What is dual materiality? - ESG

Key information:

• The dual materiality principle sets out the disclosure requirements for non-financial Sustainability reporting.
• Corporate Sustainability reporting based on dual materiality can reveal ESG risks and opportunities.
• ESG reporting in accordance with the CSRD directive and the ESRS reporting standard will be mandatory for most companies in the future, but it can be used to bring European standards to the company.
• Dual relevance includes Sustainability issues, but also their impact on corporate finances

Details below!

According to the CSRD, from 2024 large companies currently under the NFRD and from 2025 other large companies (meeting the criteria in 2013/34/EU) will have to report on Sustainability issues. Such a report will have to meet the requirements of the ESRS reporting standard and will be subject to mandatory auditing. It is also worth noting that with the broader implementation of the CSRD, virtually all companies will be involved in the Sustainability reporting process, this is due to the requirements placed on the larger players, who will also have to consider the supply chain, including, among other things, the impact on the community and the environment. In addition, the GRI 2021 standards cite dual materiality as an important element. ESRS reporting standards identify the principle of dual materiality as the main motivator for selecting topics in the report, and it is this rule that determines disclosure requirements.

What is dual materiality?

Double materiality is the rule in reporting ESG of the company and is the basis for the company's Sustainability disclosure. The double materiality rule is designed to ensure that reported information is important from an ESG (Environmental, Social, Governance) perspective. It allows assessment of the environmental and social impact of operations, but also the impact of ESG factors on financial performance. A topic is considered to be of dual relevance if it is significant from the perspective of one or both of the following of the following:

1. Materiality of the impact on the environment - More specifically, what effect a company has or will have on its surroundings, people or the environment. This includes not only the operational activities of a given company, but also the supply chain, among others. Both negative and positive impacts are taken into account.
2. Financial materiality - in which the financial impact of factors ESG on the company. Cash flow, financial performance, ability to raise financing and cost of capital can fluctuate depending on the length of the period, such as short, medium or long.

The importance of dual materiality in ESG management

Non-financial ESG reporting makes it possible to introduce the European Sustainability standard into a company. This makes it possible to improve stakeholder relations and minimize the impact of Sustainability issues on operations and financial performance. Assessing materiality allows for a more thorough analysis in making decisions related to Sustainability. For the sake of example, let's assume a situation in which a certain company abandons its investment in a mining interest. From the perspective of materiality of impact on the environment, this decision is considered pro-environmental. However, from the perspective of financial materiality, such a move may be suboptimal. In such a situation, the process of assessing dual materiality may prove crucial.

How to implement double relevance analysis?

The European Reporting Advisory Group (EFRAG) in August 2023 released preliminary "conceptual guidance on dual materiality" (European Sustainability Reporting Guidelines) abbreviated as ESRG. The aforementioned document outlines how the process of double materiality analysis should look like.

Analysis of the materiality of the impact on the environment

1. identify the Sustainability parameter to be assessed

You should select the parameter whose relevance you want to analyze. If in doubt about the selection of a parameter, it is advisable to consult an expert and carry out the following analysis.

2. evaluation of the sustainability parameter

2.1 Determine the scale of the impact on the environment

2.2 Determination of the extent of the impact on the environment

2.3 Identify opportunities to repair the impact on the environment

3. preliminary significance of the influence of the analyzed parameter

Using the results from the previous step, we calculate a preliminary impact materiality index, adding together all the selected options.

Impact materiality index = Scale of impact + Scope of impact + Opportunity to repair impact

Then the result obtained is compared with the values in the following table

4. assessment of the significance of the parameter

Taking into account the results of the 2nd and 3rd steps, we forecast what direction the analyzed impact may take. Also, it is worth considering what is the probability of the impact in different time periods.

Financial materiality analysis

The authors of the EFRA Guide (ESRG) propose that the term "Sustainability theme" include both the main themes and their sub-themes, as well as more specific issues. The process of identifying financially relevant topics is based on an objective evaluation mechanism that ensures comparability. It is recommended that the same approach be used for each parameter related to Sustainability. Financial materiality should be understood as the impact of these issues on a company's financial performance.

