Doubling down: ESG regulation gives materiality a bigger stake

US companies are deeply familiar with the concept of financial materiality through their filings with the Securities and Exchange Commission (SEC). Companies have detailed agency guidance and decades of practice to help navigate their materiality determinations (SEC's MD&A guidance and SAB99), underpinned by the relevant Supreme Court rulings (Basic/TSC).^{1, 2} These determinations are focused on the financial performance and prospects of the company, and whether certain information would have changed or influenced the decision-making of a reasonable investor.

A foundational concern for many in our capital markets has been that sustainability performance and the environmental, social and governance (ESG) topics that underpin this have not been clearly incorporated into the approach to materiality for the purposes of SEC filings. This may be limiting the comprehensiveness, clarity and decision-usefulness of corporate disclosures.

Financial materiality

Materiality has, however, taken on a broader meaning. This has been driven by market participants expanding their view of the sources of value creation and its risks, opportunities and dependencies; and seeking disclosures that capture this broader view — which necessarily incorporates sustainability themes. These efforts, over several decades, have produced a new disclosure ecosystem and changed the way companies think and talk about corporate performance, making sustainability and ESG part of mainstream practice and discourse. 

Adding sustainability to financial materiality

Over the last two decades, an increasing number of institutional investors prioritized sustainability topics and began to include them in their engagements with portfolio companies. These investors increasingly saw sustainability – or ESG – issues as key to long-term value creation and saw incorporating them into their investment management practices as part of their fiduciary duty. By introducing sustainability issues into the investor-corporate dialogue, companies had to respond constructively in their disclosures and year-round investor engagements on their most important ESG topics.

When initially asked to begin talking about sustainability by institutional investors, companies often had simple-sounding questions (with complex answers): What are our material sustainability topics? How do we identify them? Once we've identified them, what are the key performance metrics or targets to illustrate our performance? What, where and how should we disclose relevant information?

ESG disclosure frameworks have helped structure the way this conversation between corporates and investors developed around sustainability topics, illustrating the ways that approaches to materiality – in the context of sustainability - have developed (and how they differ).

The disclosure framework and sector-based standards created by the Sustainability Accounting Standards Board (SASB) were developed to provide an infrastructure for companies to respond to these requests from institutional investors. SASB, which has now been folded into the International Sustainability Standards Board (ISSB), defined materiality as disclosure topics that “are reasonably likely to significantly impact the financial condition, operating performance, or risk profile of the typical company.”³ By prioritizing sustainability topics using a lens of financial materiality, companies could begin to provide the market with a minimum benchmark of investor-focused disclosures on ESG themes. By taking a sector lens and providing criteria for the metrics provided, the SASB standards supported the development of company-level sustainability disclosures that could be compared by analysts across peer groups.

Beyond financial impacts – but back to financial impacts

The SASB approach expanded the financial materiality lens – and investor focus – to include sustainability. However, as is widely known, sustainability topics are not viewed solely through the lens of their financial impact on a company but through a broader and societal view of impact as well.

In generating goods and services, companies can create significant negative social and environmental impacts (such as greenhouse gas emissions contributing to climate change) in addition to positive impacts (such as investments in historically disadvantaged communities); examples of both categories of impacts are countless.

Significantly, those negative social and environmental impacts have tended to go unreported in traditional financial reporting (in the form of externalized social and environmental costs). Lack of reporting does not make those negative impacts any less real. Many have commented that such negative impacts (whether on communities or ecosystems) can ultimately crystallize into financial risks touching a company’s supply chains, locations and operations (e.g., plastic waste used to be an unacknowledged externality).

Over time, civil society groups not only brought this issue to the public’s attention but also incited action by identifying the problem, accounting for its costs and highlighting negative impacts. This caused entities with significant plastic waste footprints to adjust their product packaging and account for their impact. Many issues have gone through this cycle of moving from impact materiality to financial materiality.

In terms of communicating these social and environmental impacts in a structured way to stakeholders, the Global Reporting Initiative (GRI) became the most broadly used global sustainability reporting framework. Sustainability materiality began as a term related to stakeholders, defined by GRI as “the organization’s significant economic, environmental and social impacts; or that substantively influences the assessments and decisions of stakeholders.”⁴

This approach is informed by the concept of sustainable development, namely: meeting the needs of today without compromising the needs of tomorrow.⁵  For over a decade, many of the world’s largest companies have conducted materiality assessments informed by this approach and have published disclosures that are, to some extent, related to a company’s impact on its stakeholders across the ESG issue spectrum.

