ESG Materiality

By David Labistour

David Labistour retired from MEC, a Canadian national retailer specializing in outdoor apparel and equipment in June 2019, after serving as the CEO for 11 years. During his tenure, the organization was frequently recognized for its ESG leadership, ranked as Canada’s most trusted Brand by the U.K. based RepTrak Institute in 2017 and 2018, and 2nd most trusted in 2019. The organization was named Canada’s Greenest Retailer by the Retail Council of Canada (2017), Canada’s Top 100 Employers numerous times, including by Forbes in 2018, and ranked Canada’s Best Brand by Canadian Business magazine (2016, 2017).

What is materiality?

Simply put, materiality encompasses all the issues that the leadership of an organization needs to consider when assessing their opportunities and risks, the factors that could have both significant positive and negative impacts on the company and cannot be ignored. While financial materiality is well established and reported in the areas of accounting, regulation, and law, there is increasing pressure to understand and include non-financial issues such how decisions are made in a company (governance), the diversity of human resources and effects of company activities on communities (social), reliance on energy and water, and operational emissions (environment).

The 5 largest framework and “standard” setting institutions — CDP, Climate Disclosure Standards Board (CDSB), Global Reporting Initiative (GRI), International Integrated Reporting Council (IIRC), and the Sustainability Accounting Standards Board (SASB), are working together with the International Organization of Securities Commissions (IOSCO), International Financial Reporting Standards (IFRS), European Commission, and the World Economic Forum’s International Business Council towards an agreement on the elements necessary for a comprehensive, integrated corporate reporting framework. This collaboration has identified the importance of materiality and defined it, on the one hand, as "financial materiality" or "impacts inwards”, and on the other, "environmental and social materiality" or "impacts outwards." The audience for the former is investors, lenders, or other creditors and focused on issues that influence enterprise value. The audience for the latter is a broad set of stakeholders, including governments, consumers, business partners, responsible investors, employees, civil society organizations, local communities, and vulnerable groups who have an orientation to larger macro issues in the areas of economy, environment, and people.

Why?

Most large public and private organizations already use materiality as the foundation for their sustainability work, however, the increasing importance of ESG reporting is requiring greater clarity and transparency in this regard. Additionally, there is an increasingly compelling data that supports the business case for a deep understanding of an organization’s "impacts inwards” and "impacts outwards". A comprehensive Harvard Business School research paper published in The Accounting Review, noted that firms with strong ratings on material sustainability topics outperform firms with poor ratings. More revealing, firms with strong ratings on immaterial sustainability topics do not outperform firms with poor ratings on the same topics.[1].

In a new book entitled “How Boards Work” by economist Dambiso Moya, she notes that hasty, imperfect ESG is not the way for business. “Good environmental, social and governance practices take a company from financial shareholder maximization to multiple stakeholder optimization: society, community, employees. But if done poorly, not only does ESG miss its sustainability goals, but it can also make things worse and let down the very stakeholders it should help.”[2]

The challenge for leadership today is to align the company’s purpose, business model, and strategy with a systems level change while also maintaining profitability. This requires deftly managing the complexity of the investment process in both tangible and intangible assets in ways that anticipate future shifts by embedding new and different social and environmental objectives into organizational practices and decision making. But companies cannot be all things to all people and must focus resources and energy on the big things — what matters most to stakeholders and what will have the most impact on a business — is materiality. An analysis and understanding of the things that are material gives business leaders the confidence to focus not just on the important things but also to let go of those things that are not.

How? Know Thyself.

ESG is not about ticking a standard set of environmental, social, and governance boxes. It requires an honest exploration and understanding of the specific set of issues material to a particular business, its unique culture, customers, staff, supply chain, industry, shareholders, community, media, NGOs, governments, and regulators. It must also include deep insight into the organization’s reliance and impact on natural and ecological resources, and consideration of the dependencies or domino effects, while not immediately obvious, that can have compounding impacts down the line. All this knowledge starts with a materiality assessment.

If no process is in place in your organization, a good place to begin is with the end in mind. What matters, why and how to report? First, get familiar with the different reporting frameworks and pick the one that fits your business and industry. While the organizations mentioned above are working to harmonize reporting frameworks, and all include materiality in their reporting guidelines, their approaches and industry relevance are different. Regardless of company or the size and nature of activities, these “standards” will provide good context on the types of things to consider in a materiality assessment.

Next, do some research on the analytical approach. Most of the big accounting firms have information available on the process. There are also any number of NGO and consultancy sites providing frameworks, documentation — and services, if required.

