The benefits of an ESG materiality assessment

Financial materiality is a familiar concept to most business leaders. By identifying the concerns and business activities that can affect an organization’s financial well-being, financial materiality helps organizations focus on the most critical issues that could affect their bottom line, based primarily on the perspectives of investors. ESG materiality, on the other hand, looks beyond financial impact to consider nonfinancial factors that could affect the long-term sustainability of a business as indicated by a broader range of stakeholders. ESG materiality assessments can be formal or informal. The level of rigor and documentation that is needed to support an organization’s identification of critical issues varies depending on the subjectivity of the frameworks in use and the intent and location of the organization’s ESG disclosures.

Embedded in ESG materiality is a concept known as double materiality. Financial materiality generally looks inward at the company – it examines how the company’s activities might influence stakeholder decisions about the company and erode or create business value over time. Under double materiality, a company also looks outward to examine how its operations and decisions affect the outside world. In other words, double materiality poses two overarching questions:

• How significantly do sustainability-related issues affect the company’s ability to perform and grow enterprise value?
• How significantly do the company’s business model and activities affect others?

Whether a company elects to consider issues from a single- or double-materiality perspective is driven by its broader strategy and objectives as well as the sustainability frameworks and standards to which it aligns.

Different frameworks and standards establish different rules about materiality. Some, like the Sustainability Accounting Standards Board (SASB) (now part of the International Sustainability Standards Board (ISSB)), center investors as the primary stakeholders with disclosures that focus on issues affecting a company’s ability to create value over time. Others, like the Global Reporting Initiative (GRI), consider a broader range of stakeholders and focus on issues that contribute to overall sustainable development, and these call for a double-materiality approach.

Expectations about how companies should approach materiality also vary across jurisdictions, and U.S. regulators have taken a different approach than those in the European Union (EU). In the United States, the Securities and Exchange Commission (SEC) takes an investor-centered approach in its recently proposed rule regarding climate-related disclosures, focusing on climate-related risks and opportunities that might affect enterprise value and ensuring information reported does not mislead investors.

On the other hand, in the EU, the European Financial Reporting Advisory Group (EFRAG) views materiality in a much broader light. While value creation is important within EFRAG’s proposed sustainability reporting standards, EFRAG takes the position that double materiality is the “pivotal principle” for an organization’s assessment and that organizations must consider and disclose external impacts just as they do internal impacts.

For companies that want to assess materiality, the first step is to assemble a cross-functional team to own the materiality assessment process (the process owners). This team will identify the relevant frameworks for consideration and also engage, at some level, with the company’s key stakeholders: investors, employees, customers, competitors, regulators, and others as applicable.

Once identified, stakeholders are surveyed for their views on what ESG issues and risks are material to the business. In addition to direct feedback from stakeholders, other existing resources, such as internal documentation and industry research papers, might help to create a complete picture of the company’s ESG exposures. Process owners should look at a comprehensive universe of topics to identify what is relevant to the industry and the company’s operations. For example, supply chain risk might be highly relevant for a manufacturing company, but less so for a professional services firm.

To complete the materiality assessment, results from stakeholder engagement are compiled, ranked, and visualized. A scatter plot can be helpful in pinpointing the most important topics for the organization, with variations that can focus on single- or double-materiality perspectives. For example, in a double-materiality scenario, the X-axis might represent the significance of a company’s ESG impacts (on others), with the Y-axis representing the degree of influence on stakeholder assessment and decisions (about the company). In general, topics that fall in the upper right section of the scatter plot would be the most significant.

After carefully evaluating results, company leaders can then deliberate on strategy and next steps. Throughout the process, process owners should carefully document the materiality assessment approach and the resulting decisions to enable auditability.

For a company starting from ground zero, a third-party facilitator can support the materiality assessment process by helping to identify stakeholders, determine relevant topics, and provide a menu of options for stakeholder engagement. A third party can also help interpret results and prioritize issues to determine how and when to take action. In the universe of hundreds of ESG topics, only a small subset might be relevant to any given company. Even among those that are relevant, companies might need to prioritize their approach according to available resources.

Because the materiality assessment process is inherently subjective, it can be susceptible to bias from leadership and management, who are close to the business. Bias can be reflected in the way stakeholders are selected or omitted, how relevant topics are identified, and how questions are asked of stakeholders. A third party can educate the management team, board, and other stakeholders on these aspects to help establish a common language – all of which can reduce the likelihood of skewed results.

Over the past years, ESG materiality assessments have emerged as a best practice for companies that want to better manage nonfinancial risks and opportunities. From creating a shared language to helping organizations focus on the issues that matter, a materiality assessment provides the foundation for analyzing risk and opportunities and shaping a company’s sustainability strategy.