Sustainability Materiality

Sustainability Materiality​​​​​​

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​Photo: "Choices" by keepitsurreal is licensed under CC BY-SA 2.0.

The growth of sustainability (also known as the triple-bottom line, environment, social and governance (ESG) and corporate social responsibility) in the business context has been dizzying.  With this movement, though, comes some uncertainty around how managers should respond.  One of these points of inquiry is how to determine which social, economic and ecological issues managers should pay attention to and which issues they should ignore.  Unlike financial reporting, reporting on sustainability is voluntary.  This means that the process by which companies determine what issues are deemed relevant or material is largely left up to the company.  As a result, there does not exist a standardized process by which companies determine what is relevant or, in the context of this article, material.  Regardless, managers are increasingly working to conduct a sustainability materiality assessment and to produce a sustainability materiality matrix for their firms.  It is recognized best practice that a company report on those relevant issues that “have a direct or indirect impact on its ability to create or maintain or erode economic, environmental, social value for itself, its stakeholders, the environment, and society at large.”[i]

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What is Materiality?

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The term materiality comes from the field of accounting.  Materiality is defined as those items that should be reported in detail in financial statements because they are likely to impact the economic welfare of decision-makers.  In the accounting context, these decision-makers tend to be investors and the goals tend to be economic.  So, if a business decision, transaction, or event is significant enough that they could impact a investors’ decisions, it would be considered material and thus should be reported. 

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Sustainability materiality draws on this concept and has been applied to what is known as a materiality matrix.  A materiality matrix is a diagram that maps issues according to the degree of impact on society or stakeholders and the degree to which the issue impacts the company in question as illustrated in the Y and X axes in the diagram below.   

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Initial definitions of sustainability materiality refer to those social, ecological and economic issues that have a direct impact on business performance. Also called Single Materiality, these issues are deemed material because decision makers, like managers and investors, need to be aware of them and incorporate them when making informed decisions.  Consider the ecological issue of climate change and its relevance to the insurance sector.  Insurance companies are heavily impacted by a changing climate as unpredictable weather events can wreak havoc on the predictability embedded in insurance premiums.  Thus, climate change is a material issue for insurance companies because company profit levels are at stake as the issue grows in severity. 

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Double materiality or 'impact materiality' refers to those social, ecological or economic issues that emerge as a result of company behaviour.  But they are material only because this corporate behaviour has a corresponding impact on the company.  Consider an example. Water scarcity is a material issue for a company like Nestle whose business is highly dependent on the availability of clean water.  That said, Nestle's operations, including the products they produce and distribute, contribute to the concern of water scarcity.  In this way, Nestle's contribution to the issue and the corresponding financial impact on Nestle implies double materiality. 
 

While broadening the scope of sustainability materiality in this way (single to double) is helpful, it does not quite get at those issues that are directly integrated with the company’s core operations.  In other words, embedded as an assumption in double materiality is that there is a business case associated with responding to the material issue in question.  This is because presumed in double materiality is that anytime a company contributes to a social and ecological issue, it will in some way subsequently negatively affect them.  While this might be true if we presume an infinite time horizon, we have to consider a time horizon that reflects the reality of how managers make decisions (e.g. 5-8 years).  Also, double materiality presumes that companies are passive in the corresponding impact of social and ecological issues on their business and don't actively protect against any ensuing impacts regardless of whether the social or ecological issues is worsening.  

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With that in mind, we must consider those issues that matter to stakeholders and society, yet do not negatively impact business.  Even worse, we must consider situations where the growth of these issues positively impacts firm performance.  Answering these questions pushes us beyond single and double materiality to what I call True Materiality.  These are the more pressing materiality issues because they force companies to fully understand how the assumptions built into their business model are inextricably tied to the issue at hand.

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Business Model

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To understand what is True Materiality, students of business must understand a company’s business model.  Doing so involves understanding three main tenets of how a business generates profitability and then analyzing the relationship between these three activities and social and ecological issue.

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1. How does the business model reduce costs?

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The first area of focus is understanding how a business reduces its cost.  In this category, what is material is based on whether a company’s natural incentive to reduce costs increases social and/or ecological issues.  This is quite different from a situation where social and ecological issues drive up costs as would be the case with single materiality or how the company's contribution to the issue increases company costs.  These are important to consider too but they are not material in the sense that the company has grown dependent on the exacerbation of these issues for survival, specifically around cost reduction.

