describing its value-added analysis to support more informed investment decisions, Sustainalytics noted that certain "key ESG issues, if unmanaged, may have significant negative impacts on an issuer's business and/or the environment and society". This raises the possibility of certain issues - such as human rights - not being viewed as "financially material" to a reporting organization even though it may have significant negative impact on society.

RobecoSAM described how it feeds "financially material sustainability data" into its integrated analysis to determine fair value. Just to be clear, the latter refers to the value of a share price. Based on its assessment of sustainability risks and opportunities, a certain percentage gets added or subtracted from share price to determine the eventual "fair value". Annual reportback by members of the UN Principles for Responsible Investment (PRI) suggests that this integration with the fair value analysis of listed equities is still a minority practise. While possibly half (USD 60 trillion) of Assets under Management (AUM) world-wide are signed up to the PRI today, this obviously does not imply that all signatory members overnight apply all the principles to 100% of their portfolios. In the recent independent evaluation of the PRI following ten years of its existence, the PRI itself acknowledges that its signatories' implementation still lacks depth.

RobecoSAM assured participants that it considers both the downsides (risks) and upsides (opportunities) when adjusting value, despite using (like IIRC) the risk analysis matrix and considering magnitude alongside probability as framing criteria. Its integrated analysis involves assessing financial materiality by examining impact on the  business value drivers - namely revenue growth, profitability, capital efficiency and risk profile. This is based on the financial value drivers identified by Alfred Rappaport in the 1980s, as I highlighted before (see Integrated Reporting of 21 November 2014). They are also employed in the methodology of Sustainalytics, which in its Extended Shareholder Value Model makes the link between ESG issues and the financial value drivers - including cost of capital and tax rates.

The "financial" impacts are also the focus of the FSB Task Force, which highlights the lack of "reporting regimes" or disclosure instruments that specifically extend the analysis to this level (in particular financial risks). The first of its seven recommended principles for climate disclosure addresses materiality, stating that "Disclosures should present relevant information". In explaining this principle, it zooms in on "business model and strategy" (like the IIRC <IR> Framework). It argues that a company "should provide disclosures to the extent the underlying aspects can have a significant impact on the business model, strategy risks, or future cash flows". Traditionally, the latter is of primary interest to financial analysts and investors. The primary interest of the Task Force is financial reporting (considering disclosure venue / placement), and it displays greater concern about "risks". Its definition of "materiality" describes it as being about "information on economic, environmental, social and governance performance or impacts that should be disclosed" (own emphasis).

Back at the Conference master classes, Jean-Pascal Gond of Cass Business School described the focus on the financial dimensions of ESG impacts as a form of legitimization. With it comes the risk of being too narrow or reductionist in focus.  Heather Lang of Sustainalytics described it as thinking more about financial materiality as you narrow it down. Their approach to thresholds in determining materiality is not focused exclusively on "financial" materiality though. It is not a simple mathematical formula of determining significance only in financial terms. Clearly the unpacking of costs and benefits is not an exact science (as yet). Even financial accounting standards have always made clear that materiality involves (experienced) judgment, one that considers of both quantitative and qualitative information, as well as financial and non-financial information.

Read Part I on the GRI Global Conference 2016, 31 May

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