ESG

Double Materiality: A Matter of Semantics or Substance?

By Marjella Lecourt-Alma, CEO of Datamaran

The definition of a business-critical risk or opportunity is changing, as corporate leaders grapple with a flow of disruptions - geopolitical, economic, supply chain, social, and public health. What remains constant is the responsibility of business leaders to have a clear, objective, defensible, and adaptive approach to determining their strategic priorities and disclosing relevant information. 

We see this with recent regulatory developments, including the recent landmark climate disclosure proposal by the United States Securities and Exchange Commission (SEC) and last year’s Corporate Sustainability Reporting Directive (CSRD) launched by the European Commission (EC).

These two developments make it clear that what was once voluntary is now mandatory, and that the convergence of environmental, social, and corporate governance (ESG) and financial risks is accelerating. This convergence is commonly referred to as “double materiality,” an approach that considers both the financial, or outside-in, and impact, or inside-out, perspectives when evaluating material issues. 

Technical considerations aside, this principle solidifies the grand awakening of the capital markets and regulators to the significance of ESG and, perhaps more importantly, the need for business leaders to very clearly define who they and their companies want to be in today’s disruptive reality. 

While our current geopolitical, economic, and public health crises may not make the organizational argument for ESG or double materiality, they definitely reinforce the need for more genuine corporate leadership on a wider range of issues that goes beyond the traditional balance sheet. And while progress has been made in certain areas, there exists a dearth of action and urgency - why we’re now seeing an acceleration of legal and political pressures. 

So, what is double materiality exactly? And why is it becoming institutionalized as law?

At its core, materiality is an accounting principle that defines which information is useful. Companies commonly use materiality assessment processes to identify financial risks and issues and determine what risks are material to their bottom line. 

Traditionally, materiality was only focused on the inward. Disruption from recent global events reinforces that the inward-looking approach is insufficient and risky. That’s why regulators are now institutionalizing a double materiality approach - to improve the reliability and comparability of information leveraged by investors and other stakeholders, on one hand, and to drive and scale sustainable solutions forward, on the other. 

With the rise of ESG, there is now a more concerted effort to evolve our understanding of materiality, and account for outward impact. In other words, how might this company have an impact on climate change, human rights issues, or public health? Until recently, it never accounted for the reverse. 

Double materiality assesses risks and issues from both a financial and impact standpoint. It identifies issues that reflect an organization’s social and environmental impacts, as well as information that supports stakeholder and strategic decision making. What this means is that companies need to take both an outside-in and inside-out perspective when considering material issues. The landmark SEC proposal reinforces the importance of companies looking at material impacts from both a wider risk and opportunity perspective, too.

 Similarly, in February of this year, the Council of the European Union (EU) agreed their position (‘general approach’) on the EC’s proposed implementation of the CSRD. The first set of Sustainability Reporting Standards (draft standards) will be available mid-2022 and the first set of standards (final) are to be available in 2023. As a result of this proposal, from 2024 over 50,000 companies must report in accordance with mandatory EU sustainability reporting standards and conduct a double materiality assessment

Various other regulatory authorities are incorporating the principle and ethos of double materiality in their requirements, including EFRAGGRI, and IFRS

Let’s take a few steps back to look at how we got here

When we look at ESG standards development over the past years, we see a progression and maturation of how to define “sustainability leadership.” Sustainability leadership first meant more reporting and more transparency, which led to those big, “bible” reports where everything and anything was reported on. That was before the standards were created.

We’re now at a point where reporting is no longer enough, but it’s about “better strategy” and how to be a good corporate citizen. That requires greater investment in ESG expertise and intelligence across the whole company, and also an ability to have some level of foresight into what’s next, what’s changing, and how to address that - without silos.

The inflection point

Until today, ESG reporting has been defined mostly by voluntary practices, as the key policy makers (market authorities as well as national and international regulators) adopted a ‘sit and stare’ approach and let the markets decide how to deal with ESG. 

The tide has turned, with jurisdictions now racing to introduce strict mandatory requirements and capital market players competing for the best quality ESG insights that support a double materiality approach. 

As we see with the SEC proposal, these requirements will respond to market developments that have been brewing for some time. The SEC’s nod to the Task Force on Climate-Related FInancial Disclosures, or TCFD, crystalizes the importance of policy making and voluntary frameworks as a precedent to hard law. The lines between voluntary and mandatory are blurring faster than ever before. 

To put it simply, we’re now undoubtedly at a stage where: strategy comes first and metrics second. Now, it’s climate change. What's next? Regulators won't stop here. That’s why it’s important for corporate executives to consider a double materiality approach that is comprehensive, data-backed, and forward-looking, and goes beyond the traditional compliance checkbox exercise. Ultimately, it’s about value creation just as much as it is about risk mitigation. 

This is what the convergence of financial and ESG materiality is all about. For instance, in the short-term, it might not make sense from a financial standpoint to pull out of a whole market, as we’re seeing many companies do in response to the war in Ukraine. But, it is good business leadership and in the long-run the right thing to do. This is a critical moment for companies to focus their efforts on rethinking what is truly a strategic priority for today and tomorrow.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.