Mastering ESRS Double Materiality: Overcoming Key Challenges
By Constanze Duke, Senior Sustainability Consultant
For the third installment in our blog series, Navigating CSRD: A Comprehensive Series to Guide Sustainability Professionals, we want to dive deeper into key technical challenges practitioners may encounter during double materiality assessments (DMAs). As a quick refresher, double materiality refers to the significant impacts companies have on people and the environment (impact materiality) along with sustainability-related risks and opportunities that are likely to affect company financials (financial materiality). According to the EU’s Corporate Sustainability Reporting Directive (CSRD), reporters must comply with the mandatory European Sustainability Reporting Standards (ESRS) prepared by the European Financial Advisory Group (EFRAG). The CSRD requires double materiality assessments because their comprehensive nature provides deeper insight for stakeholders and enables companies to make better long-term strategic decisions.
Challenge #1: Identifying impacts, risks and opportunities (IROs)
Practitioners often are concerned about the potential number of IROs a DMA could generate. The process begins with an initial list of relevant and potentially material topics that typically contains 30–50 items. Because we assess each topic for actual and potential impacts, as well as risks and opportunities across the value chain, it’s easy to envision how an IRO list could quickly grow to hundreds. Not all of them will ultimately be material, but this is nevertheless a daunting number. Our top recommendation is not to let the process overwhelm you. If you don’t have any tools to help create an initial list of topics, start with the ESRS topics and subtopics and be cognizant of industry context. For instance, manufacturers may need to focus on supply chain transparency, while financial institutions might prioritize climate-related financial risks. Understanding these dynamics can provide a valuable starting point as you begin identifying IROs.
It can also be useful to create two separate but interconnected workstreams for IRO identification, one for impacts and another for risks and opportunities. Maintaining the connection between these lists while identifying IROs is important because impacts usually lead to risks and opportunities. Separate lists make sense for the severity assessment portion of the DMA because the impact criteria (scale, scope, irremediable character) differ from the risks and opportunities criteria (likelihood, magnitude). Involve your enterprise risk management team from the get-go to maximize capacity for risk identification and facilitate quantifying the financial effects of ROs later.
Subject matter expertise is important to generate a comprehensive list of impacts. In addition to leaning on internal SMEs, as you would to identify risks and opportunities, seek out external partners, like community organizations, NGOs, academics and consultants. Without a solid understanding of social and environmental issues, including thresholds and intersectionality, the risk of overlooking impacts is high. Finally, engage stakeholders in a targeted and ongoing way to help generate, validate and refine your topic list.
Challenge #2: Setting defensible thresholds
Companies typically have financial materiality thresholds in place to cover common business risks managed through an enterprise risk management program. Therefore, setting thresholds for financially material risks and opportunities is a lesser challenge than setting thresholds for impacts. That said, quantifying financial effects tends to be fraught with uncertainty and may require the help of external subject matter experts.
For impacts, we are looking for a defensible threshold to ward off potential criticism about vague or arbitrary approaches. Our first recommendation is to develop criteria to flag impacts that are highly likely to be material. This could apply to all impacts deemed irreversible, for instance. In addition, it can be helpful to compile a list of environmental thresholds and social norms and flag any impact for which the sustainable operating criterion hasn’t been met. For example, we know that emitting greenhouse gases, withdrawing water at a higher rate than the replenishment rate, serious workplace injuries or low wages are all unsustainable. The Sustainable Development Performance Indicators (SDPI) of the United Nations Research Institute for Social Development are a good starting point to gather these thresholds.
We don’t recommend using these indicators to mark impacts as immaterial, though. For instance, just because a company has not been fined for anti-bribery violations doesn't mean anti-bribery is immaterial. Even for flagged topics, considering context and stakeholder feedback can provide another layer of confidence. Thresholds can also be found in scientific literature and through organizations or tools like the following (among others):
But what about the remaining topics? There are multiple options, but two that stand out for practical reasons are reaching consensus through stakeholder panels (expert panels if needed) and using clear criteria to anchor impact severity scales. For example, if 1 = negligible, 2 = minor, 3 = moderate, 4 = significant and 5 = critical, and all these terms are clearly defined, both 3 and 4 are justifiable materiality triggers. Better yet, combine the two approaches by applying the scale to impacts first and then presenting them to your stakeholder panel for feedback. Most importantly, document everything in a way that makes sense to the average reader of your report.
