By Janine Guillot and Jeffrey Hales
The legal concept of “materiality” is foundational to the corporate disclosure regime in the US. It provides the conceptual basis for the disclosure of certain information used by investors in making voting and investment decisions. At the Sustainability Accounting Standards Board (SASB), we have often referred to “financial materiality” as a guiding principle for our work. Indeed, we believe that disclosure standards make the disclosure of financially material information more decision-useful by enhancing the extent to which those disclosures are reliable, consistent across time, and comparable across peers. However, a recent article, “Corporate Governance Update: ‘Materiality’ in America and Abroad” (May 1, 2021), misunderstands SASB’s position on the topic of materiality and especially misunderstands SASB’s use of the term “materiality” in a global context.
SASB’s Standards Development Process Has Not Changed
The authors suggested that certain changes SASB recently proposed to the definition of materiality in our Conceptual Framework represent a “deliberate step” toward the broader concepts of materiality that underpin the European Commission’s sustainability reporting directive and the World Economic Forum’s stakeholder capitalism metrics project. This is not the case.
SASB remains, as it has always been, focused on facilitating decision-useful and cost-effective disclosure of financially material sustainability information to investors and other providers of financial capital. To that end, SASB’s standards-development process continues to be evidence-based and market-informed, and our approach continues to require evidence of investor interest and evidence of financial impact before proposing to include a topic in SASB Standards. Our research seeks out such evidence, and our due process is designed to garner insight into those issues from investors, issuers, and other subject matter experts.
We agree with the authors that the concept of materiality articulated by the US Supreme Court is well-suited to the evolving nature of capital markets and the changing information needs of investors. As the authors note, the Court’s definition is fundamentally linked to the reasonable investor, the notion of which evolves over time. Therefore, a concept of materiality based on the needs of the reasonable investor “provides a framework for addressing new issues and shedding issues whose importance has waned.” As changes have occurred in the broader economy and in the composition of corporate valuations, the information that capital markets, and thus reasonable investors, need to efficiently price securities and vote their shares has also changed.
Clarity Hasn’t Always Prevailed
SASB recognizes that the use of the term “materiality” in the realm of sustainability disclosure has created significant confusion. A wide range of disclosure frameworks and standards have adopted an array of proprietary definitions of materiality focused on different users, subject matters, and objectives. For example, two of the most widely used sustainability standards—those of SASB and the Global Reporting Initiative (GRI)—have historically used fundamentally different definitions of materiality. This has led to a market dialogue in which even informed participants must take pains to avoid talking past each other.
In this context, there is a need to clearly describe the approaches used by the various sustainability disclosure frameworks and standard-setters and establish a common language and structure that can create market coherence. SASB’s collaborative work with the “Group of Five” standard-setters and framework providers, in which we articulated a shared vision for how various concepts of materiality are interrelated, was intended to develop mutual understanding across preparers and users of sustainability information in multiple markets. The “Group of Five” work articulated the primary materiality concepts used by the authors, and it illustrated the role of different frameworks and standards. SASB’s role within this ecosystem is to support the disclosure of financially material sustainability information to investors and other providers of financial capital. Other standards, most notably GRI’s, meet the needs of a wide range of stakeholders for information about a company’s impacts on the economy, environment, and people.
The collaborative work of the “Group of Five” formed the basis for the “building blocks” approach now being embraced by the International Organization of Securities Commissions (IOSCO). This approach recognizes that company operations and investment portfolios span jurisdictions that operate with different legal definitions of materiality, most significantly the US and the European Union. A “building blocks” approach could dramatically reduce the complexity and fragmentation that characterizes the global sustainability disclosure landscape by establishing a common baseline of financially material information that could be used by all jurisdictions. The “building blocks” approach could reduce reporting complexity for preparers, provide global investors a baseline level of financially material, decision-useful information, and maintain the flexibility of jurisdictions to create additional building blocks, as they deem appropriate, based on their own legal frameworks and public policy objectives.
