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On 21 April 2021, The European Commission adopted a legislative proposal for a Corporate Sustainability Reporting Directive (CSRD). One of the key provisions of the CSRD is that companies in scope would have to report in compliance with European sustainability reporting standards (ESRS) adopted by the European Commission as delegated acts, on the basis of technical advice provided by the European Financial Reporting Advisory Group (EFRAG).
EU rules on non-financial reporting currently apply to large public-interest companies with more than 500 employees. This covers approximately 11,700 large companies and groups across the EU, including:
other companies designated by national authorities as public-interest entities
The proposed [draft] Exposure Draft to ESRS with double materiality as the basis includes three categories of standards: the cross-cutting standards, the topical standards, which include environmental, social, and governance Information, and the mention of sector-specific standards which will come later.
This [draft] ESRS standards will be tailored to EU policies while building on and contributing to international standardization initiatives. The final timetable will depend on how the Parliament and Council progress in their negotiations. If they reach an agreement in the first half of 2022, then the Commission should be able to adopt the first set of reporting standards under the new legislation by the end of 2022. That would mean that companies would apply the standards for the first time to reports published in 2024, covering the financial year 2023. SMEs listed on regulated markets could use these simpler standards to meet their legal reporting obligations, while non-listed SMEs could choose to use them on a voluntary basis.
The undertaking shall report sustainability matters on the basis of the double materiality principle.
The Exposure Draft ESRS requires an undertaking must determine its material sustainability impacts, risks and opportunities. Disclosure requirements for material sustainability impacts, risks, and opportunities are standardized by sector-agnostic or sector-specific level ESRS. When relevant, these disclosure requirements are complemented by entity-specific disclosures. Impact materiality and financial materiality assessments are intertwined and the interdependencies between the two dimensions should be considered in these assessments.
Benefits of Double Materiality Reporting
Key findings in a paper led by Professor Carol Adams include:
The identification of financially materiality issues is incomplete if companies do not first assess their impacts on sustainable development
Reporting material sustainable development issues can enhance financial performance, improve stakeholder engagement and enable more robust disclosure
Focusing on the impacts of organizations on people and planet, rather than financial materiality, increases engagement with the Sustainable Development Goals
Corporates’ ESG performance is being rated and assessed based on the ESG-related risks they face such as natural disasters, climate change, regulatory penalties, or the danger of stranded assets like oil fields and coal mines. Other scores measure the impacts of the company itself on the environment, society, and governance. Scope ESG Analysis GmbH argues that if a solar-panel manufacturer, paying local staff well (and assuming good performance on other ESG issues being assessed as well), but located on a low-lying coastline vulnerable to rising sea levels. The company has a good ESG impact score, but the business is in danger, hence a poor ESG risk score is possible. Without fair comparison among different ESG rating methodologies, investors could get confused about the differences between two ESG ratings for the same entity.
ESG scores fail to capture double materiality is not exactly new to market participants. Tesla Motors Inc (TSLA) has argued the case for being overlooked for its “positive impact” on environmental contributions (opportunities in cleantech) by designing developing, manufacturing, leasing, and selling electric vehicles, and energy generation and storage systems worldwide. However, its ESG ratings suggest otherwise.
Tesla’s MSCI rating is “A” (an average score), with “product safety & quality” and “labor-management” being the “ESG Laggard” materiality issues. And an Implied Temperature Rise of 2.63°C is on track for warming that would impede global climate goals, as suggested by MSCI. The company has a Sustainalytics score of 28.5, making it medium risk and putting it in 41st place out of 82 automobile companies. It stands at position 8,237 out of 14,735 in the Sustainalytics’ global universe.’
For corporates seeking to improve their ESG ratings, referring to double materiality for the identification of its principal impacts, risks, and opportunities as required by ESRS is a great place to start.