Materiality Assessments: Getting Value from the Process

This blog has been a long time in the making – and full disclosure, it is still not the blog that we keep promising to write. In previous blog posts, we discussed the limitations of a ‘materiality matrix’ approach and then recommended what we consider fundamental criteria for a better approach to materiality. We then promised a ‘third blog’ outlining a new approach to corporate sustainability materiality assessment, what we call the Prioritisation Radar. It is a process that we have piloted and developed over the last decade to help companies explore their operational and value chain impacts, the strategic risks and opportunities that they present, and prioritise where to act to support sustainability. That blog is turning into a guidebook, and we hope to share it soon.

In the meantime, we wanted to reflect on what we are seeing in the current state of practice when it comes to materiality. While we believe that we have developed a helpful way for companies to assess and visualise impact materiality and its relationship to financial materiality -and feedback from our work with companies supports this- we are also encountering systemic barriers to the adoption of what we would call an ‘impact driven’ approach.

We fear that, in the rush to adopt double materiality under CSRD and the new emphasis on financial materiality approaches under IFRS, companies may be losing sight of the purpose of materiality assessments. When the process is not structured to generate a thorough understanding of your operational and value chain impacts, your company may misunderstand and/or misrepresent its risks and opportunities.

Materiality – the basics

In corporate sustainability, a materiality analysis is a structured process used to determine which sustainability topics are most relevant or "material" to a business and its stakeholders and rightsholders. While materiality analyses are often driven by reporting obligations, when executed with care, they not only improve meaningful disclosure, but can also inform both your core business strategy and your strategy for sustainability.

Differentiating between impact materiality and financial materiality

The EU’s Corporate Sustainability Reporting Directive (CSRD) obliges in-scope companies to report in line with the European Sustainability Reporting Standards (ESRS), embedding the principle of double materiality into their disclosures. Double materiality demands accountability both for how your operations impact people and the environment (impact materiality) and for the factors that can shape enterprise value (financial materiality).

Initially, the CSRD brought considerable momentum to the idea of double materiality and the need to consider impact materiality on par with financial materiality. Unfortunately, the continued uncertainty around the EU omnibus process, and its implications for the CSRD, along with the wide-spread adoption of the new IFRS sustainability reporting standards have muddied the water.

It's important to note that assessing impact materiality has always been a required activity when reporting in accordance with Global Reporting Initiative (GRI) standards. Material topics are defined by GRI as “topics that represent the organization’s most significant impacts on the economy, environment, and people, including impacts on their human rights.” The GRI emphasises that organisations should be guided by impact materiality in their disclosures and that material topics cannot be deprioritized on the basis of not being considered financially material. Similarly, the EU ESRS notes that impacts should be captured by the impact materiality perspective irrespective of whether or not they are financially material.

In contrast, IFRS S1 and S2 focus on financial materiality from an investor perspective (recognising that ESG risks and impacts may translate into financial risk). But even here, the IFRS requires the disclosure of information about how an entity’s activities impact people and the environment when those impacts give rise to sustainability‑related risks or opportunities that could reasonably be expected to affect the entity’s prospects, and the related information about those impacts is material to primary users. In other words, even this financial materiality standard expects impact materiality inputs for more fulsome disclosure. As a result, companies are encouraged to use insights from impact-focused assessments such as the Global Reporting Initiative (GRI) standards as an input – IFRS and GRI have signed collaboration agreements to support interoperability.

As more global jurisdictions adopt or adapt IFRS Sustainability Disclosure Standards, Chief Financial Officers and Chief Legal Officers in relevant jurisdictions are increasingly paying attention. Yet, many of these actors are anchored in the perspective of financial materiality, where the threshold is that information needs be disclosed only if its omission or misstatement could influence the economic decision of users. Financial impact is assessed in relation to the overall financial picture (often, this threshold will be set at 1-2% of Net Income, Earnings Before Taxes (EBT), or Total Assets).

That’s why it is crucial for your sustainability and/or reporting teams to work with your finance and legal teams to understand how your company currently assesses financial materiality and to help them to understand how impact materiality can (and we argue, should) help to inform financial materiality. It is also crucial that all parties understand the continued external demands for credible sustainability-related impact disclosures (irrespective of whether they are deemed financially material).

The core materiality process

European Financial Reporting Advisory Group (EFRAG) guidance notes that your materiality assessment should include:

1. Understanding your business operations, your value chain, and the context in which you operate;

2. Identification of actual and potential sustainability-related impacts, risks and opportunities; and

3. Assessment to determine appropriate quantitative and/or qualitative thresholds for materiality by considering potential severity and likelihood as well as unmitigated risk.

While no specific method is prescribed, you are required to explain the process that you used to identify and assess your material sustainability-related impacts, risks and opportunities and how they interact with your strategy and business model.

