Implementation guidance on materiality assessment from EFRAG

EFRAG reviewed the initial draft of the Implementation guidance for the materiality assessment on August 23. This document outlines practical information and FAQ on the materiality assessment. After the initial review, this document will be released for a public commenting period of four weeks, following which the final document will be released after approval.

EFRAG drafted the European Sustainability Reporting Standards (ESRS) which was adopted by the European Commission as a delegated regulation on July 31, 2023. The organization works closely with EU regulators on the technical requirements for sustainability reporting under the Corporate Sustainability Reporting Directive (CSRD). As outlined in the adopted delegated regulation, a “materiality assessment” is a required activity for organizations to determine the scope of “sustainability matters” that should be reported under the CSRD. It is therefore, a crucial starting point of sustainability initiatives.

The draft Implementation guidance for the materiality assessment builds on previous work by Global Reporting Initiative who helped construct the concept of “double materiality” for sustainability and develop the stakeholder process for materiality assessment. Indeed it is mentioned in the implementation guidance that “(a)n assessment performed under GRI constitutes a good basis for the assessment of impacts under ESRS.” To reinforce interoperability with the ISSB standards, it is also mentioned that “(r)eflecting the equivalence of the scope of financial materiality in ISSB standards and ESRS, an undertaking that applies ESRS is expected to be able to comply with the identification of the risks and opportunities to be disclosed under IFRS.”

Several key concepts cross-referenced between the regulation and the standards included as annexes to the regulation are important for understanding:

• The materiality assessment is “the process to identify all material impacts, risks and opportunities across environmental, social and governance topics” and “the starting point to determine the material information to be disclosed in the sustainability statement on these material impacts, risks and opportunities”.
• Sustainability matters are “(e)nvironmental, social and human rights, and governance factors, including sustainability factors” defined in the EU regulations. They “can be material from an impact perspective or from a financial perspective or from both”. These matters are defined in the CSRD at the topic level, and also at the sub-topic and sub-sub-topic level.
• Impacts, risks and opportunities (IROs) refers to the scope of activities that should be covered in the sustainability statement. The term ‘impacts’ “refers to positive and negative sustainability-related impacts that are connected with the undertaking’s business, as identified through an impact materiality assessment”, and “the term ‘risks and opportunities’ refers to the undertaking’s sustainability-related financial risks and opportunities, including those deriving from dependencies on natural, human and social resources, as identified through a financial materiality assessment”.
• Impact materiality and financial materiality are two dimensions of materiality that composes “double materiality.” A sustainability matter can be determined to be material either “impact” or “financial” perspective, or both. It is material “from an impact perspective when it pertains to the undertaking’s material actual or potential, positive or negative impacts on people or the environment over the short-, medium- and long-term. Impacts include those connected with the undertaking’s own operations and upstream and downstream value chain, including through its products and services, as well as through its business relationships.” (ESRS 1 paragraph 43); “from a financial perspective if it triggers or could reasonably be expected to trigger material financial effects on the undertaking. This is the case when a sustainability matter generates or may generate risks or opportunities that have a material influence, or could reasonably be expected to have a material influence, on the undertaking's development, financial position, financial performance, cash flows, access to finance or cost of capital over the short-, medium- or long-term.” (ESRS 1 paragraph 49).

• Relevance is the criteria by which an organization determines whether a sustainability matter should be reported. It is based on “the significance of the information in relation to the matter it depicts” or “its decision-usefulness..for the primary users of general purpose financial information…and/or for those users whose interest is on the undertaking’s impact”.

The guidance places importance on the determination of “materiality” from a “double materiality” perspective. A particularly interesting formulation of the interaction between impact and financial materiality is illustrated by the following graphic, in which impact materiality and financial materiality are determined separately, and an area of intersection is present such that a certain sustainability matter can be considered “material” from both impact and financial perspective

Does this mean that two separate, independent materiality assessments should be conducted? The answer provided by the implementation guidance is to start with the impact materiality assessment, since the financial materiality assessment shall consider the outcome of the impact materiality assessment which may trigger risks and opportunities. An assessment of financial materiality that does not have impact materiality implications may be supplemented.

Since reporting organizations vary in scale, complexity and context, the ESRS does not dictate a particular process for materiality assessment. Rather, the guidance outlines a process derived from current best practices which includes an assessment of the context and definition of stakeholder engagement, the identification of potential sustainability matters and impacts, risks and opportunities, and the determination of the final list based on an objective, threshold-based method. Finally, the reporting of the process and output should be conducted based on the relevant ESRS standards, particularly IRO-1, SBM-3, and IRO-2.

To determine impact materiality, the implementation guidance provides further clarification of the key criteria of severity and likelihood.

• Severity of the impacts needs to be determined for positive or negative impacts, and for potential or actual impacts. For negative impacts, severity is determined based on three factors: scale, scope and irremediable character. For positive impacts, severity is based on scale and scope factors. It could be reported on a scale from “less severe” to “most severe” based on a qualitative or quantitative determination across the sub-criteria.
• Likelihood of the impacts is an additional dimension to be added to the severity dimension and assessed for potential positive or negative impacts. The likelihood can be measured “qualitatively or quantitatively…(and it) could be described using general terms (e.g., unlikely, highly likely) or mathematically using probability (e.g., 10 in 100, 10 percent) or a frequency over a given time-period (e.g., once every 10 years).”

As the implementation timeline of CSRD approaches, the scope of a materiality assessment envisioned under this regulation becomes more clear. It builds on the impact materiality framework of the GRI standards, and is in alignment with the financial materiality emphasis of the ISSB. The materiality assessment is emerging as a process that seeks to identify the most significant impacts and financial implications relevant for analysts of sustainability statements, supplementing the analysis of financial statements. This information becomes relevant for investment analysis incorporating sustainability and financial statements.

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