Double materiality as an unexpected remedy for reporting fatigue

This blog "Sustainability leadership in the age of ESG compliance – double materiality as an unexpected remedy for reporting fatigue" has been written by Charlie Hodkinson-Ashford and Nikkie Vinke of Corporate Citizenship (an SLR Company).

Sustainability reporting has become so commonplace, that it is easy to forget how much of it remains voluntary – or at least, how much of it is published to meet the demands and expectations of investors, customers, employees and other stakeholders, but not regulators. But while many companies align their reporting with voluntary standards such as GRI and SASB, implementation is patchy and comparability remains low. Regulatory initiatives to ensure consistent, comparable disclosures have remained localised, often mandated on a “comply or explain” basis. That is now changing.

The European Commission is increasing sustainability reporting requirements for public and other large companies. Climate disclosure, in particular, is becoming increasingly mandated in line with the TCFD Recommendations, from the UK and Switzerland to the US (with California proposing to do what the SEC may not) and Singapore. And the new International Sustainability Standards Board (ISSB) is setting out to do for sustainability reporting what international accounting standards have done for financial reporting. The regulatory push is strong – already, 65% of global C-suite executives say the changing regulatory environment has led their organisation to increase climate action over the past year.

But while regulators try to narrow down on mandatory disclosures, the scope of what they are trying to regulate has never been so poorly defined. Part of this is the fault of sustainability practitioners, perhaps too eager to proclaim an ESG investment revolution. Part of it is the fault of raters, promoting ESG as a single, quantifiable score, despite the many and varied investor approaches to ESG.[1] Part is the fault of marketers, rebranding as “sustainable” or “ESG” in name only – at least until regulators announced closer scrutiny of greenwashing tactics. In the US, politicians and pundits have further muddied the waters.

Regulators therefore face the unenviable task of trying to standardise something upon which nobody can agree. Already, fractures have emerged – in particular, the ISSB’s proposed standards reject the European definition of “double materiality”, instead focusing on a still uncertain definition of “enterprise value”, which critics say gives too little prominence to companies’ environmental and social impacts.[2] While standards setters attempt to iron out these issues and force at least some degree of alignment, companies will likely continue to face a fragmented and even contradictory set of disclosure requirements across jurisdictions.

Still, regulation and standardisation will surely bring benefits to company reporting. Accountants and auditors are already being “parachuted in” to fix flawed ESG data. According to one survey of US executives, 96% are planning to seek external assurance of ESG data this year. Investors and other report users will benefit from greater comparability and reliability of reported data, even as they continue to have differing approaches to interpreting the data.

Of course, companies bringing in new systems, processes and talent will encounter new challenges along the way. Many are also concerned that greater regulation could open the door to increased legal risk. A recent survey of in-house counsel found that, while only 2% reported ESG-related litigation in 2022, 28% said their exposure had deepened. This may be true, but it’s hard to pin this solely on regulators. Investors and other stakeholders will continue to demand ever-deeper disclosure of ESG data, plans and targets, whether or not regulators intervene.[3] Efforts to standardise definitions and align disclosure requirements should therefore be welcomed.

One way or another, a global regulatory baseline for ESG is beginning to emerge. But a baseline is not leadership. More important is context – every company is different, and leading companies will continue to be those that communicate their own sustainability path (see examples here). What good is it if a healthcare company reports average pricing data, but has no strategy for leveraging technology and innovative distribution channels to reach underserved populations? What good is it if a car company discloses detailed projections for how future extreme weather patterns might impact its factories, but not how it plans to outperform competitors in bringing electric vehicles to market? What investors, regulators and other stakeholders should be focused on most, is the balanced picture of the company’s material risks, opportunities and impacts.

Companies must remember that compliance is not an end in itself. Standardisation of ESG disclosures should give companies the freedom to focus on what makes them unique. Perhaps unexpectedly, the concept of double materiality[4] – soon to be made mandatory in European reporting standards – may therefore be a blessing in disguise.

Double materiality can function as a principle that not only enables compliance, but drives a more ambitious, differentiated approach to sustainability strategy and reporting. Risks that are more likely to have an important impact on revenues, assets or reputation should enjoy close monitoring. So too should companies’ significant environmental and social impacts, which may themselves be linked to future financial risks and opportunities. Through this approach, companies can embed their business strategy and goals in an understanding of their sustainability context, and more effectively communicate their vision to key audiences – investors, regulators and other stakeholders alike.

Authors: Charlie Hodkinson-Ashford and Nikkie Vinke

[1] Even in 2012, the Global Sustainable Investment Review claimed that 22% of professionally managed assets “incorporated ESG concerns” into their investment selection and management. In reality, this figure covered everything from traditional “ethical” investment (screening out of “sin” stocks), to ESG risk weighting, to impact investing. Proponents of ESG as an enlightened form of capitalism – simply the outcome of rational investors maximising their long-term returns – may claim that “ESG is not about ethical standards and ethical values”. In reality, the definition has never been clear-cut.

[2] Meanwhile, European attempts to define a taxonomy of sustainable activities led to fraught arguments over the inclusion of gas and nuclear, while its proposed social taxonomy has been put on hold.

[3] According to Bloomberg writer Matt Levine: “Once upon a time, ‘securities fraud’ meant lying about earnings… Investors did not care about the ESG behavior of public companies, and now they care very much… The ESG statements haven’t replaced the financial statements, but they exist parallel to them, and they are… perhaps not equally important, but certainly important enough to produce lots and lots of lawsuits.”

[4] Following a double materiality approach, an ESG issue is considered material for reporting based on one or both of two overlapping dimensions:

• Impact materiality: issues related to an organisation’s material positive or negative impacts on people or the environment (inside-out);
• Financial materiality: sustainability risks and opportunities material to the organisation’s cash flows, development, performance, position, cost of capital or access to finance (outside-in).