On January 5th, 2023, the European Union Corporate Sustainability Reporting Directive (CSRD) entered into force. The CSRD is a new EU legislation that will require a broad range of European companies, as well as international companies with substantial European operations, to report annually on their environmental, social, and governance (ESG) activities and performance.

This directive puts sustainability reporting on par with financial reporting. Considering an increased interest in high quality ESG disclosures, the CSRD can be seen as a leading indicator for future developments in sustainability reporting. The CSRD increases the number of companies that will have to report on their ESG performance from approximately 11,000 to 50,000: all large European companies, entities listed on the EU regulated market, as well as international companies that generate over 150 million euros annually in the EU will be subject to the CSRD.

What are the CSRD reporting requirements?

To comply with the CSRD, companies will have to report their sustainability information using the European Sustainability Reporting Standards (ESRS), which were specifically developed to satisfy the CSRD’s reporting requirements. The European Commission has released the revised draft of the ESRS for public consultation and expects to adopt the standards by the end of August. According to the revised draft standards, all companies will have to report information detailed in the ESRS 2 General Disclosures, including:

• Scope 1, 2, and 3 greenhouse gas (GHG) emissions.
• The company’s strategy, business model, and market position, as well as an explanation of how each of these relate to sustainability.
• A list of material impacts, risks, and opportunities and their effects on the company’s business model.

Companies will also be required to conduct a double materiality assessment, which will inform additional required disclosures. The double materiality assessment should cover the following topics: climate change, pollution, water and marine resources, biodiversity and ecosystems, circular economy, own workforce, workers in the value chain, affected communities, consumers and end-users, and business conduct. For topics that the company determines to not be material, it should include a brief justification of why those topics are not considered material.

How is double materiality defined?

In contrast to all other major sustainability reporting standards and regulations, the CSRD requires disclosure of ESG information from a “double materiality” perspective. Broadly, “materiality” can be defined as information that is considered significant to a stakeholder’s decision-making process, and sustainability standards and regulations have historically approached the issue primarily from a financial materiality perspective. Under the CSRD, companies will have to consider materiality from two different perspectives:

Impact materiality: how the company’s operations affect people and the environment. For example, for a timber company, the adverse effects of logging on the local ecosystem would be considered a negative environmental impact.

Financial materiality: how sustainability risks and opportunities affect the company’s financial performance. For example, how the costs and quality of natural resources influence the financial performance for a manufacturing company.

The CSRD’s double materiality assessment requires accounting for both financial and impact materiality, and the interdependencies between the two perspectives.

Impact Materiality

The ESRS recommends that companies begin the materiality assessment by evaluating their impacts. Under impact materiality, companies should determine and assess both potential and actual negative and positive impacts on people and the environment. Impacts include those caused by the company and those which are directly linked to the company’s operations, products, or services. Impacts on the upstream and downstream value chain should also be evaluated. These impacts should be evaluated in short, medium, and long-term time horizons.

For actual positive impacts, materiality is based on the scale and scope, and for potential positive impacts, it is based on the scale, scope, and likelihood. For actual negative impacts, materiality is based on the severity of the impact, while for potential negative impacts, it is based on the severity and likelihood of the impact. Severity is based on:

• Scale: how damaging the negative impact is for people or the environment.
• Scope: how widespread the impact is. In the case of environmental impacts, the scope can be understood as the size of the affected area. In the case of impacts on people, the scope can be defined as the number of people adversely affected.

Irremediable character of the impact: whether and to what degree the negative impacts could be remediated. For example, how much it would cost to restore the environment to its prior state.

Financial Materiality

Under the CSRD, financial materiality can be seen as an expansion of the process that companies typically follow for determining what information should be included in their financial statements. Companies should disclose both sustainability risks and opportunities that can affect their financial performance. Potential risks and opportunities include influence on the company’s cash flows, financial position, cost of natural resources, or access to financing. The materiality of risks and opportunities is assessed by the size of the potential financial effects and likelihood.

What are the steps for performing a double materiality assessment?

Performing a double materiality assessment can be a complex process. Knowing where to start makes it significantly easier. Here are five steps that companies can follow:

• Identify relevant stakeholders: Engaging with relevant stakeholders is a key part of the double materiality assessment. Companies can gain a better understanding of how people and the planet are affected by its operations by engaging with both internal and external stakeholders, which may include employees, investors, customers, or suppliers, among others.
• Create a list of sustainability topics for the assessment: There are multiple sustainability aspects that companies can assess for each ESRS standard. However, to make the materiality assessment more applicable, companies should assess aspects that are the most relevant for their context and sector.
• Perform the assessment: Using the list of relevant sustainability matters, companies can then perform the double materiality assessment. To assess impacts, companies should consider their severity and likelihood as described in the section on impact materiality. Similarly, for assessing risks and opportunities, companies should follow guidance for financial materiality.
• Define materiality thresholds: The ESRS standards do not prescribe specific quantitative or qualitative thresholds for determining whether an impact is material. Rather, companies have to assess specific characteristics as described in sections on impact and financial materiality and report on the topics that are significant to the company’s operations, can influence decision making, or can improve transparency.
• Identify material sustainability matters: Once all relevant impacts, risks, and opportunities are assessed, companies can create separate ranking lists for positive impacts, negative impacts, risks, and opportunities. Information on material impacts, risks, and opportunities should be disclosed in accordance with the respective topical ESRS standard.

HXE Partners’ Take

The CSRD effectively codifies the concept of “double materiality” — previously a voluntarily applied approach for sustainability disclosures. Although these ESG reporting requirements will affect primarily only large EU-based and international companies initially, we expect the demand for more complete ESG disclosures will continue to increase, and the CSRD establishes a new regulatory baseline that will be referenced globally. With the first CSRD reports due in 2025 for some companies, we recommend that impacted companies start preparations now.