With new reporting requirements starting in 2024, the EU’s Corporate Sustainability and Reporting Directive (CSRD) is currently making waves in the world of sustainability and ESG. Of course, there’s plenty to talk about in the directive, but one topic that appears to be dominating discussion is double materiality.
Put simply, double materiality is the idea that companies must consider:
- How their business is affected by ESG issues; and
- How their business has an effect on society and the environment
While this might sound straightforward, undertaking a double materiality assessment can be quite complex, and it’s also the source of some debate.
In this guide, we help you get to grips with double materiality, looking at its definition, why it matters, why it’s debated, and how you can incorporate it into your ESG and sustainability program.
Let’s get started and take a closer look.
what is double materiality?
While there is yet to be a universally accepted definition of double materiality in the ESG and sustainability world, the underlying concept comes from the widely-recognized financial definition of materiality.
In accounting, something is considered ‘material’, if it is “reasonably likely to impact investors’ decision-making” in which case, it must be recorded in detail. In other words, the information is so critical to the organization that omitting it from reporting would impact an investor’s ability to make a decision.
Under this definition of materiality, what gets determined as material versus immaterial will vary based on the organization. Something that is material for a small business might be immaterial for a large enterprise due to relative size.
For instance, if a small business with a revenue of $200,000 per year purchases a piece of equipment for $20,000, this would be material information. On the other hand, for a large business with $2 billion in revenue per year, a $20,000 purchase may be immaterial.
When it comes to ESG and sustainability, however, this concept goes beyond financial information. It asks organizations to look at a two-way street: how external ESG issues impact them and how they impact ESG matters either directly or up/down the value chain.
Although the conversation is typically around climate risk , double materiality can relate to any dimension of ESG. With this in mind, it’s important to recognize that investors are more than just financial stakeholders. Local communities and the public as whole are also stakeholders in your business.
why is double materiality important?
In the past, a major criticism of ESG and sustainability programs is their lack of stringent reporting requirements, which sometimes resulted in organizations greenwashing their efforts.
Double materiality attempts to change this by demanding reliable, and data-driven reporting. It means that anything in the ESG space that has a material impact needs to be included in disclosures to investors and other stakeholders.
The idea is that by requiring a higher degree of transparency, companies will be compelled to take double materiality ESG seriously, furthering the transition to net zero to limit global warming by 2030.
what is a double materiality assessment?
A double materiality assessment helps you determine which sustainability issues are material to your organization and identifies which activities you should prioritize within your ESG strategy.
Part of the assessment involves looking both upstream and downstream along the value chain. For instance, if a company purchases its electricity from a coal plant, this poses a material risk for the company even though they may not be directly responsible for the coal plant’s climate impact.
On the other hand, if that company decided to switch to a clean, renewable energy source, this would also result in double materiality considerations. It may pose a financial risk in the short term, but could result in financial gains over time and a positive impact on nearby communities and the overall global climate.
examples of double materiality in different industries
During double materiality assessment, companies are encouraged to look both inward and outward at how their practices impact ESG issues and vice versa. Here are a few examples of how this can result in positive ESG change:
- Financial sector: A bank decides to lend only to corporations that are not causing harm to the environment. This improves the bank’s performance and public perception and lowers risk, while also supporting a healthier environment.
- Professional services: An accounting firm implements a wellness program for their employees. In turn, this helps the firm retain and recruit employees, and lower absenteeism.
- Manufacturing: A manufacturer switches to using a clean, renewable energy source. This contributes to net zero goals, improves the air quality of surrounding communities, enhances brand value and reputation, and also reduces costs over time.
- Retail: A clothing company switches to vendors that use fair labor practices. This leads to gains for workers, while also reducing the company’s risk of public backlash for poor business practices.
- Agriculture: A farm implements a new system to capture and use rainwater for their crops, meaning less draw on the local water supply and reduced costs over time.
- Energy: An energy producer that relies heavily on fossil fuels invests in R&D to transition to renewable energy production. This ultimately contributes to meeting global net zero targets, while also appealing to investors looking to make a positive environmental impact.
- Education: A university reviews its gender and diversity policies to ensure it’s operating in an inclusive manner. The university becomes more accessible to historically marginalized groups, which benefits students, employees, and its reputation.
the debate about double materiality
Despite its promise, double materiality has been the source of much debate and controversy. This is largely due to its abstract nature, which has prompted the following concerns:
- Lack of standardization: The first reason is that there are many different ways to approach double materiality. Things that are considered material for one organization may not be considered material for another and as a result, reporting is ripe for interpretation and potential greenwashing.
