What is double materiality and what does it mean for central banks?

February 28, 2022|Written by David Clarke

Double materiality describes how corporate information can be important both for its implications about a firm’s financial value, and about a firm’s impact on the world at large – particularly with regard to climate change and other environmental impacts.

The principle of double materiality is set to be integrated into national and international reporting standards, with potentially significant consequences. The ability of the financial system to support the shift to a net-zero economy depends on investors, regulators and other stakeholders having access to high quality information about firms’ climate impacts. The adoption of double materiality could be key to this process.

Double materiality extends the accounting concept of materiality

In US law, information is defined as ‘material’ if there is a substantial likelihood that a reasonable person would consider it important. It is now widely agreed that climate risks and opportunities can be material to the value of companies and financial institutions, and are therefore worth reporting on. Initiatives such as the Taskforce on Climate-related Financial Disclosures have sought to improve the quality and consistency of the information that is available.

The idea of double materiality comes from a recognition that a company’s impact on the wider world can be material, and therefore worth disclosing, for reasons other than that they have a direct effect on firms’ financial value.

There is increasing awareness that, as well as being impacted by the effects of climate change, the financial system is also making a significant contribution to the problem. A major effort is now underway to align financial flows with climate goals, such as via the Glasgow Financial Alliance for Net Zero, which brings together financial firms responsible for assets of more than $130tn.

Whether the objective is mitigating risk or managing impacts, there is a need for lenders, investors, regulators and other stakeholders to access data from companies about their activities. Double materiality reporting is intended to deliver this.

Double materiality is subject to differing interpretations

Double materiality is sometimes used to describe how a firm’s impacts can have an indirect effect on their financial value. This is a ‘weak’ interpretation of double materiality, in that it is only a relatively minor extension of the existing principle of materiality. For example, investors might want to know about a company’s polluting activities because of the possibility they will cause reputational damage or open it up to litigation. The number of climate-related lawsuits has been rising sharply in recent years.

A stronger interpretation is that a ‘reasonable person’ might consider information about a firm’s impacts important for reasons other than its immediate financial performance. For example, they might think companies should not engage in activities which contribute to the destruction of the ecological or social systems, systems on which that company and its workforce depend.

The practical application of double materiality in corporate reporting depends on the audience for which it is intended. While some lenders and investors might be more focused on issues that affect a company’s financial performance, there may be a demand from employees, customers and civil society to understand firms’ environmental impacts for their own sake.

Adoption of double materiality reporting could have important implications

The information investors have access to affects the decisions they make, and how capital is allocated. And what gets measured by companies affects what gets managed inside those companies. So improved sustainability reporting requirements may facilitate effective management of, for example, emissions and other environmental impacts within firms.

Access to better reporting of companies’ impacts could also help investors to pursue more impact-oriented investment strategies. Or it could help other stakeholders like trade unions or civil society groups to hold companies to account – preventing them from having to trawl through pages of inscrutable financial information.

Europe is leading the way

Policymakers and regulators are now grappling with the question of whether and how to embed double materiality into their rules.

The International Sustainability Standards Board (ISSB) is currently developing what it intends to be a comprehensive global baseline of disclosure standards on climate and other environmental, social and governance matters. However the ISSB standards are expected to focus on financial materiality, which means they will have to be added to by jurisdictions intending to adopt double materiality.

A double materiality perspective has featured in EU reporting requirements for some time –  companies are required to report on how sustainability issues affect their business, and about their own impact on people and the environment. It is now seeking to beef up the requirements via a new corporate sustainability reporting directive, which it hopes will make reporting more comprehensive and comparable.

The US Securities and Exchange Commission (SEC) is due to introduce climate disclosure requirements, but these are widely expected to have a narrower scope than Europe’s rules. There is also a possibility of legal wrangling. Some corporate interests have warned against making the rules too onerous, although SEC staffers have reportedly said the severity of climate risks necessitates a narrow definition of materiality.

The UK is set to consult on new sustainability disclosure requirements in 2022, which are expected to herald the introduction of double materiality. The move was announced in a greening finance policy paper ahead of the Cop26 summit.

Central banks are taking up the mantle of double materiality in other respects. For example, the Dutch National Bank conducted research to calculate the biodiversity footprint of financial institutions in the country. They found it to be comparable with the loss of over 58,000 km² of pristine nature – more than 1.7 times the size of the Netherlands.

Debate mirrors wider discussions over climate and financial regulation

The question of whether double materiality should feature in reporting requirements goes to the heart of what such disclosures are for. Are they merely about allowing investors to maximise their financial return, or do they serve a wider purpose? The debate over the SEC rules shows this question is already hotly contested.

Until recently, financial regulators have paid attention to climate change solely based on the short-term danger it poses to financial institutions and to the financial system – but this is beginning to change. Supervisors are increasingly taking a broader view of their responsibilities, and in some cases being armed with specific mandates to support environmental goals. It may be that double materiality will grow in importance as part of this trend.

This article draws on an excellent introduction to double materiality, written by Matthias Täger of the Grantham Institute at the London School of Economics.

This page was last updated March 23, 2022

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