In this corner, DJSI; and in this corner, materiality. Ding!
July 2015 User View by Robert G. Eccles, Professor of Management Practice at Harvard Business School, and Tim Youmans, Researcher at Harvard Business School, United States
“If we we’re serious about meaningful reporting on ESG performance, the focus should be on targeted, business-relevant metrics and a simple, transparent reporting process. The era of being part of a green ranking for the sake of being rated has passed.”
THOSE were the final two sentences in Ann Klee’s article “Ratings Good for the Environment?” published in the May/June issue of The Environmental Forum. Ann is General Electric’s (GE) Vice President, Global Operations – Environment, Health and Safety. She is echoing a theme we hear in our research across many industries, namely that the current state of sustainability reporting is in some ways, “contra-materiality” when the proper meaning of the term “materiality” is understood. In this post we will illustrate this point using the examples of GE and of the Dow Jones Sustainability Index (DJSI).
Our ongoing dialog with current and former financial and sustainability executives across the global 1000 landscape uncovers a broad, two-part message of contested terrain. On one hand, the application of materiality to ESG reporting has made those efforts more tightly focused and more clearly linked to value creation, often reducing the length of, yet enriching, annual reports, 10-Ks and 20-Fs. On the other hand, these same executives report that they are bogged down with tremendous immaterial sustainability reporting burdens which actually detract from their firm’s value creation efforts. The bottom line is that broad-based sustainability indices are not materiality indicators, and thus are not material themselves.
So how did we end up with this state of affairs? It would appear that many corporations, with the best of intentions, have acquiesced to stakeholder and sustainability rater pressures to aggregate broad sustainability measures of questionable material value. Ann Klee reports that in 2014:
“GE developed responses to more than 650 individual questions from ratings groups. The process took several months and involved over 75 people across the organization, with virtually no value to our customers or shareholders, and even less to the environment. Having too many competing rating groups diverts resources from activities that can truly impact sustainability.”
In an upcoming journal article, author Youmans will highlight the case of a financial services firm, including its experience filling out the energy and water consumption section of the 2014 DJSI evaluation. While energy consumption and water use are not material for this firm (and likely not for its sector), it still had to coordinate and consolidate energy and water reporting on all facilities in all regions across the globe, taking up valuable employee time on immaterial reporting. Many firms report similar immaterial sustainability reporting experiences across a broad range of topics and reporting instruments including, but not limited to, the DJSI.
Two drivers may be behind this: (1) many institutional investors have adopted DJSI scoring (and similar) as one of a growing set of ESG screening factors and (2) broad-based sustainability index performance improvement has made its way, with the best of intentions, into senior executive variable compensation in a growing number of firms. Few CEOs want to see their firm’s score downgraded, particularly if it affects their bonus. Therefore, in the near term, management in these “best intentioned” corporations will continue to be burdened with a huge amount of immaterial sustainability reporting.
As an admitted oversimplification of Chapter 5 “Materiality” of author Eccles’ recent book, The Integrated Reporting Movement: Meaning Momentum Motives and Materiality (author Youmans was a key contributor to Chapter 5), the power of materiality comes from three sources and one guiding principle: Materiality, at its essence, is entity-specific, audience and time frame dependent, and based ultimately on the judgment of the board of directors.
Materiality’s guiding principle is conciseness. As clearly stated in both the International Integrated Reporting Council’s and Global Reporting Initiative’s underlying reporting principals, boards that have the courage to be concise and limit reporting to only material information, are also sending the meta-message that they have the ability to exercise this judgment … in other words, to govern. Thus, materiality is also the antidote to greenwashing.
Recent quantitative research from our colleague George Serafeim shows that “firms with high materiality scores and concurrently low immateriality scores have the best future stock performance” [emphasis added]. In “First Evidence of Materiality” Serafeim and his co-authors show empirical evidence that focusing on the material issues creates value. In this research, firms that score high on reporting the Sustainability Accounting Standards Board (SASB)’s industry-material issues while also minimizing reporting on immaterial issues outperform benchmark equity indices over the long term. Given such first evidence, in the early rounds of this contest between materiality and broad-based sustainability index reporting, it is our opinion that materiality is currently losing on points but gaining ground every round.