#5 Materiality Matters

Materiality Matters

Materiality is one of those subjects in sustainability and ESG that seems simple at first but becomes rather complicated when one delves into the subject. Especially so, as we begin to explore the concept of double materiality.

Materiality (including double materiality) is mostly known as a conceptual tool for choosing what ESG topics a company should report on or consider in terms of ESG risks. The origin of the concept itself can be traced back to the concept of materiality used in accounting. As we have discussed in previous articles, there are 2 ways of viewing materiality:

• Financial materiality: those ESG issues that affect the company's ability to generate future cashflows, in other words, its enterprise value.
• Environmental and Social materiality: those ESG issues where the company's business activity generates negative sustainability impacts that affect the stakeholders. 

In order to gain a better understanding of materiality, we will look at it from a qualitative, as well as quantitative perspective and by the end of our article, we will look the currently in use tools to measure materiality.

Not all ESG issues matter equally to different companies

Let’s look at a few examples to better understand materiality by looking at a single issue in various business sectors. We will look at Scope 1 greenhouse gas emissions (GHG emissions for short), which means GHG emissions from a business’s own operations.

In industries where revenues depend on an activity that is GHG intensive, in other words, if increasing revenue in the primary business line cannot be done without increasing GHG emission as well, then for companies in that industry Scope 1 GHG emissions are financially material. For example, airlines cannot increase revenues without likely increasing Scope 1 GHG emissions at the same time. In this case, ignoring special pricing structure, extra services and assuming that more passenger kilometres equal more revenue and more emissions. Based on this, we can say that GHG emissions are a financially material issue for airlines.

Consider the case of banks for the same issue. A bank’s own operations also produce GHG emissions (on-site combustion for heating office buildings, company cars, etc.) however increases in revenues are unlikely to be related to these activities and even if they are, by expanding the number of offices or subsidiaries the bank has, we can’t say that there is a strong relationship between revenues and GHG emissions as was in the case of airlines. Therefore, we can say that Scope 1 GHG emissions are not financially material for the banks.

Can you measure materiality?

In the above examples what we explored was only a qualitative assessment in terms of materiality. In most cases, this is all that companies do and is often enough. But for both types of materiality it is worth exploring whether individual issues can be expressed in financial terms as it can help understand the risk inherent in a particular ESG topic.

Financially materiality

The GHG emissions of airlines example above can easily be measured in monetary terms because airlines in Europe are obligated to buy emission allowances for their GHG emissions as part of the European Union Emission Trading Scheme. Therefore, there is a market price for Scope 1 GHG emissions in the case of airlines (88.28 euro per tonne CO₂ equivalent at the time of writing). There is however no such market for bank’s Scope 1 emissions. Looking at other issues such as recycling, which is financially material for FMCG companies, it becomes more difficult to associate costs with recycling. The relationship between revenues and recycling rate is much more complex than it was in the case of airline revenues and Scope 1 GHG emissions. There are numerous factors such as the Extended Producer Responsibility scheme fees in different EU member states, revenues or cost savings from recovered materials, CAPEX and OPEX associated with recycling and the reverse logistics needed and many other factors. Serious modelling undertakings to monetise materials issues are generally too costly for determining materiality and are currently beyond the Scope of what is expected by standards and legislation, it is mostly relevant in the case of risk management.

Non-financial materiality

In the case of environmentally and socially material issues (non-financial for short), it is even harder to associate monetary values with these issues. There methodologies for quantifying these costs are much harder to do accurately, they are usually done via proxies, and most often companies do not associate costs with non-financially material issues. Why is it worth trying to monetise these issues anyway? The materiality of various environmental and social issues is becoming more and more dynamic as corporate transparency increases and issues can quickly become financially material. It is worth knowing the potential business downside of non-financial issues as well, as it can help secure executive level buy-in by making the business rationale explicit for taking a double materiality approach. We will explore dynamic materiality in our next article.

How to identify key sustainability issues?

So, if our assessment is mostly qualitative and many issues cannot be quantified, how do we assess materiality and rank the various issues, particularly environmental and social materiality?

There are 3 possible approaches for conducting a materiality assessment, which needs to be preceded by identifying the relevant stakeholders. Once the list of stakeholders has been identified they are typically grouped in to internal and external stakeholders and if time and resources are a constraining factor then generally internal stakeholders are both surveyed and interviewed, and external stakeholders are sent a questionnaire asking them to identify those issues they consider material. It is best practice to start dialogues with various external stakeholders and industry leaders in terms of sustainability do this. One of the industry leaders in personal products (a company ranked first in its sector in the 2020 S&P Dow Jones Sustainability Index) is known for its engagement with NGOs and other stakeholders. Additionally, there are now a few service providers who monitor social media and news feeds to help identify and keep of track material issues in a particular industry.

6 reasons why you should conduct a materiality assessment

The broader purpose of materiality is to have a complete picture of the impact of your business’ activity on the environment and society and the impact of climate change on your business.

• Big picture - Better understanding of the company’s total business performance and ESG impact
• Transformation - Materiality can inform business strategy to be more sustainable
• Buy-in - Identify issues relevant to stakeholders to improve stakeholder engagement
• Retention and recruitment - Double materiality assessment demonstrates to employees that the company is committed to sustainability
• New possibilities - Understanding double materiality can open up surprising new avenues of cooperation both in business and with stakeholders
• Preparation - The upcoming CSRD regulation will require double materiality reporting for large companies in the EU from FY2024 – better start preparing now

Want to know more? Read the rest of our article series:

• #1 What is ESG?
• #2 Where do you start with ESG reporting?
• #3 What are the challenges in ESG reporting?
• #4 Integrating ESG into your company’s value creation narrative
• #5 Materiality Matters