Double and Dynamic Materiality
- Sammy Cole
Should companies focus solely on how ESG issues affect their bottom line, or should they also be cognisant of their broader impact on society and the environment?
This question revolves around the double materiality concept, which acknowledges that materiality can extend further than what is financially material to a company and encompass a business’ wider impact on the world.
In fact, a company’s impacts on the planet and society (outward impacts) often evolve into financially material impacts (inward impacts). This process is explained by the term dynamic materiality.
In 9fin’s latest ESG Educational, we delve into how double materiality and dynamic materiality are interlinked; we look into what these concepts really mean, their importance, and sustainability standards’ diverging approaches to the topic of materiality.
Double and dynamic materiality
Fundamentally, materiality is an accounting principle. Something is material if it could have an impact on how a company performs, or threaten targets and objectives. Through an ESG lens, this means ESG factors that could pose a threat (but also an opportunity) to a business and its bottom line. For example, extreme weather such as drought or flooding which could cause significant disruption to a business and make it more difficult to get insurance.
The issue with this perspective of materiality — single materiality— is that it doesn’t reveal anything about a company’s impact on the world around it, but only how vulnerable its profits are to ESG factors. In comparison, following a double materiality approach means considering corporate ESG information both in terms of:
- The impact of sustainability issues on a firm’s financial value (inward impacts)
- The wider impact a company has on the planet and people (outward impacts)
This is where dynamic materiality comes in. The process of dynamic materiality means that what is financially immaterial to a company or industry today (i.e. outward impacts) could become material tomorrow. It also emphasises that certain triggers could speed this process along. In this way, it looks at materiality more as a process that unfolds over time — and often very swiftly.
Importantly, double materiality and dynamic materiality are interrelated concepts acknowledging different details of the same process; while the former explores how impacts can be both financially and non-financially material, the latter expresses the dynamics that propel an issue to move along the materiality continuum.
A simple example highlighting both concepts would be if a company extracts water from an area of high water stress. Both the company and local communities would be at risk if this water extraction leads to a low-level water table. The firm may not be able to operate efficiently if it has limited access to water and the depleted or contaminated water could pose health risks for local communities. In fact, these risks are interconnected and could impact each other; the outward risk could turn inward if a company receives bad publicity as a result of water overexploitation or if it is unable to operate effectively due to sanitation issues. Understanding both impacts would therefore enable the company to most effectively mitigate this risk.
Living in a single materiality world
Nonetheless, in many ways we are still operating in a single materiality world. ESG ratings, for example, are used amply by investors and fund managers to guide and inform investment decisions. Despite this, the vast majority of ratings continue to focus primarily on a company’s ability to create long-term value and its exposure to environmental, social, and governance risks, i.e. single materiality. This fact is not always made clear by ESG rating agencies and can cause confusion. Those using scores, or investing in funds that rely on scores, may be under the impression that these ratings relate to a company’s positive impact on the planet and society, when in reality, they may only consider risk to financial returns. Read more in 9fin’s educational on ESG ratings.
But ignoring the implications of both double and dynamic materiality can have detrimental consequences. Some examples in high yield:
- Amigo Loans: Between 2018 and 2020, Amigo, a subprime guarantor lender, was not adequately assessing whether a customer could afford to borrow its loans. Initially, this impacted its customers (an outward impact); Amigo extended unaffordable loans to borrowers and a quarter of guarantors had to step in to help make repayments. However, this outward impact quickly turned inward; in 2020, regulators discovered the company was not carrying out correct checks on customers. The resulting mass of compensation claims threatened to bankrupt Amigo. In May 2022, the company agreed to settle claims at a rate of around 40p in the pound. To make these payments, Amigo will need to raise £45mn by 26th May 2023. Its stock has plummeted from £1.2bn in 2018 to £15mn in 2023. In February 2023, the FCA waived a fine of £72.9m to improve the chances of a bigger redress payment for borrowers. Amigo said on 10 March that it was now “unlikely” to raise the required money before the deadline. If Amigo does fail to raise the money, compensation payouts will be smaller and Amigo will be liquidated.
- Teva: As one of the largest producers of opioid painkillers during the height of the opioid crisis, Teva had an adverse (outward) impact on public health. The US opioid crisis has caused more than 500,000 overdose deaths over the past two decades, including more than 80,000 in 2021 alone, according to government data. Teva’s outward impact has evolved into significant inward impacts following the thousands of lawsuits that have been filed against the company. In 2022, Teva finalised a $4.25bn settlement with around 2,500 local governments, states and tribes over the company’s role in the opioid epidemic. 9fin clients can read 9fin’s ESG QuickTake on Teva.
