How materiality can help reporting meet the demands of investors

The materiality process helps to define key issues when assessing the impact of ESG risk.

In his 2018 letter to CEOs, Larry Fink calls for companies to have a social purpose and pursue a strategy that considers societal impact and broad, structural trends that affect potential for growth.¹   

And he is not alone. From EY’s investor survey, we know that investors are becoming increasingly interested in long-term value creation and support Fink’s stance. In fact, in last year’s survey, 92% agreed with Fink’s view.²

But few companies are effectively demonstrating how their strategies do this, or even how they intend to develop them. In fact, they are still grappling with this concept, let alone embedding it into strategy. 

So how can companies develop a strategy that considers societal impact? This article explores how the materiality concept can be used to help identify the key sustainability information to consider in a business strategy, while adhering to the requirements of the Global Reporting Initiative (GRI) and the International Integrated Reporting Council’s (IIRC) <IR> Framework. Specifically, it explores the evolving concept of materiality, how materiality is linked to environmental, social and governance (ESG) risk, and how greater integration of the organization’s existing materials, processes and enterprise knowledge can support better reporting while meeting the demands of investors.

Sustainability materiality is a complex and evolving concept

Materiality is a concept founded in long-established financial accounting procedures. This concept has been borrowed, adapted and applied to nonfinancial information. The GRI’s guidance tells us that we should focus sustainability reporting on the organization’s material issues. In defining these, we should ask ourselves whether the issues to cover in the sustainability report and disclosures are important enough to influence a stakeholder’s decisions in relation to the business.

Tension has been growing around how, for the purpose of sustainability reporting, organizations should be focusing on issues that could affect the value of the business. Organizations could be taking an inward look (e.g., the impact of human rights infringements on reputation, talent retention and security of supply) or including external issues that affect the business (e.g., loss of biodiversity, human rights infringements on individuals, climate change and the rights of future generations and ecosystems).

The UN Global Compact (through the Sustainable Development Goals (SDGs)) and the Global Reporting Initiative (GRI) (in its revised standards) are asking companies to focus reporting on outward impact (i.e., impact on the economy as opposed to impact on the business).

In its latest standards, the GRI seeks to clarify its definition of materiality. It says that relevant topics are those that can reasonably be considered important in reflecting an organization’s economic, environmental and social impacts, or influencing the decisions of stakeholders. In this context, “impact” refers to the effect an organization has on the economy, the environment and society.

However, measuring this impact is not straightforward and many organizations find they are struggling with applying this concept. 

Key considerations in supporting the materiality assessment 

There are two critical considerations beyond the materiality process that can support a materiality assessment:

1.       Defining a scale for assessing impact

There are various tools available to measure and prioritize material topics. These tools mainly leverage the approaches applied by risk professionals in assessing enterprise risks. The Delphi approach is the most common of these: it is a structured communication technique that relies on an external panel to assess risks according to a predefined scale. The scale used in assessing material topics has relied on internal stakeholders by having them assess the expected impact on the business.

An organization may agree a predefined scale that can be used to assess the impact of the organization on the economy, environment and society. This can be done at a validation workshop with internal and external stakeholders, where identified material topics can be prioritized. This may be a strong first step in assessing impact, before measuring material topics with other analytical tools, such as scenario analysis and probabilistic models.

Our approach to measuring impact is outlined in the diagram below:

1.       Mapping material issues against ESG risks

Globally, regulators continue to extend requirements for organizations to disclose risks within their mainstream annual reports and filings. For example, in Australia, Recommendation 7.4 (contained in the third edition of the Australian Securities Exchange (ASX) Corporate Governance Council Principles and Recommendations) asks ASX-listed companies to “disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks.” And in Europe, the EU Directive on nonfinancial reporting requires reporting of issues relating to human rights in the supply chain, to communicate both what the organization is doing to protect human rights and to disclose business risks associated with human rights infringements in the supply chain.

Many organizations point to their annual sustainability reports and their materiality assessments as meeting this expectation. Yet evidence indicates that there seems to be limited connectivity between material sustainability topics and enterprise risks. For example, the report, Sustainability and enterprise risk management: The first step towards integration³, sought to understand how well-aligned disclosures were between organizational risks and material sustainability topics. The report found limited connectivity suggesting limited organizational effectiveness for identifying, managing and responding to significant social and environmental risks.

Risk assessment and materiality assessment processes have traditionally had different objectives but should be more closely aligned. At a minimum, organizations may consider mapping their material sustainability topics to their enterprise risks. This can help integrate potentially longer-term risks into enterprise risk management (ERM) processes which may lead to better oversight and resource allocation for managing these material topics. While these risks might seem less likely today, they could have significantly greater consequences in the long term, which organizations can be better prepared for.

Examples of sustainability risks and how they can be identified are detailed below.

Recognizing the opportunity for a well-designed materiality assessment to contribute beyond the content of the sustainability report can help facilitate better engagement and investment from the business. Improving the depth of analysis to support materiality processes can also increasingly become important as investors begin to rely more heavily on these disclosures or even start undertaking their own assessments.

EY is experienced in undertaking materiality assessments and has knowledge in incorporating megatrends analysis and considering emerging risks (including the Sustainable Development Goals (SDGs)). We can work with other EY teams to leverage our proprietary tools and methodologies (including impact assessment and measurement) to support you to create a sound materiality process and assessment.

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

Certain services and tools may be restricted for EY audit clients and their affiliates to comply with applicable independence standards.  Please ask your EY contact for further information.