- Questions around the intended audience: Secondly, determining who disclosures are intended for is tricky and often debated. Historically, reports of materiality in financial disclosures were aimed at investors only. They had specific needs and interests and were familiar with complex financial reports, however, double materiality widens the audience. This means a variety of investors are looking for information, including non-profits, employees, labor unions, local communities, and the general public. Providing lengthy financial data isn’t always appropriate so what should these reports look like?
- Unclear what material means: Finally, determining what activities have a material impact on the environment, climate, or any other ESG issue is proving difficult and complex. A corporation’s activities could have a positive impact on their balance sheet, but a detrimental impact on the environment, so do impacts become material only if they matter to investors? Or should the stakeholders be widened to include the general public? If it’s the latter, impacts would become material if they matter to a ‘reasonable person’. But what is a ‘reasonable person’ exactly? To some extent, this involves a level of subjectivity.
Despite these concerns, organizations like the International Financial Reporting Standards Foundation (IFRS) are trying to address double materiality challenges in the financial industry by requiring specific disclosures. Their work through the International Sustainability Standards Board (ISSB) has made it widely accepted that materiality should include climate-related and ESG-related issues. This is a start, but there is still work to be done both within and outside the financial sector.
Similarly, in the EU, the new Corporate Sustainability Reporting Directive (CSRD) offers a more robust financial disclosure regime. Let’s dive deeper now by looking at how the EU is approaching double materiality.
double materiality in the EU: NFRD & CSRD
To date, the EU has been a major proponent of double materiality. In fact, the concept has been integrated into the EU regulatory framework for sustainability reporting for several years now with the aim of changing attitudes.
This is important because in many cases, poor conduct on environmental issues is rewarded with higher profits or investment returns, however the EU’s NFRD, and more recently the CSRD, aim to change this status quo.
Here’s a summary of how the EU regulatory frameworks take a double materiality approach:
NFRD
The EU Non-Financial Reporting Directive (NFRD) came into effect for all EU member states in 2017. It required large public interest entities to disclose information on ESG matters. This included climate-related information that affected the value of the organization and any of its activities that had an impact on ESG issues or climate change.
Despite its efforts to incorporate double materiality, the NFRD faced criticism that its reporting requirements were insufficient and did not enable investors and stakeholders to truly assess an organization’s ESG impact.
CSRD
Set to come into effect from 2024, the Corporate Sustainability Reporting Directive (CSRD) expands the scope of the NFRD. Not only does it apply to small and medium sized public interest entities, but it also explicitly requires companies to take a double materiality approach.
As such, companies should “report both on the impacts of the activities of the undertaking on people and the environment, and on how sustainability matters affect the undertaking.”
It defines a double materiality perspective as one where “the risks to the undertaking and the impacts of the undertaking each represent one materiality perspective.” It also requires reporting companies to consider who will use the information and ensures appropriate reporting is provided for those audiences.
steps to incorporate double materiality into your ESG and sustainability program
With double materiality now taking center stage, it’s time to begin thinking about how it will affect your organization. Although every organization’s approach to double materiality will be unique, there are some general steps that can help when you’re first getting started.
1. Understand your requirements
Before you begin, it’s important to understand what regulations affect your requirements to report financial and non-financial information, depending on your location, industry or size. This can also help you determine what’s material and immaterial to your organization.
2. Conduct a double materiality assessment
As explained above, a double materiality assessment can help to understand your impacts, risks and opportunities. It will help you set your ESG/sustainability strategy and prioritize your activities – ultimately reducing risk.
3. Keep detailed notes about how you’re approaching double materiality
Many standards require that you provide details about how you’re planning, managing, budgeting for, and implementing a double materiality perspective. For instance, to uncover insights, are you doing stakeholder interviews, surveys, scenario planning or other analyses?
4. Collect and report the right information
Doing double materiality right means collecting a wide range of financial and non-financial information, and this can get complex. Rather than rely on a mix of spreadsheets and reporting tools, it’s a good idea to bring all your information together into one source of truth using software such as the AMCS Sustainability Platform, which is designed to help you automate and manage your entire ESG reporting program.
In conclusion, although ESG and sustainability reporting requirements seem to change every day, double materiality looks like it’s here to stay. You can get ahead by understanding what’s required of your business, and by taking proactive steps to implement a double materiality perspective.
If you need help unraveling double materiality for your business, reach out to an AMCS expert today and see how our platform can help automate and manage your entire ESG and sustainability program, including double materiality and beyond.