Reinforcing the concept of double materiality with the CSRD Directive

What does double materiality mean?

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Double materiality is one of the basic principles for sustainability reporting. The NFRD has already required companies to report from two perspectives:

– the ‘outside-in’ perspective describes on how sustainability issues affect their performance, market position and future;

– the ‘inside-out’ perspective explains their impact on people and the environment. This is called ‘double materiality’.

The fitness check of the CSRD has shown that those two perspectives are often misunderstood. Several research have identified issues of applying double-materiality. In corporate sustainability reporting, companies tend to highlight good performance, but hide poor results. In some cases they use sustainability reporting to legitimise their unsustainable activities and – in extreme cases – mislead stakeholders.

Therefore, it was necessary to strengthen the concept of double materiality in corporate sustainability reporting.

Materiality – from the accounting perspective

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The term ‘materiality’ itself is nothing new. It is a well-known accounting principle. In accounting, materiality (or significance) helps to decide whether and when a piece of information should be taken into account. IFRS standards  require companies to make materiality judgement through their preparation of financial statements.

According to The International Accounting Standards Board,

„Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general-purpose financial statements make on the basis of those financial statements, which provides financial information about a specific reporting entity.”

The materiality concept in this way works perfectly in financial reporting; however, it does not serve the information needs of other stakeholders: employees, customers, or local communities.

Double Materiality – the union

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Double materiality, on the other hand, is stakeholder focused, and concentrates not only on the information need of company shareholders but also on the whole spectrum of stakeholders. This includes both the above mentioned “Outside-In” and “Inside-Out” perspectives, each of them represents one materiality perspective.

The latest draft of the ESRS (2022 november – ESRS 1 General requirements) reinforces the concept of double materiality. Regarding ESRS 1, double materiality has two dimensions: impact materiality and financial materiality. As Global Reporting Initiative (GRI) describes: “Double materiality is the union (…) of impact materiality and financial materiality.”

The starting point is the assessment of impacts. Impact refers to the positive or negative ESG impact of the businesses. Companies are required to explain how they apply criteria regarding both impact materiality and financial materiality. Appropriate thresholds are necessary to determine which impacts, risks and opportunities are the most important, addressed by the companies as material.

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1. Impact materiality

A company’s sustainability matter is material when it has actual or potential positive or negative impacts on people or the environment over the short-, medium- and long-term time horizons. Sustainability matter includes impacts caused by any part (upstream or downstream) of the whole supply chain.

While materiality is based on the severity of negative impacts, with potential negative impacts, we should consider their likelihood, too. Severity is based on the scale, scope, and irremediable character of the impact.

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2. Financial Materiality

A corporate sustainability impact may be financially significant or turn into financially material when it becomes relevant for the investors and lenders. The standard emphasises the importance of risks or opportunities that significantly influence cash flow, performance, and financial or market position.

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3. Other materiality concepts – do not be confused!

Recently, other materiality concepts have emerged, such as “dynamic materiality”, “core materiality” and “nested materiality”. However, they were later discarded, claiming that the double materiality concept alone was enough, and that these additional definitions were causing confusion.

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Author: Mária Farkas – Senior Sustainability & CSRD Expert at denxpert

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Sources:

Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL – as regards corporate sustainability reporting: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52021PC0189  

First Set of draft ESRS: https://efrag.org/lab6