Challenge #3: Navigating time horizons
Per ESRS’s Materiality Implementation Guidance, IROs need to be evaluated in the short, medium and long term. These time horizons can be defined by companies, but short-term timelines generally align with the traditional timeline for making business decisions, while the long-term horizon should fall between 2050 and 2100. We can also think of these timelines as early-, mid- and late-century. Inevitably, the severity of IROs will vary across time horizons.
For climate-related risks, companies now widely use global reference scenarios to evaluate impacts in the medium- and long-term via scenario analysis. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services has also developed global reference scenarios for biodiversity, but these are not yet commonly used outside of a policy context. We encourage practitioners to explore and apply them, driving broader adoption.
A localized or sector-specific version of scenario analysis can be deployed to develop narratives for the future of most other risks where global reference scenarios don’t yet exist. Once IROs have been evaluated, practitioners need to decide how the results translate into materiality. Averaging the severity scores of IROs could dilute impacts that are material in the medium or long term and need to be addressed sooner rather than later.
For impacts that are likely to increase in severity over time, which includes most environmental impacts, we recommend the maximization approach, meaning that even if an impact is material only in the medium or long term, it should be deemed material. Wanting to err on the side of caution is a sound explanation for this approach, especially since actions to address long-term impacts need to be planned now. This tactic can also work for social impacts if materiality assessments are dynamic. For instance, a social impact that is only significant in the short term can be material now but might drop off the list later.
For risks and opportunities, we recommend a weighted approach, since a financial or operational risk might be severe for a short period (e.g., a worker strike) but then become irrelevant, potentially distracting resources if it is flagged as material based on short-term criteria alone.
Challenge #4: Surviving the executive validation meeting
Many of us have experienced those nerve-wrecking executive validation sessions where leadership have the opportunity to question, move or remove material topics from the list at the end of the materiality assessment process. Executive feedback continues to be important, but ESRS-aligned double materiality does not support arbitrarily removing topics, because that would compromise the data-driven process you’ve worked so hard to establish. Therefore, it’s important to collaborate and set the right expectations with leadership teams from the beginning.
For example, you may involve leaders in the risks and opportunities assessment portion if possible. Explain that the assessment is likely to reveal tensions between the IROs you’ll identify and existing business objectives. These validation conversations can be difficult depending on your industry and the maturity of the company’s sustainability program, raising questions like: Is there something about our business that is inherently unsustainable? Are we creating a lot of irremediable impacts? And if so, are there alternatives we can explore? If not, do we need to reevaluate our business model? And if that’s not an option, how will we report on those business activities? Leadership teams generally agree that it’s better to have these conversations internally early on to prepare for such questions from stakeholders.
When the assessment is complete, gather senior leaders to present findings backed by a solid, data-driven, defensible methodology that justifies every topic on the list. Finally, call out any conflicts you’ve discovered proactively to initiate those challenging conversations that will drive progress on sustainability performance. This will be most productive if leaders have received foundational sustainability training. Otherwise, you may find yourself spending the bulk of these conversations explaining sustainability terms and concepts.
In this piece, we highlighted some of the key challenges of ESRS-aligned double materiality assessments and made recommendations for overcoming them. Our experts can partner with you to:
Generate a starting list of relevant, potentially material topics and identify associated IROs
Perform IRO severity assessments and develop a defensible methodology for setting thresholds and determining materiality
Leverage ongoing, targeted stakeholder engagement to help prepare and close gaps in your assessment
Help navigate the presentation of your finalized topic list
Develop customized training sessions for officers of your company
We’re here to support you
Our goal is to help our clients publish double materiality assessments that hold up to stakeholder scrutiny and can serve as a building block for an integrated sustainability strategy that meets CSRD requirements. Reach out to us at info@isosgroup.com to learn more about our approach to double materiality assessments and how you can best prepare.