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One of the crucial steps in the sustainability assurance process is that of checking whether material issues have been correctly identified and tackled in a company’s sustainability or integrated reports.
While verifying materiality claims is often only the first step of the assurance process, it can have crucial implications for its success.
In this article, we will have a closer look at the components of sustainability materiality assessment from the perspective of auditors and assurors, as well as at the challenges and hurdles associated with navigating the nuances of materiality from both a financial and impact perspective (according to the so-called "double materiality" framework that's prevalent in ESG).
The concept of materiality traces back to financial accounting. In this space, materiality assessments enables companies to only focus on transactions that are important and representative of their financial performance.
In contrast to this, non-financial materiality in the context of ESG ("Environmental, Social, Governance") refers to the process of identifying and prioritizing ESG issues that can significantly impact an organization's financial performance, reputation, and stakeholder relations. This form of materiality assessment can help businesses focus on the non-financial risks that are most relevant to their internal operations and stakeholders, and it is sometimes required in the context of non-financial and sustainability regulatory disclosures.
Single materiality and double materiality represent two different approaches to understanding the materiality of sustainability and ESG issues. The double materiality approach guides organizations in identifying not only what environmental and social issues are important for their potential financial impact on the organization (so-called “financial materiality”, or "inside-out" perspective), but also the impact of the organization on the economy, environment, and society at large (so-called “impact materiality”, or "outside-in" perspective).
For example, under a “single materiality” approach, a company might only consider the financial implications of climate change risks by looking at the potential impact of certain adverse events (such as extreme climate events) on its operations, supply chain, etc., focusing on how these risks could affect its financial performance.
In contrast, double materiality entails taking into account both financial materiality and impact materiality. Under a double materiality approach, it is important to ask questions like: "How does the organization's operations and activities impact the environment and society?" in addition to questions concerning financial materiality.
The European regulatory framework around sustainability disclosures (championed by bodies like EFRAG and crystallized in the EU Taxonomy for sustainable economic activities, but also in the CSRD and related regulations) follows the double materiality approach. The reason for this is that double materiality can provide a more holistic view of an organization's ESG and sustainability performance. According to the ESRS General requirements, “a sustainability impact may be financially material from inception or become financially material, when it could reasonably be expected to affect the undertaking’s financial position, financial performance, cash flows, its access to finance or cost of capital over the short-, medium- or long-term. Impacts are captured by the impact materiality perspective irrespective of whether or not they are financially material.”
Because of its origin within financial auditing, accounting firms have historically been driven to an approach to sustainability materiality which is rooted in financial materiality auditing practices. This involves relying on so-called materiality thresholds, and on a logic that prioritizes limiting assurance risks and the need to prevent potential liabilities.
However, the landscape of sustainability auditing and assurance is increasingly populated by assurors with an environmental services and sustainability background. Within this group, sustainability materiality is more often approached through holistic lenses, with the goal to ensure long-term sustainability of the company, seen as a system.
Dialogue between these two groups is critical to ensure more standardization within materiality audits. However, this doesn’t come without challenges: sustainability materiality is a complex topic, and it often requires a multi-disciplinary approach and collaboration. There are no universal hard rules, although there are some guidelines. An example of these are the Global Reporting Initiative (GRI) standards, or the high-level guidance offered by some official regulatory standards (such as the ESRS within the European regulatory framework for corporate sustainability disclosures).
The first source auditors should take into account when evaluating the correctness and completeness of their clients’ materiality assessment is whether the organization has correctly identified material topics, as mandated and defined by specific national or international regulations.
Actually, usually assurance is performed to check compliance with a specific regulation or directive and therefore, the auditors’ main task is to check whether the information reported by the company matches with the standards laid out in the framework in question. Sometimes regulations only provide high-level guidance as to what specific topics should be considered as material (for instance, based on the industry), and focus more on how and where material topics should be reported.
Materiality assessments are performed to reduce complexity, and only focus on what has the (or has the potential to have) the greatest impact. This is why one of the obvious places to start from when beginning a materiality assessment is: “What does this company actually do?”.
If a company operates in the financial sector, does it make sense to focus on aspects such as direct water and energy usage? Surely, the company in question will be involved in direct water and energy consumption associated with its office management and operations. But if the organization operates in the financial sector, direct water consumption will be secondary with respect to other ways in which the capital it manages might impact water resources indirectly. For instance, the investments and loans it facilitates could support industries with significant water footprints, such as agriculture or manufacturing.
It follows that a materiality assessment in the financial sector might prioritize the evaluation of the environmental and social impacts of its financial products and services, rather than direct operational impacts like water and energy use. This approach ensures that the assessment focuses on areas where the company has the most significant potential to influence sustainability outcomes, thereby enabling it to allocate resources and develop strategies that can have a more substantial positive impact on global sustainability challenges.
Moreover, the relevance of specific material impacts can vary greatly across different industries. In the technology sector, the ethical sourcing of rare minerals that are used to build hardware could be considered material. In contrast, the financial sector might focus more on responsible investment and the social and environmental impacts of the projects it finances. Sector-specific materiality means that companies cannot assess impacts in isolation but must consider the broader context of their industry and the specific issues relevant to their business model.
Being located mainly or predominantly in a certain geographic area can help determine whether a company is exposed to a certain set of environmental and geo-political risks.
