Summary

•  Companies are making substantial voluntary disclosure in the formal of ESG or Sustainability Reports

• There are pressures from a number of bodies to start to include ESG and other non-financial disclosures within GAAP financial statements or MD&A

• While materiality is a concept that has significant history and litigation clarity, applying such materiality guidelines to ESG disclosures is going to stress directors and management of public companies

• There is a large gap between materiality for purposes of equity investors and materiality for the myriad of stakeholders that now are interested in corporate performance

• In particular, the discount rates used to determine material amounts for equity holders bear little relation to the discount rates that might be used in forming public policy.

• This process of bringing ESG disclosures within the context of securities regulations will be messy

 The law and practice of determining the materiality of financial disclosures or the obligation to make timely financial or non-financial disclosures has been honed over decades. The definition provided within Canadian securities regulation remains the most definitive approach: Securities legislation defines the term material change as “a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any of the securities of the issuer and includes a decision to implement such a change made by the board of directors of the issuer or by senior management of the issuer who believe that confirmation of the decision by the board of directors is probable”. [1]

Of course, this definition allows for a very wide variety of interpretation and is very often interpreted ex post. That is, if the stock price moved apart from the general market when a piece of information emerged, by definition it must have been material and therefore should have been disclosed at the first instant that the company and its Board were made aware of it. As was noted by Thomas Madden: “In deciding whether and exactly how much to disclose, materiality, and perhaps significance, may be determined ex ante, but it can only be verified as correctly made ex post facto, and then it is fraught with bias and unfairness.[2]

Despite the inherent issues with the determination of materiality in a securities context the general view is “I know it when I see it.” However, there are strong currents that would expand disclosures made by companies to elements that are not currently inherent in the disclosure standards and thus may call into question previous decisions concerning materiality. These are generally considered under “Sustainability” or “ESG” disclosures. Companies have made significant strides in disclosing information under these general headings in response to investor and other demands. However, national or global standards for such disclosures have so far remained elusive, although such standards may emerge within the next few years. While groups such as the Global Reporting Initiative (“GRI”) have made substantial progress in defining disclosure standards within supplementary reports on climate and ESG, the next phase of global standards will likely attempt to bring ESG reporting into the context of disclosure generally and under the purview of securities regulators. It is expected that the International Sustainability Standards Board (“ISSB”) will issue standards as early as the last half of 2022 and depending on national bodies, legal requirements may commence in 2023 and 2024. In October of 2021, the Canadian Securities Administrators (“CSA”) also started down the “standards” route by issuing for comment: “Consultation Climate-related Disclosure Update and CSA Notice and Request for Comment Proposed National Instrument 51-107 Disclosure of Climate-related Matters”. While this particular National Instrument dealt only with climate related disclosures[3], I would expect that the CSA will start to tag along with other global initiatives (that is, global except for the US).

All of these efforts to bring global standards for ESG as a fundamental part of all disclosure involves a determination of materiality. The disclosure of immaterial information can be confusing to users and obviously not economic for issuers[4].

I believe that it will be important for issuers and securities regulators to address the definitions of materiality especially where such definitions start to wander from the well-established pattern that has been developed in regulation and litigation over the years.

In an extremely useful article published in September of 2021 authors Sveinung Jørgenson, Aksel Mjøs and Lars Jacob Tynes Pederson[5] (collectively “JMP”) examined the distinction between materiality for the purposes of ESG disclosure and the purposes of financial and securities disclosure and noted a substantial tension between the two definitions. In addition, they discussed the concept of dynamic materiality, where matters that may have been considered as immaterial in one quarter become significant elements of disclosure in a subsequent quarter – pandemic preparedness being a very recent example.

The questions that they raise include “material for whom, and why and when?” In the classic definition of materiality for financial and other securities disclosure, the answer is easy – material to current and prospective acquirors of securities of the issuer. And while assessing materiality ex ante is not always easy, it is a clear lens. There may be disclosures that are required to be made by issuers where materiality is not relevant – where there is mandated disclosure by regulators or legislators. In my opinion,, these disclosures should always be tagged as such as it would be inappropriate for users to believe that all disclosures are considered by the issuer to be material.