1 Identify the financial parameter being evaluated against the ESG parameter

According to ESRG 1, it is necessary to determine exactly against which Sustainability issue we will assess financial materiality. It is also worth deciding at what level of detail we will evaluate. The more precisely we define the area in which we will move, the more precise the analysis will be. Typically, the assessment conducted should revolve around "sub-topics" and "sub-sub-topics" to increase accuracy.

2. identification of financial effects

In this step, the focus should be on finding the impact of the Sustainability theme on the value of the company. There can be both financially negative and positive consequences, the important thing is that these effects are not included in classic financial reports.

2.1 Continued use of employees

This stage analyzes the company's ability to continue using resources that are crucial to the business process. For this purpose, we use the following aspects:

• prices and margins - How resource costs affect a company's financial condition,
• resource market and availability - How the market situation and availability of resources affect the company's operational continuity,
• degradation and usefulness period of resources - What is the degradation and useful life of the resource and the possibility of maintaining or repairing it,
• regulations/restrictions - How regulations and external factors can affect a company's ability to use resources.

This stage focuses on analyzing whether the company will continue to be able to effectively use the resources fundamental to its operation. This is important in terms of financial materiality because these factors can affect the economic aspects of a company's operations, generating risks and opportunities.

2.2 Relationship dependence

In this step, it is checked whether the key relationships necessary to maintain production, are stable and can be maintained on the same basis. The following elements are taken into account:

• Financial institutions and financial capital providers,
• Contractors and supply chain,
• Customer relations including all elements that affect them (ethics, satisfaction, privacy, PR and marketing, etc.) and the related implications for the company,
• External stakeholders,
• Society/communities and their acceptability of negative externalities caused by the company.

In a nutshell, we are investigating whether the current relationship, with the aforementioned groups, can be maintained on the same terms.

3. determine the financial materiality of the Sustainable Development theme

In this step, a final assessment of relevance to the previously selected Sustainability issue is made. In order to do this effectively, it is necessary to build on the analyses from Step 2 and describe them in the table below:

If the result obtained is key, significant or important, the financial effect is treated as significant. If the result is informative or minimal, the effect can be considered financially insignificant and the analysis process can be terminated or further analyzed.

Best practices for double relevance

It is important to remember for what purpose this rule was created. Its main advantage is the simplified disclosure requirements, which are often subjective, but note that due diligence (also described in ESRS 1 and ESRS 2) continues to apply, Therefore, it is crucial to select topics that take into account dual relevance.

The new reporting standards may be problematic for many businesses in the near future. In case of doubt or uncertainty, it is recommended to contact and cooperation with experts. Thus, it is important to keep in mind the three duties of dual materiality:

1. Mandatory process - In order to define the issues that will be included in the non-financial report, a self-assessment of the company through a dual materiality analysis is necessary,
2. Mandatory disclosures - if the topic is relevant due to one or both of the materiality must be included in the report,
3. Mandatory reliability - The results of the analysis will be subject to a mandatory audit, so it is important that its quality is at a high level.

Benefits of implementing dual materiality

A beneficial aspect of the dual materiality principle is the possibility of finding new threats or opportunities for the company. It is also important to learn about the company's impact on the environment, which can result in an improved image, stakeholder and customer relations. Increased awareness of the company's processes can also result in expansion of the strategy Sales and/or marketing. Of course, don't forget that this will be a mandatory element for Sustainability reporting.

A dual relevance perspective and why it's worth your interest

At the moment, the double relevance rule is in the development stage and will probably be further refined, and the process of its analysis itself will receive appropriate tools and techniques. It is already clear that this will be an integral part of any enterprise. The directives and intentions of the regulator point to the necessity of Corporate Sustainability. In order to take full advantage of the opportunities involved, it is important to keep abreast of developments in the EU and to prepare your company adequately for ESG-related changes. Disclosure requirements and ESRS reporting standards can mislead many people, which can lead to serious consequences, especially in the context of the Sustainability Reporting Liability Directives.

It is worth taking an interest in the topic of dual materiality not only because of the obligation to use it, but also because of the potential benefits that may be associated with it.