Getting to Impact: Integrating Double Materiality in Responsible Investment Strategies

Key Insights:

Responsible investment strategies have evolved to encompass the integration of environmental, social and governance (ESG) risk factors, as well as impact investing. As ESG reporting requirements become standardized, it’s important to consider how they align with investor preferences. At the core of major ESG reporting frameworks is the materiality assessment, with some frameworks going a step further and requiring a double materiality assessment covering both finance and impact. This article focuses on the key distinctions between financial, impact, and double materiality concepts and the related implications for issuers and investors. 

ESG and the Concept of Materiality

Much of the debate about the global alignment of sustainability disclosure rules revolves around the concept of materiality. In financial reporting, companies typically assess materiality with a focus on the information needs of potential and existing investors and lenders. According to the International Financial Reporting Standards (IFRS), information is financially material if omitting, obscuring, or misstating it could be reasonably expected to influence investor decisions.¹ Materiality within the context of ESG reporting helps to provide the criteria for determining whether a sustainability topic or information should be included in an ESG disclosure.² 

The International Sustainability Standards Board (ISSB) disclosure standards and the U.S. Securities and Exchange Commission’s (SEC) climate disclosure rules both define materiality based on an assessment of the financial risks that a sustainability issue poses to a company’s cash flow and enterprise value. 

In contrast, the recently enforced Corporate Sustainability Reporting Directive (CSRD) and the Sustainable Finance Disclosure Regulation (SFDR) in the EU both adopt a double materiality approach, which includes both financial materiality and impact materiality, or the effect a company or investment has on people and the planet.

Impact Materiality and Double Materiality: Going Beyond Financial Outcomes

ESG-focused investor strategies are evolving beyond financial materiality of ESG issues to include assessments of the broader impact of investment strategies. Thus, issuers who limit sustainability and climate disclosures to align only with financially material ESG topics may also be hindering opportunities to demonstrate their external impact. 

According to the European Sustainability Reporting Standards, a sustainability topic or information is material from an impact perspective if the undertaking is connected to actual or potential significant impacts on people or the environment and is related to the sustainability topic over the short, medium, or long term. 

Double materiality is the combination of impact materiality and financial materiality. A sustainability topic or information meets the criteria of double materiality if it is material from the impact perspective or from the financial perspective, or from both perspectives.³ SFDR, which mandates the disclosure of sustainability information by financial services firms, also requires that firms disclose how they manage ESG risks that impact their financial performance, as well as the impact of investment decisions on sustainability factors.

Getting to Impact Through Double Materiality Assessments

Despite fiduciary duty being the primary responsibility of investors, the term is subject to interpretation across different regulatory environments. Traditionally, fiduciary duty prioritizes investment factors with direct financial outcomes, while a more progressive model applies a broader lens that balances long-term financial outcomes with ESG factors that could impact value over long time horizons.⁴

As the concept of fiduciary duty evolves globally, there has also been a trend towards greater emphasis on sustainability outcomes and impact, reflecting a broader interpretation of value beyond immediate financial returns.⁵ Double materiality assessments are key to adopting an impact perspective. This method not only uncovers potential risks and opportunities that may be missed by taking a financial focus only, but also contributes to evaluating investments' impacts on the environment and society. 

According to the Climate Bonds Initiative, the first quarter of 2024 saw the volume of aligned green, social, sustainability, and sustainability-linked bonds reach USD 272.7 billion – the highest ever on record. Europe maintained its position as the largest regional source by contributing USD 149.5 billion, or 55% of the total volume priced in Q1 2024.⁶ Such growth, driven by steady demand for sustainable finance products like green bonds, underscores the increasing interest in impact-oriented investments. The growing appetite for sustainable investment products highlights the need for issuer double materiality assessments, and issuers across the globe are taking note.

Double Materiality in Practice: The EU, Canada and China 

In 2024, large financial institutions and listed companies in the EU will conduct their materiality assessments under the CSRD’s double materiality standard and begin to collect data for reporting in 2025. As part of the double materiality exercise, European issuers need to engage meaningfully with stakeholders and understand material sustainability risks, impacts and opportunities in their value chains. Driven by a regulatory push in the EU, the first wave of CSRD reporting will provide valuable learnings on the double materiality approach for issuers globally.