Supplemental ESG Disclosures

In current ESG reporting, the concept of “material for whom, and why and when” requires issuers who produce such reports to think very carefully about the audience for disclosures. Apart from the ubiquitous and annoying general purpose “virtue-signalling,” issuers will typically be concerned with their investors and potential investors, employees, customers, legislators and thought leaders or NGO’s who could influence one of the above populations. There will be lesser concern with regulators, who always have the possibility of mandating disclosures, private or public to meet their needs. Once these general populations have been identified there is a challenging task of assessing whether a particular issue is sufficiently important to a sufficiently large component of each of these populations to make disclosure useful to that population. Then there is an even more difficult assessment of whether on balance the disclosure, net of the accounting cost and confidentiality implications is truly “value-enhancing.” While there is much discussion of the concerns of various stakeholders to a corporation, directors of an issuer must be convinced that they are adding value to the corporation and its shareholders by such disclosure or they would be considered in breach of their fiduciary duties. This is similar to the calculus that must be undertaken whenever a corporation decides that it will support a charitable institution.

An example might be useful. Consider the case of a fast-food restaurant chain where the upstream supply chain must deal with animal culling and processing. The chain is essentially carried by retail customers like you and me. As humans, we are likely genuinely concerned with animal cruelty, but at the same time are predominately consumers of animal products. Disclosure of the animal cruelty policies of the supply chain, the efforts that the restaurant might use to police the supply chain and the degree of conformance are likely all useful disclosures. There is a large population, with relatively homogenous concerns and a significant ability to negatively affect value if the restaurant gets it wrong. These disclosures likely belong within the context of an ESG report as the company’s mandated disclosures likely indicate the supply chain risks of the organization and likely the directors have satisfied themselves that the risk is controlled.

Consider the same restaurant chain and its Scope 3 downstream emissions – that is, the emissions created by its customers from consuming its products – including associated methane. It will likely be difficult for the company to assess any particular audience for such a piece of disclosure, any useful reliability of such a measure and any value that could be ascribed to such disclosure. NGO’s that already don’t like fast food are unlikely to be swayed by such disclosure and its customers are already aware that they have to control their own carbon footprints (if they care).

Given the current environment, it is likely that corporations will err on the side of more disclosure in ESG reports as even an immaterial consumer of such reports may be well-financed enough and vocal enough to cause issues for the corporation. The most significant risk for most corporations in 2022 is that an adventurous government may be persuaded to make uncosted decisions in response to a vocal threat. Corporations also need to be aware of the influence of players such as Blackrock, who would appear to also be interested in uncosted societal “improvements.”

In conclusion, the assessment of materiality in a supplemental ESG report must start with value to the corporation and its shareholders, consider the populations that are of a size and influence that is much more likely to affect the value of the corporation and then likely err on the side of excess disclosure. In addition, in keeping with the conclusions reached by JMP[6], corporations must be prepared to be dynamic in both their selection of disclosures and in their assessment of materiality.

Securities Disclosures for ESG

As noted, there are strong pressures to bring ESG disclosures and particularly climate change transition disclosures within the context of MD&A disclosures mandated by securities regulators or as may be specified by Generally Accepted Accounting Procedures (“GAAP”). The degree to which these disclosures may be mandated will depend to some degree on the securities regulators as well as whether there is a push to place these disclosures into GAAP. The placement of such disclosure requirements into securities regulation, directly or indirectly will bring concepts of materiality to bear.

In the most recent consultation paper by the CSA[7], it was apparent that the CSA was itself struggling with whether to simply mandate disclosures or to mandate disclosures that were “material” In this consultation paper it was apparent that the CSA was maintaining its focus on materiality in a securities context. Its definition was: “ An issuer is not required to disclose information that is not material in respect of items 1 [Strategy] and 3 [Metrics and Targets]. An issuer must exercise judgment when it determines whether information is material in respect of the issuer. Would a reasonable investor’s decision whether or not to buy, sell or hold securities in the issuer likely be influenced or changed if the information in question was omitted or misstated? If so, the information is likely material.

In addition, with respect to GHG emissions, the CSA was struggling with whether these should be disclosed in all cases or whether they should be disclosed only in cases where they were “material.”

Particularly in the case of climate change disclosures, the concept of materiality is fraught with issues and if securities regulators intend to bring these disclosures into the same position as MD&A disclosures, directors of public companies will be even further at risk of ex post analysis being subject to bias and unfairness.

