The EU’s incoming Corporate Sustainability Reporting Directive (CSRD) has sparked a feisty debate. That’s because the new rules feature a twist on a key concept in corporate reporting – materiality.
Materiality is used to judge the impact that a specific business risk or opportunity could have on a company and its shareholders, typically in financial terms, and therefore whether they should include it in corporate reports. For example, the cost of switching suppliers post-Brexit could be large and may affect your profits and shareholders’ decisions. But the cost of choosing one item of stationery over another is small and therefore immaterial.
This will be familiar terrain for many businesses. However, CSRD is set to broaden the concept. Not only does it relate to a non-financial subject matter – sustainability – but it covers companies’ risks and their own impact. This means, for example, that companies will have to consider how vulnerable they are to climate change, plus the extent to which they’re contributing to it.
But what does all this mean in practice for companies affected by the new rules, and how should they start getting ready?
What is non-financial materiality?
Non-financial materiality has been around for some time. Lots of companies already use it to help decide which sustainability risk factors to include in their corporate reports, based on how likely those risks are to affect users’ decisions.
Popular voluntary sustainability frameworks, including those from the Task Force on Climate-Related Financial Disclosures (TCFD) and the Global Reporting Initiative (GRI), also guide companies to use materiality assessments.
But the EU’s rule-makers are going further. Their Sustainable Finance Disclosure Regulation (SFDR) already mandates investors to consider material sustainability risks, forcing them to seek disclosures from companies about these risks.
And now the CSRD, in phased enforcement from January 2023, will require large businesses operating in the EU to measure and report non-financial risks and impacts, as well as their responses to them.
What is double materiality?
The CSRD departs from what has gone before in relying on the concept of “double materiality” – how sustainability issues might create risks for the company, plus how the company’s activities impact people and the environment.
Crucially, double materiality recognises that the reach of corporate activity extends beyond the realm of finance and investors, affecting employees, customers, suppliers and communities. It also aims to tackle the widespread problem of greenwashing.
Double materiality assessments already significantly affect investors’ decisions. “Most of our financial services clients now follow the SFDR and TCFD disclosure requirements,” notes Pratap Singh, senior director at research provider Acuity Knowledge Partners. “The impact will be a large pool of funds diverting towards businesses that positively impact the environment and society.”
Why is double materiality contentious?
Double materiality has sharply divided investors and companies worldwide. In contrast to the EU regulator, the International Sustainability Standards Board (ISSB) has ruled out the concept.
As Michael Herskovich, global head of stewardship at BNP Paribas Asset Management, explains: “The debate is about whether we’re only interested in how events affect companies’ financial prospects, or in how corporate actions affect society, the environment and other companies. We support the [EU] approach and have challenged the ISSB to take a more holistic view.”
A spokesperson for International Financial Reporting Standards (IFRS), which created ISSB, says it is working with the GRI and the EU to achieve interoperability. “There is an MoU with GRI, and ISSB is working with the EU to achieve interoperability. So it can and is working alongside double materiality reporting,” said the spokesperson.
Where should companies start?
Several reporting frameworks, including those from the GRI and TCFD, provide guidance and tools for assessing non-financial materiality. Material risks might include threats to the business’s reputation, strategy and business model, and impacts may include familiar problems such as carbon emissions and waste.
A materiality assessment should also include a view on the likelihood of an event happening and the timeframe involved. However, companies are warned not to exclude factors such as climate change just because they are long-term.
It may also involve more regular work and more communication with stakeholders. For instance, reporting platform Workiva’s Environmental, Social and Governance (ESG) Practitioners Survey found that 49% of senior decision-makers now review materiality every three to six months to keep up with changing stakeholder views.
Singh notes that Acuity’s materiality assessment process begins with prioritising critical issues. The team then identifies the key stakeholders for each issue and sends them questionnaires. It ranks the results for those issues, benchmarks against peers and the wider industry, and performs deeper, hands-on research on particular topics using primary and secondary data and stakeholder interviews.
A similar approach is followed at Workiva. “Early in our ESG journey, we engaged with internal and external stakeholders to assess the materiality of value drivers,” says Mandi McReynolds, the firm’s vice-president of global environmental ESG.
“For example, one driver we identified was that ESG progress directly affects an organisation’s ability to gain capital investment, therefore affecting business growth. So we measure our success on this front partly by how many ESG investment funds include Workiva.”
A company’s sector will also influence how it assesses materiality. BNP Paribas’ ESG analysis concentrates on sectoral differences; it shows, for example, that climate change is the most material factor in the real estate sector, while human capital management is what’s on the line in commercial services.
What are the challenges?
Determining non-financial materiality is littered with challenges. “It tends to take three years to implement diligent TCFD reporting due to all of the governance, risk and related processes that need to be in place before meaningful climate scenario modelling can start,” says Humperdinck Jackman, managing director at advisory firm ESG PRO. “But businesses are woefully unprepared. They’ve not assembled that data, nor for other ESG factors such as around energy use, governance, employee management and human rights.”
Insufficient data can undoubtedly lead to an inaccurate picture of ESG impacts and perceptions of greenwashing.
David Harrison, a fund manager at the Rathbone Greenbank Global Sustainability Fund, says: “Double materiality reporting varies substantially in quality and scope. We see some good practice where reports explicitly and transparently link capital expenditure to decarbonisation, for example. But others are vaguer, with no tangible metrics.”
Daphne Biliouri-Grant, a senior adviser at risk consultancy Sibylline, warns firms not to try measuring everything at once if they’re new to materiality assessments. It’s better to start by assessing a handful of items most relevant to the company.
Academics and politicians have recently proposed measuring “triple” or “context-based” materiality, which looks at ESG impacts even more widely: for example, how climate or biodiversity changes might affect a company’s entire supply chain or business ecosystem.
Triple materiality is not yet clearly defined, and most companies say it’s not currently on their agenda, but it could be an area for development in the future.
The focus for now is on meeting the challenges of double materiality in the EU, and finding ways for unaligned standards and regulations to work alongside each other. That means disclosure requirements are likely to evolve rapidly as data and practice improve. As Harrison says, “we would be wary of anybody claiming to have all the answers at this point.”