According to Vilfredo Pareto, an Italian economist and sociologist (1848-1923), 80% of the effects tend to proceed from 20% of the causes, as observed in his ‘Cours d’économie politique’ (1896). The Pareto principle, widely known as the 80/20 rule, is an essential guide for decision-makers as they seek to distinguish between the few vital and the many trivial factors.
The rule, which goes to the core of the notion of ‘materiality,’ is unfortunately often disregarded. There probably is a solid neuroscientific explanation for this systematic failure, but there is no excuse for what is ultimately a lack of thought leadership.
The same issue is afflicting sustainable finance: materiality seems to be eluding many financial market participants and influencers.
Consider the two most challenging questions when assessing materiality from an ESG perspective: from what point of view and within what timeframe? The answers are subject to heated discussions creating significant confusion. In a note earlier this year, the CEO of the Sustainability Accounting Standards Board (SASB) had to step in to clarify its concept of materiality following some misunderstanding caused by a paper published in the New York Law Journal.
SASB focuses on ‘financial materiality’ to drive the disclosure of ’issues that are reasonably likely to impact the financial condition or operating performance of a company.’ The institution explicitly references a company’s enterprise value as the bottom line and takes a practical approach to the time horizon.
In its Corporate Sustainability Disclosure Directive, the European Union relies on a ‘double materiality’ concept. It requires that companies consider not only financial materiality (impacts inward) but also environmental and social materiality (impacts outward).
The WEF and others are promoting a complementary ‘dynamic materiality’ concept whereby firms must disclose information that is not financially material today if it could become material in the future, i.e., if impacts outward could become material impacts inward. In fact, the EU justifies its double materiality approach by invoking dynamic materiality: ‘the positive and/or negative impacts of a company on [ESG factors] will increasingly translate into business opportunities and/or risks that are financially material.’
This is all intellectually beautiful, but practically overwhelming. Materiality is shooting itself in the foot. A look at the ESG ratings illustrates as much: agencies rely on dozens of key performance indicators to inform their corporate ratings. Screening these KPIs on their websites and watching the relative weight ascribed to each of them show that the ESG agencies, like many, are getting lost in the immaterial world. Pareto, where are you, my man?
These circumstances create an exceptional opportunity for corporates to establish themselves as industry thought leaders. By identifying and disclosing material ESG drivers following an 80/20 philosophy, integrating them into strategic, operational, and financial objectives, and communicating about them frequently and coherently with military discipline, corporate leaders can regain control of the ESG narrative and drive a constructive dialogue with investors.
Corporate narratives cannot be hijacked by those lost in minutiae. Neither can the climate crisis and societal issues.