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Looking to wrap your head around Double Materiality Assessments? In this blog, we’ll walk you through the following key topics:
- Introduction and CSRD background
- Double materiality explained: impact and financial materiality
- How to conduct a double materiality assessment (DMA) in 4 Steps
- Leveraging SAP Profitability and Performance Management to automate your DMA and ESRS reporting
Introduction
The European Union’s Corporate Sustainability Reporting Directive (CSRD) fundamentally shifted the business landscape. It sends a decisive message: integrating sustainability into core business strategies is no longer optional, but essential. Currently, the CSRD applies to large, listed companies with over 500 employees, but its scope is expanding to affect 50,000 companies, extending the EU taxonomy and ESG disclosure requirements to both EU and non-EU businesses. Consequently, businesses are urgently seeking to grasp a vital aspect of this directive: the double materiality assessment (DMA). In this article, we will explore the double materiality assessment (DMA), a crucial process fundamental to fulfilling the CSRD reporting requirements.
Corporate Sustainability Reporting Directive (CSRD) Background
The CSRD was approved by the EU Council in 2022, and it is an important component of the European Green Deal. It mandates companies report on the environmental, social, and governance performance of their activities across the entire value chain. While the CSRD sets the overall framework for sustainability reporting, the European Sustainability Reporting Standards (ESRS) provides detailed standards to ensure compliance. Together, they create a comprehensive system for sustainability reporting. The CSRD is a key component of the EU’s Sustainable Finance Action Plan (SFAP), supporting the objectives of the European Green Deal and the transition to climate neutrality by 2050. It replaces the Non-Financial Reporting Directive (NFRD), significantly expanding the scope and requiring more comprehensive sustainability reporting from a broader range of companies. For more detailed information, you may refer to the previous blog titled "Manoeuvring Through the Complexity of EU Sustainable Finance: Corporate Sustainability Reporting Di....
Double Materiality Explained: Impact and Financial Materiality
The CSRD introduces the crucial concept of double materiality, establishing it as a fundamental principle for sustainability reporting through its mandate and the accompanying ESRS. The goal of the double materiality assessment is to identify the material impacts, risks, and opportunities (IROs) related to sustainability matters to be reported (ESRS 2 SBM 3). Through this process, companies can determine which ESG topics they must cover in their sustainability reporting as well as the specific disclosure requirements of the ESRS that apply to them. This approach not only considers the financial impacts of climate risks on the company, but also how the company's operations impact the climate and other dimensions of sustainability. Here’s how the ESRS describe it:
“Impact materiality and financial materiality assessments are inter-related and the interdependencies between the two dimensions shall be considered. In general, the starting point is the assessment of impacts. A sustainability impact may be financially material from inception or become financially material when it translates or is likely to translate into financial effects in the short-, medium-, or long-term. Irrespective of them being financially material, impacts are captured by the impact materiality perspective” - ESRS 1 General principles, p. 11
According to the ESRS, double materiality involves a dual perspective: (1) examining how a company's activities affect the environment and society ('inside-out' or impact materiality) and (2) assessing how sustainability issues influence the company's development, performance, and position ('outside-in' or financial materiality). See Figure 1: What is double materiality?
How to Conduct a Double Materiality Assessment (DMA) in 4 Steps
In late May 2024, the European Financial Reporting Advisory Group (EFRAG) published the finalization of the first three ESRS Implementation Guidance documents. The publication was open for public feedback, and it addresses the most challenging aspects of the ESRS implementation. One of them focusses on the DMA process (EFRAG IG 1: Materiality Assessment). The ESRS requirements are principles-based, requiring unique solutions for all undertakings. This EFRAG IG 1: Materiality Assessment Guidance offers tools to comply with ESRS, considering their unique circumstances like business model, strategy, legal structure, complexity, and governance. However, the guidance provides a general framework for completing a DMA; it does not provide a strict approach. In this section, we have simplified the double materiality assessment flowchart into a 4-step guide to conduct a Double Materiality Assessment according to the ESRS requirements. We also include a description of the specific DMA approach taken in the SAP Profitability and Performance Managment (PaPM) Sample Content ESRS Disclosures Management (SXQ). This content was designed to streamline, manage, and automate the ESRS reporting process, ensuring accurate and efficient sustainability disclosures.
Step 1: Understanding the Context and Identifying Stakeholders
“The list in ESRS paragraph AR 16 is a good starting point for the identification of sustainability matters, but it should not be used as a checklist substituting a materiality assessment. It is an inventory of the sustainability matters covered in the sector agnostic topical ESRS. Sector-specific and entity-specific sustainability matters (see ESRS 1 paragraph 11) should also be considered on top of this list.” - EFRAG IG 1: Materiality Assessment, p. 42, Paragraph 175.
In this initial step, the company reviews its business context and engages with relevant stakeholders, building on previous materiality assessments, if available. The goal is to develop an overview of its activities, business relationships, and key affected stakeholders, which will help identify significant IROs.
