Materiality does not flow only along non-financial aspects such as “diversity”.
Financial Materiality too is important and is now gaining rapid acceptance among
investors who assess ESG performance. If an issue can impact the company’s financial performance, such an issue is a Financial Material Issue. A hefty, regulatory fine for ‘corporate misbehavior’ could be considered as financially material. The subsequent loss of brand value is another financially material loss (some materiality issues are of both financially material as well as socially material and are termed as Double Material).
“Identifying sustainability matters that are financially material for the reporting
entity based on evidence that such matters are reasonably likely to affect its
value beyond what is already recognized in financial reporting..”-(ifrs.org)
A March 2021 study by Nicolas Madison and Eduardo Schiehll showed that when
financial materiality is applied, a company’s ESG performance scores to be “changing significantly.” “Environmental pillar issues, and particularly natural resource use, are predominantly responsible for the changes” (www.researchgate.net-The Effect of Financial Materiality on ESG Performance Assessment- March 2021).
Lately, climate related damages have emerged as a leading factor in financial
materiality. In 2015, Volkswagen was revealed as hiding toxic diesel emissions. This resulted in almost $35 billion in fine and settlement costs. The company’s cash outflows projected through 2021 were affected as a result.
The BP Deepwater Horizon oil spill that was reported in 2010 led to civil and criminal penalties to BP. The Company was held for “gross negligence and willful misconduct in its practices leading up to the accident”. 11 people were killed and BP was fined $20.8 billion. The penalty was one of the largest global corporate fines imposed.
In their writing, David A. Katz and Laura A. McIntosh (Corporate Governance Update: “Materiality” in America and Abroad) said ESG information should not be seen as material unless it directly impacts the company’s economic valuation. Such views are considered as the traditional view of financial materiality. In the modern context, some discuss materiality as a broader concept encompassing “any information that investors ask for or deem important.”
This is rapidly becoming true. As Harvard Law reported:
“As more and more investors begin to make investment decisions based on ESG
information that appears to have limited or no direct impact on a company’s
financial valuation, ESG information is more likely to be considered material even
under the current legal definition of materiality..”(law.harvard.ed)
Financial Materiality therefore has a direct bearing on ESG scores of a company.
