Implementing Double Materiality
Double materiality is a foundational principle in successful ESG programs.
Double materiality is a hot topic in boardrooms these days, as senior executives and board directors grapple with rapidly changi
Double materiality is a hot topic in boardrooms these days, as senior executives and board directors grapple with rapidly changing fiduciary duties.
The concept of “materiality” emerged early in the development of modern accounting and financial reporting practices. At its core, materiality is a principle based on two related concepts. First, corporations should disclose the information that is significant, important, and relevant to stakeholders who use their reports to make decisions. Second, corporations need not disclose information that does not rise to the level of materiality. This approach allows for more efficient processes and clearer reporting, as unnecessary clutter is removed. Materiality, therefore, is an approach to “filter in” and “filter out” information, based on its relevance to report recipients.
There are many factors that go into deciding if information rises to the level of materiality in financial reporting. These include the information’s importance to stakeholder’s decisions, regulatory requirements (including quantitative thresholds), financial reporting standards, and contextual conditions such as company size, industry, and economic environment. These factors are not static, so organizations must continually monitor and reassess what constitutes material information for their stakeholders.
In recent decades, corporate Environmental and Social Responsibility (ESR) programs and socially responsible investment trends (i.e., ethical investing) have come together in a new business movement called Environment, Social, and Governance (ESG).
Whether responding to pressure from investors, customers, employees, or regulators, company leaders and board directors now find themselves required to report information on a wide range of ESG topics that go far beyond traditional financial metrics.
Many investors want to know that their money is invested in companies that align with their moral values. They may also want to reduce the risk that their portfolios will be impacted by corporate transgressions such as environmental accidents, human rights abuses, or legal penalties. Many young staff members want to work for progressive companies and believe that their efforts are making a difference in the world. Similarly, a growing number of consumers and businesses are using their purchasing power to compel their vendors to align with their social and environmental priorities.
Finally, ESG programs have moved beyond the realm of corporate self-governance and shareholder activism, with many governments and authorities moving rapidly to enact ESG legislation and regulations. As a result, many corporate officers and directors are finding that their fiduciary duty has been formally expanded to include a duty to manage, oversee, and report on ESG-related matters, particularly with respect to risk management and governance.
Along with expanded fiduciary duty, business leaders now find themselves obligated to track and report on business metrics across a wide range of environmental, social, and governance dimensions.
As a general concept, “materiality” means the same thing in an ESG context that it does in traditional financial reporting. Organizations that report on ESG topics must decide what information will be significant, important, and relevant to stakeholders who use their reports to make decisions. They also must determine which ESG information can be excluded, to make reports clearer and to make the reporting process more efficient.
Knowing what to monitor and report on in ESG, however, is not always straightforward. Unlike financial reporting, which has mature guidelines and regulations, the practice of ESG is still in its relative infancy. ESG frameworks and standards, such the Global Reporting Initiative (GRI) framework, the Sustainable Accounting Standards Board (SASB), and the Task Force on Climate-related Financial Disclosures (TCFD) have helped to provide guidance, but much debate and confusion have remained about what constitutes materiality in ESG.
More recently, however, emerging ESG regulations, such as the European Sustainability Reporting Standards (ESRS), are helping provide clarity, with more prescriptive definitions of ESG materiality. Central to this is the concept and definition of “double materiality”.
Simply put, the concept of double materiality means that organizations should consider materiality from two different perspectives and for different audiences. Rather than looking at reporting only as a financial exercise for the benefit of shareholders, business leaders should also consider the broader impact that an organization has on the world it operates in and the people it affects.
Double materiality represents two different perspectives, each with a different primary audience:
Double materiality therefore codifies the idea that companies have an obligation to track and report on material information beyond financial performance to consider the broader public interest.
Furthermore, what started as voluntary reporting exercise for many organizations is fast becoming a legal and regulatory requirement. The European Sustainability Reporting Standards (ESRS), which take effect for 2024 reporting for the first wave of affected companies, provide more specific definitions for the two components double materiality:
“A sustainability matter is material from an impact perspective when it pertains to the undertaking’s material actual or potential, positive or negative impacts on people or the environment over the short-, medium-, or long-term. A material sustainability matter from an impact perspective includes impacts caused or contributed to by the undertaking and impacts which are directly linked to the undertaking’s own operations, its products, and services through its business relationships. Business relationships include the undertaking’s upstream and downstream value chain and are not limited to direct contractual relationships.”
ESRS 1 General principles, p. 11
“A sustainability matter is material from a financial perspective if it triggers or may trigger material financial effects on the undertaking’s development, including cash flows, financial position and financial performance, in the short-, medium- or long-term. This is the case, in particular, when it generates or may generate risks or opportunities that significantly influence or are likely to significantly influence its future cash flows. Future cash flows, together with other critical factors such as business model, strategy, access to finance and cost of capital, are likely to influence the financial position and financial performance of the undertaking in the short-, medium- or long-term.”
ESRS 1 General principles, p. 12
Here a few simple real-world examples to explain the concept of “outside-in” and “inside-out” impacts in an ESG context.
Large technology companies like Google and Microsoft operate large datacenters that consume significant amounts of energy. Reducing energy consumption and transitioning to renewable energy sources is an important way for these companies to lessen their negative impacts on the environment. Viewed in another way, the existence of their large datacenters may already provide a net positive environmental benefit, as customers of these datacenters no longer need to operate their own smaller, and presumably less efficient technology operations.
From a social perspective, these firms act as custodians of massive amounts of user data, and thus have a responsibility to protect this data from breaches and misuse. This includes ethical considerations around how data is collected and used. Furthermore, large tech firms are often scrutinized for their workforce composition, especially in terms of gender and ethnic diversity. These firms are large employers for high-value jobs. The way these companies hire and promote staff can have a significant impact on society at large.
Tesla is another interesting example. From an impact perspective, the rise of electric vehicles is helping to fight climate change through reduced vehicle emissions, while at the same time, contributing to environmental damage through the mining of rare earth materials. Tesla is also supporting the proliferation of car-dependent public infrastructure, which may undermine efforts to promote more sustainable public transit and society-enhancing walkable communities.
From a financial perspective, rapid advancements in technology and changing consumer demands for more environmentally friendly batteries will have a major bearing on the investment decisions that Tesla makes and its financial performance in the future.
Consumer Goods Companies
Finally, let’s take the example of Nike. Financially speaking, their ability to provide sustainable product lines are becoming key factors in their market competitiveness, as consumer preferences shift towards these types of products. Impact-wise, Nike has various efforts that aim to reduce waste, especially for non-biodegradable materials. ”Reuse-a-shoe” is an example of such a program, whereby old shoes and manufacturing scrap are collected and transformed into high-performance materials that are used to make new shoes. Nike claims that this program has helped to redirect over 100 million pounds of waste from landfills.
While the concept of double materiality is straightforward, implementing in a real-world setting is not necessarily so. For example, the GRI framework identifies over 30 ESG domains that companies should consider, including energy use, materials, emissions, biodiversity, employment diversity & equal opportunity, child labor, non-discrimination, forced labor, consumer privacy, anti-corruption, anti-competitive behavior, and many more.
While this is a helpful framework, the wide range of topics presents many challenges and questions. Do all companies need to report on all factors? What should an organization prioritize first? How often and how quickly will these priorities change? What is the threshold for ESG information that causes it to rise to the level of materiality?
To help answer these questions, many organizations turn to the practice of double materiality assessment.
Double materiality is a foundational principle in successful ESG programs.