Financial materiality is the second half of double materiality.
What is it?
Financial materiality involves identifying information that is considered material for primary users of general-purpose financial reports in making decisions relating to providing resources to the entity. Information is deemed financially material “…if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that they make on the basis of the undertaking’s sustainability statement.”
For example, if the missing information is relevant to their assessments about a company, an investor or creditor would make a different decision than if they had the missing information.
In all the European Sustainability Reporting Standards (ESRS), risks and opportunities refer to sustainability-related financial risks and opportunities, including those based upon dependencies on natural, human and social resources. Companies need to identify these risks and opportunities through a financial materiality assessment.
How might financially material sustainability matters affect a company?
They could affect its development (growth), financial position (balance sheet), financial performance (income statement), cash flows, and access to finance or cost of capital (cost of borrowing). These effects may be in the short-, medium- or long-term. Risks and opportunities are not limited to the present, but may be the result of past events or future events.
Keep in mind that financially material sustainability matters are those both within the company’s control and beyond its immediate control. For example, material risks and opportunities could be due to business relationships (upstream, downstream) that are beyond the scope of consolidation used for financial statements. That is why value chain mapping is a vital tool in assessing risks and opportunities along a company’s entire value chain.
What are some examples of financially material impacts?
The Task Force on Climate-related Financial Disclosures provides good examples of climate-related risks and opportunities in its publication: Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures.
Climate-related risks and opportunities can be viewed as two sides of the same coin. On the risk side, risks classified as transition risks are brought about by changes in societies and economies moving toward a lower-carbon economy. Transition risks include policy and regulatory risks, technological risks, market risks, reputational risks, and legal risks.
Why does this matter to companies?
Consider, for example, policy and regulatory risks. Changes in the regulatory landscape like the imposition of or increase in a carbon tax could pose material financial risks for companies in carbon intensive industries. If a carbon tax is imposed or increased, the increased pricing of greenhouse gas (GHG) emissions could result in higher compliance costs (operating costs). To reduce their compliance costs, companies may choose to retire existing high carbon emitting assets and incur financial losses from the early retirement. Capital expenditures to replace the retired assets would be a material financial impact as well.
Opportunities may also be present.
Companies with water intensive production processes could redesign their processes to reduce water usage and reduce costs. One opportunity is the industrial reuse of water, where the same water is used more than once. This is relevant for companies in high water stress locations. In reuse systems, water can be treated to meet specific quality standards for a particular use. One potential option is onsite reuse where a facility can collect, treat, and reuse the water.
Another option might involve public-private partnerships where local governments provide companies with treated recycled water. These partnerships benefit both the company and communities. In fact, this example fits nicely into the ESRS topical social standard ESRS S3 Affected Communities. Disclosure Requirement S3-4 involves information about “Taking action on material impacts on affected communities, and approaches to managing material risks and pursuing material opportunities related to affected communities, and effectiveness of those actions.” This partnership has financial benefits to both the company and the community.
In my next post, I will talk more about value chains and value chain mapping and its relevance in ESRS.