The Sustainability Buzz

Trend Watch: Materiality and Sustainability

Dirty Factory - Materiality and Quantifying ExternalitiesMateriality is a term that is popping up more often these days in discussions of sustainability, particularly as it relates to reporting.  We thought we’d take a look at the concept of materiality in sustainability this month and see what the implications are for companies that are trying to find better ways to measure and communicate their green performance.

Dr. Peter Graf, Chief Sustainability Officer of SAP, posits that “Sustainability is really all about externalities.”  From there, we could say that materiality is all about identifying and prioritizing externalities.  And right about here, we’d better stop for some definitions.  Externalities, from an economic perspective, are costs or benefits that aren’t represented in the prices of things and that have an effect on those who aren’t part of the original transaction.

In other words, if you buy a widget from Company X for $10 and Company X manufactures in the town where I live and puts out so much pollution that my daughter develops asthma, the external cost of that pollution (in terms of the cost of my daughter’s subsequent treatment for asthma) is not reflected in the $10 you paid for the original widget.  Company X is getting a free pass on the pollution they’re creating.  Conversely, if you buy a widget from Company Y for $10 and Company Y manufactures in the town where I live and has significantly reduced its use of water in the manufacturing process to keep its own costs low and therefore my town is less likely to suffer severe water shortages and my vegetables don’t die because I can’t water them, the external benefit of Company Y’s smart water policy (in terms of my not having to spend extra to replace my dead vegetables) is not reflected in the $10 you paid for the original widget.  I’m getting a free ride on the company’s foresightedness.

Materiality is the degree to which any of that matters to someone making economic decisions (generally understood as a decision to invest or not) about either Company X or Company Y.

For most of the 20th century, the answer was that most of the externalities described above were not considered material.  Company value was based almost solely on financial performance which was disclosed through a standard set of financial reports, codified since 1973 by FASB (Financial Accounting Statements Board) and enforced by the Securities and Exchange Commission.  Material externalities included things like whether a CEO had a terminal disease or whether the company was under investigation by a government body.  But over the last 15 years, more attention has been paid to externalities that relate to both the social and environmental components of the world in which companies operate.

In 2010, the Securities and Exchange Commission voted to require disclosure of how business and legal actions related to climate change may impact a business.  This action followed an October 2009 ruling that shareholders must be permitted to submit shareholder resolutions seeking information on a company’s financial risks from social and environmental issues.  It had become increasingly clear to the SEC that issues arising from climate change could have a material impact on the financial performance of any particular company, and stakeholders had a right to know what that might be.

Materiality Matrix - GRI ReportingOver the same period, the Global Reporting Initiative, the non-profit organization that maintains the comprehensive sustainability reporting framework that is used world-wide, was also tackling the question of materiality.  Its reporting guidelines recommend a materiality matrix, shown here, that helps companies identify those economic, environmental and social impacts that have the most importance to stakeholder assessments and decisions.  Those issues that land in the upper right hand quadrant of the graph are the ones of highest priority and can drive short and long-term planning.  A number of companies have begun to use this type of materiality matrix.  Among the leaders are Ford and BASF.

What is clear from all of this is that there is beginning to be some convergence of thinking on what represents materiality in sustainability reporting.  Further clarity was provided by the recent publication by Ceres, Oxfam and Calvert Investments of a report to be used as a guide “on disclosure and management of global impacts”.  The guide covers in detail the tangible risks faced by seven sectors of the economy from climate change and how those risks may impact each sector’s entire value chain.  If you’d like to read the guide, you can download it here.

As we approach consensus on what the material issues of a firm are in regard to sustainability from a stakeholder perspective, companies will increasingly need a way to measure and report those issues.  While it may still be years before a detailed standard is agreed to by the various organizations working on them, there is no question that accurate, verifiable reporting on material sustainability will become the norm.

Now you may be thinking, “But I’m not part of a public company or one that reports to GRI.  What does this have to do with me?”  It’s important because this is a case of the only trickle-down effect that’s actually known to work.  As more companies provide this type of information on a regular basis, it will gradually become more and more expected of all companies.  Ernst and Young reports that customers and employees are the number one and two drivers of sustainability initiatives.  That’s regardless of company size.  And they’ll demand it.

So now might be a good time to start thinking about how you’re going to define materiality, measure performance and report it effectively.  Our Green Performance Strategies can be a big help in that area.  You can read more about GPS here.

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