A 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.

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 taking a critical view on 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 from whom I respect and learn. I don’t qualify for being a member of the sustainability Taliban or the #sustainability flat-earthers. I have recently spent a lot of time on consultation documents and academic 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 #doublemateriality is the sensible mandatory starting point. However, having read the work on #contextmateriality, it appears this is a more detailed methodology for measuring impact and #financialrisk. Conceivably this methodology poses a more significant threat to the financial and economic interests of asset owners and companies 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 and governance, along with case law, redefine fiduciary duty for investors, company boards, and governments. #Assurance around the nature of #climaterisks and drivers and what they mean for company valuations are still evolving. The legal interpretation of #greenwashing as financial ‘deception and fraud’ are being tested in the courts. The definition will be shaped by more class actions on #governments, #corporates, and #financialinstitutions.

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, the concept of 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 Cooptation appraoch 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. #Singlemateriality being on the company. #Doublemateriality being on the company and the company 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 also rely on for their wellbeing.

Assuring climate disclosure

The current assurance (risk reduction) challenge is how these science-based measurements on carbon, climate, and biodiversity loss 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 veracity of what they disclose 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 take in climate.

Historical and recent legal cases are setting cases 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 in by section463 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, there is insufficient evidence (Disclosure) to demonstrate 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. If their investment decision will destabilise climate or ecosystem, or if the asset they are investing in is at risk because of climate and biodiversity loss. This approach feels the right direction.

Regulator’s #greenwashing intervention

This year has witnessed significant ‘greenwashing raids’ on notable investors in Europe and the US. 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 been clear that it is a priority, as have 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 standards for access to their markets.

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 #ExxonMobil 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 (#fiduciaryduty) 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 historic aspect should be on the mind 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 of its products as “green”. The company is massively ramping up #fossilfuel 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 process of disclosure and reporting 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

Originally published at https://www.linkedin.com.