The Sustainability Buzz

Materiality Matters: How Emerging Sustainability Standards Could Drive Financial Performance

Einstein at blackboardConventional wisdom has held that sustainability investments require trade-offs in a company’s financial performance.  This has often been true as long as companies have taken a project-based approach to sustainability, blindly throwing money at renewable energy or waste reduction or carbon-cutting projects with little or no connection to an overall strategy.  These projects, while they are certainly worthwhile and possibly yield some quick savings, may still be irrelevant to managing risks and costs associated with unsustainable practices at a business’ core.  And these risks can jeopardize the long-term financial viability of a company and scare away investors.  But it doesn’t have to be that way.  By adopting a strategy that focuses on environmental, social and governance issues that are most material to an organization’s value, companies can drive both sustainability and financial performance.

Last July, we introduced the concept of materiality as it relates to sustainability and told you that it was a way to determine if external risks and costs of doing business really matter to the organization’s long-term economic health and general viability.  As it turns out, identifying whether these externalities are material is important, as evidenced by a report released earlier this week, Natural Capital at Risk: The Top 100 Externalities of Business (produced by Trucost and TEEB Business Coalition), which found that primary production and processing industries have externality costs of $7.3 trillion.  (Yes, that’s with a T.)  Even if only a small percentage of these costs are material, that’s still a lot of money (and associated risk).

But here’s the catch with materiality–it can often be tricky to determine which environmental, social and governance (ESG) risks are actually material to one’s business.  Even once you’ve identified what’s material, those externalities can be difficult to quantify.  Difficult, yes, but not impossible.  (We know because that’s part of what we help companies do.)

Luckily, this week was a good week for companies struggling to determine what’s material and how it relates to financial performance.

First, the Sustainability Accounting Standards Board (SASB), a non-profit modeled on the Financial Accounting Standards Board (FASB) that is developing industry-specific standards for publicly traded companies to incorporate ESG issues in their annual financial filings, released their first set of guidelines for the financial sector.  For seven different industries within the sector, these guidelines identify a list of potentially material ESG issues and rank them by how material they are for each individual industry.  SASB plans to develop these guidelines for 89 industries in 10 different sectors.

To determine how material an issue is, SASB evaluates three different areas: evidence of interest, evidence of economic impact and a forward-looking adjustment.  The evaluation of interest reveals how often a specific issue arises in each industry, the evaluation of economic impact shows whether mismanagement of the issue will affect traditional value parameters (i.e. return on capital), and the forward-looking adjustment may change the level of materiality if an emerging issue has a high likelihood to create a big impact on outside stakeholders.

The second big release of the week was from the International Integrated Reporting Council (IIRC), which released a draft framework for integrated reporting.  A year ago, we talked about integrated reporting, which sits at the intersection of financial and non-financial reporting.  It ties together financial and non-financial performance measures to provide a more accurate picture of corporate value.  It’s designed to help investors and other stakeholders better understand how financials are impacted (positively or negatively) by things that haven’t typically been quantified in the past in a financial report–things like employee retention, community outreach and resource efficiency.

The IIRC defines six kinds of capitals that a company should evaluate and the report on the degree to which they are creating, compromising or eliminating value in these categories.  The six capitals are: financial (self explanatory), manufactured (physical assets), intellectual (branding, reputation and intellectual property), human (people, such as employees), social and relationship (with communities, NGOs or other outside groups) and natural (air, water, land, biodiversity).

The upshot of all of this is that it helps clarify for companies what they should be measuring.  After all, there are no benefits to measuring something that provides you with no real information or doesn’t impact your overall strategy–be it financial, environmental or otherwise.  As companies become more savvy and realize that they need not just a series of ad-hoc projects, but a real sustainability strategy, it becomes increasingly difficult to measure performance in a meaningful way and ensure that they’re focusing on the right things.  Assessing materiality is one way to define what’s important, but as standards begin to emerge, they also help companies focus their efforts on quantifying the ESG issues that will truly impact financial performance and long-term health of the business.  And in our new era of big data–where you could measure everything and learn nothing–it sure is helpful to have some tools in your belt to focus your time and resources on measuring the right things.

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