Although these collaborative efforts have intended to enhance clarity, they have also highlighted a key source of confusion. There is a crucial difference between concepts of materiality used to guide standard-setting and those that are used to inform a company’s disclosure choices in the legal jurisdiction(s) in which the company operates. As SASB makes explicit in the proposed revisions to our Conceptual Framework (see Paragraph 18), our standard-setting process filters the broad universe of sustainability issues to the subset of topics that are reasonably likely to materially affect the financial condition, operating performance, or risk profile of a typical company within an industry—in other words, those topics for which investors would most benefit from consistent, comparable, reliable disclosure.
This should not be taken to imply that the reporting company does not exercise judgment in making its disclosures. As the exposure draft goes on to explain (see Paragraph 26), a company should—using the definition of materiality appropriate in the legal jurisdiction in which it operates—determine for itself which SASB Standard (or Standards) are relevant to its business, which disclosure topics are reasonably likely to have material financial implications, and which associated metrics to report. SASB’s Standards Application Guidance suggests that companies apply the Standards on a “comply or explain” basis, meaning that the company should explain its rationale for omissions or modifications.
More Work Remains to Be Done
Another common source of market confusion is time horizon and, relatedly, SASB’s use of the term enterprise value. The changes SASB has proposed to our Conceptual Framework were intended to clarify misconceptions outside of the US resulting from SASB’s use of the term “financial materiality.” Specifically, outside the US, the term “financial materiality” was often interpreted as meaning that SASB’s standard-setting process uses a one-year time horizon for evaluating financial impact. SASB’s standard-setting process has never used a one-year time horizon.
Because SASB prioritizes sustainability topics for inclusion in the Standards based on evidence of financial impact and evidence of investor interest, using research and consultation with companies and investors to explore various aspects of the topic, the “appropriate” time horizon naturally depends on the time horizon that both investors and companies use to make capital allocation decisions. As noted in the Conceptual Framework exposure draft, those time horizons can vary based on a range of factors, including industry-specific characteristics, such as cash flow and business cycles, the expected duration of capital investments (by both issuers and investors), and the planning horizons typically used by management in an industry for strategic decision-making. When SASB evaluates a sustainability topic with a longer-term time horizon, the questions we explore include the likelihood that the risk will materialize, the anticipated magnitude of its financial impact, and the degree to which it is being considered by investors today—and to which it may therefore influence a company’s cost of or access to financial capital in the near term.
SASB introduced the term “enterprise value” into proposed revisions to our Conceptual Framework to make clear that SASB Standards have always been intended to provide investors with the information needed to enable an investor to assess a company’s value, including a company’s current value relative to its potential future value and/or the value of its peers. We refer to enterprise value” instead of market value in our Conceptual Framework because enterprise value is more relevant across different asset classes as well as to both public and private companies, recognizing the significant use of SASB Standards by a range of investors in both the public and private markets.
Although the US Supreme Court’s “reasonable investor” concept has served US capital markets well for many decades, we believe it is more challenging than ever for companies to practically apply this concept in the face of increasingly heterogenous investor views regarding what constitutes relevant information for making investment and voting decisions. That’s why we believe strongly in the value of generally accepted sustainability disclosure standards. A rigorous, transparent, market-informed standard-setting process, grounded in evidence of investor interest and evidence of financial impact, is an invaluable tool for both companies and investors working to develop a common language around the connection between sustainability factors and enterprise value.
As SASB works to evolve our standards and help simplify the sustainability disclosure field, we also aim to promote greater clarity around our work, our Standards, and their use by companies and investors. In that regard, the dialogue prompted by the article will serve as a valuable input as we consider the next steps on revisions to our Conceptual Framework. It is only through dialogue and consultation with the issuer and investor communities that we will collectively succeed.
Janine Guillot is CEO of SASB. Jeffrey Hales is Chair of the SASB Standards Board and the Charles T. Zlatkovich Centennial Professor of Accounting at the University of Texas at Austin.