As if “materiality” under the securities laws wasn’t a difficult enough concept, investors supporting various ESG frameworks and standards have been adding to the complexity. Responsible Investor published a short piece that summarizes comments submitted by six global asset managers on the IFRS 2020 Consultation on sustainability reporting. Unfortunately for those working on the company side, it means having to play “mix and match” with ESG reporting frameworks to try to satisfy multiple investor mandates.
To break it down, we have:
1. Traditional materiality, which relates matters that are directly linked to financial impacts from the viewpoint of the “reasonable investor”. As has been long established. traditional materiality focuses on financial risks TO the company. SASB takes this approach with its standards.
2. What I call “new materiality,” reflecting the perspective of stakeholders and impacts of a company. New materiality goes beyond a pure financial perspective and compels companies to evaluate their impact ON stakeholders and the communities in which they operate. This is the direction GRI takes in its reporting framework.
3. “Double materiality,” which encompasses both traditional and new materiality matters. Under the EU Non-Financial Reporting Directive (EU NFRD), companies are required to assess and report on both financial and non-financial matters. The European Financial Reporting Advisory Group (EFRAG), which advises the European Commission, follows the double materiality path.
4. “Dynamic materiality” – a concept acknowledging that materiality is a moving target, stemming from the idea that “stakeholders of companies have the capacity to determine what is material for a company” enabled by technology and social media. Some see this as similar to traditional materiality (in that as new information becomes known, it adds to what is important to investors in the total mix of information); others may liken it to The Blob of materiality.
Traditional Materiality: Financial Costs and Risks
This is using the old-school materiality lens (i.e., TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976)) to a company’s ESG matters. The archetypal approach would be to gather and evaluate input from a variety of corporate departments/functions to reflect the multidisciplinary nature of ESG. However, counsel should assess potential liabilities to disclosing as newly material an activity or matter that is itself not new. In other words, why was something not considered financially material previously? Given that the SEC issued guidance on climate change disclosures in 2010, some may question why climate matters were not disclosed in the past.
New Materiality: Non-Financial Impacts Beyond the Fenceline
The two critical elements of new materiality that radically differ from traditional materiality are:
– Assessment and consideration of things that don’t directly affect corporate finances, or may be contingent/not estimable.
– Assessment and consideration of external stakeholders beyond investors. There is a hidden recursive double-whammy here as it requires understanding both what information external stakeholders consider important, and how the stakeholders will react (which rather depends on the extent and nature of the information made available to them).
A good overview of new materiality is here.
Double Materiality: What Does Commissioner Peirce Think?
Acting Corp Fin Director John Coates suggested last month that global comparability would be a desirable thing for ESG reporting. Although he laid out some advantages to doing that, it doesn’t seem like people are rushing to embrace the idea. SEC Commissioner Hester Peirce made a statement last week to caution against a move toward global sustainability reporting framework. In particular, she took issue with the “double materiality” – here’s an excerpt:
The European concept of “double materiality” has no analogue in our regulatory scheme and the addition of specific ESG metrics, responsive to the wide-ranging interests of a broad set of “stakeholders,” would mark a departure from these fundamental aspects of our disclosure framework. The strength of our capital markets can be traced in part to our investor-focused disclosure rules and I worry about the implications a stakeholder-focused disclosure regime would have. Such a regime would likely expand the jurisdictional reach of the Commission, impose new costs on public companies, decrease the attractiveness of our capital markets, distort the allocation of capital, and undermine the role of shareholders in corporate governance.
Let us rethink the path we are taking before it is too late.
Dynamic Materiality: “Anything You Say Can and Will Be Held Against You”
The idea of dynamic materiality has potential significant legal uncertainty and complexity, but may also be an accurate reflection of where things stand today. As John pointed out a couple weeks ago, what is “material” took a recent odd (perhaps scary) turn when a supposed April Fool’s day joke by VW didn’t go as planned.
Richard Levick has long helped companies with crisis communication strategies (he also spoke on a webcast for us a couple years ago about “Politics as a Governance Risk” – even more relevant now). Richard recently wrote about companies being stuck between Scylla and Charybdis on responding to social issues of the day:
Brand neutrality is dead… Political contributions have become the new supply chain liability. But so is your DEI, environmental footprint, labor practices and more.
In the past, companies feared consumer boycotts. Today, the speed, ubiquity and ease of global social media – combined with intangible assets (including brand value) making up 90% of current company market valuation – make reputational risk a material matter regardless of which materiality you choose. And that could make an argument validating dynamic materiality.
