Materiality Assessment

Why do companies undertake “materiality” assessments for ESG matters? The reasons are threefold: first of all, regulatory requirements essentially mandate it so that companies disclose the type of ESG information that might be material to a reasonable investor. Secondly, stakeholders want ESG information, but particularly ESG information that is material. And finally, companies need to know what ESG matters are material to them so that they can use that information to better execute  business strategy.

Financial Materiality

As we all await the SEC’s final new rules on climate disclosure – expected to emerge in the second quarter of this year – it’s a pretty good bet that the SEC’s final rules won’t disturb the formulation of the “materiality” concept that practitioners have been long acquainted with: “financial materiality.”

The SEC’s rule proposal last year focused on “financial materiality” – defined as “information that can have an impact on public companies’ financial performance or position and may be material to investors in making investment or voting decisions.” The SEC could have gone other ways, such as exploring the notions of “double,” “dynamic,” and “nested” materiality, but the SEC avoided any mention of those alternative definitions in its rule proposal – probably due to the looming specter of a legal challenge over its authority to do so.

However, you should be familiar with these alternative definitions as other regulators – either within or outside the US – or other stakeholders may ask you to provide climate disclosures beyond “financial materiality.”

Single materiality is inwardly focused: “how does this impact the company?”

Double materiality is both inwardly and outwardly focused: “how does this impact the company as well as our stakeholders?”

Nested materiality essentially is a hybrid of the single and double materiality standards.

Dynamic materiality is materiality that may be changeable or fluid over time.

“Reasonable Investor”

Going back to financial materiality, the input of your independent auditors when making a materiality determination is invaluable, as well as inevitable in most cases. The auditors will be applying the SEC’s Staff Accounting Bulletin No. 99 – and this statement last year from the SEC’s Chief Accountant is a good primer on how to apply SAB 99.

The financial materiality analysis is made through the lens of a “reasonable investor.” Those within a company should place themselves in the shoes of what a reasonable investor would think. This is easy to say, but the reality is that it’s an elusive threshold because materiality determinations are challenged with the benefit of hindsight. What might seem reasonable to you might not to a court that is tasked with deciding whether your materiality determination is actionable.

What type of ESG information does a “reasonable investor” react to? Stock price movements aren’t the final word when analyzing which disclosures are material, but they sure can be instructive. A recent study – “Which Corporate ESG News Does the Market React To?” – conducted by George Serafeim and Aaron Yoon found that stock prices react only to industry-specific financially material ESG news, and the reaction is larger for news that is positive, that receives more news coverage and relates to social capital (relative to natural or human capital) issues.

Investors that submit shareholder proposals to companies might use a company’s ESG disclosures (or lack thereof) to help them determine whether to submit a shareholder proposal to that company. Or a company’s ESG disclosures could lead an investor – or a group of investors – to undertake an activist campaign against management. Other stakeholders – such as customers or communities – also could use that information to partake in activism. So there are many reasons why you want to disclose all material ESG information publicly.

Line-Item Requirements

In addition to the judicial “reasonable investor” threshold, there are a number of line-item requirements in the SEC’s regulations that elicit ESG disclosures. In other words, companies are required to make these types of ESG disclosures even though a reasonable investor might not deem them to be material. In a sense, the SEC’s rules make them de facto material by mandating them.

When the SEC adopts final climate disclosure rules in the near future, there will be a host of these line-item requirements in the climate arena. Proposed new Item 1501 and 1502 of Regulation S-K, among others, has a host of various climate-related requirements in there – ranging from assessing “physical risks” and “transition risks” – to carbon offsets and internal carbon pricing – to targets and goals and board oversight. Not to mention the impact all this has on the financial statements. As noted in this Reuters’ article, companies should be planning their data strategy now to meet the coming line-item requirements.

The SEC bolstered rules that have resulted in more social disclosures a few years ago – particularly focusing on human capital and board diversity. And the SEC says it will be proposing rules that will result in even more human capital disclosures by the end of this year. There is a laundry list of governance line-item requirements that the SEC has had on the books for the past two decades, ever since the Sarbanes-Oxley Act and Enron.

Protecting Yourself

Protecting yourself when making a materiality decision is key, particularly when the decision is made not to disclose something. Sure, a misleading disclosure can get you in trouble. But an omitted disclosure can be even worse. You want to bounce disclosure ideas off as many people as possible, and as high up the corporate ladder as you can.

When it comes to climate matters – when internal and disclosure controls are being built for the first time, when a financial materiality analysis is being applied for the first time – there is a heightened risk that something can go wrong. So you want as many resources as you can muster to ensure you’re not off the mark.

How ZMH can help: We can help you to tackle “materiality” assessments. ZMH offers a low cost, turn-key solution with an approach that focuses on:

1. Mapping your company’s current ESG profile against the SEC’s baseline disclosure requirements to identify potential gaps (our “Baseline Assessment”);
2. Identifying what should be your company’s appropriate internal resources and expertise with the goal of addressing any gaps in disclosure that are identified;
3. Helping to develop your TCFD, Scope 1 and 2 and other disclosures to assist in meeting the SEC’s minimum expected disclosure requirement.
4. Conducting a comprehensive ESG Materiality Assessment in order to better understand how your various stakeholders – including but not limited to clients, suppliers, employees, etc – deem material to your company’s overall ESG impact.