Based on the approaches taken by SASB/ISSB and GRI, there are two closely related but distinct concepts in the context of materiality and sustainability:

• Financial materiality of sustainability topics is in essence an "outside in" concept; how do sustainability topics affect the performance and prospects of a company? (represented by SASB/ISSB)
• Impact materiality of sustainability topics is contrastingly an "inside out" concept; how do the company’s activities impact the world around it? (represented by GRI)

EU and double materiality

The European Union is implementing a comprehensive package of capital market reforms to achieve the policy objectives of the Green Deal, cutting economy-wide carbon emissions by 55% by 2020 and reaching net zero by 2050. The Corporate Sustainability Reporting Directive (CSRD) is a structural feature of these reforms that will exponentially increase the volume and rigor of sustainability information that companies disclose.

Companies scoped in to the CSRD will have to report against the EU's European Sustainability Reporting Standards (ESRS) that address an unprecedently extensive set of qualitative and quantitative ESG disclosures^.6

The CSRD combines the “impact materiality” and “financial materiality” of sustainability topics in a structurally significant way. The extent of a company’s reporting required under the ESRS standards will largely be determined by the outcome of a "double materiality" assessment, an approach prescribed by the ESRS that incorporates the definitions of financial materiality and impact materiality^.7

These requirements (though extensive) will be somewhat familiar to companies that already implement materiality assessments on sustainability. Despite that familiarity, the EU's approach is specific, and existing approaches will require extensive adaptations to enable companies to comply with the ESRS standards, including but not limited to a robust value chain risk analysis, value chain mapping, impact remediability and documentation of the double materiality process. 

Practical considerations and known unknowns

• Leverage and adapt existing practice: Advanced sustainability reporters familiar with GRI will note familiarities in elements of the EU's approach to materiality. However, it won’t be enough to just demonstrate the outcome of the double materiality assessment, though the outcome is critical to how a company will report against the standards. The double materiality assessment process itself must be planned, timed in accordance with compliance requirements, socialized with stakeholders, disclosed and is itself subject to attestation (alongside the sustainability topics that it identifies as material).
• Understand scope and applicability: For many group structures, the CSRD may provide a series of options for structuring reporting against the applicable ESRS standards. Will the reporting take place at the level of scoped-in European subsidiaries or will it be conducted at a higher level through the relevant available consolidation approaches? To be compliant with CSRD, a double materiality assessment will need to functionally align with the reporting structure the company chooses. However, this question of reporting structure will remain open for many companies as interpretational issues are clarified under CSRD and while the Member State transposition process remains incomplete.⁸
• Monitor interpretive guidance: As with any new regulation, there are open interpretational issues and questions of implementation. Several EU institutions and market participants have noted the lack of interpretive guidance around the implementation of the ESRS standards^.7 For example, in relation to the double materiality assessment, the European Central Bank (ECB) noted the lack of indicative thresholds to be applied when considering if a sustainability topic rises to the level of being material under either the financial or impact materiality approaches. In the US, SEC registrants can refer to guidance such as SAB99 for rules of thumb to think through these questions in the context of preparing an SEC filing. Market participants have pointed out that to avoid both defensive over-reporting and opportunistic under-reporting (and avoid a mass of disclosures that cannot be compared), equivalent guidance will be needed for the ESRS standards. The European Commission has asked The European Financial Reporting Advisory Group (EFRAG) to prioritize the development of such guidance. Companies scoped in to CSRD will have to monitor such guidance as it is published.
• Apply reasonable judgment and flexibility: At this stage, the approach to the double materiality assessment will be iterative, and companies will need to apply reasonable judgment and flexibility:

Some companies will start with a lighter-touch assessment adapted from existing approaches to get a sense of the scale of the potential reporting burden.

Others will dive into a full assessment. This will include looking at value chain impacts across ESRS-defined sustainability sub-topics, evaluating by severity and likelihood of impact and identifying financial dependencies related to those topics.

• Key considerations to explore will be the level of granularity needed to undertake the assessment, which internal and external stakeholders should be consulted, and to what extent existing company analysis (e.g., enterprise risk assessments) can be leveraged as input to the evaluation.
• Document approach and assumptions: As both the outcomes and the process for conducting the double materiality assessment will need to be assured under the CSRD, it will be necessary for companies to clearly document the steps undertaken to complete the assessment and any assumptions applied (e.g., materiality thresholds). Companies may choose to work with their auditors to understand these assurance expectations.