– Lawrence Heim
President Joe Biden is set to issue an executive order on climate disclosure within capital markets, according to John Kerry, the US Presidential Special Envoy for Climate. Details are not available yet, but that one sentence pretty much says it all.
Theranos Redux? Why Governance Needs to Underpin E&S Commitments
Meeting greenhouse gas emissions/climate challenges will be a monumental undertaking for years to come and will require an array of solutions, some of which haven’t even been invented yet. Solutions will offer technological advances, social/environmental benefits and huge business opportunities. Fortunately for everyone, some will be successful and beneficial. Others may do more harm than good.
This Bloomberg article about a carbon capture company caught my attention for several reasons. One is that some form of ambient CO2 capture may be necessary to achieve reduction targets. But another reason is that in my years of auditing and fraud training, I’ve become somewhat competent in spotting patterns/trends in data and behavior. And – based solely on that piece – I see eerie similarities here to Theranos. And there is more reason this is top of mind given this week is the 20th anniversary of the Enron failure. This company is painting itself as a savior, but is it realistic?
Most companies know that chasing “E” goals needs to include using internal “G” processes and staff (indeed, the SEC’s recent Risk Alert on The Division of Examinations’ Review of ESG Investing points out this very thing). Here’s another reminder to proceed with caution. If you’re making public commitments of environmental/social progress based on third-party performance, you need to vet the service and qualify your statements. You may wind up with more risks & liabilities than you bargained for, especially if the third party doesn’t make good on their own promises.
Environmental Solutions & “The Law of Unintended Consequences”
Let’s look at an interesting element of technical solutions (such as carbon capture) that companies could end up getting dinged for: secondary impacts. Newton’s Third Law (with some poetic license) holds true in environmental solutions – a solution that solves one problem may create a secondary problem.
What is a “secondary impact”? In my view, a secondary impact is a meaningful environmental effect (or risk) that is created as a result of the intended benefit. Two examples of this are:
– I once visited a client site that had spent quite a bit of money to reduce their Scope 2 emissions (those that are associated with power purchased from the utility). The centerpiece of the reduction strategy was an on-site company owned and operated fuel cell. What the company had overlooked is that the fuel cell chemistry resulted in CO2 emissions that drastically increased the site’s Scope 1 (direct) emissions. I don’t recall the absolute emissions numbers and whether this resulted in an overall CO2 emissions reduction given the electricity production, but it had a real impact on how emissions were reported.
– An article on the Japan shipping industry’s evaluation of capturing and converting CO2 into methane as a fuel points out implementing the technology “would mean developing special vessels to transport the CO2. Key to commercialization would be the viability of shipping CO2 long distances.” So… transporting large volumes of CO2 in ocean vessels to reduce CO2 emissions from other ocean vessels? That’s a head scratcher.
This article from the Yale School of Environment also describes negative latent impacts of large scale tree planting.
… planting programs, especially those based on large numerical targets, can wreck natural ecosystems, dry up water supplies, damage agriculture, push people off their land — and even make global warming worse.
Unintended consequences can also show up as product issues that affect the business. More examples:
– Increasing the water recycling/reuse rate at one paper mill I audited years ago saved water and money, but made the paper turn brown. The mill was unable to remedy the problem and ended up reducing their water reuse.
– In order to reduce waste and save on raw material costs, one company dramatically increased their used product recovery and repair rates. Because the used products had to be washed before being put back into circulation, the more they upped their recovery, the more water they used.
The moral of the story is that companies should thoroughly evaluate identified solutions in advance. Use a wide angle “life cycle” view to eliminate surprises – and encourage directors to ask difficult questions.
– Lawrence Heim
Like many of you, I anxiously await the release of the new James Bond film No Time to Die. Sadly, this will be Daniel Craig’s final turn at the role, who in my opinion has been the finest Bond ever. It may also be the last time we see Bond’s stunning Aston Martin DB5. Although after the car’s total destruction in Skyfall, Q did rebuild it for the subsequent Spectre, so maybe there is hope.
One bond that isn’t going away is the sustainability-linked bond (SLB) – at least according to JPMorgan Chase. Last month, Marilyn Ceci, global head of the bank’s ESG developed capital markets (DCM) group offered this prediction:
The SLB market will grow from $6.9 billion (the volume for January-March 2021) to $100 – $130 billion before the end of 2021. She expects the global issuance of green bonds generally to grow almost 50% – to around $690 billion – in 2021 alone.
