You’ve watched the news for two weeks – on February 3, 2023 a Norfolk Southern freight train carrying hazardous materials derailed in East Palestine, Ohio causing an environmental catastrophe. This is a horrible situation impacting the health and safety of the community and emergency responders. Cleanup activities may take years depending on the amount of groundwater contamination and its migration. The company will face tens of millions in costs, penalties, claims and third party lawsuits. This incident spurred questions around here about ESG risks and disclosure, so I did a little research.
I looked at Norfolk Southern’s latest SEC 10-K for fiscal year 2022 (filed in EDGAR on February 2, 2023 ironically) and the company’s 2022 ESG Report to see how events like the East Palestine derailment are addressed. I found some good things but also have questions about consistency of ESG and 10-K risk factor disclosures, which may offer lessons to other companies disclosing ESG risks.
The company disclosed 19 individual 10-K Item 1A material financial risk factors. According to the description of Item 1A risks, these are “risk factors [that] could have a material adverse effect on our financial position, results of operations, or liquidity in a particular year or quarter, and could cause those results to differ materially from those expressed or implied in our forward-looking statements.”
Not surprisingly, several apply to chemical transportation and spills/incidents. For instance:
As a common carrier by rail, we must offer to transport hazardous materials, regardless of risk. Transportation of certain hazardous materials could create catastrophic losses in terms of personal injury and property (including environmental) damage and compromise critical parts of our rail network. The costs of a catastrophic rail accident involving hazardous materials could exceed our insurance coverage. We have obtained insurance for potential losses for third-party liability and first-party property damages (see Note 17 to the Consolidated Financial Statements); however, insurance is available from a limited number of insurers and may not continue to be available or, if available, may not be obtainable on terms acceptable to us…
Federal and state environmental laws and regulations could negatively impact us and our operations. Our operations are subject to extensive federal and state environmental laws and regulations concerning, among other things: emissions to the air; discharges to waterways or groundwater supplies; handling, storage, transportation, and disposal of waste and other materials; and, the cleanup of hazardous material or petroleum releases. The risk of incurring environmental liability, for acts and omissions, past, present, and future, is inherent in the railroad business…
We may be subject to various claims and lawsuits that could result in significant expenditures. … A catastrophic rail accident, whether on our lines or another carrier’s, involving any or all of release of hazardous materials, freight loss, property damage, personal injury, and environmental liability could compromise critical parts of our rail network. Losses associated with such an accident involving us could exceed our insurance coverage, resulting in a material adverse effect on our liquidity. Any material changes to current litigation trends could also have a material adverse effect on our liquidity to the extent not covered by insurance…
The Management Discussion and Analysis (MD&A) section, Note 17 also contains information about financial risks and liabilities for third party claims and environmental matters. In addition, other business matters of concern are discussed in the MD&A that don’t rise to what the company decided was the Item 1A threshold.
I am not a regulator so my opinion about the quality of these disclosures isn’t determinative – or even meaningful by anyone’s account. Although short/concise, they address environmental damage and third party liabilities in relation to chemical releases including those from a “catastrophic rail accident.” Some could argue these may be boilerplate or too short, but I am not sure how much more detail is necessary or achievable given the variables at play relating to a railcar accident.
ESG Materiality Disclosure
The company’s ESG report includes an ESG Materiality Assessment that was conducted using
“… information from leading sustainability reporting frameworks such as the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board Rail Transportation Sector to formulate our relevant issues and disclosure topics.
To ensure an inclusive and comprehensive assessment, we engaged several stakeholder groups, requesting feedback from five key groups: executive leadership team, employees, investors, customers and suppliers. Our selection criteria focused primarily on participant knowledge of the business, influence on our overall business objectives and relations with Norfolk Southern… Engagement methods included interviews with our executive leadership team and customer, while employees, investors and suppliers were invited to complete our online survey.”
The result was 19 reported material ESG risk factors that were split into 7 low, 4 medium and 8 high risk (meaning highly important to stakeholders and to the company). One – Emergency Preparedness & Response – appears to cover spills and rail car accidents. Accident/incident metrics are disclosed on pages DS-7 and 8.
