Preparing for CSRD - Understanding the genesis of the Double of Materiality

As of January 1, 2024, the non-financial performance declaration of European companies will change and become more ambitious, moving from the NFRD to the CSRD (Corporate Sustainability Reporting Directive).

The main aim of the CSRD is toharmonize corporate sustainability reporting andimprove the availability and quality of published ESG data.

The latest publication from the AMF (Autorité des Marchés Financiers) confirms that CSRD implies "a strengthening and standardization of reporting obligations". It specifies that"companies will have to publish detailed information on their risks, opportunities and material material impacts in relation to social, environmental and governance issues, according to a principle of "double materiality "".

To help you prepare for the CSRD, and because "Dual Materiality" is the cornerstone of this new sustainability reporting directive, we've put together a series of articles to help you understand, dissect and put this "Dual Materiality" principle into practice.

1. Understanding the genesis of the Double of Materiality
2. Financial materiality - Detecting climate-related risks, dependencies and opportunities
3. Impact materiality - Identifying and assessing the company's impact on the outside world (coming soon)
4. Beyond regulation - Why every company should do a double materiality analysis (coming soon)
5. Our practical guide to setting up a dual materiality matrix

And because at Beavr we like to put concepts into context, today we'd like to help you understand the genesis of the concept of Double Materiality.

‍

1. What is a material impact?

While double materiality has come to the fore with the CSRD, the concept of materiality is not new, since it is one of the foundations of financial reporting.

As defined by US GAAP (Generally Accepted Accounting Principles), "materiality is an accounting principle that requires all items that are reasonably likely to influence investor decision-making to be recorded or disclosed in detail in a company's financial statements".

This means that any information that helps investors and shareholders understand the potential impact of a factor on a company's financial performance can be considered important, and therefore material.

The concept of materiality therefore reflects a perspective focused on the company and its financial value, and in particular on the potential loss of value that "material" issues, notably environmental, social or governance (ESG) risks, could cause investors to suffer.

In recent years, the financial sector has become a key arena for climate action. Finance's interest in climate issues has a dual origin:

• Investment and financing activities linked to climate objectives (energy transition, etc.), also known as impact investing. ‍
• ESG risk management, for example climate-related risks such as extreme weather events or rising carbon prices.

‍

2. Dual materiality: a response to the need for transparency in finance

Nevertheless, materiality, focused solely on the financial performance of companies, was no longer adapted to reflect the reality of companies' impacts on their ecosystems.

To complement this vision, financial players have turned their attention to the concept of external materiality, i.e. taking into account the impact that organizations have on the environment, society and human rights.

The emergence of the concept of external materiality has gone hand in hand with a heightened - but unfortunately unmet - demand for the granularity, quality and usability of companies' extra-financial performance data.

Indeed, without access to reliable, high-quality data on the impacts of their investments, financial players often feel unable to make decisions related to climate or, more generally, ESG risk management.

For a better understanding, here are the main cases in which financial players need sustainability-related data to make decisions:

• Investors have a risk-based approach and therefore want to assess the various ESG risks.
• Investors implement a specific sustainability-oriented investment strategy out of conviction.
• Investors, especially long-term or institutional investors, are rational and see that CSR assets are better valued and more stable.

‍

3. Double materiality: taking into account the impact of organizations on their ecosystems

Thanks to the work of the TCFD, it is now accepted within the financial markets that climate-related impacts on a company can be significant and must therefore be disclosed.

The concept of double materiality takes this notion a step further: it's not just the impacts of ESG risks on the company that can be material, but also the impacts of a company on its ecosystem (environment, social and governance).

Dual materiality therefore comprises two perspectives of materiality:

‍Financial materiality

This perspective encompasses all the risks and opportunities linked to sustainable development that are likely to positively or negatively affect the company's development, performance and position in the short, medium or long term, and thus create or erode its corporate value.

Environmental and social materiality (now called "impact materiality")

This perspective concerns issues that reflect the actual or potential significant impacts on people and the environment of the company's operations and its upstream and downstream value chain.

Dual materiality represents a paradigm shift. It means recognizing that the responsibility of companies and financial institutions does not end with their financial performance, and that they must also manage and take responsibility for the actual and potential negative impacts of their decisions on people, society and the environment.

‍

4. Dual materiality: a structuring principle of CSRD

The application of this concept began in 2019, with the adoption of the European Union's Sustainable Finance Disclosure Regulation, which requires investors to disclose not only the risks to themselves, but also their investments' negative impacts on the planet and society.

Dual materiality is at the heart of the new European regulation on non-financial reporting: the CSRD (Corporate Sustainability Reporting Directive), which replaces the NFRD.

As part of the preparation of this new European directive, EFRAG, the European association in charge of developing accounting and non-financial standards for the European Commission, has proposed a definition of double materiality, distinguishing between financial materiality and impact materiality.

This double materiality is an absolutely essential part of this new non-financial reporting standard, since it constitutes the new standard for identifying the key ESG issues that are a priority for each organization.