McKenzie Fulkerson-Jones, ESG Analyst, dives into the rise of conversations around double materiality as a two-pronged approach to ESG investing: evaluating risk and impact.

 

September 30, 2022

 

According to the Financial Accounting Standards Board (FASB), “the omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” Put another way, information is considered to be financially material when it risks affecting a company’s financial performance and its ability to create economic value for investors and shareholders. FASB is the organization responsible for establishing accounting and financial reporting standards for companies in the United States and, with that, U.S. regulators subscribe to FASB’s specific definition of financial materiality.

 

There is a rising sentiment that this definition of financial materiality is no longer adequate. This shift began in earnest over the past two decades when some of the largest asset owners began pushing Wall Street to focus on the importance of risks not addressed by FASB—most notably climate change. These investors, largely insurance companies and pension funds, felt they owned all the “tail-risk” in the market as it related to the effects of climate change and other serious breaches in corporate governance. As the evidence of climate-related damage piled up, these large investors concluded that traditional Wall Street analysis was not doing enough to evaluate these risks.

 

These institutional investors helped fuel the growth of ESG investing, which is based on the idea that environmental, social, and governance factors – like climate change and poor corporate behavior – are financially material risks. The growth of ESG investment products helped amplify the voices of smaller investors that also believed it was time for additional types of risks to be deemed material, as long as these factors pose a financial risk to the company and/or would affect investor decision-making. Such risk factors include things like:

    • Climate change risk to operations: Risk to a company’s facilities located in areas that according to climate change models will be negatively affected by climate change;

 

    • Diversity, Equity, and Inclusion (DEI) performance risk: Poor performance in DEI has been linked to poor long-term financial performance; (1) and

 

    • Climate change emissions regulatory risk: Emissions are considered a risk because of their high likelihood to be regulated by governments, which will have major financial ramifications for companies that are not yet making efforts to reduce their emissions.

 

Now what about double materiality?

 

Double materiality is perhaps a natural evolution of ESG but with a significant twist. Double materiality is a term that originated in Europe and includes two types of materiality: financial and impact. Impact materiality goes beyond risk mitigation; it refers to the impacts that a company’s activities have on communities and the environment (formerly referred to as externalities). So financial materiality is about the inputs (both financial and ESG) that could lead to financial risk, and impact materiality is about the outputs that have an impact on society and the planet – combined, the inputs and outputs are referred to as double materiality. The very existence of this term implies that both types of materiality should matter. Indeed, many investors would like to have this type of information to inform their investment decisions.

 

Double materiality has gained traction in Europe, leading to it being codified in the EU Sustainable Disclosure and Taxonomy Regulations, and further clarified in the soon-to-be-effective EU Corporate Sustainability Reporting Directive.(2) (3) Therefore, in Europe, publicly-listed companies with more than 500 employees must disclose not only their ESG risks but also their ESG impacts.(4) Furthermore, financial firms must indicate whether or not an ESG investment uses the double materiality standard.(5)

 

So what does this mean for us here in the U.S.? Given the global nature of financial markets, consistency on this matter could only be beneficial. Global standards that reference double materiality are indeed being developed, but currently only under the auspices of the International Financial Reporting Standards Foundation, which is used in 140 countries globally, but not in the U.S. As mentioned at the outset, U.S. accounting standards are set by FASB, which is not considering adopting double materiality at this time.

 

Despite the standards not changing in the U.S. yet, double materiality has already begun to break through domestically, as evidenced by its uptake by a very big financial player. JPMorgan Chase just launched its first double materiality product. Even without U.S. standards in place, other investment firms will likely follow suit.

 

With stateside adoption just beginning, we expect that U.S.-based ESG ratings providers—such as MSCI and Sustainalytics, which have so far been focused on rating companies based on the financial materiality of ESG risks—are likely rushing to develop double materiality ratings products.

 

However, it is important to note (as we have in past pieces) that without U.S. regulation in place to mandate ESG disclosure, the accuracy and comprehensiveness of the data provided by investment firms or ESG ratings providers will be limited. SEC regulations that require disclosure of greenhouse gas emissions are coming, but that’s just one slice of ESG. Additional SEC disclosure and impact measurement requirements are needed to make double materiality data and ratings a broad reality in the U.S.

1 “Why Diversity and Inclusion Matter: Financial Performance (Appendix),” https://www.catalyst.org/research/why-diversity-and-inclusionmatter-financial-performance/

 

2 “Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088,” https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32020R0852

 

3 “Questions and Answers: Corporate Sustainability Reporting Directive proposal,” https://ec.europa.eu/commission/presscorner/detail/en/ QANDA_21_1806

 

4 “Corporate sustainability reporting,” https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/company-reporting-andauditing/company-reporting/corporate-sustainability-reporting_en

 

5 “Sustainability-related disclosure in the financial services sector,” https://finance.ec.europa.eu/sustainable-finance/disclosures/sustainabilityrelated-disclosure-financial-services-sector_en