Unlike financial materiality, impact materiality is difficult to assess in “isolation”, especially for large companies. Large companies often operate on a global scale, sourcing materials and components from a vast network of suppliers spread across different countries. Each node in this network not only contributes to the company's final product but also brings its own set of ESG impacts. Assessing the materiality of these impacts requires a comprehensive understanding of the entire value chain, from raw material extraction to product disposal.
Looking at the whole value chain to determine material issues is already a requirement for some companies, for instance for certain large organizations that are also now subject to regulations such as the new European supply chain due diligence directive (CSDDD), the Lieferkettengesetz in Germany as well as other, similar regulations.
Measuring value chain impacts, of course, adds up to the complexity of materiality assessments, and can lead to an exponential increase of the data points companies and auditors need to report on and verify.
Because sustainability materiality is so broad and it often entails evaluating not only quantitative metrics like “CO2 emissions”, but also a number of qualitative social and governance impacts, interviewing key stakeholders is often a key step in the determination of material issues.
But how are key stakeholders actually identified?
According to the GRI, stakeholders are ‘those groups who have invested in an organization along with those who have other types of relationships with the organization’. This definition is purposefully vague. There is no “blueprint” to identifying relevant stakeholders, and this is due to the unique governance structure of each organization.
This can cause considerable headaches for auditors, because they might lack some of the “insider knowledge” to correctly identify all the relevant stakeholders involved in the materiality assessment process. Being successful in this endeavor often relies on the auditors’ experience, judgment and knowledge of the specific industry or vertical their client is situated in.
It's important to mention that, under a double materiality framework, the term "stakeholders" often encompasses all of those groups who are affected by the company's activities and business relationship. This is exactly the approach taken in the ESRS, where stakeholders comprise of two groups: "affected stakeholders" and users of sustainability disclosures. For example, existing and perspective employees can be identified as key stakeholders in health and safety topics. Therefore, auditors have to ensure their views and interests have been included in the materiality assessment.
In the ESRS guidelines, “severity” and “likelihood” are considered two major determinants of impact materiality.
Severity in itself is a complex factor, and its definition can vary based on whether negative or positive impacts are considered. Within the ESRS framework, severity of negative impacts is determined by the scale, scope, and irremediability of the impact, while severity of positive impacts is only a factor of scale and scope. Likelihood is only relevant for potential impacts. Again, within the ESRS, severity takes precedence on likelihood when considering human rights impacts.
When it comes to financial materiality, what’s taken into account is the likelihood and magnitude of financial impacts. The financial magnitude of impacts can be calculated on the short-, medium- and long- term. Again, this is specific to the ESRS guidelines for materiality assessment. You can find more information here.
Unlike a regular materiality assessment performed “in house” by the company, the auditing process of materiality often involves identifying and reporting relevant audit risks - that is, the chance of errors occurring throughout the audit process.
It is easy to see audit risks could be seen as inversely related to materiality. The more materiality topics a company discloses on, the higher will the risk of errors in the audit process be.
However, simply looking at the sheer volume of material issues is not enough, when it comes to sustainability materiality. In these areas, even a small misstatement could be seen as having a very large negative impact on the organization or on other stakeholders.
This is why it’s crucial to handle audit risks carefully. One way to look at audit risks is to check where most mistakes were made in the past. If looking at past years’ reports unearths issues with, for instance, CO2 calculations or other crucial sustainability KPIs, that is something that the assuror might need to pay close attention to.
A materiality matrix is usually developed by the client’s in-house sustainability team, and it maps the correlation between company impacts (as identified by the team) with the perception of relevant stakeholders. Building a materiality matrix is not mandatory, but it is highly recommended, for example by the GRI.
When present, checking the materiality matrix and whether it matches with the client sustainability reports can help simplify the work of sustainability auditors significantly.
Thresholds are used to determine which material issues a company will or will not disclose on.
In the realm of financial materiality, this is usually done by identifying transactions that have a significant percentage impact on the financial statements. This approach is guided by widely accepted accounting principles, such as setting a benchmark of 5% of total pre-tax revenue.
Unlike the straightforward percentage-based thresholds of financial materiality, sustainability materiality operates on a more nuanced level. The initial step often involves identifying material topics, based on one or more of the criteria listed above. Following this identification, reasonable thresholds might need to be determined upon an internal discussion and collaboration among the auditors.
Regulations (like the ESRS) do not include exact prescriptions or guidelines for materiality thresholds, but it is encouraged that they are based on the "scale, scope and irremediable character" of impacts, and they can be informed by its existing due diligence or risk management processes.
The role of the auditor is then to ensure that the materiality thresholds used can be reasonably justified and supported by the available evidence, and /or that the relevant stakeholders' considerations and voices have been taken into account.
As we have seen, auditing a company's material issues is an essential component of the sustainability auditing process, as it significantly influences the entire sustainability assessment process, informing strategic decisions and stakeholder engagement strategies. However, assessing and auditing sustainability materiality is relatively more complex and nuanced than evaluating financial materiality, and it requires more cross-functional collaboration between auditors with different expertise and their clients.
However, auditors dedicate extensive time scrutinizing various metrics and conducting document analysis, which can detract from focusing on this critical aspect of the assurance process.
By automating part of their document analysis work, Briink helps auditors significantly reduce the time spent on routine metrics checking and document analysis. This allows for more time and resources dedicated to engaging with relevant stakeholders, and delving into other strategic considerations of materiality assessments. If you are a sustainability auditor and you are interested in learning more about how you can integrate Briink within your unique workflow, you can request to test our tools for free - or subscribe to our newsletter for more insights on how AI is revolutionizing ESG and sustainability data collection, verification and assurance!
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