The CSRD - Corporate Sustainability Reporting Directive - will come into force in 2024, and will oblige more and more companies to produce demanding annual non-financial reports on their environmental and social impact, as well as on their governance mechanisms (ESG).
The notion of "dual materiality" lies at the heart of the political philosophy espoused by the Europe that saw the birth of the CSRD. A "political philosophy", because in the emergence of new international ESG reporting standards, European and American visions clash. While Europeans and Americans are broadly aligned on the need to standardize ESG reporting by companies, the "double materiality" requirement is the main point of disagreement between the institutions driving standardization projects on either side of the Atlantic, namely theInternational Sustainability Standards Board (ISSB) in the United States and the Taskforce of theEuropean Financial Reporting Advisory Group (EFRAG ) for the European Union.
What is the "Materiality" of an ESG issue?
Before discussing "double materiality" and its implications for companies, it is important to understand the concept of "materiality". Materiality" is a concept that originated in the financial world, but has now been transposed to the field of CSR with the systematization and standardization of extra-financial reporting.
The term "materiality” is historically used in the world of financial auditing and employed in CSR to designate the relevance, or level of importance, of a piece of information or data, in terms of the impact it can have on a company's performance and associated decision-making.
An ESG issue, and the information associated with it, is said to be "material" for a certain company when it is likely to have a strong impact on its ability to create financial and extra-financial value for itself and its stakeholders, whether internal or external, and therefore to influence the decisions of economic players and the various stakeholders when it comes to the company in question: investors, credit organizations, public authorities, partners, etc .
The gradual alignment of financial and non-financial reporting requirements underpins a new consideration of non-financial factors, and ESG factors in particular, in terms of their importance for a company's sustainable performance.
What is "double materiality"?
As part of an ESG approach or reporting, "simple" or "financial" materiality consists in considering the potential impact of ESG factors on the company's financial performance. This is akin to an analysis of the company's extra-financial risks. For example: is my company exposed to such and such a type of natural disaster?
The principle of double materiality supplements this simple "financial" materiality with an "impact materiality" that considers the effects of the company's activity on its environment, nature and society.
- Financial materiality following an "outside-in" logic: The impact of ESG factors on an organization's financial performance. In particular, this materiality analysis will present the company's exposure to risks linked to climate disruption via the potential financial consequences.
- ESG Materiality or "Impact Materiality" following an "inside-out" logic: The impact of the organization's activities on the environment, society and governance.
- Double Materiality: The ESG strategy and the data included in extra-financial reports take into account the environmental and social risks to which the company is exposed, on the one hand, and the impact of the company's activity on the planet and society, on the other.
Why is a simple materiality approach not enough for an ambitious ESG strategy?
When a company is content with a "simple materiality" approach, certain social or environmental information, potentially important for the sustainability of the earth's living conditions, runs the risk of not being estimated as material and therefore integrated into the company's future strategy and performance analysis.
Ahistorical example of this type of information is "the quantity of greenhouse gases emitted by the company". In absolute terms, an increase in a company's carbon footprint from one year to the next will not impact its financial performance, and could even be a "logical" consequence of a flourishing business. However, it is no longer possible to ignore the weight of corporate activity in the total GHG emissions that are accelerating climate disruption, and the fact that this climate disruption poses numerous risks for all people and companies, and in particular for the activity of the companies behind it.
The dual materiality approach is important because it precisely links a company's environmental impacts to their consequences for the company's direct and indirect ecosystems , and ultimately to the potentially considerable risks to the company's financial performance.
The main idea behind the "double materiality" approach is that, from a company's point of view, there is a deep interconnection between the risks to which it is exposed and the sources of these risks. To put it another way and more simply, simple materiality presents companies as "potential victims and/or beneficiaries", while double materiality presents companies as "potential victims and/or beneficiaries" AND as "potential responsible parties" for impacts, whether positive or negative.
For the company, adopting a double materiality ESG approach will enable it to identify new opportunities, better understand and proactively manage risks, and accelerate its transition to a sustainable business model.
What is a "double materiality analysis"?
The aim of a "double materiality analysis" is simply to determine which ESG issues are "material" for the company, i.e. likely to affect its strategy and sustainability. The materiality analysis will also seek to prioritize these issues, and to define indicators that can reliably tell where the company stands in relation to each issue, or how it and its stakeholders may be affected by each issue.
Example: Is the quantity of greenhouse gases emitted by the company an important piece of information when making decisions about the sustainability of its activity?
In addition to the forthcoming legal obligation under the CSRD to carry out a recurring double materiality analysis for its company, this analysis will enable each company to identify its priority ESG issues, mobilize resources towards the most critical issues for its internal and external stakeholders, and identify the data that will be integrated and shared in the company's extra-financial reports.
What is a materiality matrix?
A visual deliverable of a materiality analysis can be a "materiality matrix". A materiality matrix can be used to graphically prioritize a company's ESG issues in order to quickly identify the "material" issues on which the company should focus its efforts, prioritize its actions and produce accurate reporting.
A "simple" materiality matrix is classically represented in two dimensions, one axis showing the importance of ESG issues for the company's business and the other their importance for internal and external stakeholders: employees, trade unions, shareholders, investors and rating agencies, customers, suppliers, public authorities, NGOs, academia ... A matrix can also include a representation of the nature of the issues: social, societal, environmental, governance, financial, business...
Another way of presenting a simple materiality analysis is to supplement the information on the importance of a CSR issue with the company's current level of performance with regard to this issue, so that a CSR action plan emerges naturally by visualizing the issues on which the company needs to maintain or increase its efforts.
A double materiality matrix will generally represent financial materiality, i.e. the importance of the issue for the company and its stakeholders combined, on the x-axis and impact materiality on the y-axis. In this case, ESG material issues will normally be those that maximize financial materiality OR impact materiality.
A look back at the ideological opposition between the ISSB and EFRAG concerning materiality
In the context of the emergence of new non-financial reporting standards, ISSB advocates a simple materiality approach to accounting and reporting, following the example of the TNFD for biodiversity. Simple materiality is aimed more at an investor audience, whereas EFRAG advocates a dual materiality approach, with data disclosure intended for multi-stakeholder use.
Accounting, whether financial or extra-financial, and its reporting and auditing standards, "influences the understanding and steering of corporate activity, and therefore potentially the progress of the entire economy" (Maurice Levy).
The differences in approach between the ISSB and EFRAG, and the debates that these differences generate, reflect two worldviews that will have a major influence on the evolution of companies' business models, their impact on the environment and, ultimately, whether or not they achieve the environmental and social objectives that are crucial to life on earth.
The financial materiality approach, as the only obligation for companies, defends a vision of the world in which nature is at the disposal of economic activities and the profitability generated for shareholders, without the company having any responsibility or accountability towards nature.
So at Traace, in addition to offering our customers an ESG software software that facilitates the collection, analysis and reporting of all their ESG data, we are convinced of the importance of imposing a double materiality approach on companies' extra-financial reporting, so that sustainable business models emerge in the future.
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