The “Summer of CSRD” series – the materiality assessment process

The EU’s Corporate Sustainability Reporting Directive will have broad impact. Approximately 50,000 undertakings are expected to have a reporting obligation. The recently finalized European Sustainability Reporting Standards specify the information required to be reported under CSRD.

As we recently posted, this summer’s ESG must-read is ESRS 1, which contains the general requirements applicable to CSRD reporting. The objective of ESRS 1 is to provide an understanding of the architecture of the ESRS, the drafting conventions and fundamental concepts used and the general requirements for preparing and presenting sustainability information in accordance with CSRD.

Understanding ESRS 1 is therefore critical to preparing for CSRD reporting. It will drive not only disclosure, but also the underlying processes and controls. As a threshold matter, understanding ESRS 1 also is important for developing the project plan for CSRD readiness.

Each post in this “Summer of CSRD” series discusses selected aspects of ESRS 1, in a bite-sized read, in more or less the order presented in ESRS 1.

In the last post, we discussed double materiality and its two dimensions: (1) impact materiality; and (2) financial materiality.

In this post, we discuss the materiality assessment process set out in ESRS 1.

A materiality assessment is the starting point for sustainability reporting under the ESRS. Performing a materiality assessment is necessary for the undertaking to identify the material impacts, risks and opportunities (IROs) to be reported.

Sustainability matters to be included in the materiality assessment

When performing its materiality assessment, the undertaking is required to consider the list contained in ESRS 1’s Application Requirements of sustainability matters covered in the topical ESRS. This list is intended as a tool to support the undertaking’s materiality assessment. The Application Requirements note that using the list is not a substitute for the process of determining material matters. The undertaking still needs to consider its own specific circumstances when determining its material sustainability matters.

Assessing impact materiality

In assessing impact materiality, the undertaking is required to consider three steps:

• Understanding of the context in relation to its impacts, including its activities, business relationships and stakeholders.
• Identification of actual and potential impacts (both negative and positive), including through engaging with stakeholders and experts. In connection with this step, the undertaking may rely on scientific and analytical research.
• Assessment of the materiality of its actual and potential impacts and determination of the material matters. In this step, the undertaking is required to adopt thresholds to determine which of the impacts will be addressed in its sustainability statement.

Impacts are captured by impact materiality irrespective of whether they are financially material.

Assessing financial materiality

The starting point for the financial materiality assessment is the identification of risks and opportunities that affect or could reasonably be expected to affect the undertaking’s financial position, financial performance, cash flows, access to finance or cost of capital over the short-, medium- or long-term. In this context, the undertaking is required to consider:

• The existence of dependencies on natural and social resources as sources of financial effects; and
• Their classification as sources of (1) risks (contributing to negative deviation in future expected cash inflows or increase in deviation in future expected cash outflows and/or negative deviation from an expected change in capital not recognized in the financial statements) or (2) opportunities (contributing to positive deviation in future expected cash inflows or decrease in deviation in future cash outflows and/or positive deviation from expected change in capital not recognized in financial statements).

The undertaking must consider how it is affected by its dependencies on the availability of natural, human and social resources at appropriate prices and quality, irrespective of its potential impacts on those resources. The Application Requirements include the following examples of how impacts and dependencies are sources of risks or opportunities:

• When the undertaking’s business model depends on a natural resource – for example water – it is likely to be affected by changes in the quality, availability and pricing of that resource.
• When the undertaking’s activities result in negative impacts, such as on local communities, the activities could become subject to stricter government regulation and/or the impact could trigger consequences of a reputational nature. These might have negative effects on the undertaking’s brand and higher recruitment costs might arise.
• When the undertaking’s business partners face material sustainability-related risks, the undertaking could be exposed to related consequences.

The undertaking is required to consider the contribution of identified risks and opportunities to financial effects in the short-, medium- and long-term based on (1) scenarios/forecasts that are deemed likely to materialize and (2) potential financial effects related to sustainability matters deriving either from situations with a below the “more likely than not” threshold or assets/liabilities not, or not yet, reflected in financial statements.

The potential financial effects to be considered include (1) potential situations that, following the occurrence of future events, may affect cash flow generation potential, (2) capital that is not recognized as an asset from an accounting and financial reporting perspective, but has a significant influence on financial performance, such as natural, intellectual (organizational), human, social and relationship capital, and (3) possible future events that may have an influence on the evolution of such capital.

Once the undertaking has identified its risks and opportunities, it is required to determine which are financially material for reporting, based on a combination of (1) the likelihood of occurrence and (2) the potential magnitude of financial effects determined on the basis of appropriate thresholds. A sustainability impact may be financially material from inception, or it may become financially material.

Other considerations 

ESRS 1 also indicates the following in connection with the materiality assessment process:

• In general, the starting point is the assessment of impacts, although there also may be material risks and opportunities that are not related to the undertaking’s impacts.
• The undertaking must apply the criteria for impact and financial materiality using appropriate quantitative and/or qualitative thresholds. Appropriate thresholds are necessary to determine which IROs are identified and addressed by the undertaking as material and to determine which sustainability matters are material for reporting purposes.
• Impact and financial materiality assessments are inter-related. The interdependencies between the two dimensions must be considered.
• In identifying and assessing the IROs in the undertaking’s value chain to determine their materiality, the undertaking must focus on areas where IROs are deemed likely to arise, based on the nature of the activities, business relationships, geographies or other factors concerned.

The relevance of stakeholders to the materiality assessment process

Stakeholders are described as those who can affect or be affected by the undertaking. ESRS 1 indicates that engagement with affected stakeholders is central to the undertaking’s sustainability materiality assessment.

There are two main groups of stakeholders:

• Affected stakeholders: these are individuals or groups whose interests are affected or could be affected – positively or negatively – by the undertaking’s activities and its direct and indirect business relationships across its value chain.
• Users of sustainability statements: these are primary users of general-purpose financial reporting (existing and potential investors, lenders and other creditors, including asset managers, credit institutions and insurance undertakings) and other users of sustainability statements, including the undertaking’s business partners, trade unions and social partners, civil society and non-governmental organizations, governments, analysts and academics.

The Application Requirements indicate that, in addition to the stakeholders listed above, common stakeholders are employees and other workers, suppliers, consumers, customers, end-users, local communities and persons in vulnerable situations, and public authorities, including regulators, supervisors and central banks.

Nature also may be considered as a silent stakeholder. Ecological data and data on the conservation of species may support the undertaking’s materiality assessment.

The Application Requirements note that an undertaking may engage with affected stakeholders or their representatives (such as employees or trade unions), along with users of sustainability reporting and other experts, to provide inputs or feedback on the undertaking’s conclusions regarding its material IROs.

Next up: mandatory and materiality-based disclosures. 

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