What's the difference between financial materiality and materiality with respect to sustainability? This question is at the heart of "assuring," or verifying, a company's sustainability report. And it's not as simple and straightforward as it may seem.
Financial materiality is about how quantitatively significant something is. Although there is no specific hurdle rate, it's what a reasonable person would view as important to be concerned about. As such, certain eco-metrics can qualify. Think carbon emissions for a power plant generating electricity or water consumption for a company like Coca-Cola.
But sustainability materiality is a much broader concept, says Peter Minan, KPMG's assurance leader of U.S. climate change and sustainability.
"It's not just about quantitatively significant data, but determining what type of data is meaningful to a company's stakeholders," he says. "If you don't know which stakeholder groups are important and what's important to them, it's hard to put forth meaningful data."
This article is the second of a three-part series. The first story (http://www.fa-mag.com/green/news/8124-accounting-for-sustainability.html) traced the trajectory of the Global Reporting Initiative, or GRI, a multi-stakeholder-based, consensus-seeking global institution that has developed and continues to refine frameworks and guidelines for environmental, social and governance (ESG) reporting.
Despite its usefulness, ESG data--like the rest of the data collected by the investment industry--has become its own separate silo, unconnected to the whole. Ultimately, the idea is to help corporations, as well as investors and other stakeholders, to connect the dots between a company's ultimate strategy and various ESG and financial issues.
This article discusses some of the tricky issues related to verification/assurance by accounting firms and others of the information contained in corporate sustainability reports.
Part three will look at efforts to create "integrated reports" designed to help investors analyze a company's strategy and connect the dots between the complex and inter-related environmental, social, governance and financial issues that determine a company's success. The players here range from Prince Charles and the Financial Accounting Standards Board to the GRI and Harvard University.
Beyond Judgement Calls
Sustainability reports are about transparency regarding ESG factors such as carbon emissions, workplace issues and corporate governance. According to Carrots and Sticks: Promoting Transparency & Sustainability, a 2010 report produced by KPMG, the United Nations Environmental Program and the University of Stellenbosch business school, there are now a total of 142 country standards or laws related to sustainability, and about two-thirds of those are mandatory and the rest voluntary.
But just as financial reporting has become so complex and so detailed as to render many corporate financial statements virtually non-transparent, sustainability data has the same potential. Investors want comparability among companies--something that has led some companies to publish everything suggested in the GRI Guidelines.
That said, publishing more data doesn't necessarily equate to better data, Minan argues. Since there is a huge variation in the businesses that companies conduct, as well as a broad range of stakeholders, the relevance and materiality of different ESG issues varies by company and industry.
"You've got companies making different judgments and different interpretations within industries over data that is in some cases subjective," Minan says. "That's part of the reason we think assurance is such an important part of the future here."
The GRI Guidelines stipulate that companies are required to list their stakeholders, show how they prioritized them, and explain how they reached out to them. But according to Nancy Mancilla, co-founder of the ISOS Group, a consultancy that assures sustainability reports, stakeholder engagement--along with materiality, which is closely related--is the weakest link in the sustainability reporting process.
"Many companies worry about interacting with their stakeholders, and are concerned about the feedback they might get from opening up in a community forum," she says. "They are afraid that nonprofits will want too much from them, and they do not understand what they should be reporting in terms of stakeholder engagement. They may cite their presence at conferences or beach clean-ups. But it really should be a more focused engagement where they are discussing their key sustainability issues."
Stakeholders, not shareholders? This is not as radical as it may seem. In their book, OneReport: Integrated Reporting for a Sustainable Strategy, Harvard University Business School professor Robert G. Eccles and Grant Thornton partner Michael R. Krzus argue that the information needs of institutional investors are converging with those of the broader stakeholder community--environmentalists, health activists and other NGOs, labor, communities, and the like.
Institutional investors are increasingly seen as "universal owners." As such, they own parts of the entire economy, and they, like society at large, absorb the high cost of externalities. When, for example, companies in one part of their portfolio produce an externality like toxic chemicals that seep into the groundwater, companies in other parts of their portfolio (health insurers, for example) pay for it.
But according to Eric Hespenheide, Deloitte & Touche LLP's global leader of sustainability and climate change, audit and enterprise risk services, the importance and value of different ESG information varies by constituency. And the degree of importance has yet to be worked out. "There are some [stakeholders] that are very much committed to it--NGOs, single issue folks," he says. "For me, the issue is how to translate that to something that can be meaningfully acted upon by citizens."
