The necessity of disclosing financially material information is a well-established accounting concept that has long been adhered to broadly across financial markets. Over the past several years, as ESG issues have become an increasing focus for financial institutions, regulators, governments and indeed the general public, there have been calls for related information to also be disclosed due to the material impact ESG performance has on a company’s various stakeholders. Hence, the idea of ‘double materiality’.
The concept of double materiality was first introduced by the EU Commission in what has become the Corporate Sustainability Reporting Directive (CSRD). The Directive mandates that over 50,000 companies in Europe conduct a double materiality assessment and disclose information on environmental matters, social matters and treatment of employees, respect for human rights, anti-corruption and bribery and diversity on company boards. This disclosure requires an evaluation of the potential impact on employees, the environment and society and not simply the financial implications for the investor.
In the US, double materiality has not as yet been embraced. The US regulator the Securities and Exchange Commission requires disclosure of information on a company that is material if “a reasonable person would consider it [the information] important” when valuing a company. As Max Schanzenbach and Robert Sitkoff argue US law requires any integration of ESG factors in investment decisions to be linked to ‘risk-return’ and not those that simply provide ‘collateral benefits’ to the environment or society.
Still, how often with a sufficiently long time horizon is there really a difference between double and financial materiality? Such a distinction is rare and rather than these impacts being ‘non-financial’ they are actually ‘pre-financial’. Making investment or business decisions based, even in part, on climate-related information or other sustainable performance factors will surely have a long-term financial impact. Environmental and social issues can translate into financial risks in many ways. These include the prospect of new regulation, the potential for future legal liabilities based on environmentally irresponsible activity or negative effects on a company’s reputation and performance caused by changing consumer attitudes or the wellbeing and morale of its employees.
There are plenty of examples of situations when an impact on an employee or on the environment ends up in the financials or has a material chance that it will do so. Conduct at banks prior to and poignantly in the aftermath of the financial crisis did hurt the banks financials as well as the taxpayer. The world has woken up to the potential economic destruction of climate change and biodiversity and is very likely to make sure the biggest emitters will pay and those who offer net-zero solutions to benefit. The financial prospects of clothing retailers who ignore fast fashion or human rights abuses in their supply chains are likely to suffer financially as consumers become more conscious of waste.
More broadly, businesses, and in particular investors, must consider that there is a real long-term risk that continued environmental and social irresponsibility could lead to rapid destabilisation of the financial system. In this knowledge, investors are increasingly choosing to incorporate climate-related and other relevant sustainability performance information into their decision-making process, not just to circumvent the issues outlined above, but to create genuinely positive and impactful environmental and societal change. All of which, demonstrates the true financial materiality of such information.
As such, failing to disclose on a double materiality is actually detrimental to long-term financial materiality. Ignoring material social and environmental risks and opportunities is done at a company’s financial peril and viability, and if we are, as an industry, to operate in a way that is truly transparent and effective, we must consider this type of information to be acutely financially material.
