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The concept of double materiality is core to materiality assessments and reporting frameworks, but especially to the European Sustainability Reporting Standards (ESRS). The ESRS has an entire section dedicated to defining double materiality. Clearly, it is an integral process of sustainability reporting and should be understood before conducting materiality assessments.
In this article, we take a close look at the guidelines of the ESRS as it pertains to the concept of double materiality.
ESRS is the set of reporting standards that companies are required to follow under the Corporate Sustainability Reporting Directive (CSRD). The CSRD, which applies to large organisations in the EU starting in 2023, is a sustainability reporting regulation aimed at increasing transparency on a company’s non-financial performance.
The European Financial Reporting Advisory Group (EFRAG) was appointed by the European Commission to develop the ESRS. At the time of writing, EFRAG has released 13 European Sustainability Reporting Standards exposure draft standards addressing different sustainability themes and reporting areas. In its disclosure requirements, the ESRS requires companies to follow the principle of double materiality in their reporting practices.
At its core, double materiality is quite a simple concept. The idea is that an ESG (Environment, Social, Governance) aspect can impact a company’s financial bottom line or operational performance, and that the company can have an impact on that same aspect. Nothing revolutionary there, but important for understanding and assessing materiality.
In the ESRS, double materiality forms the basis for sustainability disclosures, as it should. However, the ESRS uses a slightly more complex understanding of double materiality. In the ESRS’ definition, double materiality is impact materiality and financial materiality combined.
This means that only issues that are found to have an impact and that influence financial performance should be included. The ESRS is very intentional about establishing a link between financial and non-financial information, an area critically lacking in the current state of corporate sustainability reporting practices, hence their definition of materiality. In its definition, the ESRS draws a clear distinction between impact materiality and financial materiality.
For example, a company’s water use impacts the availability of a commodity in a community. In water-stressed areas, this can be an issue for the company and the community there, leading to potential depletion or a low-level water table, which then threatens the survival and the well-being of both parties. For the business, access to water affects its ability to operate. For the community at large, depleted or contaminated water stock poses health risks.
Assessing materiality is a process for companies to identify and prioritise issues material to the business. The application of the double materiality principle provides an additional filter to the assessment process while ensuring that companies consider their outgoing impacts on ESG issues, in addition to being impacted by those issues.
Any aspect of sustainability is material if it involves potentially significant impacts that could hurt the performance of a business or of the aspect itself. Impacts can be either positive or negative, or both, depending on the risks and opportunities surrounding the matter.
It should be noted that impact materiality extends to the supply chain as well, even if there is no direct contact or engagement with the aspect. For example, modern slavery in the supply chain is considered a material aspect of an FMCG (Fast Moving Consumer Good) that sources raw cocoa from a farm run by its supplier.
This begs the question: how can you determine the importance of a material matter? Using our example above, modern slavery could very well exist in any FMCG’s supply chain, so how do we know if it is relevant to include it within our prioritisation of material matters? Materiality is determined by two factors:
In the case of grave human rights impacts, the severity of it should override likelihood, meaning that if there is a small potential for human rights violations, it is considered material even if it is not likely to happen. This draws on precautionary principles, where the European Sustainability Reporting Standards is taking a pre-emptive approach to issue detection where human rights are concerned.
Financial materiality refers to a sustainability matter impacting future cash flow or enterprise value. Impairments to assets and liabilities as well as factors for enterprise value creation such as the six capitals in the Integrated Reporting <IR> framework are part of this category of enterprise value.
Financial materiality can be difficult to establish, given the intangible relationship between non-financial information and the balance sheet. Matters like employee morale and workplace diversity are difficult to quantify and even more difficult to connect to short-, medium-, or long-term financial performance. Despite this challenge, the end goal of many sustainability reporting frameworks is to establish that link, difficult as it may be.
ESG factors can affect a company’s financials in the following two ways:
Financial materiality is prioritised by the likelihood that an issue may occur and the magnitude of its financial impact. By contrast, environmental and social materiality is focused on those aspects related to company impacts on or from the environment/social spheres.
Double materiality helps companies avoid focusing too narrowly on certain issues and ignoring their impact on the environment and society. By considering both the financial impact of sustainability issues on the company and the company's impact on the environment and society, companies are encouraged to take a more long-term approach to sustainability issues. This can lead to better reporting and decision-making.
Overall, double materiality helps companies to better understand and manage their sustainability risks and opportunities. Furthermore it hto communicate transparently with stakeholders about their sustainability performance. This can help to build trust with investors, customers, and other stakeholders, and ultimately contribute to a more sustainable and resilient economy.
Depending on a company's size, operations and core product, the European Sustainability Reporting Standards will require compliance with specific legislation in the future. We now present some of these important regulations.
Companies that fall within the scope of the CSRD will have to become acquainted with the concept of double materiality. Materiality assessment processes must be refined to accommodate this principle. The key to this is to develop an evaluation tool and matrix that can rank sustainability matters on the severity of impact and and how likely they are to happen. This tool should include input from a variety of people who are influenced by the company's activities.
From 2024, corresponding reporting will gradually become mandatory for companies with more than 250 employees, €40 million in net sales or €20 million in total assets.
From January 1, 2023, the Lieferkettensorgfalftspflichtengesetz obliges all companies based in Germany and companies with a branch office in Germany to implement sustainable supply chain management.
This includes among other things safeguarding human and workers' rights, preventing the release of environmentally harmful substances, and introducing a grievance mechanism.
The requirements from the LkSG will apply to companies with at least 3000 employees from 2023. From 2024, they will also apply to companies with at least 1000 employees.
In the future, companies subject to the CSRD will also be required to disclose information on how and to what extent the company's economic activities are linked to environmentally sustainable and thus "taxonomy compliant" activities.
The EU Taxonomy focuses on issues such as pollution prevention, transition to a circular economy, and sustainable water usage. This includes the obligation of in-depth analyses of a company's economic activities with regard to social and environmental dimensions.
The analyses and action-taking for all three of these regulations cannot be done without collecting and evaluating a large amount of data. Powerful ESG software is ideal for such analyses.