22.01.2024

Finance Business Next

The materiality analysis in sustainability reporting

22.01.2024  | Thomas Weber

According to the introductory text to the Corporate Sustainability Reporting Directive (CSRD), companies should only be required to disclose information that is necessary for an understanding of their impact on sustainability aspects or that is necessary for an understanding of the impact of sustainability aspects on the company's business performance, results and position. However, a company must also report on the process for determining the information included in the management report. In turn, the sustainability reporting standards should contain guidelines on this process.

In an initial proposal, the EFRAG (European Financial Reporting Advisory Group) presented the 'rebuttable presumption' procedure. According to this, the presumption was that all reporting requirements of the European Sustainability Reporting Standards (ESRS) must be reported on unless the company can prove that a sustainability standard (or even an individual data point) is not material for the company in question and is therefore not reported on.

This proposal was the subject of much controversy and was ultimately withdrawn by EFRAG. In its final publication of the ESRS dated 22.12.2023, the EU Commission has now stipulated that, in addition to the ESRS 2 standard, which is mandatory for all companies, a company's reporting requirements should be based on the results of a materiality analysis. This means that if a sustainability aspect is identified as material as part of a materiality analysis, it must be reported on in accordance with the requirements of the relevant sustainability standard.

Definition of materiality according to ESRS 1

According to ESRS 1 chapter 28, a sustainability aspect is material if it meets the criteria for impact materiality or financial materiality or both. The significance of the term 'materiality' lies in the fact that the assessment of materiality is the starting point for sustainability reporting (chapter 26). Conversely, this means that the information prescribed in a standard (or a sub-topic) can be omitted if this information is assessed as not material (section 34b).

ESRS 1 Appendix A (AR 16) lists the sustainability aspects that must be taken into account when assessing materiality. The aspects are divided into environmental, social and governance topics. It should be noted that the list is a tool to support the assessment of materiality and does not replace the process for determining the material aspects. This list may need to be supplemented by company-specific topics.

Principle of double materiality

The principle of dual materiality is a fundamental expansion of the scope of reporting in the annual financial statements. While the so-called outside-in perspective has so far been the main aspect to be considered in financial reporting, including the management report (financial materiality), in future sustainability reporting will also have to report on the actual or potential impact of the company on its environment (people, environment, society) (impact materiality, inside-out perspective).

It is rightly pointed out that both materiality aspects are interlinked and therefore the interactions between the two dimensions must also be taken into account. It is sufficient for the reporting obligation if the materiality of one perspective is fulfilled.

Financial materiality

Financial materiality refers to aspects relevant to business management, such as the company's financial position, financial performance, cash flows, access to finance or cost of capital (ESRS 1 Chapter 38). However, it should be noted that the scope of financial materiality for sustainability reporting is an extension of that for financial reporting, as it also includes information that is reported on in the sustainability statement, e.g. the company's impact on the environment, which in turn has an impact on the company. This may relate to its business model, its market position, its attractiveness as an employer or its financial situation. The time horizons on which sustainability reporting is based are also significantly extended (long-term = over five years). The probability of occurrence and the potential extent of the financial impact must be taken into account.

Impact materiality

The materiality of impacts refers to the significant actual or potential positive or negative impacts on people or the environment in the short, medium or long term. These are impacts relating to environmental, social and governance aspects. In the case of actual negative impacts, materiality is based on the degree of severity; in the case of potential negative impacts, it is based on the degree of severity and the likelihood of the impact. The degree of severity is measured according to the extent, scope and irreversibility of the impact.

Double materiality

The principle of double materiality has long been anchored in the international standards for (voluntary) sustainability reporting (including the GRI Standards). Unlike in the European ESRS, however, this principle is not applied in the first standard S1 ("Global Baseline") of the International Sustainability Standards Board (ISSB) for companies required to report in accordance with international accounting standards. The ISSB takes the view that reporting should only reflect the investor perspective and limits reporting on environmental aspects (Standard S2) to the financial impact on the company.

Description of the materiality analysis in accordance with ESRS 2

ESRS 2 (IRO-1) stipulates in chapters 51 ff. that a company must disclose its process for determining its impacts, risks and opportunities and for assessing their materiality. The aim is to provide an understanding of the process for determining and assessing these in order to provide a basis for determining the disclosures in the sustainability statement.

In the description of the process, the methods and assumptions used to determine the impact on people and the environment as well as the process for determining the risks and opportunities that have or may have a financial impact must be presented in accordance with the principle of dual materiality. The extent to which the process relates to individual business processes or geographical circumstances, for example, and whether affected stakeholders were involved must also be stated.

The description of the process must also include a description of the prioritization of the aspects that are ultimately selected for the sustainability statement, including the use of qualitative or quantitative thresholds. Criteria include the relative severity and probability of occurrence of the impacts or the probability, extent and nature of the impacts of the identified risks and opportunities. If applicable, the use of risk assessment tools, the decision-making process and the associated internal control procedures must also be reported here.

The requirements in ESRS 2 (IRO-2) add to this that the disclosures in the sustainability statement must also include those topics that were omitted as a result of the materiality assessment. If a company comes to the conclusion that a topic is not material, it can explain the conclusions of its assessment for this topic in accordance with section 58.

Implementation

Due to the lack of explanations in the ESRS, each company is required to find its own approach to the preparation, implementation and follow-up of a materiality analysis. In doing so, the respective company-specific requirements with regard to resources and existing competencies must be taken into account. While large and/or capital market-oriented companies often use the support of consulting firms to prepare and carry out the materiality analysis and prepare the results for the company management, the majority of companies that will have to report in the future are confronted with the question of how they can meet the expectations of a proper implementation of the materiality analysis with their organizational and personnel resources. Despite this individual starting situation in the company, a careful approach is essential. This necessity arises not only from the significance for subsequent reporting, but also in particular from the requirement for the auditor to be able to trace the process and the conclusions drawn from the results.

Thomas Weber