Materiality lies at the heart of any approach to ESG. It is the way in which corporates can prioritise different ESG factors, both in terms of operations and investment management, and is about identifying what matters most to the business.
At its simplest, it means that a topic is ‘material’ both in financial and non-financial terms – operationally and systemically. Today the ESG world seems split between a focus on operational risks and an understanding of the growing importance of ‘outbound’ or impact issues.
Impact of business on society and the environment matters
Ignoring outbound issues is considered problematic by many experts, especially as the integration of impact allows for assessing greater nuance in understanding the impact of corporate operations on the support systems that underpin society and the economy, such as ecosystem services, societal stability, growing inequality and the like.
The intersections between climate change, food security, water access, biodiversity, deforestation, inequality, human rights and much, much more are increasingly clear, and as Amit Bouri, chief executive of the Global Impact Investor Network (GIIN), points out, “Given all the challenges we face … ESG through a [sole] lens of financial materiality will not be sufficient to address such global issues.”
How do you prioritise double materiality issues?
To help understand how different topics can be prioritised in terms of double materiality, Matthias Täger, a researcher at the London School of Economics (LSE), divides double or systemic materiality into two categories.
First, environmental impacts by a company that eventually get visited on the company through legal liability or reputational damage, what Täger calls “weak” double materiality; secondly because a ‘reasonable person’ might consider the information material for reasons other than direct financial repercussions, what Täger calls a strong conception of double materiality, which includes long-term damage to the financial (or other environmental or social) systems.
Current regulatory approaches are diverging
Differences in regulatory approach seem to be growing. Within the EU, the Green Taxonomy and the forthcoming Corporate Sustainability Reporting Directive (CSRD) are built on the importance of the double materiality concept.
Yet the US-based International Financial Reporting Standards (IFRS) Foundation, which provides standardised accounting standards in around 120 jurisdictions, appears to be focused on single materiality. Through its recently launched International Sustainability Standards Board (ISSB), it intends to bring sustainability into financial disclosure.
The ISSB’s draft proposals, published in March 2022, are focused on the provision of ‘globally consistent and transparent sustainability reporting standards’ specially to help investors and business leaders make informed decisions and ‘strengthen capital markets.’
ISSB is focused on financially material risks to operations
The ISSB’s focus is on developing standards that will provide information that enables investors to assess enterprise value, which is a historically financial figure. The IFRS says that its approach will entail companies reporting on impact if it is relevant to enterprise value.
This means that the information required by IFRS Sustainability Disclosure Standards is likely to overlap substantially with the impact information required for public policy reasons, not least because information that is relevant to society is likely to be relevant to investors in assessing enterprise value.
An IFRS Foundation spokesperson said that “the ISSB is looking at risk to enterprise value which is company specific. Systemic risk is the remit of central banks and regulators (the ISSB is in close dialogue with IOSCO), and they are interested in the aggregate effect on markets of climate risk – the information the ISSB’s standards seek to elicit will help with that.”
The assumption appears to be that standardised sustainability accounting standards will provide sufficiently robust information for the management of system risk.
The question here is whether this is sufficient to build an extra layer of sustainability reporting to help expand financial disclosure, or whether the challenges 21st century societies face require solutions driven by data covering the impact of our actions.
Certainly it has now become orthodoxy that climate-related impacts on operations can be material and should be disclosed to investors, in large part due to the work of the Financial Stability Board (FSB) and the recommendations of the Taskforce on Climate Related Financial Disclosure (TCFD).
What is less clear is the extent to which the impacts of operational performance on the climate – or any other element of ESG – is relevant stakeholder concerns
Europe is focusing on risk and impact – double materiality
Standards and accounting practices are by definition not neutral, as they affect capital allocation and market dynamics. As society and a broader network of stakeholders become more focused on the impacts companies have on the environment and society, it is hard to argue that outbound impacts should be excluded from companies’ financial reporting.
Trager says that “the latest EFRAG standard drafts are a promising deviation from the ISSB’s line. Disclosing according to these EFRAG guidelines would automatically cover ISSB requirements but also take into account the information needs of stakeholders other than short-sighted financial investors (e.g. public and private pension funds, sovereign wealth funds, individuals who want to invest sustainably, regulators with a public good mandate, etc).”
Flexibility in reporting risk and impact will be key
The reality is that materiality is a complex issue and the ways in which it is defined will continue to be contested. Single and double materiality are at the heart of the debate but dynamic materiality matters too.
Gordon Tveito-Duncan, chief executive of ESG scoring platform GaiaLens, points out that as regulation and market dynamics change, so do expectations of performance, and a rigid framework will not help with understanding transition. For energy companies transitioning over time, for example, GaiaLens calculates a dynamic materiality score.
What matters is who is asking the question – perspective can often help define what is material, or of most concern, to the individual or institution asking.
Decision-useful data that builds understanding of the consequences of economic and corporate action is now being demanded by stakeholders across the spectrum, expanding the universe of interested parties to employees, communities, NGOs, activists and, of course, customers.
As Trager adds, “While [the EFRAG] guidelines are still very broad and can be interpreted in widely different ways, their spirit aims at providing the informational infrastructure needed to transition from a financial system that is destabilising the climate, and thus itself, to a more sustainable financial system.”
Without the adoption of a double materiality frame, the ISSB’s sustainability standards will neither capture systemic risk – arguably the most dangerous type of risk – nor will it help in improving firms‘ accountability in sustainability matters.