What the new “dual materiality” ESG approach means – and why JPMorgan is a fan

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Should a company or investment fund only care about making money, or should it also care about the environment, social justice and good governance (ESG)? Can the two objectives overlap? Do they already? These questions are at the heart of what is called “dual materiality”. Although the concept has been incorporated into new European regulations, it has yet to make significant inroads in the United States, even if Wall Street behemoths like JPMorgan Chase & Co. embrace the idea. The question is to know what information must be declared and who decides?

At a basic level, it’s an accounting principle, referring to something that can impact – be important to – the performance of a business. Significant risk can threaten targets or objectives, which is of great interest to investors. In the context of ESG, this is called single materiality and primarily refers to environmental, social and governance factors that can pose a threat or opportunity to a business and its bottom line. This doesn’t tell you anything about how “green” a company’s business practices are, but rather how vulnerable its earnings are to ESG risks.

2. What is “dual materiality”?

This is where green comes in. “Dual materiality” adds the risks a company’s activities pose to the environment and society to those it potentially faces internally. How any materiality should be applied in corporate financial reporting remains the subject of intense debate. For now, the reports vary wildly, making it difficult for investors to compare and make informed decisions.

3. Who writes the guidelines?

The International Sustainability Standards Board, launched in 2021 at the UN climate summit COP26, is attempting to draft global rules for climate and sustainability reporting. The ISSB is under the auspices of the IFRS Foundation, which developed the accounting standards used today in more than 140 countries. (The US is a notable exception to IFRS. It uses what’s called GAAP, or generally accepted accounting principles.) Meanwhile, the US-based Sustainability Accounting Standards Board has guidelines for the materiality – also called “outside-in”. – which is already used by hundreds of companies. In addition, the Global Reporting Initiative provides “inside-out” standards for reporting a company’s impact on people and the planet. Some companies use SASB, some GRI, some both, and some one of the many other disclosure systems now available.

The ISSB this year incorporated SASB standards into its initial proposals, which would require companies to disclose the material impact of external ESG risks on their business. She also indicated an openness to dual materiality; one official noted that investors care about a company’s broader impact because of the potential “ripple consequences” on a company’s cash flow. This is why the ISSB strives to coordinate its rules with the GRI, which is partly funded by governments. Some sustainability advocates and accounting experts, however, have expressed concern that the ‘connectivity’ between internal and external risks could be lost if they are not integrated into a single set of standards. The ISSB said it plans to review the comments as it seeks to complete its standards by the end of the year.

5. What’s happening in Europe?

Almost a decade ago, the European Union began requiring companies to disclose non-financial information in an effort to make companies more responsible for social and environmental issues. This was the first time the disclosure requirements included the concept of dual materiality. But large gaps quickly emerged in the quality and quantity of information. Thus, a revamped European regulation provides companies with more explicit requirements and obliges many other companies to comply. This so-called Corporate Sustainability Reporting Directive will come into force in 2023.

The United States has largely focused on improving the quality of single materiality reporting, through the work of the SASB. For example, this year’s Securities and Exchange Commission proposals would also require listed companies to detail the costs of extreme weather events and capital investments to reduce their greenhouse gas emissions. An SEC official said in May that the agency’s goal was “to achieve as much interoperability” as possible between what the SEC might require and the basic standards of the ISSB.

Historically, corporate reporting has focused on the short term and touched only lightly on environmental and social issues. But climate change and societal tensions linked to the Covid-19 pandemic have made these problems harder to ignore. This has led to requests for additional information, as what may be a small problem for one company can be a big problem for the communities in which it operates and can turn into a bigger challenge. Water availability is often cited as one of these issues. In the United States, some Republican-led jurisdictions have begun penalizing banks and asset managers for adopting ESG reporting, arguing that it goes too far in introducing progressive policies into investment decisions. On the other end of the debate, some climate change activists and other ESG advocates have criticized current efforts for not going far enough to reduce greenhouse gas emissions or address inequality.

8. Will there be a worldwide reference with the two forms of materiality?

This is unclear, as there is no agreement on whether and how to link internal and external reporting requirements. For now, GRI reporting is voluntary. Eventually, the ISSB rules, although also voluntary, are likely to be widely used, similar to existing international accounting standards. The European operations of American companies such as McDonald’s Corp. and General Motors Co. will likely need to comply with EU dual materiality rules to operate in all 27 EU countries. JPMorgan announced in September that it would begin offering its clients a data analysis tool covering dual materiality.

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