Discover more from ESG on a Sunday
Week 4: Why double materiality matters
In this issue: ▸ Double everything ▸ In a single materiality world... ▸ …Exxon gets AAA ESG rating ▸ The time has come for double materiality ▸ Inverted ESG analysis ▸ And much more...
Double everything. It sounds good. Always double the amount, double the gain, double the experience. As a word, double is easy to sell (unless of course it is about the pain, suffering and destruction). Instinctively, the feeling many of us get when hearing this word is rather positive. It is more of something.
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In the world of free market liberal economies, or capitalism, the framing of the responsibilities of companies and their boards has shifted back and forth over the years. Stakeholder capitalism versus shareholder capitalism.
The core of the issue has always been, and is, what companies, their boards, employees and their products and services are responsible for and what they can be held accountable for.
In simple terms, it’s about what they are impacted by (and how they respond and manage that) and what they are themselves impacting (through their business operations, products and services).
In other words, there’s a double materiality at play.
In a single materiality world…
Nevertheless, we come from, and in many ways still operate in, a single materiality world.
Explained in simple terms like this: The company is impacted by the climate emergency; the board sits down and draws a risk map, ranks the severity and probability, places the post-its on a whiteboard – and the magic 🪄 is there.
Now they know that the climate emergency may impact their business in 5 years and they have assigned an action to it. We cut our emissions or we pose some questions to our suppliers. The potential cost is in most of the cases not put in a financial table in the balance sheet of the company, but it is sort of there in the “integrated reports”.
They have done their homework. They now “know” what sustainability risks they need to focus on. Importantly, the risks are not hindering them to expand any line of business or develop any line of products and services since these things are not related.
In other words, they found a way to manage “outside” risk so they can continue doing business as usual. The business growth targets are not related to the business sustainability management.
It is not explained how the company will grow in segment X in relation to the materiality risk identified by company. Does it hinder or help the company to reach its targets? Are there any numbers? Is there an interview with the Head of Sales who explains how the ESG materiality will add to their capacity to reach their targets? No.
… Exxon gets AAA ESG rating
The single materiality practice is pretty much following an US-based shareholder capitalism view on what companies should disclose on “soft material issues”.
As Azish Filabi, Executive Director at The American College Maguire Center for Ethics in Financial Services, said recently: “Current law appears to require, at a minimum, that companies shall disclose all matters, including ESG matters, that are material to a reasonable investor. What constitutes ‘material,’ ‘reasonable,’ and even at times ‘investor’ isn’t always clear.”
Yes, even what is material is itself open to widely varying interpretations, dependent on a number of factors.
So you see where it leads us… It is “complicated” indeed.
At the basic level, a material risk is an accounting principle, referring to something that may have an impact on – be material to – how a company performs.
A material risk can threaten targets or goals. But only maybe! Because in the context of ESG, this is known as a single materiality and refers mainly to ESG factors that may pose a threat or opportunity to a business and its bottom line, such as extreme weather.
It doesn’t tell you anything about how “green” a company’s business practices are, but rather how vulnerable its earnings may be to ESG risks. That’s why you have Exxon who manages oil and extraction in CO2 efficient ways and therefore gets subsidies from the US government to adjust and improve their facilities to protect them from climate emergency. And they get a AAA ESG rating for it. Jolly it is.
The time has come for double materiality
In reality, the material risk is double. It’s two-sided. It’s a double materiality, and that kind of materiality has made a big entry the into corporate world lately. It is related to the CSRD regulation, and I will come back to this topic later this year.
But now we have the name for it, “double materiality”, and even though it’s a step in the right direction we must not get ahead of ourselves. We are changing the agent, but we are not changing the underlying premisses the agent needs or is expected to react on. The Corporate Charters, the legally binding rules that CEOs and boards are held accountable for, have not changed, do not include any reference to a double materiality or any reference to anything else then profit and risk.
Risk is still first and foremost interpreted as market and financial risk.
What is double materiality?
Let’s have a deeper look into what double materiality is and how it works.
The word material was first introduced in the U.S. Securities Act of 1933. Since the 1940s, the SEC has defined material information in the context of financial statements as “those matters as to which an average prudent investor ought reasonably to be informed before purchasing the security registered.”
Former US Supreme Court Justice Thurgood Marshall, in a landmark case in 1976, wrote that an item is material if there is “a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision.”
Critics of the SEC’s current proposal argue that the existing materiality principle is sufficient to incorporate climate or other environmental, social, and corporate governance (ESG) issues into company reporting. Companies should determine for themselves, as they currently do, whether such issues are material or immaterial. There is no need for new disclosure rules to address such issues, they say.
Double materiality isn’t incorporated in Securities and Exchange Commission rules or proposals. Nor does it shape the bulk of ESG ratings provided by firms such as MSCI Inc. US regulators have largely focused on improving the quality of reports on single materiality by, for example, requiring publicly traded companies to detail their costs from extreme weather events or capital investments to help reduce emissions.
An SEC official said in May 2022 that the agency’s aim was “to achieve as much interoperability” as possible between what the SEC could require and global standards.
Double materiality is old Lady Europe’s response
But that’s not how old Lady Europe sees it. European regulators, which have been ahead of their US counterparts in formulating disclosure requirements on climate change, have come up with an attempt at reconciling the need for investors to have greater information on ESG issues and the question of whether such factors are deemed financially material. The result is “double materiality”.
The concept of double materiality describes how corporate information can be important both for its implications about a firm’s financial value, and about a firm’s impact on the world at large, particularly with regard to climate change and other environmental impacts. The idea of double materiality comes from a recognition that a company’s impact on the world beyond finance can be material, and therefore worth disclosing, for reasons other than the effect on a firm’s bottom line.
Almost a decade ago, the EU began requiring companies to report non-financial information in an attempt to make them more accountable for ESG issues. That was the first time disclosure requirements included the concept of double materiality.
But wide gaps soon emerged in the quality and quantity of information, amid complaints that the rules weren’t well understood or applied. So a redrafted EU rulebook provides companies with more explicit requirements and forces many more businesses to comply. That so-called Corporate Sustainability Reporting Directive will be phased in for the 27 EU countries starting in 2024.
Who is “a reasonable person”?
Double materiality is still up for debate and requires further analysis.
“Yes, in principle the impacts of a company or a portfolio on the climate or the wider environment can be material — but how do we know what exactly is a material impact?” asks Matthias Tager, a PhD candidate in Environmental Policy and Development at the London School of Economics.
The answer, says Tager, fundamentally depends on one’s view of why information on environmental impacts should be material in the first place. In his view there are two probable reasons:
Environmental impacts could translate into financial risks, for example, through legal liabilities or harms to a company’s reputation.
A reasonable person might consider the information material for reasons other than direct financial repercussions.
“The question of what double materiality means thus turns into a question of who the ‘reasonable person’ is, and what their interests are, which in turn define what counts as material – in other words, [what’s] important to them,” Tager explains.
And I do agree with Matthias on this one. Do we regard boards and CEOs, who legally do not have an obligation to take the environmental impacts of their business operation and their products and services into account, as a “reasonable person”?
We have seen over the course of history what that “reasonable” really looks like, and we know that CO2 emissions are going up, and we know that income equality is increasing, and we know that tangible improvements of the underlying non-sustainable economic system need to change, at double speed.
Next week: Inverted ESG analysis
Next week, I will present a new ESG analysis concept that may change the way we view what the core ESG driver for companies is. I call it “Inverted ESG analysis” and it has some features that will start a discussion. I’m sure about that.
Have a great double week!
Here are some useful links on the topic of double materiality:
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