Doubling Down on Impact Reporting

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U.S. companies that conduct significant business in Europe are in for the strategic and compliance challenge of a lifetime. Accustomed to doing their best to provide sustainability information to investors via voluntary reporting frameworks, they must now prepare to adopt a rigorous sustainability reporting regime and wrap their collective minds around a new concept: double materiality.

The aim of the European Green Deal is to accelerate the transition to a low-carbon, sustainable economy. By taking into account the current and future needs of a broader constituency of stakeholders, governments are expanding the concept of corporate accountability. Their goal is to compel companies to think beyond conventional calculations of profitability to factor in the impact they have on the world. Companies will find it harder to ignore previously unpriced externalities and must reckon with how much value they are creating or destroying, not only for themselves but for those affected by their activities.

Understanding and measuring the impact that a company’s economic activity is having on the world is a more expansive and novel task than weighing the effects of events, both real and anticipated, on a company’s financial performance and likely prospects. It requires identifying and understanding effects that the company’s activities, value chain, and products have on the workers, communities, geographies, and ecosystems with which it interacts.

Assessing the impact of a conceptually unlimited set of potential harms or benefits that can arise from corporate activity represents a huge challenge for corporate management, especially when the disclosure of such impacts is regulated.

The Green Tip of the Spear: The EU and the Green Deal

The European Green Deal sets ambitious economywide sustainability targets, such as reducing greenhouse gas emissions by 55% by 2030 and achieving net-zero emissions by 2050. The EU’s policy toolkit is extensive: It covers emissions trading schemes, a carbon border adjustment mechanism, a taxonomy of sustainable economic activities, corporate sustainability due-diligence requirements, and expanded fiduciary duties, alongside other initiatives. These efforts are intended to have extraterritorial effects; in developing the Green Deal, the European Commission assessed that around 80% of the negative impacts of EU economic activity may sit outside its borders.

The Corporate Sustainability Reporting Directive (CSRD) is part of the Green Deal package of reforms. Any U.S.-based company with more than a minimal footprint in the EU is likely to find itself subject to its disclosure requirements. For example, an EU-incorporated company (regardless of the jurisdiction of its ultimate parent) that exceeds certain very modest revenue, turnover, or employee thresholds will need to comply. While the EU has had a sustainability reporting requirement for around a decade under the Non-Financial Reporting Directive, the CSRD is intended to apply to five times as many companies. It will expose sustainability reporting to the same rigor as financial reporting and incorporate the requirement to report on impact materiality alongside financial materiality, making for double materiality.

U.S. public companies are deeply familiar with the concept of financial materiality through their filings with the U.S. Securities and Exchange Commission (SEC). For decades, companies have used SEC Staff Accounting Bulletin No. 99 and the SEC’s detailed guidance on what to include in the required management discussion and analysis section of their financial reports to help them navigate their materiality determinations. However, those guidelines are focused on the financial performance and prospects of the company from the perspective of the “reasonable investor.” Assessing impact materiality (though related) is a conceptually and qualitatively different process.

The Interplay Between Impact and Financial Materiality

Though distinct, impact and financial materiality often bleed into each other. A negative social or environmental impact can, over time, become financially material (some more quickly than others). For example, a polluted waterway might harm a community for years before public pressure and increased awareness cause the polluter to be subject to fines and reputational damage (negative financial impact). Materiality is also a dynamic construct, a process of becoming, that responds to a variety of mechanisms, including advances in scientific knowledge and civic advocacy. In this evolving context, companies might have to recognize harms that they have previously disregarded.

However, business has become accustomed to enjoying the latitude to leave externalities unpriced; for example, the cost of the skyrocketing obesity epidemic in the United States leaves no mark on the profits of processed food manufacturers. Many social and environmental harms have taken a very long time to reach the level where they might be considered financially material. The double materiality construct spans this interaction effect — and its mismatched time horizon: It asks for the identification of those environmental and social impacts before the point where they have risen to the threshold of being financially material to the company itself.

Assessing impact materiality is not nearly as straightforward as determining traditional financial materiality. Types of impacts and the contexts in which they occur vary widely. In addition to the impacts themselves being differentiated, they might not easily translate to a financial value.

