The “Summer of CSRD” series – understanding materiality

The EU’s Corporate Sustainability Reporting Directive will have broad impact. Approximately 50,000 undertakings are expected to have a reporting obligation. The recently finalized European Sustainability Reporting Standards specify the information required to be reported under CSRD.

As we recently posted, this summer’s ESG must-read is ESRS 1, which contains the general requirements applicable to CSRD reporting. The objective of ESRS 1 is to provide an understanding of the architecture of the ESRS, the drafting conventions and fundamental concepts used and the general requirements for preparing and presenting sustainability information in accordance with CSRD.

Understanding ESRS 1 is therefore critical to preparing for CSRD reporting. It will drive not only disclosure, but also the underlying processes and controls. As a threshold matter, understanding ESRS 1 also is important for developing the project plan for CSRD readiness.

Each post in this “Summer of CSRD” series will discuss selected aspects of ESRS 1, in a bite-sized read, in more or less the order presented in ESRS 1.

In the last post, we discussed the qualitative characteristics of reported information, which are addressed in chapter 2 of ESRS 1.

In this post, we move on to chapter 3 of ESRS 1, which discusses materiality. We will break up chapter 3 into a few posts, starting with an overview of what materiality means for purposes of CSRD.

Most ESRS disclosures only will be required if determined by the undertaking to be material. CSRD takes a double materiality approach. The two dimensions of double materiality are (1) impact materiality and (2) financial materiality. A sustainability matter is material if it meets the definition of impact materiality, financial materiality, or both.

Impact materiality

A sustainability matter is material from an impact perspective when it pertains to the undertaking’s material actual or potential, positive or negative impacts on people or the environment over the short-, medium- or long-term. A material sustainability matter from an impact perspective includes impacts connected with the undertaking’s own operations and upstream and downstream value chain, including through its products and services, as well as through its business relationships. In this context, impacts on people or the environment include impacts in relation to environmental, social and governance matters.

The materiality assessment of a negative impact is informed by the due diligence process set out in the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises. For actual negative impacts, materiality is based on the severity of the impact. For potential negative impacts, materiality is based on the severity and likelihood of the impact. Severity is based on the scale, scope and irremediable character of the impact. In the case of a potential negative human rights impact, the severity of the impact takes precedence over its likelihood.

In the case of positive impacts, materiality is based on (1) the scale and scope of the impact, for actual impacts, and (2) the scale, scope and likelihood of the impact, for potential impacts.

Financial materiality

A sustainability matter is material from a financial perspective if it triggers or could reasonably be expected to trigger material financial effects on the undertaking. This is the case when a sustainability matter generates risks or opportunities that have a material influence, or could reasonably be expected to have a material influence, on the undertaking’s development, financial position, financial performance, cash flows, access to finance or cost of capital over the short-, medium- or long-term.

The scope of financial materiality for sustainability reporting is an expansion of the scope of materiality used for determining information that should be included in the undertaking’s financial statements. The financial materiality assessment corresponds to the identification of information that is considered material for primary users of general-purpose financial reports in making decisions relating to providing resources to the entity. In particular, information is considered material for primary users of general-purpose financial reports if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that the users make on the basis of the undertaking’s sustainability statement.

The materiality of risks and opportunities is assessed based on a combination of the likelihood of occurrence and the potential magnitude of the financial effects. Risks and opportunities may derive from past events or future events. In addition, the financial materiality of a sustainability matter is not limited to matters that are within the control of the undertaking. It also includes information on material risks and opportunities attributable to business relationships beyond the scope of consolidation used in the preparation of financial statements.

ESRS 1 indicates that dependencies on natural, human and social resources can be sources of financial risks or opportunities. Dependencies may trigger effects in two possible ways: (1) they may influence the undertaking’s ability to continue to use or obtain the resources needed in its business processes, as well as the quality and pricing of those resources; and (2) they may affect the undertaking’s ability to rely on relationships needed in its business processes on acceptable terms.

Next up: the materiality assessment process.

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