Comparing Material Risks
One unintended consequence of the increase in ESG disclosures/transparency is that companies making headlines for ESG incidents are now subjected to scrutiny of those disclosures. Therefore, clarity and consistency are of the utmost importance in these situations. Really, those are always important – but when you make headlines and go under the microscope, things rise to a new level.
So what did I find in my comparison of the two risk disclosures? I think the best way to show that is with these two tables (for simplicity, I combined similar 10-K factors so this table only reflects 16). The tables are self-explanatory.
|Norfolk Southern 10-K Item 1A Risk Factors (fiscal year ended Dec. 31, 2022)||Included in 2022 ESG Report?|
|Cybersecurity and IT matters||Yes|
|Hazardous materials transportation/rail accidents||Yes**|
|Supply chain disruptions||No*|
|Fuel markets/energy prices||No***|
|Litigation, including lawsuits arising from a catastrophic rail accident||No|
|Failure to attract and retain talent||Yes|
|GHG emissions restrictions||Yes|
|General economic conditions||No*|
|Capital market liquidity||No*|
* It is possible these are considered subtopics under the ESG Indicator of “Economic Performance”.
** This is likely part of the ESG indicator “Emergency Preparedness & Response.”
*** It is possible this is considered a subtopic under the ESG indicator of “Energy & Water Consumption.”
|2022 ESG Report Materiality Assessment Results||Materiality Rank||Included as 2022 10-K Item 1A Risk Factor?|
|Community involvement & corporate giving||Low||No|
|Energy & water consumption||Low||Yes|
|Sustainable land use & biodiversity||Low||No|
|Local economic development||Low||No|
|Recycling, reuse & waste minimization||Low||No|
|Emergency preparedness & response||Medium||Yes*|
|Carbon emissions & climate change||Medium||Yes|
|Innovation & technology||Medium||Yes|
|Board oversight & risk management||High||No***|
|Digital & physical asset security||High||Yes|
|Legislation, regulation & government relations||High||Yes|
|Employee recruitment & development||High||Yes|
|Business ethics & compliance||High||No|
|Customer service & satisfaction||High||No****|
|Employee health & safety||High||No|
* This is likely part of the 10-K Item 1A risk factor “Hazardous materials transportation/rail accidents.”
** DEI is discussed in Item 1, but not Item 1A.
*** Corporate governance is discussed very generally in Items 1 and 10, but not Item 1A.
**** It is possible these are considered subtopics of the 10-K Item 1A risk factors “Competition,” “General economic conditions” and/or “Capital market liquidity.”
What This Means
In its ESG report, the company makes clear they are using different definitions of “materiality:”
“Materiality, as used in this report, differs from the definition used in the context of filings with the SEC. Issues deemed material for the purposes of our ESG strategies and disclosure may not be considered material for SEC reporting purposes.”
Fair enough, but I’m left unsatisfied and somewhat confused when I look at reality – especially when a crisis response is in play. To some extent I can understand how some ESG risks may not rise to financial materiality. But I am confused when a risk issue is shared between Item 1A and the ESG disclosure, how can they be rated so differently? For instance, derailment and chemical spills are reflected in multiple Item 1A risk factors, yet emergency response/preparedness is considered only medium ESG materiality. How does that work? The impact of the event and response on local community stakeholders forms the basis of clean up, litigation and other financial risks.
And there’s the problem:
Based on the company’s explanation of their stakeholder universe, it appears that communities and populations along their chemical transportation routes were not included in the ESG assessment process. Certainly, looking at things through the lens of East Palestine, that seems to be a major oversight. Perhaps it was expected that one or more of the five selected groups would act as a proxy to some extent for other views not in the room. I don’t think that happened – or it didn’t happen adequately.
Using different definitions for “materiality” for ESG and financial reporting creates opportunities for gaps, omissions and misunderstanding. I know it is common and in some circumstances appropriate. However, companies need to be careful in doing so. ESG staff should work very closely with securities counsel to thoroughly understand Item 1A risks (and other business risks discussed in the MD&A section) and their underlying causes to identify potential:
- linkages between financial and ESG risk requiring clarification in one or both reports;
- gaps in disclosures or explanation;
- differences in internal perspectives needing resolution or clarification in reporting; or
- omissions in or incomplete scopes of assessment/evaluation methodologies, especially where significant differences exist between the ESG rating and financial materiality determination of similar or related risks.