Look at the materiality matrices of some leading organizations for inspiration and ideas of what can be done.[3]

Having done the research, plan your approach. The process will depend on the size and sophistication of an organization. For large public companies, hiring a consultant to work with your Sustainability and Finance teams may be in order. For an SME, a university intern may be invaluable in providing support. Whatever the process, the outcome should be integrated into the organization’s strategic planning and lead to the development of targets and metrics. These should then be included in the annual report in a way that meets both the spirit and substance of global reporting standards appropriate to your business and scale.

Regardless of scale and sophistication, a materiality assessment should:

  1. Identify your stakeholders. Determine and define your company stakeholders by answering this question: Who might be impacted or have interest in your business, social, or environmental activities? These might include customers, investors, leadership, employees, suppliers, NGOs, government, indigenous interests, and the media. In keeping with “not being all things to all people”, prioritize. As a former CEO, I always ranked customers first followed by staff, without whom nothing gets sold or done. I also made sure to include the “externalities” of our business. The resources we consumed, our emissions, and the impact on downstream communities. As Einstein said, “Not everything that counts can be counted and not everything that can be counted counts.”
  2. Identify your criteria and indicators. Regardless of process sophistication, any materiality assessment must identify and prioritize the major indicators targeted for measurement across the breadth of your stakeholders, what matters and why. Metrics must also represent a balance between internal and external focus areas and include such things as sales, margin, profit, customer satisfaction, staff engagement, environmental impacts, health and safety, supply chain human rights, and product responsibility. The number of metrics will vary depending on your industry, resources, and the size and scope of the business’ activities.
  3. Engage your stakeholders. You will not know if you do not ask. The scope, size, and frequency of engagement with stakeholders will depend on your business size and resources. Whether this is a group discussion or a simple survey, stakeholder perspectives need to be respected. Regardless of the size or sophistication, the engagement must uncover the issues material to stakeholders, both internal and external, and then be ranked on a scale of importance as to:
    - Importance to stakeholders
    - Impact on the business
    When it came to speaking for non-traditional stakeholders, I found the inclusion of NGO’s was important even if this was uncomfortable sometimes.
  4. Cross reference, collate and plot the information. The challenge in the materiality process is ranking. Not all issues can be both high on stakeholder importance and of high business impact. I always found value in supplementing our surveys with an additional dimension of quantitative research. There is a rich source of publicly available online information, including NGO white papers, industry data, investor papers and news items — always ensure reputable sources and peer reviewed content, to the extent possible. For a visual representation of your work (also easy to include in reporting), plot the results on a matrix style chart which categorizes the impact on the business (on one axis) and the importance to the stakeholders (the other) and rank them as moderate, significant, or major.
  5. Determine materiality factors and priority. This visual summary of information reveals the relative importance of issues facing an organization. Those items falling into the top right-hand corner of the matrix usually represent areas of highest economic, social, and environmental impact. This information should be integrated into the strategic and sustainability priorities for a company as well as inform development of new products, services or projects aimed at enhancing sustainable growth.
  6. Reporting and strategy. First, close the loop by reporting your findings to your stakeholders. Review the criteria and indicators defined in step 2 above and refine, if required. These outcomes will now be key inputs into strategic planning and metrics for ESG reporting.

The bottom line is that we are now fully aware that our planetary boundaries can no longer support a business-as-usual state. We need to consider both use of resources and waste accumulation, both of which are the drivers of unsustainability. There is no universal, one-size-fits-all solution when framing future sustainable development narratives. Some experts paint a picture of retrogression, in which few people see an improvement to their well-being and livelihoods perspectives. Whether this comes to pass is an open question, one that can be forestalled and mitigated by a concerted focus on what is material to our businesses. In Dambiso Moya’s words, we need to "transition the business from one with a singular focus to one that efficiently considers multiple perspectives”.

[1] Khan, Mozaffar, Serafeim, George and Yoon, Aaron, Corporate Sustainability: First Evidence on Materiality. November 9, 2016.

[2] https://dambisamoyo.com/book/how-boards-work/.

[3] https://assets.kpmg/content/dam/kpmg/pdf/2014/10/materiality-assessment.pdf, https://www2.deloitte.com/global/en/pages/about-deloitte/articles/reporting-process-materiality.html, http://sustainround.com/2019/11/13/materiality/, https://www.nestle.com/csv/what-is-csv/materiality, https://www.adidas-group.com/en/sustainability/managing-sustainability/partnership-approach/materiality-analysis/#/the-results-our-most-material-issues.