The goal in this category is to understand the means by which companies keep costs down and then to determine which issues emerge as a result of this behaviour.  Consider the efforts of retail merchant WalMart to changeover highly inefficient refrigerators used to hold their food products.  These refrigerators are naturally costly to the merchant and their excessive use of energy contributes to ecological externalities.  There is thus a business case to respond to what is a material issue for the merchant – energy use and associated pollution.  This is typically double materiality because WalMart is both contributing to the material issue and, by doing so, is negatively impacting their performance.  

But another way that WalMart might reduce costs is by prioritizing suppliers that have found clever ways to reduce the input costs of clothing merchandise.  Toxicity in apparel runs rampant to the point that an increasing number of alarming findings have revealed toxins found in clothing that harm customers[ii].  What is more, the ecological impact of the clothing both in terms of the raw materials used and the short life span of the products is enormous.  In this situation, Walmart's efforts to reduce costs is positively correlated with the increase in customer and ecological harm. Yet, there is not a corresponding negative impact on Walmart's financial performance as we would expect to see for this to be deemed double materiality, at least not within a reasonable time period that affects managerial decisions. 

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Because the effects of these products will take a long time to appear as material for Walmart, there is very little incentive for Walmart to change course.  What is more, Walmart has a strong incentive to undermine any effort to impose these costs on the sector.  As with any profit-seeking entity, it is in their best interests to protect this low cost strategy.  As a result, material toxicity does not appear in Walmart's materiality matrix even though a majority of the clothing products on their shelves carry significant negative externalities. A key part of Walmart's corporate strategy is the immense power and control they have over their suppliers.  If a supplier wants to supply Walmart, they need to demonstrate some acrobatic cost cutting measures that no doubt incentivizes them to cut corners and find the most cost efficient and non-financial cost enhancing means to achieve this end.

Another place where materiality emerges from a cost cutting point of view is through efforts to reduce material costs.  When sugar as a raw material increased in cost, food engineers found innovative ways to replace sugar with alternative ingredients.  One ingredient was high fructose corn syrup.  Not only was this ingredient found in food, but the more general innovation of using corn derivatives led to its use in a wide variety of products including diapers and batteries.  Yet while costs were reduced, health deficiencies in food increased at the expense of the consumer.  The same story has emerged with chocolate and confectionery, where the industry has seen ballooning cocoa costs.  In response, large confectionery companies turned to palm and soy oil substitutes for cocoa to keep costs down[iii].  Yet doing so has revealed a key material issue of deforestation as a $250 billion dollar industry now uses palm trees in their products.  In these examples, food and beverage companies have a strong impact on social and ecological issues (consumer health and deforestation) but there is not a corresponding negative impact on firm operations.  In fact, the impact is positive from a profit maximization perspective again, within a reasonable time frame of managerial decision making.

In sum, in their efforts to truly understand what is material for a company, students of business must understand how the business goes about reducing costs both internally and throughout their respective supply chains and then to ascertain how this cost reduction increases social and ecological issues. 

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2. How does the business model increase its revenues?

Understanding how a company earns its revenue is the second means by which to identify material sustainability issues.  Intuitively, one can think of a wide range of companies that earn their revenue in ways that increase social or ecological issues.  That’s not to say that they don’t create benefits to society too but it is hard to escape the reality that some of these companies make a direct contribution to some of the greatest social and ecological issues of modern times.  Energy companies no doubt earn a significant percentage of their revenue through the exploration, production and distribution of fossil fuels.  As a result, climate change is a material issue for oil and gas companies in the same way that it would be a material issue for the transportation sector, which relies extensively on the internal combustion engine.  Similarly, mining companies earn their revenue through practices that are directly tied to negative externalities whether that be pollution and deforestation or the prevalence of the mined materials throughout global supply chains.  In addition, securing these revenue sources often means ensuring relatively submissive communities that surround mining operations, resulting in Indigenous and community welfare becoming a key material issue for companies in mining. The above examples would not appear in traditional definitions of a materiality matrix there is a confirmed negative impact on firm performance of continuing with the status quo.  While this is becoming increasingly evident, there was no doubt interest on the part of business to delay this inevitability to the cost of stakeholders and society.  Looking at this using a True Materiality lens highlights the relevance of the issue to the business model rather than just the impact of the issue on the business model.  