Shortly after Marilyn made that comment, BlackRock announced a $400 million expansion of a $4 billion revolving credit facility in which it pays slightly lower fees & interest if it meets targets for women in senior leadership and Black and Latino employees in its workforce. The filed amendment contains specifics. We don’t know whether it was BlackRock or its lenders who wanted to add these terms to the debt deal – it helps both sides show that they’re making commitments to ESG, and it could add momentum to the SLB trend.
The first SLB was issued in 2019, meaning SLBs are a newer subset of the broad category of green bonds. SLBs are an interesting animal, offering both carrots and a stick to issuers.
The carrots: SLB proceeds can be used for general corporate purposes rather than being limited to a specific green or social project, and the issuer gets a reputational bump for offering a sustainability instrument.
The stick: if the issuer misses the sustainability goals/performance metrics, they must pay bondholders a premium that is established at issuance. Some are saying this is a different shade of “say-on-climate” – with bondholders determining whether the metrics are appropriate and whether they’ve been satisfied.
Another unique aspect is the economic certainty of SLBs. When evaluating green upsides, much uncertainty is built into predictions – global market conditions, mercurial consumer behavior, pricing dynamics, supply chain risk. It can be difficult to demonstrate the ROI on expenditures related to sustainability performance monitoring or not achieving the sustainability goals. SLB covenants, on the other hand, specifically define the real cost of missing the mark – pre-emptively answering certain “what if?” questions and making an ROI calculation for project monitoring costs more defensible than other green investments.
What You Can Do
If you have the opportunity to raise capital through SLBs, how can you make sure you can verify that you’ve hit your targets? First, knowing the cost of missing SLB sustainability goals in advance should make it easy to justify monitoring and assurance efforts – but here are some wrinkles that could arise:
– Is the company using emissions offsets to achieve at least part of its GHG reduction commitments? There are meaningful risks associated with offsets (see my blog below!) – therefore, additional monitoring activities are warranted.
– Are SLB targets related to social or workplace condition improvements in the company’s supply chain? Companies should consider augmenting industry-wide supplier audit/monitoring programs by either participating directly or engaging qualified third parties to conduct supplier evaluations in parallel with – or as a replacement to – industry programs.
– How is raw data concerning the goals collected and verified? Automated systems such as meters and probes are great, but they are not flawless and need ongoing maintenance. Procedures to detect errors or failure should be put into place and it may be optimal for those to be manual to some extent.
Carbon Offsets: Widespread “Sustainability” Practice is Under Internal Review
Liz blogged a few weeks ago about investors specifically discouraging portfolio companies from using carbon offsets to achieve net zero goals. As reported in this piece by World Oil, the Nature Conservancy is also launching an internal review of its carbon offset & trading projects and procedures. Offsets have a long history of controversy, misuse and fraud, yet play an outsized role in corporate Net-Zero pledges and strategies.
This is big news, as WorldOil points out:
The internal review is a sign that it’s [The Nature Conservancy] at least questioning some practices that have become widespread in the environmental world, and could carry implications for the broader market for carbon credits.
Carbon offsets can be a viable tool in corporate greenhouse gas reduction plans. It’s tempting to wave a hand, write a check and not give it much consideration. Yet offsets carry a large amount of risk in the mid to long term – both on a project-specific basis and in terms of maintaining a credible market.
To be valid, offsets are supposed to be “additional” – meaning that they arise from an activity that would not have occurred otherwise. As an example, offsets for not cutting trees that were intended to be harvested meets the “additionality” definition. But if those trees were never to be harvested, offsets cannot be claimed for doing nothing. Also, plant-based offsetting assets such as trees can disappear before their “job” is done, meaning the expected – and contracted – carbon uptake is incomplete. Forest fires, droughts, infestations, regulatory changes, nationalization/imminent domain and illegal harvesting are very real threats to their ability to absorb the promised amount of CO2 over the decades typically needed.
The article states that “in 2020, companies purchased more than 93 million carbon credits,” and the emissions trading market is expected to exceed $100 billion in the coming decades. That is a lot of hot air needing global credibility.
