Modest view on materiality: Court case against EXXON for financial deception will shape our understanding.

While some investors complain about the burden of reporting, it is conceivable that one day, the demand from #investors will be for #contextmateriality to understand and reduce #climatechange risk.

Discussing materiality is a challenge

For progress, it is vital to have these broad respectful debates which accommodate different views. As noted in the Harvard Law School on Corporate Governance, materiality is one of those tricky topics which will be iterative. We are lucky that many scientists and analysts are critically considering this issue. Bringing an outside perspective, I believe materiality will be shaped by factors we currently don't understand.

Materiality is complex

I am not a scientist, nor do I claim to have the depth of knowledge of many colleagues I respect and learn from. The work we deliver is to explain to companies how they can decarbonise their operations and portfolios cost-effectively and at speed. I have recently spent too much time on consultation papers on standards and materiality, prompting a few thoughts. 

Modest view of a user of financial information

I would define myself as a "user of financial information", trying to adapt to the new system and understand how to direct liquidity to impact outcomes. I believe double materiality is the sensible mandatory starting point. However, having read the work on context materiality, I think this is a more detailed methodology for measuring impact and financial risk. This methodology poses a more significant threat to asset owners and companies' financial and economic interests with high adverse effects on carbon, climate and biodiversity. 

Factors that will shape materiality 

In the long run, investors' aversion to risk and destruction of capital will shape the level of disclosure and the definition of materiality. Meanwhile, existing corporate codes, governance, and case law redefine fiduciary duty for investors, company boards, and governments. Assurance around the nature of climate risks and drivers and what they mean for company valuations is still evolving. The legal interpretation of greenwashing as financial 'deception and fraud' is being tested in the courts. More class actions on governments, corporations and financial institutions will shape the definition.

Existing materiality is far from perfect.

Materiality on its own is not isolated. It is at the core of quantitative and qualitative analysis of a business and investment decision. At the same time, financial standards and reporting on revenue, profit, assets, and liabilities have been around for years. However, the system is far from perfect. Every few months, a Wirecard, Carillion, or Rolls Royce case provokes a crisis in auditing and the accounting sector, prompting an inquiry by the regulators. This trend is not a new or isolated example of bad behaviour; a pattern exists, as the history of Enron and WorldCom demonstrates.  

 Concepts of materiality in sustainability 

The IFRS and ISSB consultation process brought some exciting conversations and analysis from Re_Generation  on the responses to materiality. This was followed up with a public letter highlighting the perceived nonsensical definition / definitional cooperation approach in the consultation process. In traditional accountancy, the term means any item or issue which might impact the investor's decision. In the lexicon of ESG, it means the significance of a particular climate impact. Single materiality being on the company. Double being on the company and the company's impact on the environment, society, and governance. Context materiality transcends the limited lens of traditional finance-oriented materiality by focusing instead on organisations' impacts on vital capital resources that stakeholders rely on for their well-being.

 Assuring climate disclosure 

The current assurance (risk reduction) challenge is how these science-based carbon, climate, and biodiversity loss measurements are reported. The challenge for investors is how these are translated into financial metrics to provide assurance and an understanding of risk. While agreeing and indeed adopting the best approach is presently contested. Assurance over non-financial (Sustainable, climate, impact factors) information disclosed by an entity enables organisations to build trust in the accuracy and integrity of what they say and how they understand current and future risks. The most widely used standards for non-financial information today are ISAE 3000 and ISAE 3410.  

Fiduciary duty must be taken in climate.

Historical and recent legal cases are being set to test climate disclosure and fiduciary duty. For example, in the 2022 Ashden Trust Vs the Charity Commission[1] case heard before Lord Justice Green. "This ruling clarifies the law and redefines fiduciary duty in the light of climate change and, more broadly, for the benefit of all charities. It is also likely to be influential in other jurisdictions and will interest other categories of investors".

UK companies' law

Under UK governance legislation, CEOs and Boards are required to meet the fiduciary board duty as defined by section 463 of the UK Companies Act 2006 (CA 2006), which states: "Directors of a company are liable to compensate the company for any loss suffered because of an untrue or misleading statement included in the statutory director's report, strategic report, directors' remuneration report, or corporate governance report". In addition, legislation such as the FSMA 2000 section 90 states that "liability is established when a claimant has suffered a loss due to omissions in disclosure".

 Governments must comply with disclosure.

In July 2022, Client Earth won a case against the UK government's Net Zero targets. The High Court found in favour of the claimant. It supported the claim that the Government's net zero strategies to decarbonise the economy do not meet its obligations under the Climate Change Act to produce detailed climate policies. Furthermore, insufficient evidence (Disclosure) demonstrates how the UK will achieve its legally binding carbon budget. The UK Government has eight months to update its climate strategy to include a quantified account of how its policies will achieve climate targets. 

The EU has set the policy direction.

The EU has taken the double materiality policy direction as a critical part of its strategy to combat climate change and align with the 1.5C target in the Paris Agreement, which benefits investors by providing more information. Whether their investment decision will destabilise the climate or ecosystem or if the asset they are investing in is at risk because of climate and biodiversity loss. This approach feels like the right course. 

Regulator's greenwashing intervention

This year has witnessed significant 'greenwashing raids' on notable European and US investors. Which sets a precedent and indicates regulators are ready to act. Within its Sustainable Finance and Roadmap 2022 -2024, ESMA made tackling greenwashing a priority and reiterated its focus in February 2022. The FCA has made it clear that it is a priority, as has the SEC. Exchanges such as the LSE that want to attract ESG and Sustainable/ Impact Debt and Equity listings will risk their competitive position if they do not maintain high market access standards. 

Greenwashing is 'deception' in the courts.

Greenwashing, for many, is considered the mislabelling in the 'marketing' of goods or services. However, this concept is set to change. The Massachusetts Attorney General Maura Healey case against Exxon Mobil interprets 'greenwashing' as corporate fraud and 'deceptive practice' advertising to consumers and investors. The charge is that there is not and has not been an accurate historic disclosure (fiduciary duty) of the business's risk by engaging in fossil fuel-driven climate change – including systematic financial risk.

Exxon's Historical and current disclosure of climate risk is challenged.

The historical aspect should be on the minds of company boards and auditors. As documented by the BBC,   as early as 1982, Exxon's scientists knew of the risk of its products and the negative climate-related impacts. In addition, the case alleges that Exxon's current advertisements and related marketing target consumers with deceptive messaging about Exxon as a good environmental steward and its products as "green". The company is massively ramping up fossil fuel production and spending only about one-half of 1% of revenues on developing clean energy. Exxon's attempts to have the case thrown out have failed, and the subsequent court case is set for the 27th of September, 2024. 

The market will decide.

After the Economist's accurate critique of the ESG capital markets, some commentators say that the talk of its imminent demise is a la mode, ignoring that financial institutions and investors prefer returns and profits over risk. Investors will have spent the summer watching record forest fires, droughts, and hottest temperatures. Whatever they say in public or around dinner tables (ESG is over, it woke, it is anti-capital, etc.!), they will still factor in climate risks to protect their capital. 

Investors will demand more information

Ultimately, investors want to reduce risk and will demand more material analysis. Therefore, as the disclosure and reporting process gains pace, more metrics data will be in the market, which will supersede the use of ESG rating. New trends will emerge to which analysts and investors will respond. The exciting and interesting part will be how the auditors and the accountants respond to forward-looking material risks.

We'll get there in the end.

J.M