Nathan Griffiths: Will double materiality be a game changer?

Nathan Griffiths: Will double materiality be a game changer?

Wet- en regelgeving ESG
Nathan Griffiths (foto archief EY) 980x600.jpg

By Nathan Griffiths, Sustainable Finance, EY Netherlands

In 2024 the CSRD came into force: large corporations based or operating in the EU are required to make sustainability disclosures in a more standardized format, aligning to the European Sustainability Reporting Standards. One requirement which may prove to be particularly relevant for investment funds is how companies determine what they will report.

Crucially, the CSRD (Corporate Sustainability Reporting Directive) requires companies to report on the sustainability impacts, risks and opportunities which are material to them both financially (‘outside-in’) and in terms of the impact the company has on people and the environment (‘inside out’), through the double materiality assessment.

Why is materiality important?

For many the jury is still out on whether incorporating sustainability considerations – or ESG – has a positive impact on their operational and investment performance. A valid criticism from both within and without the sustainability industry is that it has evolved into a box-ticking exercise. The ESG rating of a company may have very little relationship to its actual sustainability as many people will understand the term. Undoubtedly, the providers of ESG ratings have come a long way over the past decade with weightings adjusted to better capture sectoral dynamics and important topics. Nevertheless, it remains the case that a final ESG score may be built on more than 300 variables and 1000+ data points.

In reality, it is likely that no more than 10 sustainability factors can be considered material for any particular company. Assuming that companies get their double materiality assessments right, at both a sectoral and company level the introduction of this process can potentially lead to the identification of what is actually relevant and important. By extension, this should provide companies with greater focus in their sustainability strategies. Conversely, companies not considering factors that their peers find to be important will also be exposed.

The process

The importance of the process is reflected in the seriousness with which many companies are treating the double materiality assessment, and the efforts being taken to design and execute the process to deliver the most meaningful results. There are no specific requirements as to how the assessment should be performed. However, it should take into account wider stakeholders, beyond financial investors. This, in truth, should be fundamental to the concept of sustainability, and particularly a company’s impact on the outside world. Importantly, the double materiality assessment will be subject to external audit.

It will take time for all companies to identify the most effective process for undertaking the assessment. The requirement to score both the potential scope of a topic and the probability of a negative or positive outcome will lead to subjectivity in the early years. Over time, the process will no doubt be enhanced and improved by the application of artificial intelligence, to both identify and quantify the size of the impacts, risks, and opportunities. Ultimately however, the outcome can only be positive for investors looking to more clearly define which companies should be considered more sustainable.

The evidence so far

Companies with higher ESG ratings, the so called ESG Leaders, do seemingly exhibit long run outperformance. However, many rightly argue that ESG scores do not reflect real world sustainability. It is also questioned whether this outperformance is the result of ESG integration or because of other factors. Academic studies on the topic have proved inconclusive.

More recently, MSCI research released in March 2024 sought to adjust for other potential explanatory variables, such as sector and country biases, size, and style factors. After analyzing stock market returns in developed market equities over a period of 17 years, to 31 December 2023, MSCI concluded that the outperformance of the top quintile ESG companies was indeed in part a result of their management of financial ESG risks – the outside-in impact. This manifested through superior earnings growth, rewarded through stronger share price performance, rather than multiple expansion. Intuitively, this would be expected as a reflection of better management of risk and cost.

... and the potential outcome

With increased focus and attention applied to determining, measuring, and reporting, the materiality of a company’s positive and negative impacts (inside-out), the noise and subjectivity around sustainability should be reduced. Stakeholder attention will also be more focused on the factors that matter within each sector or a particular organization. By isolating those material factors, we should ultimately be able to better assess whether such impacts are a significant driver of operational performance and financial returns. In turn, that should lead to sustainability or ESG labelled funds being better constructed, with less subjectivity involved in company analysis and portfolio construction.