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Materiality, Standards and Ratings: How they All Fit Together

Sustainable investing industry jargon can be challenging.  Certain terms may seem straightforward but are more complex if you look deeper.  Over the past three weeks, our ESG Practice Playbook has been covering some fundamentals, which we would like to briefly revisit here.

The concept of financial materiality in the U.S. is connected to a 1976 Supreme Court case.  Publicly listed companies must disclose material information when there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”1

In the ESG world, financial materiality topics differ from industry to industry.  For example, what’s most relevant to a company like Amazon is not necessarily what’s most relevant to Tesla, Nike, or Exxon.

Enter the Sustainability Accounting Standards Board.  SASB provides guidance on ESG disclosures not covered in traditional accounting, and also a framework for determining which data points are material across industries. The U.S. Supreme Court definition remains the foundation for SASB standards, but as SASB expanded internationally, their definition of materiality was updated:

“Information is financially material if omitting, misstating, or obscuring it could reasonably be expected to influence investment or lending decisions that users make on the basis of their assessments of short, medium, and long term financial performance and enterprise value.”2

Asset Managers may leverage SASB standards as a base, and add their own research to arrive at a proprietary financial materiality matrix.

Other notions of materiality can also go beyond the investor perspective.  The Global Reporting Initiative (GRI), for example, takes a broader stakeholder approach in its standards.  In addition, there is a growing understanding that topics that are of material importance to stakeholders may become financially material to companies over time.  This concept has become known as “dynamic materiality.”

ESG ratings agencies which use materiality to define and weight the importance of ESG topics in arriving at scores and ratings are continually evolving.  As MSCI states in its ESG Industry Materiality Map, “We recalibrate the model, including identifying industry Key Issues and setting weights, every year based on the latest data and research as well as input from our regular client consultations.  As a result, you should expect to see changes in this ESG Industry Materiality Map over time.”3

Research has shown that “firms with good performance on material issues and concurrently poor performance on immaterial issues perform the best.”4 For a deeper dive on material sustainability topics and corporate performance, check out this milestone paper, Corporate Sustainability: First Evidence on Materiality, by Khan, Serafeim, and Yoon.

[1] TSC Indus. V. Northway, Inc., 426 U.S. 438 (1976)