Comparability, Completeness, and Timeliness
Although the GRI provides a framework with guidelines recommending what information companies should report, it does not provide standards for how those indicators should be measured. Nor, in most cases, are there any yet. Carbon emissions are the notable exception. (The World Resources Institute/World Sustainable Business Council protocol is arguably the de facto standard for measuring carbon emissions.)
But even in terms of carbon emissions, organizations currently measure their indicators differently. This means that ESG information is not, for the most part, comparable across companies or even among those in the same sector.
Beyond that, much of the ESG information that is reported is fairly simplistic. Take water usage. "Most operations use water and discharge water, and often alter it in some fashion," Hespenheide says. "But what's the proper measure? Is it simply volume or should it include quality?"
And there is similar complexity around waste. Right now, most companies measure tons of waste that go to the landfill. But not all waste is created equal. Some of it, for example, can be recycled.
"There's a whole variety of measurement issues yet to be vetted and addressed," says Hespenheide, who describes the ultimate challenges as "comparability, completeness, and timeliness."
The question arises: With so little understanding of stakeholder engagement and materiality and so few standards, how does the verification of sustainability reports by third parties actually work? Anybody, after all, can verify these reports.
If a company is following the GRI Guidelines, there are three levels of reporting (A, B and C,) which reflect the quantity of data a company is reporting. Since ESG reporting involves a learning curve, as well as putting the proper controls in place to collect the data, it takes at least a couple of years to reach the "A" level. Verification of a report by a third party is signified by a plus sign. Reports can be found at the GRI's website, http://www.globalreporting.org/ReportServices/GRIReportsList.
All assurers are supposed to analyze the data that is reported, assess the systems that are in place, and then try to see if the claims that were made were valid. Even so, the methodologies that different assurers use can vary tremendously.
ISOS Group, for example, does not issue negative opinions at all. Rather, it scores companies based on the tests it runs and gives them a report of its findings. The score does not need to be made public, and companies have the opportunity to make corrections and request another review.
"We really want to encourage companies to improve their processes," says ISOS co-founder Mancilla. "We have found a few cases where figures were not reported accurately in the report. Companies were allowed to correct them and then site that they had made a correction."
If companies don't receive a high enough score, she adds, they simply do not earn their plus. But that hasn't happened. "They've all been determined to go back and correct things," Mancilla says.
Professional auditing firms, long steeped in the tradition of verifying financial results, have a different approach. A "review," or negative opinion, reflects inquiry and analysis and limited checking of underlying data. It is expressed as "nothing has come to our attention."
A positive opinion, on the other hand, involves a more detailed examination and is expressed as "in our opinion, in all material respects."
According to Ann Brockett, Ernst & Young's Americas leader of climate change and sustainability assurance services, the greatest challenge is "working with systems and processes and controls that are really still under development."
Lies, Damned Lies and Sarbanes Oxley
In the wake of Sarbanes-Oxley, companies were told that simply getting the numbers right was not enough; they also had to have the proper systems and controls in place to properly track their financial data. In a somewhat parallel fashion, traditional accounting firms are encouraging companies to put information technology systems in place to identify sustainability data.
"Compensation decisions and strategic decisions are being made based on sustainability data," says KPMG's Minan. "You want to be sure that the data is internally consistent and reliable, and you have to have controls and processes in place to do that. That's even before you get to external assurance."
According to Minan, the "better companies" are working on getting those internal controls and processes in place.
"Companies are starting to make business and strategic decisions that are, among other things, based upon data that is not traditionally financial data," he says. "Some companies are having to look at the controls in place to generate that data because it's becoming core and critical and strategic. What you're not seeing is behind the scenes as these better companies are integrating their strategies played out in the sustainability reports with their core business."
Although Deloitte's Hespenheide says the focus on carbon emissions has created an opportunity to have deeper conversations with companies about the most cost-effective and efficient sources of energy and strategies for managing future energy costs, they often ask what that has to do with sustainability.
"If you're in electricity generation, you require lots of water," he says. "They are aware of that. But they have not recognized what that represents in terms of their future prospects if [for example] they are operating in an area where water is increasingly scarce due to climate change or just because other businesses that have moved in and are hogging up some of the water supply.
"They haven't drawn the connection," he says.
A former investment banker and veteran financial journalist, Ellie Winninghoff's work can be found at: www.DoGoodCapitalist.com. She can be contacted at: ellie.winninghoff (at) gmail.com.