When you read the notes to companies’ Annual Reports you will come across the concept of financial materiality. Should a company uncovers an error that caused it to misstate revenues, expenses, or valuations, if the amount of money involved does not exceed a certain threshold, it is not required to restate its financial results. Why? Because if the impact of the error would not materially affect the company’s business, investors, suppliers, and/or other stakeholders, the cost of a restatement would outweigh the benefit.
The concept of materiality also applies to ESG disclosures. Investors and other stakeholders need to know how various ESG issues affect companies, and vice versa (more on that “vice versa” in the next paragraph) but it would be too costly to have every company compile data and run analyses on every ESG issue when some of them have little relevance to a company’s activities. While there is general agreement that materiality should apply, there is no global consensus on how to define materiality in the ESG arena. In this article, we attempt to shine some light on this topic.
Single or Double?
Probably the biggest debates in this arena centers on the issue of “double materiality” – in a nutshell, the question is: should materiality in ESG disclosures be based exclusively on the financial impact of an ESG issue on the company (an investor’s perspective), or should it also reflect the impact of the company’s activities on the environment, and on society in ways other than environmental? The Global Reporting Initiative (GRI) recently addressed this in an article, “The materiality madness: why definitions matter.”
In general, we believe it is reasonable to expect sustainability disclosures to consider the potential financial/business impact of ESG issues for the company and its stakeholders and also how the company’s activities impact sustainability for society. In fact, it is not difficult to identify feedback loops between societal impact and financial consequences. Even if everyone embraced this double materiality point of view, it would not necessarily lead to consistent ESG materiality disclosures across companies.
Take a look (as we do all the time) at ESG materiality assessments from various companies. You will quickly discover that companies in different sectors naturally focus on completely different ESG-related issues. That means that direct comparisons of ESG assessments across companies in different sectors can be challenging and should consider factors such as company size, changes a company has made over time, and growth, among others. Here, we consider two examples: pharmaceutical giant Novartis and Bank of America.
Novartis
In its latest ESG Materiality Assessment, Novartis states, “ESG topics are considered to be material to Novartis if they have a substantial likelihood of influencing the judgment and decisions of key stakeholder groups and significantly impacting overall business performance.” Novartis also considers materialities under Generally Accepted Accounting Principles (GAAP). Makes sense. That’s a good start.
Financial vs. Non-Financial Materiality
Novartis goes on to state that sustainability and ESG can have indirect financial implications for its business (and for all businesses). It notes that ethical misconduct and product recalls can result in fines, and climate change is increasing the likelihood of pandemics and extreme weather events that can disrupt its ability to manufacture products. Novartis notes that while issues like these will eventually show up in its financial statements, that may take time. In its own words (which we whole-heartedly applaud), “we need to be forward-looking when it comes to assessing the potential effects of ESG topics.”
Those points are not likely to pose dilemmas with respect to addressing ESG issues. But how about these, also covered in the Novartis report:
Stakeholders
Novartis can help the world achieve SDG #3 (Good Health and Well-being), which is great for some of its stakeholders, such as non-profit and charitable organizations, and healthcare providers. However, drug companies cannot give away their products or sell them at or below cost or they would go out of business. That would be bad for other stakeholders, including investors and employees, and for society, too. This is a great example of the natural tension that can arise among stakeholder groups with respect to ESG issues.
Patient Health & Safety – Pharmacovigilance, Safety Profile, & Quality of Drugs
(As an aside, we think “pharmacovigilance” is a great word, but is way too long to use in Scrabble). Novartis writes in its report that the safety and quality of its products has a direct impact on patient health. To put it bluntly, if the company lacked good quality controls, its medicines could harm or even kill patients. This would be very bad for Novartis’ business and for society, a good example of double materiality. Maintaining sufficient quality is table stakes in the pharmaceutical industry. Enough said, right? Maybe not. Novartis also points out that being a strong performer in this regard “goes a long way towards establishing medicine-producing companies as trusted, which in turn makes their products more trustworthy for patients.” That also has financial and societal impact.
Access to Healthcare – Affordability & Pricing
Novartis says that responsible pricing for innovative and generic medicines considers regional affordability, a favorable cost-benefit ratio, and overall healthcare costs. Sounds good, and supports SDG #3. It notes that affordable and responsible pricing levels can increase shareholder confidence and reduce reputational risk. All good. However, Novartis also points out that its drug pipeline, including its innovative gene therapies, has faced significant societal pressure over pricing. The pharmaceutical industry is challenged by this ongoing public debate on pricing. How can companies continue to develop innovative therapies if they cannot recoup their research and development costs and shareholders cannot earn a fair return on investment?
Bank of America
Using Bank of America as representative of the financial services industry, its ESG materiality assessment lists various frameworks it uses to guide its disclosures, including the GRI, SASB, the Task Force on Climate-Related Financial Disclosures, and the World Economic Forum’s International Business Council’s stakeholder capitalism metrics. Phew.
BofA highlights certain topics that are important to its business success and to its stakeholders that would not be front-and-center for a drug manufacturer like Novartis. For example,
- Cybersecurity & data privacy: identifying and addressing vulnerabilities and threats to customer and employee data security, preventing fraudulent transactions, breach of privacy or data security, and responsible use of big data.
- Community development & impact: strategic lending, investing, and philanthropy to support economic development in the community.
- Social advocacy: promoting equality and inclusion by investing in programs and initiatives to advance societal issues, and engaging with public policy makers to empower diverse groups.
- Transparency, accountability & reporting: providing clear, accountable and comparable business and sustainability information to the public.
BofA mentioned environmental justice (the idea that people of all cultures, races, ethnicities, and socioeconomic backgrounds deserve fair protection from environmental and health hazards, as well as equal access to the decision-making processes behind environmental policies and development) more than once. Not surprisingly, this was not highlighted in Novartis’ report – another example of why ESG materiality differs by industry.
Environmental issues apply across industries, but not in ways that offer useful comparisons. For example, Novartis notes that pharmaceuticals “can have a significant, negative long-term impact on natural resources and society” in terms of wastewater and drug disposal. There is nothing comparable for the financial services industry (of course, if the crypto ecosystem is seen as a financial service we note that bitcoin mining uses more electricity than some mid-sized countries). Lest we despair, note that many ESG topics covered in materiality assessments are common across industries, including:
- Ethical & Compliant Business Practices
- Diversity, Inclusion & Corporate Culture
- Employee Acquisition & Retention
- Fair Working Conditions
- Supply Chain Management & Mitigating Third-party Risk
We end with the observation that the investment community, the business community, and world are still in the early stages of understanding and defining ESG materiality. We believe progress is being made, to everyone’s benefit. OWL is dedicated to providing the data and tools stakeholders need to navigate through this issue.