Impact materiality forms the foundation

A materiality assessment anchored in an understanding of your company’s potential and actual sustainability-related impacts is crucial to sustainability reporting and to the development of a credible sustainability strategy. A credible understanding of impact materiality is crucial to understanding financial materiality. This should not be a parallel process: instead, impact materiality should precede and inform your determination of financial materiality.

Companies rely on the resilience of the environmental and social systems around them and as a result, it is in their strategic interest to contribute to their resilience (many would argue it is also a moral obligation). That means that companies (and investors) can’t understand sustainability-related risks and opportunities and their financial materiality without a true understanding of impact materiality (double materiality). It also means that companies can’t really understand impact materiality without considering the health of the social and environmental systems that underpin their operations and those of their value chain.

How do you assess impact materiality?

Impact materiality is often evaluated by considering a combination of severity (scale/scope/remediability) x likelihood. When considering impacts, it is crucial to build an understanding of inherent risk (the potential for impact without any controls in place), current risk (the risk with current controls in place), and residual risk (the risk that remains after proposed new controls are accounted for). Assessing inherent risk is crucial for understanding the effectiveness of and for justifying continued investments in existing controls. Understanding current risk is crucial for understanding residual risk and the need for any further investment in additional controls.

Rather than rank-ordered list of material topics, consistent impact categories (very low, low, medium, high, very high) can often be more meaningful to internal and external stakeholders and help them to better understand relative importance. In our radar prioritisation process, we categorise impacts as minimal, moderate, significant, or very significant, or, more specifically:

1. Minimal

2. Moderate or potentially high with reliable controls in place

3. Significant, with considerable resources needed for further mitigation and control, or

4. Very significant, with the organisation needing to alter its strategy to address them.

We also want to promote caution in using low likelihood to reduce impact materiality scores, particularly with respect to human rights risks. Likelihood is not the most important factor in assessing the salience of a human rights risk – any likelihood of human rights impacts can be considered material. Companies may also have current impacts on the environment, people, or their rights. Often, these impacts don’t fit on a probability scale from extremely unlikely to extremely likely. Current impacts can generate future reputational, legal, financial, and other business risks. One option is to extend your probability scale from extremely unlikely to ‘actually occurring’. Another is to capture actual impacts as extremely likely on the existing probability scale, while flagging them as actual impacts. Whatever solution your company adopts, it is important to provide a complete picture that includes both possible and actual impacts and that does not hide current impacts by assessing a low likelihood that they will occur again in the future.

Also, be cautious about outsourcing your impact materiality work or having outside consultants drive the process. Evaluating impact materiality presents a crucial opportunity to involve internal subject matter experts and internal leaders to better understand actual and potential impacts, challenge key narratives around issues, and raise awareness about why material impacts are strategically important. When materiality is an internally driven process and/or guided by sustainability experts, it also allows your company to build a more in-depth understanding of the relationships between sustainability-related impacts and the risks and opportunities they present to the business. While it has become common for companies to seek out one advisor to conduct a full double materiality assessment, the skills required to support an assessment of impact materiality and those required to support the determination of financial materiality can be quite different. Companies may benefit from different support teams for these two processes.

How do you translate impact materiality into financial materiality?

To answer this question, we need to revisit common corporate approaches to financial materiality. Again, financial materiality is thought of as the point at which inaccuracies in your data would impact decision making for financial users. This makes topics either financially material or not. This ‘financial’ view of materiality can therefore clash with an ‘impact’ view of materiality.

First, you need to be clear on the thresholds your company currently uses to assess financial materiality. What's the most important number on the financial statement? For many companies, this will be net income or Earnings Before Taxes (EBT), for others, it may be total assets.

Translating impact materiality into financial materiality is often assessed based on the magnitude/severity of the financial effect (operational, reputational, credit, market, liquidity, etc) x likelihood of occurrence. In many companies, assessment of financial materiality will require an expansion of the evaluation methodology within your Enterprise Risk Management (ERM) system. Be cautious about moral hazard in quantifying the financial impact to the company of environmental and human rights risk. The Ford Pinto case has become a mainstay in business ethics courses for a reason – Ford chose cost and production schedule over safety and later paid the price. That’s why, as we note above, companies need to pay particular attention to actual impacts (no matter how small).

What value can be derived from the materiality process?

We argue that the value a company can derive from the materiality process begins with the quality and integrity of your impact assessment. Did you consider a broad range of impacts, instead of just the topics listed in regulations and voluntary standards or the common topics already reported in your industry? Did you assess those impacts in relation to what is needed to maintain social and environmental resilience?

Where and how you take action depends on the reason for your materiality assessment, your findings, and your company’s current practices. If your materiality process was primarily for disclosure purposes, you now have your material topics to report on. Hopefully though, your objective was also to inform strategy. If so, then you can use your findings to set goals, and determine strategic actions. Your findings can also help you to identify topics where your company needs to draft a credible public position. In short, understanding your company’s impacts, while it can be an intimidating prospect, can help you to take credible action on the areas of greatest impact, risk, and potential opportunities.