Make finance less opaque to your business

WHAT HAPPENS when stakeholders have a vastly different view to a company about an issue such as pay conditions in the supply chain, or executive remuneration? Whose view counts? More importantly, is the issue actually material to the business? And, if it is, how does the company know, and what is it doing about it?

Materiality is a core challenge facing companies that are seeking to join sustainability (or non-financial impacts) to business strategy. The processes by which they determine what issues are material to them, though well established in the realms of financial reporting, are still immature in many companies when it comes to sustainability issues, if they have emerged at all.

Materiality Futures is a comprehensive new report on the subject, authored by Chris Tuppen, a partner of Fronesys and a leading specialist in sustainability matters. The study examines 31 global companies that actually report on the results of their materiality determination processes. These companies report around 150 different sustainability issues between them, from which Fronesys has examined the 50 most commonly recurring themes.

So what are the findings and the lessons? Here are five issues that every company reporter needs to pay attention to.

First of all, Materiality Futures shows that even among the companies that are most transparent in reporting their sustainability impacts, there is a real lack of transparency regarding how the materiality determination process actually works. In many ways, the detail of the process is like a black box, with very little published detail on quantification algorithms and applied weightings. Interestingly, the extent of disclosures regarding both the outcomes and process generally bears little relationship to declared GRI levels.

Second, for any given issue there is often a large scatter in reported materiality levels, even when companies are in the same sector. To help quantify the spread of views, Fronesys has developed a concept called Issue Coherence Level (ICL), which indicates the degree of materiality coherence between companies, and is lower the stronger the coherence. Biodiversity is an example of an issue with a high ICL rating, pointing to a wide divergence of views: Volkswagen and its stakeholders rate biodiversity as an important issue, but then BMW and its stakeholders rate nature conservation very low.

Third, we need better metrics to understand the processes of materiality determination – this would help inside the company as well as those stakeholders who are seeking to evaluate whether companies are taking on the issues that are important to them. In this regard, in the report Fronesys proposes Materiality Convergence as a statistical measure that shows how closely a company agrees with its stakeholders across a full range of issues, with a low score indicating a great degree of convergence between views.

Let’s see how this works. Executive remuneration, especially in certain industries, is highly topical in the press, but is it material to a business? Analysing the importance of an issue on a scale of 1-10 for stakeholders and the business, most companies report that executive remuneration is a straight 5, while stakeholders vary on this anywhere between 1 and 10. Interestingly, Allianz, the financial services company, places it at the lowest end of the scale, but its shareholders rate it at the highest. With such a scatter, it must be a financial services company!

Allianz, it turns out, has the highest materiality convergence score of the 31 companies studied in Materiality Futures, alongside companies such as SAP and Intel, meaning that there is a great deal of divergence between company and stakeholder views across most issues. Are these companies out of touch with their stakeholders, or is it that they have too many different types of stakeholder to be in tune with all of them?

In contrast, Fraport and AT&T show a greater degree of convergence of views, but that might raise questions as well, as it would seem extremely odd for a company to be entirely in tune with its stakeholders. The report asks if there is an optimum convergence point and if so who has achieved it.

Fourth, the advent of Integrated Reporting, as espoused in the draft Integrated Reporting model recently released by the International Integrated Reporting Committee (IIRC), will lead to a consolidation of the reporting of a company’s most material issues. It will also lead to more forward-looking reports that illustrate a more strategic alignment between sustainability and conventional business objectives. It is clear that for any company adopting the IIRC framework, the process of materiality determination will need to be at the core of their thinking.

As Materiality Futures points out, this reinforces the need for greater transparency on how the output of the materiality process has influenced the overall, long-term strategic thinking of the company. Might this lead to a more direct link between sustainability impacts and financial reporting, including the incorporation of environmental and social externalities?

Fifth, the 31 companies in Materiality Futures are the exception to the rule, because they already report on the results of their materiality determination processes. More companies will be walking in their footsteps. Fronesys lays out some recommendations for companies starting on this journey: adopt a materiality process, publish a quantified and populated materiality matrix, review the results of your processes against peers using metrics such as Issue Coherence Level and Materiality Convergence, and be transparent about your underlying processes.

Ultimately, materiality is only getting more and more material.

Jyoti Banerjee is a partner at Fronesys