Sustainability reporting metrics are getting closer to allowing easy comparisons of companies over time — which investors like.
The recent release of the latest Global Reporting Initiative G4 standard has again focused many managers’ attention on the perennial issue of sustainability reporting. When first envisioned in the 1990s, sustainability reporting seemed to be a logical extension of traditional financial reporting. But imitating financial reporting was easier said than done.
The dream of a single nonfinancial reporting standard is that sustainability metrics can do what financial metrics do: offer easy comparisons among companies over time. For example, The Coca-Cola Co.’s price-to-earnings ratio, when compared to PepsiCo’s, tells investors something about the relative attractiveness of each company. But it’s important to remember that financial metrics get their relevance from relative performance. Any MBA will tell you that financial ratios should be used only to compare companies with similar characteristics. That usually means limiting ratio analysis to companies in the same industry. Comparing financial data from Tyson Foods with data from Cisco Systems is likely to get an investor in trouble. Comparing companies using nonfinancial metrics is even more problematic due to the fact that sustainability measures cannot be reduced into simple dollars, yen, or Euros.
With financial metrics, business executives and financial analysts can manage to a single bottom line. Sustainability managers have a more complicated challenge. No one can manage a list of 100 sustainability indicators, so a way to narrow down the list to the ones that move the needle for a company is needed.
An emerging solution has been found in the concept of materiality. Again, it was financial reporting that initially struggled with the question of what merits reporting, and this is where the concept of materiality first developed. Regulators define information as “financially material” if its omission would mislead an investment decision. Failure to expense a $10 wastebasket, for example, is not material for a company like Walmart. But the recent revelation that biotech company Theranos failed to reveal problems with its blood-testing technology is certainly material, and has cost investors billions of dollars.
As the materiality concept has expanded to include sustainability considerations, many have overlooked the fact that nonfinancial materiality is both issue- and stakeholder-centric. Financial materiality is itself stakeholder-centric. It’s designed to serve the interests of a special class of stakeholders: investors. Investors are increasingly interested in financially material sustainability information and recognize its usefulness. Volkswagen omitting the fact that it was programing its cars to cheat on emissions testing, for example, was sustainability performance information that was clearly material to investors.
Two organizations that are advancing our understanding of financially material sustainability are the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC). In yet another parallel to financial reporting, SASB has emphasized industry-level comparisons for material sustainability issues. This makes intuitive sense. Climate is material to the oil and gas industry, but less so to the medical sector. On the other hand, client data privacy is material to the medical sector, but less so to oil and gas industry. Birds of a feather impact together.
The social welfare utility of financial reporting is the allocation of capital to its best economic use, so the incorporation of financially material sustainability information into investment decisions is a valuable contribution. For the foreseeable future, environmental, social, and governance reporting will be a hotbed of financial innovation, as we are merely at the beginning of what banking quant jockeys can do with sustainability data.
Investor focus on industry-specific sustainability issues will make the financial sector a driver in social and environmental performance improvements, which is a big development. But obviously there are constituencies other than investors that have a stake in corporate sustainability performance. Most companies try to capture this through stakeholder engagement and the creation of a materiality matrix. The materiality matrix is a management tool that plots sustainability issues in two dimensions: Issues that are important to the business are placed along one axis and issues that are important to stakeholders are placed along the other. It is arguable that financially material sustainability issues will be captured on the business axis — but what about the stakeholder axis?
The problem here is that the importance of a given sustainability concern depends on whom you ask. Materiality is in the eye of the stakeholder. And a difficult truth is that many groups don’t have standing or an adequate voice in stakeholder engagement and materiality discussions; the still-ongoing dispute over the Dakota Access Pipeline in North Dakota is one example of this issue. Some of this is an economic development problem, in that stakeholders in rural or impoverished regions often lack the resources and infrastructure to project their concerns. Another barrier is the financial and human resource constraints that limit the ability of companies to do comprehensive outreach. But there are more fundamental issues that will confine the power of “stakeholder materiality” well into the future.
Nature, for example, cannot speak for itself, which is bad news for the millions of species not invited to a company’s stakeholder engagement meeting. Likewise, unborn future generations cannot opine on the consequences of a company’s carbon emissions and the consequent climate being bequeathed to them. One might imagine a company’s materiality matrix would look quite a bit different if stakeholders like these could participate.
Competing approaches to sustainability reporting are not going away any time soon. The diversity of stakeholders and multiplicity of sustainability issues ensure that managers will need a varied tool kit that includes nonstandard approaches to measuring and managing their sustainability performance. But over time, solutions to issues will arise, and as they are diffused across sectors, standard practices and performance expectations will take hold.
But don’t expect that state of affairs any time soon. For now, it seems, one-size reporting is unlikely to fit all.