Towards Double Materiality: Inputs from EFRAG's work for the CSRD

The concept of materiality and its challenges

The materiality exercise consists of identifying the most relevant and priority issues (economic, environmental, social and societal) that have a real impact on the achievement of the company’s strategic objectives and therefore on its sustainable performance (its risk management, its ability to generate and capture value); and on its stakeholders, first and foremost its investors.

Ideally, the assessment should be based on a genuine dialogue with its stakeholders, a sign of the company’s vision of its place in the ecosystem and of its desire to take this into account in its strategic orientations.

Materiality: The starting point of a CSR approach

Whatever its objective (reporting, CSR strategy, etc.), materiality analysis is becoming an essential practice for the most mature companies in terms of CSR.

It is the central tool in a formalized and structured approach to (re)making sense of policies and addressing a company’s sustainability challenges.

The results of a well thought-out and properly conducted materiality analysis (i.e. based on a relevant and robust methodological approach) should shed new light on the company. They can reveal strategic issues, regardless of the initial ambition behind the analysis.

If the principle of materiality has become more widely imposed in recent years, highlighting the desire of companies to base their CSR approach on relevant and priority issues, with an increasingly strong involvement of top management (X% of companies have conducted a materiality analysis in xxx); it has also experienced certain limitations and a change of perspective, induced notably by the evolution of materiality definitions proposed by different reporting standards and frameworks (such as ISO 26000, GRI, Integrated Reporting, and SASB).

  1. Contributions and limitations of materiality as it is currently practiced.

The observed limitations mainly concern

  • The absence of a standardized and universal methodology
    Materiality analysis methodologies vary greatly from one company to another. They are sometimes based on purely qualitative approaches, or strictly quantitative ones, or both at the same time;
  • A process of defining issues that is often not very explicit, making the exercise less credible for all stakeholders
  • The absence of verification by a third party . Indeed, third-party organizations tend to focus on verifying data collected on sustainable development;
  • An approach that is unsuitable, complex and costly for SMEs.

Beyond the aforementioned limitations, criticisms of the concept are based on the fact that conventional materiality analyses tend to reinforce the dominant ideology in business, namely to seek economic growth rather than promote more sustainable consumption patterns. Also, the absence of standards and precise rules regarding its practice makes the exercise random.

  1. Double Materiality: A Prerequisite for Sustainability Reporting
  2. Subsequently, and as part of the preparation of the future CSRD (Corporate Sustainable Reporting Directive) regulation, EFRAG – The European Financial Reporting Advisory Group – the European association responsible for developing accounting and non-financial standards on behalf of the European Commission – clarified this notion of double materiality in its first report published in February 2021, and presented its first recommendations for the new non-financial reporting standards to come for European companies, and introduced double materiality as a prerequisite for companies’ sustainability reporting.

EFRAG defines double materiality as a combination of “financial materiality” and “impact materiality”. The concept of double materiality provides the criteria for determining whether a non-financial issue or information should be included in the company’s sustainability report.

 “Financial Materiality” (or the outside-in perspective, as retained by the ISSB)  focuses on the risks and opportunities presented by environmental and social issues for the company’s activity, performance, and value in the short, medium, or long term, while “impact materiality” (or the inside-out perspective) takes into account the negative or positive impacts that the company and its activities, as well as its upstream and downstream value chain, have on the environment, people, and society.

  1. The contributions of double materiality, interests for companies

    a. A reliable methodology, which tends to standardize

In its report, the EFRAG recommends a 3-step approach

Step 1

It should allow for the identification of all potentially relevant and material sustainability issues for the company (based on a pre-list of 137 issues recommended and made available by EFRAG (Disclosure requirements)), which are regulatory disclosure requirements derived from standard frameworks.

3 proposed typologies of issues:

  • Environmental issues aligned with the 6 objectives of the green taxonomy (Climate change: mitigation and adaptation; water protection; circular economy; pollution prevention; biodiversity and ecosystems).
  • Social issues, which are distinguished by type of stakeholders: entity employees, value chain employees, affected communities, users, and final consumers. They are aligned with the objectives of the social taxonomy project: decent work; adequate living standards and well-being of users; inclusive and sustainable communities and society.
  • Governance issues, risk management, internal control, responsible practices.

From this list of issues, the company must choose

  • 22 significant ones. Issues are considered “significant” when they are material, that is, important and a priority for the company, its internal stakeholders, and its ecosystem.

Among these 22 mandatory issues, those with impact materiality and those with financial materiality (see definition above) are defined:

  • Exclude those it cannot refute (up to 115 issues) (rebuttable presumption), provided it can prove it.
  • And add other issues that are specific to it to obtain a final list of issues (double materiality issues)

Step 2

On this list of issues identified in the preamble, EFRAG recommends identifying the company’s significant positive and negative impacts (and determining their importance based on their severity – scope, magnitude, irreversibility – probability of occurrence, and urgency), with the aim of prioritizing them according to the perspective of “impact” materiality.

