New concepts and definitions
The practical implementation of the CSRD, enabled by the introduction of the ESRS, is a broad and ambitious endeavour, expanding the number of companies mandated to report sustainability data from approximately 11, 700 to over 50,000 over a 5-year period. As is the nature of such tasks, the drafting of the ESRS has required the formalisation of complex ideas and definitions as well as the introduction of new concepts. Perhaps the most influential of these concepts is that of “double materiality” as the basis for sustainability disclosures.
Double materiality
The two dimensions of double materiality – “impact materiality” and “financial materialiy” – have been defined in ESRS 1, the general requirements draft standard. The two dimensions are considered to be interrelated, and any impact identified under either or both of these dimensions should be considered a “principlal material impact” and thus disclosed in sustainability statements.
Impact materiality
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Financial materiality
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“A sustainability matter is material from an impact perspective when it pertains to the undertaking’s material actual or potential, positive or negative impacts on people or the environment over the short-, medium- and long-term time horizons.”
Both direct and indirect impacts should be considered material, including those related to operations, products, services and business relationships (upstream and downstream).
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“A sustainability matter is material from a financial perspective if it triggers or may trigger material financial effects on the undertaking. This is the case when it generates or may generate risks or opportunities that have a material influence (or are likely to have a material influence) on the undertaking’s cash flows, development, performance, position, cost of capital or access to finance.”
Past and future risks and opportunities should be considered, over short-, medium- and tong-term time horizons.
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Stakeholders
In addition to providing guidance for how to consider the interdependencies of the two dimensions of double materiality, ESRS 1 provides definitions of two main stakeholder groups, introducing the concept of “affected stakeholders” and “users of sustainability statements.” Broadly, affected stakholders are closer to the impact materiality dimension and users of sustainability statements are more closely connected to the financial materiality dimension, although these lines certainly cross.
Affected stakeholders
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Users of sustainability statements
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“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.”
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“Primary users of general-purpose financial reporting [investors, lenders and insurers], as well as other users, including the undertaking’s business partners, trade unions and social partners, civil society and non-governmental organisations, governments, analysts and academics.”
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The definitions and guidance provided in the latest draft ESRS are also applicable elsewhere and improve the usability of other European sustainability-related regulation. For example, ESRS 1 outlines that the “affected stakeholders” group should be considered as part of an organisation’s ongoing due dilligence, as well as informing the basis for the asessment and reporting of material sustainability impacts. While some specific reporting requirements have been outlined in the ESRS 2, the general disclosures draft, the stakeholder definition provided aligns with wording used to identify appropriate stakeholders in the Corporate Sustainability Due Dilligence Directive (CDDD). This alignment across legislation and guidance improves the interoperability for users and provides opportunity for those who are early to engage.
Our recommendations
With the components of European sustainability regulation beginning to fall into place, our general recommendation is to engage with new concepts and definitions proactively. It is becoming increasingly common that definitions, disclosure requirements and incentives are shared across legislation. Early engagement in one area will likely save time and resources when pursuing compliance elsewhere. Furthermore, it will crate a strong position from which to approach the sector-specific standards, recently postponed and now expected approximately one year from now.
Specifically with regards to the concepts formalised in the ESRS, it would be prudent for reporting entities to:
- Align on sustainability reporting requirements across internal teams and stakeholders. The investor expectation that sustainability-related targets are embedded within the organisation and that appropriate forecasting and analysis have been carried out is now a more formalised requirement under the draft ESRS.
- Engage in data collection early, particularly across the value chain. Upstream and downstream impacts should now be considered under the draft ESRS. Sufficient consideration and reporting of these impacts will require data to be sourced from outside the organisation, potentially for the first time.
- Involve key management members in the process, particularly for forward-looking and organisational perspectives. Investors have long appreciated sustainability reporting that provides insight into strategy, the business model and resource allocation – this is now expected under the ESRS too.