Sustainability Materiality

Sustainability Materiality​​​​​​

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

The growth of sustainability and ESG (ecology, society and governance) 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 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 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. 

Sustainability materiality draws on this concept to only some degree.  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 water scarcity and its relevance to a company like Nestle.  Nestle is a company that relies immensely on the availability of sustainable water systems to the point that, as the issue of water scarcity grows, managerial decision-makers must consider the impact of the issue on the business.  Thus, water scarcity is a material issue for Nestle because company profit levels are at stake should the issue grow in severity.

But this approach only considers a select group of issues that coincide with the interests of a business.  What about those issues that matter to society, yet do not negatively impact business?  Even worse, what about issues where, their growth, actually positively impacts firm performance?  Practitioners reference ‘double materiality’ or ‘impact materiality’ to identify issues not necessarily because of its impact on firm performance, but because of the short, medium, and long-term impact on society resulting from the company’s operations and its value chain.  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.  Only by reflecting on the core of what a business represents will the most important sustainability issues emerge. 

Business Model

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To truly understand what is material, 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.  These are important to consider too but they are not material in the sense that ignoring them would significantly exacerbate an issue that is relevant to society.  Indeed, these would constitute single materiality or financial materiality.

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 change over 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.  But another way that WalMart might reduce costs is by choosing 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 because the effects of these products will take a long time to appear, there is very little incentive for WalMart to change course.  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 become a supplier for 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, consumer harm increased substantially to the point where the revolt associated with high fructose corn syrup led to its removal in a number of food products.  The same story has emerged with chocolate and confectionary, where the industry has seen ballooning cocoa costs.  In response, large confectionary 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 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. 

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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. 

But 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. But with only 4-5 major players in the sector, 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.

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 French fries 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. 

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.

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 category, 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.  No where is the latter more prevalent than considering the unprecedented growth of salt, sugar and fat in food products.  It is not so much that these ingredients are low cost.  While they do in fact 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. 

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 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 have adverse impacts on society and/or the environment.

Materiality Matrix

Once material issues start to emerge, it is important to map these issues on 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 is relevant to a company’s business model. 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