According to the “EFRAG IG 1: Materiality Assessment Implementation Guidance”, the company shall take into account the list of matters in ESRS 1 paragraph AR 16 (see Figure 6: ESRS 1 paragraph AR 16 Sustainability matters to be included in the materiality assessment). If applicable, the company should complement this list by matters identified on an entity specific basis. Additionally, the company should examine its business plan, strategy, financial statements, and other investor information, as well as analyze activities, products, services, and geographical locations, and map its business relationships throughout the value chain.
Additional Contextual Information and Stakeholder Understanding
Before identifying IROs, it’s important to consider other contextual factors as well. These can include the legal and regulatory landscape and various published materials, including media reports, peer analyses, and sector-specific benchmarks. Understanding which stakeholders are affected by the company's operations and value chain is crucial. This involves analyzing existing stakeholder engagement initiatives and mapping affected stakeholders across the company’s activities and business relationships. Additionally, stakeholder views and interests are gathered to identify key stakeholders and prioritize them for specific ESG topics, with adjustments made as needed after further assessment.
Step 2: Identification of Impacts, Risks, and Opportunities
The second step is to identify a long list of actual and potential sector-agnostic, sector-specific, and entity-specific IROs. These include:
- Impacts that the company could have on the environment and society, including damage to nature or violations of human rights, among others.
- Risks and opportunities that could affect the company's economic performance, including reputational risks or the violation of environmental regulations.
Points 1 and 2 refer to impact and financial materiality matters, respectively. Both actual and potential IROs should be considered. Actual IROs are defined as those that have already happened or are ongoing in the reporting period, whereas potential IROs refer to those that are likely to occur in the short-, medium- or long-term future. Please see a more detailed explanation of the assessment of the financial and impact materiality dimensions as follows.
Step 3a: Impact Materiality
In step 3a, the company collects feedback and ratings from stakeholders through questionnaires and surveys to evaluate the identified list of actual and potential impacts. The stakeholders provide scores for positive and negative impacts according to their scale and scope. In addition, negative impacts must be assessed according to their remediability. These three dimensions combined provide a score for the severity of the impact, which determines the materiality of actual impacts. For potential impacts, stakeholders also provide a score for the likelihood, and the combination of the severity and likelihood scores then determines the materiality of potential impacts.
The company may decide to let a stakeholder group only rate certain ESRS topics, such as environmental topics. Additionally, the company may allocate a higher or lower relevance of a stakeholder group to an ESRS topic. This way, each stakeholder group is assigned a level of importance in relation to how affected or how knowledgeable they are about a given topic.
The stakeholder feedback is then aggregated and compared to a matrix of thresholds to determine the materiality of a potential impact (see Figure 3 for the threshold matrix for impact materiality). The horizontal axis represents the likelihood score, and the vertical axis represents the severity score.
When comparing the impact scores to the matrix, four possible scenarios may arise:
- Impacts in the red area of the matrix are considered material. These impacts are mapped to ESRS entity-specific indicators and are included in the sustainability statement.
- Impacts in the yellow area of the matrix are considered non-material and will be excluded from any further assessment.
- Impacts in the orange area of the matrix are considered uncertain and will be further assessed.
- Impacts in the yellow or red area that have a high coefficient of variation amongst responses (greater than a threshold specified by the company) are considered uncertain and will be re-evaluated. A high coefficient of variation means that the scores between stakeholders vary significantly, and stakeholders have diverse views on a given impact. In that case, the impact will be further analyzed to decide on its materiality, regardless of whether the impact had been deemed material or non-material based on the weighted averages of the stakeholder scores.
For the above scenarios two and three, i.e., uncertain impacts, EFRAG requires the company to apply objective criteria, using appropriate quantitative and/or qualitative thresholds to assess the materiality. In the PaPM Sample Content ESRS Disclosures Management, we included the possibility to conduct a quantitative analysis on uncertain impacts.
To conduct this additional assessment, these uncertain impacts are mapped to ESRS indicators and respective thresholds. Thresholds are established based on industry averages, legislative requirements, credible scientific reports, and other sources. After that, thresholds are compared to the historical values of the indicators from the previous year to identify whether an impact should be considered material or not. If one of the KPIs related to a certain impact is material, then the impact is also considered material. If all KPIs are non-material, then the impact is considered non-material.
Step 3b: Financial Materiality
In step 3b, the company, in particular the accounting and finance departments, shall provide ratings for all the risks and opportunities according to how much they will affect the organization’s performance, including financial, operational, and reputational aspects. The company gives a score for the magnitude of a financial risk or opportunity to define its financial materiality. For a potential financial risk or opportunity, the company also provides a score for the likelihood, and the combination of the two scores (magnitude and likelihood) determines its materiality.