What You Can Do
If you’re using carbon offsets as part of your net-zero strategy, it’s good to be aware that they’re not a full solution – and that they’re coming under additional scrutiny right now. It’s not a bad idea to work with your internal risk management group to conduct a risk assessment exercise. Among the potential perils:
– Reputational risk
– Contract breach
– Customer mandate non-conformance
– Loan and bond covenant breach
– Regulatory non-compliance
– Materiality disclosure non-compliance
– Third-party exposure
Once the risk picture is in focus, you can develop specific mitigation strategies – such as:
– Risk transfer (such as insurance and contractual terms)
– Verifying project assumptions, calculations, controls and technologies
– Direct involvement in project verification, monitoring and auditing
– Contingency plans for offset losses
– Rebalancing the mix of tools used to achieve reductions
– Reconsideration of greenhouse gas commitments or strategy
Biden Infrastructure Plan May Pay to Avoid Emissions
Speaking of carbon offsets, here is an interesting thought. Biden’s Infrastructure Plan announced March 31 includes a proposal to
reform and expand the bipartisan Section 45Q tax credit, making it direct pay and easier to use for hard-to-decarbonize industrial applications, direct air capture, and retrofits of existing power plants.
For a short refresher, Section 45Q values a metric ton of qualified avoided CO2 emissions at $50 (for geologic capture/sequestration) or $35 (for other methods of capture/sequestration). As a tax credit, it only applies to the owner of the carbon capture/sequestration equipment or user of the captured CO2.
But changing to a “direct pay” model could open the doors to innovative revenue sharing arrangements between electricity producers, capture/sequestration technology providers and even other parties.
After all, Q is all about innovations for Bond.
– Lawrence Heim
Netflix’s newest documentary Seaspiracy is all over social media and the news. You may have already watched it, or maybe it’s in your queue for this weekend. The movie looks at wide ranging environmental and social impacts of the seafood industry – it’s hard to watch and there’s a lot to unpack. Some are saying they went too far. But for now, let’s look at one topic with which I have direct experience: ESG claims and assurance systems.
The film’s producer interviews Mark Palmer, Associate Director USA for the Earth Island Institute’s International Marine Mammal Project (IMMP), which operates the “Dolphin Safe Tuna” label program. The “Dolphin Safe” mark is used on canned tuna to indicate dolphins were not killed as bi-catch during tuna fishing. The interview as presented in the film can be summed up in this exchange:
Producer: You [Dolphin Safe] have observers, but they are rarely there [on the fishing vessels], and they can be bribed and so you can’t guarantee that dolphin safe tuna is dolphin safe.
Palmer: That’s certainly true in terms of how the system works.
Producer: But it’s not guaranteed to be dolphin safe.
Palmer: Nothing can guarantee it’s dolphin safe.
Producer: But if it’s not guaranteed to be dolphin safe, why is it called dolphin safe?
Palmer: We can pretty well guarantee it’s dolphin safe… it’s not guaranteed in the same way that, uh.. the world is a difficult place sometimes.
To be fair, in the “they’ve gone too far” camp, the IMMP has issued a statement expressing concern about how the film presents the interview.
In the bigger picture, though, there’s some merit to examining these programs – and the “Dolphin Safe” folks certainly aren’t the first responsible sourcing assurance mechanism to be on the hot seat. Another high-profile example is the London Bullion Marketers Association (LBMA) – and their “Good Delivery List” that’s intended to incentivize responsible gold production. Recent developments include NGOs claiming systemic flaws and a major assurance provider acknowledging shortcomings in managing conflict of interest. Many other metals and the mining industry have their own – but very similar – responsible sourcing due diligence mechanisms (the proliferation of these systems is a topic for another day). Responsible timber due diligence assurance uses the same basic construct, so these issues may not be limited to gold due diligence assurance programs.
Encouragingly, these mechanisms aren’t deaf to the feedback. They are aware of improvements needed and are working to implement changes – but it takes time to develop, field test and launch solutions.
One takeaway for companies who rely on some of these programs is that major investors and financial institutions will soon be looking over your shoulder too. Jamie Dimon, CEO of JPMorganChase, stated in his 66-page Letter to Shareholders (2020):
… we will measure our clients’ carbon performance against sector-based GHG reduction targets that we’re setting for 2030 – with the goal of helping the reduce emissions from their direct operations and, in the case of oil and gas and automotive companies, reduce GHG from the use of their products.
What does this all mean? Basically, it’s reinforcement of companies’ misgivings around ESG assurance and certifications. They don’t offer the impenetrable protection of Captain America’s shield, and you can embrace that and add checks & balances. You never know when the next “Seaspiracy” will attract stakeholder attention – and investors are already developing their own systems to track, verify and question fundamental ESG information.