A polluted river is unlike an injured employee. Fines associated with local water pollution might differ from financial penalties associated with health and safety incidents, but both exact a monetary penalty. Impact materiality as defined under CSRD doesn’t have that common factor; impacts are diverse and aren’t assessed in uniform ways. However, there are specific criteria prescribed by the European Sustainability Reporting Standards (ESRS) that provide at least some parameters for the impact component of the assessment.

Companies are asked to determine impact materiality based on the scale (how serious it is), scope (how extensive it is), and remediability (how easy it is to fix). A company might assess the impact of health and safety incidents across its manufacturing facilities and deem it material because the organization had several severe injuries in the past year. Yet the same company might assess the effect of local water pollution on biodiversity and ecosystems and deem it immaterial because the scale of the pollution was limited to a small area and remediation was straightforward. A different company might determine that the reverse is true for it, if its safety incidents were limited to paper cuts and the river it polluted was connected to the Amazon basin and harmed the health and livelihoods of local Indigenous groups.

Context matters when assessing impact materiality. Companies have access to benchmarks to help them assess their context against criteria relevant to a specific impact, such as the carrying capacity of a specific watershed regarding water extraction. Nonetheless, the outcomes of an impact materiality assessment between otherwise similar companies might differ as a result of the application of those thresholds of scale, scope, and remediability being applied to the specific context of each company.

Before starting out on such an assessment, companies need to first understand and align on their value chain parameters (their upstream, operational, and downstream activities) and how their unique business context interacts with each of the topics identified across the ESRSs. Identifying potential and actual impacts, risks, and opportunities and then scoring them across the required criteria often requires engaging with stakeholders, including stakeholders that might struggle to speak for themselves. The ESRS (and associated EU guidance) reminds us that nature is a silent stakeholder (though nature has not necessarily been that silent recently). The complexity, nuance, and subjectivity associated with this approach, therefore, will likely mean that we will see varied results from companies, even those within similar industries, at least in their first year of reporting.

Since this process will also need to be audited, it will be even more important to document it, explaining not just what the company identified but how it identified those topics, whom it consulted, and how that process was fit for purpose.

Leverage Existing Processes

Companies with experience reporting against voluntary ESG frameworks might have a head start on assessing double materiality. Those that have used Global Reporting Initiative standards will already have a process in place for consulting stakeholders about a range of impacts. Sustainability Accounting Standards Board reporters will already have identified the core set of ESG topics that are financially material to their sector. Companies with robust institutional investor engagement programs have a strong sense of those issues regarded as material by different segments of their investor base, helping to inform their own deliberations around materiality.

Previous experience with increasing visibility into the supply chain can be a helpful starting point for the double materiality assessment. Companies can use existing processes, governance, and knowledge of how to collect accurate information from, and on, value chain partners to help them move toward a compliant approach for the CSRD, though with significant adaptations.

Pollyanna and Pangloss have tended to be the lead authors on many voluntary corporate sustainability reports. As a result, the EU’s required double materiality assessment might disclose, potentially for the first time, a huge, complex, and reputationally problematic set of environmental and social harms.

The EU’s standards will then require disclosure of the extent to which the company has policies, action plans, and strategies to address those harms. Many companies will have little to say on strategy regarding these themes. The EU’s intent is for that to change. Future EU policy, in the form of a directive on corporate sustainability due diligence, will extend this effort beyond the mere identification of negative impacts from business activities and impose duties to avoid and remedy those negative effects.

Related policy instruments, such as the EU taxonomy for sustainable economic activities, are partly intended to uncover greenwashing. By causing companies to disclose the revenue, capital expenditures, and operational expenditures associated with environmentally sustainable activities as defined by the EU, companies might reveal their underlying strategies with a degree of uncomfortable specificity. Given this, it’s imperative that material ESG themes form a central part in overall corporate strategy rather than residing in an impoverished silo that will be the first initiative cut in difficult times.

Double materiality presents both a compliance hurdle and a strategic opportunity. Going through a systematic process to understand the significant impacts that a company has on the planet and society across its value chain — from biodiversity to human rights — will create an opportunity for organizations to consider where potential business risks might lie in wait. But it also can help them determine where there might be opportunities to differentiate themselves in pursuit of long-term value creation. Taking this beyond a compliance exercise will give organizations new leverage to expand the scope of issues addressed by strategy.