Step 3 

Finally, EFRAG recommends prioritizing its priority issues from the perspective of “financial” materiality, based on the list of its significant impacts identified in step 2 and supplemented by other issues that may have an effect on the company’s value.

               b. An approach that encourages a change of perspective and promotes transformation

             c. Questioning the identification of its most material issues invites a change of perspective, which is a driver of transformative engagement within the company. It ensures that the company’s social acceptability is not ignored and that it takes responsibility for societal changes of our time. Ultimately, it’s about addressing systemic issues that are of clear material interest to the company.

              d. A process driven by EFRAG that enhances its credibility and legitimacy with companies

Thanks to the working document published at the end of January by the EFRAG Task Force, which sets out the guidelines for double materiality, companies can, if they wish, be gradually and effectively supported in implementing their analysis. However, they also have the option to develop their own methodology.

The step-by-step approach proposed by EFRAG will be further explained in the future CSRD (Sustainability Reporting Architecture Scheme).

Guideline 1 – Equal importance between financial materiality and impact materiality and their interdependence. The Taskforce confirms that double materiality is the only approach that aligns with the path of the energy, ecological, and social transition desired by the European Union. And it clarifies that the starting point for the materiality analysis is supposed to be the evaluation of impact materiality because a sustainability impact can become financial when it results in or is likely to result in short, medium, and long-term financial effects.

Guideline 2 – Identification and structuring of sustainability topics by the “Board”, based on the upcoming topics provided by the CSRD, in order to assess their materiality (relative importance). It is recommended, to conduct this evaluation, to adopt a higher granularity than that provided by the European Directive, and to involve the governance of the company.

Guideline 3 – The Board must identify the relevant stakeholders and users, as well as their information needs, as the basis for the decision-making process on the relative importance of the subject. It must also ensure that the impact on all relevant stakeholders is taken into account, not just based on the needs of the company.

Guideline 4 – The importance of a sustainability theme must be evaluated throughout the value chain and over all time horizons (short, medium, and long term).

Guideline 5 – Differentiation between statements regarding agnostic, sectoral, and specific parties. In addition to sustainability themes common to all companies, EFRAG recommends taking into account sector-specific practices (and EU legal requirements) as well as international agreements and standards on sustainability issues approved by the EU. Finally, the company may define specific ESG themes related to its economic activity by explaining the reasons for their inclusion.

Guideline 6 – Materiality of immature themes considered important by the Board.

Guideline 7 – Materiality resulting from EU sustainability policies, objectives, and legislation. This approach takes priority over the evaluation of materiality from the impact and financial perspectives, as indicated in guideline 1 and developed in guidelines 8 and 9.

Guideline 8 – Impact materiality assessment process to be carried out by [the Board]. Three pages are dedicated to this process, organized into 5 steps with a focus on details aimed at eliminating the unreliability of the impact materiality approach. Thus, it is specified that the final results of the assessment process of the relative importance of the impact can be presented with a sectoral granularity in a table following the model below.

Guideline 9 – Financial materiality assessment process to be carried out by the Board. This guideline defines a process to be followed by the Board to evaluate the importance of a sustainability theme from a financial perspective. The process includes an evaluation mechanism aimed at achieving a certain degree of objectivity and comparability. Any results obtained from the use of the evaluation mechanism must be weighed by expert judgment, and adjustments will often be necessary following this balancing exercise before the evaluation is finalized.

In conclusion

The principle of double materiality will allow for more relevance and usefulness for European companies and their stakeholders. It represents a real qualitative leap compared to single materiality.

The cornerstone of the future CSR Directive, the European Union aims to base its framework for non-financial reporting on the principle of double materiality. This offers the opportunity to deepen the analysis of a company’s CSR issues and highlight both the negative risks and impacts, as well as the positive opportunities and impacts generated by sustainable business models, making it a true strategic analysis tool.

Additional elements to the first recommendations are expected to be provided soon by EFRAG, which is set to deliver a first set of standards to the European Commission by October 31, 2022 (with a possible adoption of the CSRD by the end of 2022).

While the landscape of non-financial reporting has greatly evolved on both sides of the Atlantic, the concept of double materiality constitutes one of the major differences between Europe and the United States. While international standards such as the IFRS Foundation or SASB tend to cover only environmental and social impacts on businesses, primarily aimed at informing investors about their risks, Europeans propose a broader and two-way vision, as the double materiality on which the non-financial reporting framework is based takes into account both the impact of sustainability risks on the company and the impact of the company on society.

Moreover, Europe aims to accelerate the application of these new standards to promote the implementation of the European Green Deal.[1]

The European Green Deal or Green Pact for Europe is a set of measures aimed at engaging the EU on the path to ecological transition, with the ultimate goal of achieving climate neutrality by 2050. It promotes the transformation of the EU into a just and prosperous society with a modern and competitive economy.

[1] The European Green Deal or Green Pact for Europe is a set of measures aimed at engaging the EU on the path to ecological transition, with the ultimate goal of achieving climate neutrality by 2050. It promotes the transformation of the EU into a just and prosperous society with a modern and competitive economy.

Source: EFRAG PTF-ESRS- 18 January 2022

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