Who Decides What is Material With ESG Disclosures?
Published: 05 Oct 2021
There Are No Materiality Constraints on SEC-Mandated Disclosures
Some US legislators are trying to restrict required ESG disclosures; asserting that the Securities Exchange Commission (SEC) can only require disclosures that are financially material. The SEC’s mission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust. This latter point is important, because SEC-mandated, public corporate disclosures serve not only investors, but other capital market participants, such as lenders / creditors, customers, employees, landlords, suppliers, other regulators and other governments. Audited financial statements and company disclosures provide many interested parties with an independently verified book of record on which they can based financial and non-financial decisions.
Challenges in Assessing Materiality
Notwithstanding that the SEC has no limitations in its constituting legislation nor its explicitly stated mission; understanding the concept of materiality as it relates to ESG disclosures is important. Materiality depends on the eye of the beholder and their needs, which makes establishing thresholds difficult. In addition, materiality changes on a relative basis over time. The European Corporate Sustainability Reporting Directive relies on a double materiality standard for disclosures and aims to make disclosures comparable and verifiable, while giving companies the opportunity to explain particular disclosures within their own context. (see our prior blog post here). This approach moves beyond data and statistics, enabling companies to provide context and enable disclosure users to assess whether the information has an impact on its views or decisions. Reporting consistently developed historical information provides a basis on which investors and other users can evaluate the dynamic importance of the data and information, at least partially remediating the problem with understanding materiality over time.
Impact of Custom Materiality Assessments on Values-based Investing
Standard, required, comparable and verifiable ESG or sustainability disclosures provide a necessary basis from which investors can extrapolate information and make investment decisions. Companies frequently analyze whether issues are material to their firm on a pre-established time period, e.g., annually, biennially, triennially, etc. Allowing companies to re-assess materiality over different time periods means that disclosure topics are likely to vary over time. For example, a firm may identify a strategically important area that requires disclosure and attention in a biennial ESG materiality review. The firm discloses the issues and lay out a medium- or long-term plan to handle the problems. At the next biennial materiality review, the company may determine the sustainability issues are no longer material and disclosures are not necessary. For investors concerned about particular ESG or sustainability issues, this lack of disclosure consistency poses an analytical and monitoring. For ESG-type disclosures to be used as effective decision-making tools, they must be consistently measured and presented over time.
Non-Financial Materiality is Important
Regardless of legislative points of view, standard disclosures across sustainability and ESG topics, regardless of materiality in a specific company’s instance, is necessary to provide a foundation for evaluation across firms and time. Allowing companies to provide contextual guidance about how such disclosures fit into risk management activities or long-term strategy also provides useful information upon which investors and other market participants can base decisions.