- Orpea: Orpea's shares dropped 93% in 2022 after “The Gravediggers” book (written by French journalist Victor Castanet) highlighted potential malpractice at its care homes. Following the publication of the book, French police carried out raids on Orpea care homes and an independent audit found evidence of financial wrongdoing at the company. While instances of financial wrongdoing/potential malpractice would have initially been outward impacts for Orpea, the negative publicity that ensued has led to serious inward financial impacts for the company. 9fin clients can read 9fin’s ESG QuickTake on Orpea.
- PG&E: In 2019, one of PG&E’s power lines sparked wildfires in California. Long before this happened, a company email had noted that some of PG&E’s structures in the area, known for fierce winds, were at risk of collapse. The company’s own guidelines put the power line that caused the fire a quarter century beyond its useful life. Despite this, PG&E did not fix the issue; the power line remained, and PG&E continued to “greenwash” over the problem. Between 2014 and 2018, PG&E reported extensively on the potential for wildfires and how it was mitigating this risk. Following the fire, investigators found that there were systematic problems with PG&E’s oversight of the power line that sparked it. PG&E had to pay a $25.5bn settlement to victims and filed for bankruptcy. Stuart Kirk argues that “there is no such thing as greenwashing in an ESG-input context, because sustainability is not the point”. However, this example highlights that there is always the possibility for greenwashing to become a material risk, echoing the dynamic materiality concept
Double materiality and the European Sustainability Reporting Standards (ESRS)
Double and dynamic materiality still aren’t incorporated into the majority of international standards or regulation, nor do they it shape the majority of ESG ratings. US regulators have focused primarily on improving the quality of reports on single materiality, for example, through requiring publicly traded companies to explain their climate change-related costs.
In contrast, European regulators have begun incorporating double materiality into regulation. There is a dedicated section for double materiality in the draft European Sustainability Reporting Standards (ESRS) (published in November 2022), which will form a foundation for the incoming Corporate Sustainability Reporting Directive (CSRD). The CSRD will mandate nearly 50,000 companies with operations in Europe to begin reporting on sustainability factors from 2024.
All three of Europe’s financial regulators recently provided feedback on the ESRS, including on materiality. The main piece of feedback provided was the need for consistency across the ESRS and the International Sustainability Standards Board (ISSB) (part of the IFRS foundation). This is particularly due to the ISSB continuing to focus primarily on financial materiality. “ISSB deliberations are ongoing”, the European Insurance and Occupational Pensions Authority (EIOPA) wrote. “EIOPA welcomes the discussion taking place in the ISSB on this matter, and stresses the value and logic for double materiality.”
The ISSB released its first two disclosure standards for companies this month, which are expected to come into effect next January for use in annual reports for 2024 onwards. However, these standards continue to adopt an enterprise value approach, measuring how sustainability impacts a company’s valuation.
Even though European regulators are ahead of their US counterparts, there remain unanswered questions. In their feedback, Europe’s financial regulators have asked the Commission for more information on how materiality thresholds should be set once potential sustainability impacts have been ranked according to their severity. The European Banking Authority (EBA) and EIOPA both also added that more clarity is needed on the definition of “value chain” for financial services firms so that relevant sustainability impacts can be reported in a proportionate manner reflecting the different levels of risk.
Practical approaches to double and dynamic materiality
Guidelines such as the SASB Standards (which identify ESG issues relevant to financial performance in 77 industries) can provide a starting point for corporates and financial firms to understand what is financially material for different industries. However, in order to understand a company’s wider impact on the world, it is necessary to go deeper. This is why 9fin’s QuickTake process involves gaining an in-depth understanding of a company’s wider operating environment before commencing our analysis.
Our Ford ESG QuickTake provides a good example of this. Ford’s green bond (issued in August 2022) is aimed entirely at clean transportation projects. 9fin’s analysis revealed that whilst the electrification of vehicles is a necessary and positive action contributing towards the Paris Agreement, one issue we unveiled was the need to mine raw materials (used in EV batteries). These raw materials are at risk of supply bottle necks as well as serious environmental impacts.
While these two issues may initially be seemingly outward risks, eventually these impacts could turn into inward risks if raw materials are increasingly difficult to obtain or if Ford receives negative publicity for mining near vital ecosystems (the distribution of raw materials in the earth’s crust can often coincide with these ecosystems).
Overall, insights on potential inward and outward impacts should not just be used as a technical exercise, but to shed light on business-critical matters for top-level executives at a company. In turn, these insights should inform strategy and risk management.
It is vital that double and dynamic materiality are not seen as “sustainability niche” tools; both regulation and the markets are changing. The way stakeholders and regulators are looking at material issues is also changing, and businesses and financial firms should adapt accordingly.