What is ‘double materiality?’

The concept isn't new, but having financial and sustainable materiality data might be more important than ever

For true believers in sustainable investing, the impact that a company has on people and the planet can be as important as the ESG factors that affect financial risk and performance.

That is embodied in what has become known as ‘double materiality’, or the effects of a business’s practices on both its bottom line and the world at large.

With the explosion of funds that consider ESG criteria and more interest than ever in sustainable investing, it might be increasingly important for portfolio companies to disclose both categories of material issues – and for asset managers to pressure them to do so, according to a panel at the recent US SIF Forum.

Until very recently, companies have all but been handed a free pass on environmental issues, allowing them to “externalize costs onto the public,” said Linda-Eling Lee, global head of ESG and climate research at MSCI. Now, however, it is much easier to identify the big contributors to climate change, and shareholders have moved to hold corporations accountable.

“We should be thinking about it from a historical perspective,” Lee said. “Stakeholders and the public started to see that what it is that companies are doing … We have a lot of technology now – there is nowhere to hide.”

Seeking information about how company operations affect the world is consistent with the idea that businesses shouldn’t just exist to be profit-generating machines, said Michael Kramer, managing partner and director of research at Natural Investments.

“There has always been this sense that companies have a purpose to benefit the public interest. I think that’s been lost along the way in recent decades, because we’ve let companies define what it means to them,” Kramer said. “It is thrilling that the conventional finance industry is seeing that and coming on board.”

But the idea isn’t new, and putting a name, double materiality, on the concept isn’t necessarily helpful, he said.

“I don’t like the term at all. We have a lot of terms that show up in our space to reframe what we have always called ‘social responsibility,’” he said. “This is industry speak, these terms. Our clients just want to do good in the world … They don’t need to parse these issues like we do.”

Twenty years ago, ClearBridge Investments wanted all of its analysts to be ESG specialists for the companies they covered, said Mary Jane McQuillen, head of ESG at the firm.

“The concept of double materiality is not necessarily new,” McQuillen said.

Nonetheless, companies today do not disclose sustainability factors anywhere nearly as much as financially material ones, and there remains much work to be done to get accurate and comparable information, she said.

Much has change in Europe, with the Sustainable Financial Disclosure Regulation (SFDR) Articles 8 and 9, she noted. Those requirements are akin to a restaurant getting a Michelin rating, where details such as ingredients, food temperature, flavor and presentation are extremely important, she said. By comparison, current US regulations around materiality disclosure – if the restaurant analogy is made – are more like basic requirements to have a table, chairs and food of some kind, she said.

The proposed SEC rule amendments for fund and adviser marketing and fund naming, combined with the climate-risk disclosure proposal, are like having truffle shavings added to a dish, she said.

But even with more information, how it is used is more important, as data on its own its materiality neutral, Lee said.

“There are ESG data – and there are ESG metrics,” she said. “It’s actually what you do with it” that matters.

“What’s very top-of-mind at the moment is carbon emissions … When a company discloses Scope 1, 2 or 3 emissions, it’s just a number,” she said. “You have to … combine it with other data, such as where [the company] is making the emissions, and the policy implications, and you can turn it into more of a risk number.”

Natural Investments provides ratings for socially responsible mutual funds, on a scale of one to five hearts. That includes subcategories of ESG screening, shareholder advocacy and community investing.

“Clients generally trust us to do the research properly, so that if they see something in their portfolio that they have questions about, that there is a really good reason that it’s in their portfolio,” Kramer said. “The data is critical to be able to answer that question – and sometimes they don’t like the answer they get … it reinforces that values are subjective.”