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Not all material issues are as obvious as the examples above.  Consider consumer electronics, specifically mobile or tablet devices.  Perceived obsolescence is a term used in this industry that refers to consumer perceptions that their device is becoming outdated.  An example might be the perception that having only one camera lens on a device is perceived as outdated even though there is arguably little reason to dispose of one’s phone because it doesn’t have multiple lenses.  But the perception is real, as consumers feel that their device is becoming out of date.  Practical obsolescence, on the other hand, is an explicit indication that a device is becoming old as reflected in lower battery life, slower processing speeds or compatibility issues.  Unlike perceived obsolescence, practical obsolescence gives consumers little choice but to discard their current device. 

A company like Nokia’s revenue stream is contingent on both practical and perceived obsolescence.  The more this obsolescence exists, the greater the revenue potential of the company.  There is of course a limit here – if Nokia’s devices become obsolete after 1 year, a consumer revolt might ensue resulting in an impact on revenue.  This is as far as double materiality goes.  But with only 4-5 major players in the sector (Apple, Nokia, Samsung, Huawei, etc.), norms of when devices become largely determined by business, not by the market.  In fact, 2.5 years is the expected time that a device is expected to avoid the above types of obsolescence[iv].  This, of course, is at odds with ecological ambitions related to reducing e-waste which has emerged in the last couple of decades as a key ecological concern.  The BBC reported that 5 billion smartphones were expected to be discarded in 2022[v].  Moreover, exposure of people in less developed countries to the toxins in these consumer electronics has severe implications socially[vi].  Surprisingly then, the terms practical or perceived obsolescence do not appear anywhere in the sustainability reports of Nokia, Samsung or Apple as of 2023.  Yet while they recognize e-waste as a material issue, they are silent on its link to revenue potential.

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A similar approach can be used when identifying what is material in the apparel sector.  Fast Fashion has had a detrimental impact on ecological systems given the disposable nature of clothing.  Yet, the repeat purchase behaviour that characterizes fast fashion is a revenue boon for apparel companies.  It is therefore surprising that retail merchants, when discussing waste as a material issue, in no way discuss the longevity of the products on their shelves and the associated ecological costs of “disposable” and cheap products.  To illustrate the distinction among single, double, and true materiality, an example of single materiality might be political instability of the countries in which a company sources their products.  Double materiality could be how the continual sourcing of products from suppliers that support regulatory loopholes related to employee safety would subsequently impact product quality and stability.  True materiality represents the immense contribution to social and ecological issues associated with fast fashion that dramatically increase revenue levels.

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Another example might be the fast food sector.  Portion sizes over the last few decades have ballooned.  A key part of the business model of the fast food sector is to increase prices and thus revenue to match an increase in portion sizes, but without the comparable increase in costs.  No doubt, companies are incentivized to increase portions because they gain the additional revenue without the additional cost of doing so.  This means that adding more of a product to an order allows for a price and revenue boost but the cost, given economies of scale, hardly increases.  Yet the social costs associated with consumer health of these activities are enormous with obesity and obesity-related health issues reaching unprecedented levels.  So, a fast-food company’s natural incentives to increase revenues comes with a social cost. Because of the immense revenue opportunity associated with this tactic, the issue of consumer health is overlooked as immaterial from a single or double materiality perspective.  Only when we consider True Materiality and consider the relevance of this issue to the integrity of the business model, do we understand its importance as a material issue.

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In sum, students of business must understand the ways in which companies earn their revenue, with a specific emphasis on how revenue opportunities of the company are inextricably tied to social and ecological issue growth.  This goes well beyond double materiality which only covers those company behaviours that increase social issues in a way that correspondingly negatively impacts revenue.

3. How do companies increase customer willingness to pay?

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A less obvious means by which students of business can identify material issues is by understanding how companies go about influencing customer perceptions of their products and services.  Oftentimes the price a customer is willing to pay is different from what the actual price of the product or service is.  Consider a smartphone.  A customer might perceive the value of the phone such that they’d be willing to pay $900.  But the price might only be $750.  To boost revenue, businesses want to increase customer willingness to pay because doing so allows them to increase price, especially if the industry is concentrated with only a few competitors.  While there is overlap with the previous section on revenue, it is important to distinguish willingness to pay from revenue when considering material issues. 

