How CFOs Should Assess Materiality in ESG

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Ask yourself about the “why” behind ESG as a starting point for keeping up with fast-moving regulatory changes.

The dominant discussions in ESG or corporate sustainability were once about “winners and losers.” In a kind of Wild West atmosphere, ESG reporting was seen as voluntary, with many parties at the table guessing which ESG reporting standard will ultimately be the one that should be used, as well as which ESG rating investors will all rally behind. The point of departure was metrics.

These discussions are now deprioritized. Given the pace of change occurring in the regulatory domain, it’s not about lists and box-ticking anymore.

It is now evident that in 2020 and 2021 the C-suite and boards have become the “owners” of ESG. The pandemic, Black Lives Matter, climate change, to name a few, are all risks that boards and executives had to wrap their heads around. Consumers want to uncover which companies are authentically on the path to sustainability, and which are not.

A Push from Regulators: Double Materiality

So, companies are currently wondering how do I achieve and sustain this credibly? while regulators are asking about the “why” behind ESG.

A recent example of this is the European Commission’s proposal for a Corporate Sustainability Reporting Directive (CSRD). With its predecessor, the Non-financial Reporting Directive (NFRD), the EU was tiptoeing into the ESG space. It contained disclosure requirements on topics such as climate change, diversity and employee matters—topics that most companies were disclosing already. It created some critical mass fast.

Now, the CSRD has tightened the screws and 50,000 companies in the EU will be required to start disclosing on the topics that matter most to them. But what makes the potential global impact of the CSRD so special is the prominence of the concept of “double materiality,” and the ability of a phenomenon known as the Brussels Effect to take these requirements global practically straight away.

What is Double Materiality?

In essence, double materiality is about asking companies why certain ESG issues matter.

Is climate risk important to you because it has an ability to impact you financially? This is the outside-in-perspective. Or is climate important because your business is negatively or positively impacting the world around you and your key stakeholders? This is the inside-out perspective.

This exercise requires leadership to have discussions and data to support their ESG assessment. It is not an exercise where a company responds to a questionnaire of KPIs, but one that gets at the heart of a company’s strategy and risk management processes.

The concept of double materiality evolved in the past year. Last July, EU Commission Executive VP Valdis Dombrovskis sent a letter mandating that the European Financial Reporting Advisory Group (EFRAG) provide recommendations on EU non-financial reporting standards, and cited double materiality as a foundational principle for such standards. This was concretized in the publication of the CSRD proposal on April 21.

With the rising prominence of ESG, corporate leaders now feel they have gaps in traditional processes related to materiality, risk reporting and board oversight, and realize they require a systems upgrade. ESG should no longer be a siloed effort but truly integrated into all business processes.

As a result, many companies are trying to find the best home for ESG. In practice, ESG really has multiple homes. Companies are establishing ESG committees on boards, they recruit for new non-executive directors that can ask the right questions around ESG, they make the CFO responsible for holistic risk management, involve General Counsel and develop more collaborations.

Companies working to answer the question of how to create change are doing the work on getting relevant ESG topics into their risk register process, marrying ESG reporting with financial reporting and SEC filings, and putting relevant ESG trends in front of board members who instill long-term impact.

Part of the solution to creating meaningful change is bringing new people into the ESG process who are evidence and operations-driven, and who mesh with the greater emphasis on data-driven processes in corporate reporting.

Interestingly, the rise in prominence of ESG is coupled with a rise in prominence of digital transformation. Today, technology has the capability to help companies understand how to create change. With these data-driven systems, companies can map out new risks and provide evidence as to why they matter. Technology can scan vast amounts of data that are in the external landscape and rank key risks popping up in the regulatory, industry and reputation landscapes.

Given the depth and complexity of data involved in determining double materiality, there is no other way to address this challenge than using technology.

Looking Ahead: A Quick List of Predictions

  • Global regulators are likely to follow the CSRD’s model in terms of institutionalizing the materiality process on ESG. It might not be exactly the same, but it is likely to be materiality first and metrics second.
  • Following the already deeper focus on climate risk and climate change, other topics will follow suit.
  • Reporting standards will consolidate and most likely be integrated within the mandate of financial standard setters.
  • The space is unlikely to get settled anytime soon, so leaders should be prepared to keep a finger on the pulse to follow developments.

On top of the prominence of double materiality, we can already see another dimension emerge today. Companies on the leading edge of ESG believe that for some topics another “reason why” is more important than materiality of the topic. We can refer to this trend as that of corporate decency. A good example of this is diversity, equity and inclusion or employee well-being. Increasingly, corporate leaders accept these are important goals to embrace regardless the type of business you’re in and as a “normal” part of operating in the 21st century.

ESG is moving from case study to business as usual. Companies that don’t want to be left behind need to ensure a commitment from the top down that reflects a real understanding and integration of such concerns throughout the company and its value chain.

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