When determining financial materiality, another important consideration is the factors that trigger the probability of risks and opportunities. The company first identifies these factors and maps them to the corresponding risk or opportunity. Next, the company assigns a likelihood score for each factor. Finally, a weighted average of these scores is calculated to determine the overall likelihood of the risk or opportunity. As an example, energy consumption from air conditioning in office spaces tends to rise due to more frequent and intensified heat waves. The probability of this risk increases significantly if a company operates in a country without sustainable cooling strategies. This can lead to a rapid and uncontrolled surge in the use of inefficient cooling systems, further increasing energy consumption.
Additionally, to evaluate the magnitude of a financial risk or opportunity, the company has to specify the amount of the financial loss or benefit associated with the risk or opportunity as a percentage of its revenues or another financial parameter, such as net profits or EBITA, if preferred. These historical data points are then compared to a threshold to derive the magnitude score. Note that the adopted financial parameter, such as revenues, net profits, or EBITA, is subject to the discretion of the company. The procedure can be summarized as follows:
- Collect benefit/loss data from the past three years attributable to the risk or opportunity. The data can be gleaned from risk management teams that conduct in-depth analyses as well as from accounting and finance departments.
- Compare the benefit/loss to a selected financial parameter, such as company revenues, to determine the relative magnitude of the risk or opportunity.
- Aggregate this relative magnitude (ratio) using a weighted average over the years of data collection.
- Compare the weighted average to a threshold value to determine the magnitude score on a scale from 1-5.
The combination of the two scores (magnitude and likelihood) determines the materiality of the risk or opportunity (see Figure 4 for the threshold matrix for financial materiality). The horizontal axis represents the likelihood score and the vertical axis the magnitude score.
When comparing the risk and opportunity scores with the matrix, two scenarios may arise:
Impacts in the red area of the matrix are considered material. These impacts have been mapped to ESRS entity-specific indicators and have been included in the sustainability statement.
Impacts in the yellow area of the matrix are considered non-material and will be excluded from any further assessment.
Step 4: Reporting of Material Impacts, Risks, and Opportunities Related to ESRS Indicators
In this step, the results from previous analyses based on impact and financial materiality outcomes (Steps 3a and 3b) are consolidated to generate a list of material IROs, which serves as the foundation for preparing the sustainability statement. Once the individual IROs have been assessed using appropriate thresholds and methodologies, they can be aggregated for reporting purposes (refer to ESRS 1, paragraph 56). Those responsible for this task should also validate the aggregated double materiality results with management to ensure the completeness of the list of material IROs.
Finally, the reporting in line with the ESRS consists of two parts:
- The process of identifying and assessing material IROs.
- The outcome of the double materiality assessment.
For part 2, the company must report on:
- Material IROs and their interaction with the company's strategy and business model.
- Sustainability statement in line with ESRS Disclosure requirements (including the ESRS entity-specific indicators associated to material IROs).
SAP Profitability and Performance Management (PaPM) Cloud: ESRS Disclosures Management (SXQ)
The European Securities and Markets Authority (ESMA) calls on companies to set up data systems to meet the new CSRD sustainability reporting requirements:
“ESMA acknowledges that meeting the data availability and quality demands stemming from the ESRS requirements may be challenging upon first-time application of the ESRS. These demands will require the development or strengthening of their sustainability data collection and control infrastructure.”
As the CSRD establishes new standards for corporate sustainability reporting, companies need to proactively adapt to meet these requirements. By leveraging SAP PaPM Cloud’s innovative solutions, businesses can effectively manage the complexities of CSRD compliance while improving their environmental sustainability. The new CSRD obligations are expected to impact around 50,000 companies within the EU. SAP is committed to helping our customers navigate the intricate requirements outlined in the ESRS drafts. Key components of the CSRD and ESRS include double materiality, prospective information, value chain details, and sustainability due diligence. Discover how SAP PaPM can streamline your CSRD compliance journey. Stay tuned for more updates!
References
EFRAG
ESRS 1: General principles
EFRAG IG 1: Materiality Assessment
European Green Deal
ESMA puts forward measures to support corporate sustainability reporting
Sustainable Finance
Overview Sustainable Finance
Platform on Sustainable Finance
Corporate sustainability reporting
Corporate Sustainability Reporting Directive (CSRD) - 2022/2464/EU
Non-Financial Reporting Directive (NFRD) - 2014/95/EU
Questions and answers on the adoption of the ESRS
Acronyms and Abbreviations
The acronyms in this document are used as follows:
CSRD – Corporate Sustainability Reporting Directive Delegated Act – Commission Delegated Regulation Supplementing Directive 2013/34/EU as regards sustainability reporting standards
DMA – Double Materiality Assessment
DR – Disclosure Requirement
EFRAG – European Financial Reporting Advisory Group
ESMA – European Securities and Markets Authority
ESRS – European Sustainability Reporting Standards
GHG – Greenhouse Gases
IROs – Impacts, Risks, and Opportunities
NFRD – Non-Financial Reporting Directive
PaPM – SAP Profitability and Performance Management
SFAP - Sustainable Finance Action Plan
Appendix
A special thanks to Benedikt Adler, Julia Schepp, and Storie Nivers for their contributions and support.
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