In Canada, an October 2023 ESG disclosure study of 227 S&P/TSX Composite Index constituents showed that 19% of materiality assessments undertaken by Canadian issuers are currently applying a double materiality approach.⁷ In another study of institutional investors,⁸ 43% of asset managers interviewed said they were planning to launch impact-oriented products that year. However, the Canadian Sustainability Standards Board (CSSB) announced in March the release of new proposed standards for companies to report sustainability and climate-related information based on the ISSB disclosure standards, which only focuses on financial materiality. Following the release of the proposed CSSB standards, the Canadian Securities Administrators (CSA) said that it would consider the final CSSB standards, with potential capital markets-focused modifications, for incorporation into a CSA rule.⁹ To meet the demand from Canadian and international investors for double materiality information, Canadian issuers will need to report beyond the standards set by CSSB and CSA. 

China has also issued draft guidelines for a mandatory climate disclosure regime including a double materiality approach, requiring its biggest listed companies to report on a broad range of sustainability-related risks and impacts from 2025. The Shanghai, Shenzhen, and Beijing exchanges are requiring issuers to report on the impact of their activities on the environment as well as the risks and impact of environmental factors on their businesses.¹⁰

Promoting Long-Term Value

There is mounting evidence that financially immaterial sustainability issues may become financially material over time.¹¹ For instance, investors are increasingly factoring in climate-related risks and impacts, previously considered immaterial, to mitigate exposure to climate-related financial risks in portfolios. The World Economic Forum calls this process dynamic materiality,¹² showing that sustainability issues, which are only material from an impact perspective, will eventually become financially material. As a result, investors may not be sufficiently informed about potential and emerging financial risks if issuers’ ESG disclosures are limited to financially material information. A forward-looking approach to integrating dynamic ESG issues in portfolio construction and security selection may enable investors to better anticipate and respond to future material issues.

Integrating real-world impact into investment strategies further offers an opportunity to address systemic ESG issues, thereby promoting long-term value. By considering impact, investors can assess and respond to risks and opportunities associated with systemic environmental and social issues before they become apparent to the broader market. This proactive approach can allow for the early identification of potential issues, enabling investors to make better-informed decisions that mitigate risks and capture emerging opportunities. Ultimately, considering impact in investment decision-making can help investors proactively manage systemic risks that could materially affect investment returns at the portfolio level.

References

1. IFRS “ISSB: Frequently Asked Questions.” N.d. https://www.ifrs.org/groups/international-sustainability-standards-board/issb-frequently-asked-questions/. 
2. Sekiguchi, T. 2023. “Understanding what to report.” KPMG. August 31, 2023. https://kpmg.com/xx/en/home/insights/2022/10/issb-materiality.html. 
3. European Commission. 2023. “European sustainability reporting standards (ESRS)” Official Journal of the European Union. July 2023. https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=OJ%3AL_202302772.  
4. United Nations Environment Programme Financial Initiative. 2005. “A legal framework for the integration of environmental, social and governance issues into institutional investment.” October 2005. https://www.unepfi.org/fileadmin/documents/freshfields_legal_resp_20051123.pdf. 
5. UNEP FI, Principles for Responsible Investment. “Fiduciary Duty in the 21st Century.” N.d. https://www.unpri.org/download?ac=9792. 
6. Climate Bonds Initiative. 2024. “Sustainable Debt Market Summary Q1 2024.” June 2024. https://www.climatebonds.net/files/reports/cbi_mr_q1_2024_01e_1.pdf. 
7. Millani. 2023. “Millani’s 7th Annual ESG Disclosure Study: A Canadian Perspective.” October 2023. https://66e92bb4-13f5-462a-98c4-69b0f2ad5f7d.usrfiles.com/ugd/66e92b_184f379cd39d4cbfa22c1e237478ae75.pdf. 
8. Millani. 2024. “Semi-Annual ESG Sentiment Study of Canadian Institutional Investors.” February 2024. https://www.millani.ca/_files/ugd/66e92b_f15bc0c6b93b4b81bcc84af26194f6a3.pdf. 
9. Segal, M. 2024. “Canada Releases Proposed IFRS-Based Sustainability Reporting Standards.” ESG Today. March 14, 2024. https://www.esgtoday.com/canada-releases-proposed-ifrs-based-sustainability-reporting-standards/. 
10. Deloitte. 2024. “Major Chinese stock exchanges publish draft guidelines for sustainability reporting.” February 13, 2024. https://www.iasplus.com/en/news/2024/02/china-sustainability. 
11. Slovik, P., Azman, F. 2022. “Materiality of ESG factors in financial markets and financial statistics.” Irving Fisher Committee on Central Bank Statistics and the Bank for International Settlements (BIS). August 2022. https://www.bis.org/ifc/publ/ifcb58_18.pdf. 
12. World Economic Forum. 2020. “Embracing the New Age of Materiality Harnessing the Pace of Change in ESG.” March 2020. https://www3.weforum.org/docs/WEF_Embracing_the_New_Age_of_Materiality_2020.pdf.