Materiality: financial, impact, double and dynamic

Every company faces dozens of possible ESG issues. Very few of them matter enough to change its value or its effect on the world. Materiality is the filter that separates the few that matter from the many that do not.

In accounting, a piece of information is material if leaving it out could change a reader's decision. ESG uses the same idea, but there is a twist: material to whom? An issue can matter a lot to investors but little to local communities, or the other way round. That is why there are different types of materiality.

For an analyst, materiality is the most useful idea in ESG. It tells you where to spend your time. A cement company's emissions matter. Its office paper use does not. A bank's lending book matters far more than the electricity used in its branches.

Four types of materiality

1. Financial materiality (outside-in)

An issue is financially material if it could affect the company's cash flows, risk or cost of capital. This is the investor's view. The ISSB standards (IFRS S1 and S2) and the SASB industry standards are built on it.

Example: water scarcity is financially material for a beverage company because it can stop production.

2. Impact materiality (inside-out)

An issue is impact-material if the company has a significant effect on people or the environment through it, whether or not that effect costs the company money today. The GRI Standards are built on this view.

Example: a mining company's effect on local water sources is impact-material even if no fine has been imposed yet.

3. Double materiality

Double materiality combines both views. An issue is material if it passes either test. This is the basis of the EU's sustainability reporting rules (the CSRD and its standards, the ESRS).

4. Dynamic materiality

Materiality changes over time. An issue that is impact-material today can become financially material tomorrow, often through regulation, lawsuits or shifts in customer demand. Carbon emissions are the clearest example: for decades they were an impact issue, and they are now becoming a cost line through carbon markets such as India's Carbon Credit Trading Scheme.

The materiality assessment

Most large companies run a materiality assessment and publish the result, often as a matrix. The usual steps:

1. List the issues. Draw up a long list from frameworks, peers and news.
2. Ask stakeholders. Survey or interview investors, employees, customers, suppliers and communities.
3. Score each issue. Usually on two axes: importance to stakeholders, and importance to the business.
4. Plot the matrix. Issues in the top-right corner are treated as most material.
5. Validate. Senior management or the board signs off the result.

In India, the BRSR asks companies to give an overview of their material responsible business conduct issues, including whether each one is a risk or an opportunity, and how the company responds.