For climate change, for example, there are two main risks that companies are dealing with: physical changes in the world that are associated with climate risk and that may have negative effects on operations or asset values (“physical risk”) and political risks whereby government actions in anticipation of climate change may have a negative effect on values or operations (controls, taxes etc.) or more likely general economic risks due to mis-placed government policy (unemployment, taxes, excess regulation) that reduces overall economic efficiency (“transition risks”).

With very few exceptions, most companies could not believe that they will be disclosing significant net costs with respect to physical risk. Even the most exposed of companies, such as property and casualty insurance companies price climate risks into products and likely believe that their businesses remain sustainable. However, the vast majority of companies will have great difficulty in assessing material enough physical risks to require disclosure.

Part of the reason for that is discount rates. In order to conclude that a risk should be quantified or even assessed as material, a company must decide the likelihood of the risk or cost and the timeframe in which such risk or cost might occur. Holders of equity securities assess their time preferences for costs and gains through the equity discount rate. A cost today is much more significant than a cost in 20 years and security holders will weigh the materiality of such costs using a discount rate. Such a focus on the investors in corporate securities will be highly at odds with public policy makers, whose choice of a “social discount rate” for GHG policy considerations will often be only a fraction of the equity discount rate.[8]. Of course, in addition to discount rates, companies will also have to consider mitigation strategies and technology change over a prolonged period of time in determining the expected future value of such a cost. Companies will use a similar but likely risk-adjusted analysis of any future benefits from physical climate change.

The second major risk that companies need to consider in disclosure materiality is transition risk. This is the risk that government action may impose external costs or restrictions on a company due to future government policy. It should be noted that transition risk does not deal with government policies that have been enacted, but only those policies that might come into effect in the future. To date, government announcements of action on climate change have been substantially in advance of actual legislation.[9]. Disclosure with respect to transition risk is much more difficult, as assessment of what governments might do and when is fraught with uncertainty. A transition risk may appear to be material in the fall of 2021 “Half the world’s fossil fuel assets could be worthless by 2036”[10] may become less so within three months: “Oil well drilling set to rise more than 25% in 2022, industry group says”[11].

As with other disclosure elements that are not easy to quantify, either in time or amount, corporations will likely err on the side of additional disclosure such that political risk can be minimized (if that were possible). And the consideration of discount rates and probabilities that would be the case for disclosure of physical risks will likely be ignored.

The introduction of disclosure requirements for ESG into either GAAP or MD&A disclosures will be difficult for directors of public companies. Unlike the disclosures that have been subject to decades of regulation and litigation, there are likely no clear guidelines as to what materiality might mean outside of the context of mandatory disclosures. The apparent use of a securities approach to materiality will likely not be satisfactory for a number of non-equity stakeholders and I would expect that we will have many years of more prescriptive regulation and legislation around these ESG topics.

[1] National Policy: NP – 51- 201 – Disclosure Standards

[2] Thomas M. Madden, Significance and the Materiality Tautology, 10 J. Bus. & Tech. L. 217 (2015) Available at: http://digitalcommons.law.umaryland.edu/jbtl/vol10/iss2/3

[3] This proposed standard essentially parroted elements proposed by the Taskforce on Climate Related Financial Disclosures (“TCFD”)

[4] “When disclosure gets to be “too much” or strays from its core purpose, it could lead to what some have called “information overload” – a phenomenon in which ever-increasing amounts of disclosure make it difficult for an investor to wade through the volume of information she receives to ferret out the information that is most relevant.” Speech by SEC Chair Mary Jo White to National Association of Corporate Directors – Leadership Conference 2013 in National Harbor, Md. Oct. 15, 2013

[5] “Sustainability reporting and approaches to materiality: tensions and potential resolutions” Sustainability Accounting Management and Policy Journal Vol 13, No 2, 2022

[6] Ibid.

[7] “Consultation Climate-related Disclosure Update and CSA Notice and Request for Comment Proposed National Instrument 51-107 Disclosure of Climate-related Matters”.

[8] “Social Discount Rate and the Energy Transition Policy”, Rahmatallah Poudineh Senior Research Fellow, OIES & Domingo Penyalver, Researcher, Centre for Innovation in Transport, Polytechnic University of Catalonia, October 2020, published by The Oxford Institute for Energy Studies.

[9] The political equivalent to the many corporate “net zero” pledges.

[10] Half world’s fossil fuel assets could become worthless by 2036 in net zero transition | Fossil fuels | The Guardian

[11] Oil well drilling set to rise more than 25% in 2022, industry group says | CTV News