Reflections from a materiality session at DG FISMA
20 November 2019 - By Donato Calace
On Monday 11 November 2019, I had the privilege of attending and contributing to the invitation-only session on materiality organized by the EU Commission Directorate-General for Financial Stability, Financial Services and Capital Markets Union (DG FISMA).
Revising the Non-Financial Reporting Directive
With the introduction of double materiality and a full revision on the Non-Financial Reporting Directive (NFRD) “95% likely to happen,” the team at DG FISMA has been tasked to run a “fitness check” of the NFRD requirements – including the materiality definition and principles.
Together with a select group of materiality experts, including academics, corporate leaders, investors, industry associations, and auditors, we shared ideas and recommendations on the policy gaps and the direction in which the new requirements should go.
Materiality beyond reporting: some recommendations from the panel
The panel unanimously agreed that the current definition of materiality (see the box below) in the NFRD should not change. The domain of materiality definitions is already overcrowded, and a new definition would only increase the confusion and fragmentation. Rather, policy is lacking at the operational level of materiality, i.e. the operationalization of principles in concrete tests, procedures, and analytical techniques that can be used to make robust and credible materiality judgements. This is where the NFRD revision can bring more clarity.
Materiality: "to the extent necessary for an understanding of the undertaking's development, performance, position, and impact of its activities..."
The purpose of materiality goes beyond reporting. Corporate leaders leverage materiality assessments for strategy making, as a risk management process, and as an accountability compass. The ambition of the Commission is to extend those best practices and make them a standard.
On a practical level, a materiality assessment is a multi-stakeholder, multi-perspective, multi-source, multi-level (i.e. group, subsidiary) exercise. As of today, materiality preparers have a high degree of freedom in determining those variables, with the result that the overall quality, transparency, and comparability of materiality assessments are very poor. A new policy should ensure clear and detailed requirements on what constitutes a robust and reliable materiality determination process, providing auditors and users with a methodological benchmark to compare a company’s materiality analysis against.
Users of ESG information (e.g. raters, investors) most of the time find companies’ materiality determination irrelevant. More policy guidance is needed from the users’ perspective in terms of their own materiality analysis (i.e. how they identify material issues for sectors and/or portfolios), and how to read and use the preparers’ and reporters’ materiality judgements.
What would you do if you were the European Commission?
After sharing their reflections, the session participants were organized into three groups – preparers, users, and supervisors. The three groups were then asked to respond to the following questions:
Overall, they agreed that a new policy should:
- Ensure board engagement
- Require a comply or explain mechanism for material issues against a repository of minimum sectoral core themes
- Include guidance on the materiality determination process, with a principle-based benchmark methodology
- Demand third party audit
- Integrate ESG information into the management report
- Be binding.
The preparers’ recommendations
The ultimate goal of the NFRD is to incorporate ESG issues into management’s strategic thinking and bring a long term approach to the board level. This is achieved through reporting obligations. The group therefore proposed that we should define a common core of what should be reported on, to ensure comparable basic data, and define basic materiality matrices across industries.
ESG information should be integrated into one report – the management report – and ad hoc/thematic reports can integrate the information from this report. The policy has to be binding to be impactful.
The users’ recommendations
There is a lack of information on board engagement in determining what is material and what is not material. There are also problems with the quality of data. The group proposed extending the TCFD approach to other themes, including requirements on targets and governance processes to ensure that materiality and strategy are connected, and introducing industry-based materiality benchmarks.
Policy should strike a balance between defining a top-down set of material issues per industry, and setting out only a general definition and principles on what is material.
The supervisors’ recommendations
Explaining a mechanism for material issues is not sufficient. The explanation needs to be made robust and exhaustive through standardized guidance, methodology benchmarking and auditing.
There needs to be principle-based benchmarking, binding guidance and mandatory assurance on the materiality determination process.
Concluding comment – by Richard Howitt
The implications of a binding policy including these recommendations are wide and far-reaching. I asked Richard Howitt, outgoing CEO of the IIRC and former MEP who originally proposed and negotiated the NFRD in the European Parliament, to comment.Richard Howitt: “The definition of materiality remains highly contentious between reporting frameworks who view the investor as the final audience, and those who give equal weight to stakeholders, hence the Commission’s proposed double materiality approach. However, what came from this workshop, which seems unassailable to me, is that whichever materiality determination is chosen, it should be demonstrated transparently in the report.
“Of course, the question of materiality strikes at the heart of whether we should have called it ‘non-financial’ in the first place. As Donato and Datamaran rightly say, the TCFD underlines that this is deeply financially material to the company, and that increasingly we will find this to be equally true of the ‘s’ and ‘g’ in ESG too – indeed it could be argued in every one of the areas covered by the Sustainable Development Goals.
“I believe the momentum built up by the European Commission’s sustainable finance action plan, and the fact the excellent Valdis Dombrovskis is nominated to maintain this brief in the new Commission, makes it all but certain we will see a revision of the Non-Financial Reporting Directive within two years.
“This means there is urgency in addressing these questions. What we are debating about materiality today, is itself highly material to tomorrow.”
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