More on ESG Assurance: Using a Belt & Suspenders
While it’s true that many of the myriad ESG certifications/assurance mechanisms have responded to criticism by making systemic improvements, some have not. And even with improvements, gaps still exist. Either way, they don’t provide blanket protection from liability or business losses. Let’s dive in to how you can use industry assurance and labeling mechanisms in a prudent way.
In my opinion, there are two major elements to the risk:
Becoming a movie star villain. Seaspiracy is only the most recent example of becoming a reluctant movie star. A few years ago, another Netflix documentary brought economic devastation to one of my old consulting clients, and they are still struggling to get back where they were. Before that happened, I brushed off the idea that the film would have such impact. Having now seen it firsthand, I strongly suggest not ignoring it. Who knows what ESG matters – or companies – will be targeted next, and these documentaries have a track record of going viral.
Following the crowd. There are certainly advantages to using industry ESG assurance mechanisms, including the “safety in numbers” philosophy. In my experience, this tends to lead to complacency by individual companies about assurance quality and execution. But as previously discussed, those mechanisms are not perfect and you can essentially become a hostage to their flaws. Continuing to participate in or rely on these programs without doing something more may create more problems than expected.
Once a company recognizes the exposures, it should implement mitigation strategies. As a friend of mine at OECD frequently says: “You can’t outsource due diligence responsibility.” Perhaps the most effective of ways of taking responsibility are actually easy to do:
– Invite your Internal Audit group to learn more about industry assurance programs your company uses. Ask them to do a deep dive into the program’s procedures, practices, standards and auditors/assurance providers.
– Take an active role in shaping the industry assurance program(s) to close gaps or address concerns you or your Internal Audit group identified.
– Do your own monitoring of the assurance program(s) by participating in their audits where possible. Compare your experience and results with the programs’ final results. Where differences are identified, explore those with the program(s).
Finally, while not necessarily easy, it is worth considering augmenting your company’s use of industry programs with your own activities, including further use of Internal Audit to evaluate ESG risks of business partnerships or hiring qualified and screened third party ESG assurance experts.
Will Climate Pledges Outlive the Companies that Make Them?
Forever is a long time, except in corporate timelines. I remember visiting the Hoover Dam in the early 1990s and marveling at a plaque listing the construction contractors. Although construction was completed in 1936, a handful of the companies listed were still operating at the time I was there. But the world has changed in the past century. Companies aren’t really built to last.
Credit Suisse noted in 2017 that “the average lifespan of a S&P500 company is now less than 20 years, from 60 years in the 1950s.” Management is not necessarily stable over the long term. A Harvard Law study showed that CEO tenure has been on a downward trend and, for large cap companies, “the plurality of large-cap CEOs have been in the corner office between one and five years.”
These trends matter for a few reasons, but nothing may be as obvious as corporate climate commitments, especially the oh-so-popular Net-Zero pledge. This article from Canary Media does a fine job of summarizing last month’s analysis by Climate Action 100+ that benchmarked current corporate climate commitments against company actions and schedules (spoiler alert: there are substantial gaps between commitments made public, what those commitments should address and plans for execution).
Yet what I found most compelling is this perspective related to the current trends on company and CEO lifespan:
This shifts the critical question from whether we believe today’s corporate giants genuinely want to make good on these commitments to whether we think they, or their leadership, will even be around at all. Rather than congratulating companies that promise to clean up their act for a tomorrow they may never see, we need to be holding them to account for what they’re doing today.
Given the unprecedented complexity of the climate issue, uncertainty is to be expected. I hope that companies making long term climate pledges will last longer than most celebrity marriages – and it’s heartening to see companies making commitments, while recognizing this is a long term play. But will investors – many of whom already have short-term horizons – see corporate climate action from this perspective and push for nearer term goals/solutions? For companies making climate pledges that face the risk of no longer being a going concern – how will they manage or disclose the risk of failing to meet climate commitments?
This is one reason why it’s probably inappropriate to “shame” companies for favoring annual incentive programs as the vehicle for ESG metrics – it may be an annual program, but if you incentivize the correct year-over-year building blocks, it can lead to lasting change. In the fervor of this push for big change, it is worth considering the risk that a corporate climate pledge may outlive the company itself. Short-term stepping stones are a valuable part of the bridge to the future.
– Lawrence Heim