The concept of materiality is key to companies assessing their exposure to sustainability-related risks and making a sustainability-risk disclosure. Business leaders need to get to grips with the term to understand what is being asked by regulators and standard setters, and to articulate, in relation to their own business, what should and should not be prioritised. In other words, what is and is not material to that business.
While the concept of materiality appears across all sustainability-disclosure frameworks, the use and meaning of the term differs across jurisdictions and regulatory bodies, causing fragmentation and confusion.
Single materiality requires a company to demonstrate how it is affected by external factors that influence its financial position, development and performance (1). A number of regulatory frameworks use this approach: the Securities and Exchange Commission (SEC), the Taskforce on Climate-related Financial Disclosures (TCFD) and the International Financial Reporting Standards’ (IFRS) new sustainability standards, known as ISSB.
The proposed SEC climate disclosure rule requires information about a registrant’s climate-related risks that are reasonably likely to have a material impact on its business, results of operations or financial condition. It takes a narrow definition of materiality that encompasses a risk-based view and reflects the remit of the SEC to ensure financial stability is maintained in the U.S. market. Controversy surrounded the SEC’s one per cent materiality threshold outlined in its proposed rule, but it remains to be seen whether this makes it into the final version or whether a more typical Generally Accepted Accounting Principles (GAAP) approach would apply.
TCFD guidelines state that organisations should “provide information in annual financial filings when the information is deemed material” (2) but does not provide a definition of what constitutes material, instead relying on businesses to use their own processes and thresholds for determining materiality in line with their accounting principles and investor needs.
The IFRS Sustainability Reporting Standards, commonly referred to as ISSB, have also adopted a single materiality approach, despite debating the use of double materiality as the standards were being developed. Under the IFRS Standards, information is material if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that investors and lenders on the basis of its financial statements and sustainability-related financial disclosures.
In the EU, where the European Sustainability Reporting Standards (ESRS) operationalise the requirements of the Corporate Sustainability Reporting Directive (CSRD), the framework encompasses a new term, double materiality, requiring a company to report not only on external impacts affecting its financial position but the impact the company has on environmental, social and governance (ESG) factors. Getting to grips with a double materiality assessment is proving to be a challenge for many, although the phased-in transitional requirements of the ESRS will facilitate companies grappling with the scale and scope of the challenge.
Dynamic materiality and societal materiality
The Taskforce on Nature-related Financial Disclosure (TNFD) framework acknowledges ongoing interest from stakeholders in its approach to materiality and its practical application in the context of sustainability standards and disclosure. The TNFD offers an overview of materiality definitions and use, to also include the term ‘dynamic materiality’ that emphasises material issues are in flux and change over time; and societal materiality, used by the Science Based Targets Network (SBTN), emphasising an obligation to contribute to social outcomes beyond what might be required by regulation (3).
Materiality as a business threshold
Crucially, what is material remains for a business to interpret itself, regardless of whether it applies single or double materiality. Taking a science-led and data-driven approach to disclosure reporting that quantifies risk, impacts and opportunity provides the insights required to assess what is material to an organisation’s operations, business strategy and decision making.
A full view of an organisation’s value chain enables decision makers to understand and act upon information about their commercial, physical and environmental footprint and dependencies. The information can be used in scenario analyses across short-, medium- and long-term time horizons to flag the most significant impacts and risks on the value chain and identify what is material to an organisation. Impacts can arise from both slower-moving physical risks of climate change and the transition risks that can emerge over a short time horizon, depending on the speed of societal action towards net zero.
Triage materiality to prioritise decisions
Categorising the impacts of a risk to decide if it is material creates a triage approach. Materiality can be low, medium and high, reflecting a traffic-light system that helps to prioritise decisions.
Sustainability analytics enable businesses to present risk values to investors which can be interpreted and classified according to a financial threshold. This approach requires an organisation to consider the context of thresholds over which something is impactful to the business and/or causes significant disruption to operations. It is specific to each business, reflecting its accounting practices and investor expectations.
Climate and nature are material to business
Simply put, materiality can be thought of as a threshold that is defined individually and not unilaterally. Exceeding that threshold is an indication that something is material to the organisation that has defined it. While the reporting landscape is dynamic, bringing with it new disclosure requirements for business at high velocity, climate and nature disclosure reporting is increasingly material to business.
- More information about what the global disclosure framework landscape means to business is available in the Risilience Transition Risk Series briefing papers:
- EU Corporate Sustainability Reporting Directive—What Do Companies Need to Know (harvard.edu)