What is Double Materiality and Why It’s Critical for Companies’ ESG Efforts
March 5, 2023
In November 2022, the European Financial Reporting Board (EFRAG) published the draft of European Sustainability Reporting Standards (ESRS), within the framework of the EU Corporate Sustainability Reporting Directive (CSRD) that entered into force from January 2023. The CSRD affects companies based in the European Union, as well as branches and subsidiaries of non-EU companies, starting from large undertakings (recognized as fulfilling at least two of these criteria: having more than 250 employees, more than €20 million balance sheet total, and more than €40 million net turnover) and reaching over to SMEs from 2026. The first reports, from large Non-Financial Reporting Directive (NFRD), will be due in 2025. As such, it is important for companies operating in the EU to start preparing for the roll-out of the new reporting guidelines, although decisions on the equivalence of non-EU sustainability reporting standards are still pending on the European Commission’s part. A key factor in reporting equivalence and consistency across different international standards is the principle of double materiality.
The Draft ESRS requires companies to uphold the tenet of double materiality in sustainability disclosures; this perspective hinges on impact materiality and financial materiality (hence “double materiality”), seen as integrated and interconnected criteria of risks and opportunities of an undertaking’s activity, and thus also in its reporting. Impact materiality concerns how the undertaking’s operations, products and services positively or negatively have an actual or potential effect on people and environment over the short, medium and long term. Financial materiality pertains to the way sustainability matters, risks and opportunities can affect the undertaking’s financial performance, development and position; these factors of risk and opportunities also include matters beyond the undertaking’s direct control (such as business relationships with other companies) and dependency on natural and social resources. To help undertakings identify sustainability matters that are “material” to them, the Draft ESRS Appendix B (Application Requirements) contains an indicative list of sustainability matters that fall under the standards’ umbrella, sorted by topic, as well as the steps needed to determine the matters to be reported and their severity in terms of impact:
The financial materiality assessment requires, in the first place, identifying the risks and opportunities (i.e. what increases or decreases future cash inflows) and the determination of which ones among them are material to the undertaking. This determination process is based on the likelihood of occurrence and the potential size of the financial effects.
Once the undertaking has identified and assessed a sustainability matter as “material”, it proceeds to report it according to the Draft ESRS Disclosure Requirements and data points that apply to the specific matters and/or sectors.
To carry out the assessments properly and exhaustively, it is crucial to engage with stakeholders. As such, the standards identify two group of stakeholders: the “affected stakeholders”, that is, people or groups who are affected, positively and negatively, by the undertaking’s direct or indirect activities; and the “users of sustainability treatments”, a broad group of users of financial reporting, such as investors, credit and insurance institutions, business partners, government and civil society organizations.
In carrying out materiality assessments, the undertakings will take into account situations in which their actions with regard to mitigating sustainability-related risks or seizing opportunities may exert a negative effect on other sustainability matters; in these cases, the undertakings will acknowledge the issue and explain how they address the issue.
With regard to data aggregation in the reports, the Draft ESRS allows for disaggregated information by its own sector classification, by country, by asset and by subsidiary, when needed depending on circumstances and local variations. Furthermore, the undertakings will have to clarify the thresholds through which the impact and financial materiality criteria are measured and applied.
Double Materiality will be a critical element for companies to consider as part of their ESG reporting efforts, particularly as the CSRD come into effect. While non-financial reporting and materiality assessments can be complex and challenging for companies that are new to this space, various software solutions can help to provide clarity, support, and ease of navigation.