The best way to understand this is through an example.  The food and beverage industry has developed strong competencies in food engineering.  Food engineering refers to the design of food products that uses a unique collection of whole food derivatives to make new food products.  Recall the earlier example of replacing sugar with high fructose corn syrup.  We already discussed how doing so allows companies to reduce the costs associated with whole foods.  But another part of the business model of food and beverage companies is to boost willingness to pay.  Doing so involves clever marketing tactics that give the impression of value add using, for example, claims of certain nutritional benefits like fibre and omega 3s.  Some even insert certification symbols to denote health benefits.  It could also involve exploiting consumer vulnerabilities associated with product consumption.  Nowhere is the latter more prevalent than considering the unprecedented growth of salt, sugar and fat in food products.  While they do reduce costs, the real value for companies is that they can be addictive.  In fact, they are so addictive that academic scholars have likened these food characteristics to tobacco addiction[vii].  In this example, boosting customer willingness to pay by inserting addictive ingredients has an adverse effect on the health and wellbeing of these consumers. Yet using the lens of double materiality perspective, the issue of consumer health is not material.  Only through True Materiality by understanding how these tactics both boost willingness to pay and consumer health issues does it emerge as material.

Another material issue that is often overlooked is waste from packaging.  No doubt that companies can attract consumers to their products if the packaging of the product is in is large and flashy containers.  Customers are more willing to pay for products that have shelf presence.  In an effort to persuade consumers to spend more, packaging is instrumental.  For those companies that rely heavily on packaging to demonstrate the value of their products, their efforts to boost packaging and thus willingness to pay has an adverse effect on the ecological environment. 

In sum, while understanding how companies earn revenue is an important means by which to identify material issues, it is important to consider how companies influence a customer’s willingness to pay for products and services, the increase of which has adverse impacts on society and/or the environment.

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Materiality Matrix

When developing a company's materiality matrix, it is very important to go beyond those issues that carry material financial risk to companies where the X Axis is labelled as the degree of impact on the company.  Instead, the X Axis on the matrix should be labelled as the degree of relevance of the issue to the company, as defined by our three profitability categories above.  An example of a materiality matrix can be found below.  Based on the above commentary, issues are high in materiality when they are particularly pressing for society and are highly associated with the means by which the company in question reduces costs, increases revenue and/or willingness to pay.

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Appendix A

Materiality Matrix for Nestle

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​​[i] Page 2: NYU Stern (May, 2019):  Sustainability Materiality Matrices Explained.  https://www.stern.nyu.edu/sites/default/files/assets/documents/NYUSternCSBSustainabilityMateriality_2019_0.pdf. Accessed June, 2022. 

[ii] Wicker, A. (2023).  The Guardian: https://www.theguardian.com/fashion/2023/jul/02/fashion-chemicals-pfas-bpa-toxic.  Accessed January 10th, 2024.  Cowley et al., (2021).  CBC.  https://www.cbc.ca/news/business/marketplace-fast-fashion-chemicals-1.6193385.  Accessed January 10th, 2024.

[iii] World Wildlife Fund: https://www.worldwildlife.org/pages/which-everyday-products-contain-palm-oil

[iv] Komando, K. (2023).  USA Today: https://www.usatoday.com/story/tech/columnist/komando/2023/10/22/how-to-find-smartphone-expiration-date/71255625007/.  Accessed January 10th, 2024

[v] Gill, V. (2022).  E-Waste: 5 Billion Phones to be Thrown Away in 2022. BBC: https://www.bbc.com/news/science-environment-63245150, Accessed January 10th, 2024.

[vi] Vidal, J. (2013).  Toxic E-Waste Dumped in Poor Nations.  United Nations University.  https://ourworld.unu.edu/en/toxic-e-waste-dumped-in-poor-nations-says-united-nations, Accessed January 10th, 2024.

[vii] Elton, S. (2013).  Are sugar, salt and fat the worst, most addictive drugs ever.  Globe and Mail: https://www.washingtonpost.com/wellness/2023/09/19/addiction-foods-hyperpalatable-tobacco/, Accessed January 10th, 2024