Two sides of the story: double materiality

Ruud Hadders
Responsible Investment Officer - ACTIAM

Dear Caspar,

The financial sector has become an important driver of climate action in recent years. Investors have come together in alliances that advocate net zero emissions, while 90 central banks and financial regulators have joined forces in the Network for Greening the Financial System. The European Union also sees the financial sector as a motor in the transition towards a more sustainable society.

In general, climate action in the financial sector consists of setting minimum ethical thresholds and managing climate-related risks. Significant strides have been made particularly with regard to climate risks in recent years. Thanks to the work of the Task Force on Climate-Related Financial Disclosures (TCFD) and other bodies, there is now a growing general acceptance that climate-related impacts on business operations can be material and that such information should be disclosed.

However, some activities can have significant externalities without affecting the value of a company. Take the presence of conflict minerals in the supply chains of electronics companies. The purchase of minerals extracted in conflict areas in many cases contributes to the perpetuation of the conflict and thus human rights violations. On the other hand, conflict minerals have not been proven to negatively impact business value. In other words, it is not financially material in the traditional sense of the word.

In 2017 however The European Commission introduced double materiality as part of the Non-Binding Guidelines on Non-Financial Reporting Update (NFRD). Double materiality means that a negative or positive effect of a company can also be material if it does not affect its value. Companies therefore should assess and publicly disclose these externalities as part of their reporting.

Double materiality is already recognised partly in the EU's Sustainable Finance Disclosure Regulation (SFDR). Furthermore, the current Special UN Envoy on Climate Action and Finance, Mark Carney (formerly the Chair of the organisation that created the TCFD) is calling for the disclosure of double materiality to be made obligatory worldwide in the run-up to the COP26 climate top to be held in Glasgow later this year.

Although the basic definition of double materiality is now generally accepted, its actual meaning is still a subject of debate. In principle, a company's impacts on the climate or the environment as a whole can be material. But how do we know exactly what a material impact is? The material impact of water pollution can perhaps be measured fairly accurately, but what about the impact of companies on social equality, for example?

Therefore, double materiality is still an abstract concept. Its true meaning will very probably be a subject of dispute for some time yet. Until there is an actual method for measuring and reporting double materiality, everyone will interpret it in their own way, thus making it an arbitrary construct with inherent risks of greenwashing.

Introducing double materiality into reporting will increase the amount of attention given to non-financial topics. Companies made to report on them will be more readily inclined to take action and set goals to reduce their impacts, while government authorities will be able to implement and impose policies. In that case, double materiality would have a role in predicting whether a topic also becomes financially material over time.

How do you view this concept as a portfolio manager? To what extent do you take account of investment impacts on society if they don't – or don't yet – have any direct impact on the investments themselves?

Regards, Ruud

Caspar Snijders
Portfolio Manager Equities - ACTIAM

Hi Ruud,

The way investors view double materiality, very much depends on their investment horizons. I will give a few examples to explain this.

Tobacco has for many years been an investment that many Dutch sustainable investors have ruled out. Tobacco's adverse effects on public health and the associated costs to society are things everyone has known about for a long time. Just looking at the last 20 years, when investors and society as a whole can certainly be said to have been aware of the negative effects of cigarettes (accounting for 1.8% of global GDP), you can see that the financial materiality in that regard does not correspond to the sustainable materiality. If we compare the broad market returns over the past 20 years based on MSCI World (212%) with the returns in the tobacco industry based on MSCI World Tobacco over the same period (592%), you can see that the latter has done a lot better. In other words: the sustainable materiality (the costs to society) does not correspond to the financial materiality (the investor's costs). The value of the tobacco companies rose, even though the costs for society were high.

Therefore, the negative impacts of the tobacco industry were not reflected in the market value, otherwise the tobacco industry would not have performed better than the broad market. But if you look a little further, you will see that the tide seems to have turned. If we make the same comparison over the past five years, we see that the returns based on MSCI World (90%) were significantly better than those based on MSCI World Tobacco (-8%). Laws and regulations on tobacco and smoking were tightened in that period with the result that the sustainable materiality (impact on society) and financial materiality (impact on market value) now closely correspond to each other.

The oil industry is showing a similar trend. Until the end of 2019, the oil sector routinely performed better than the broad market, even though there was long-standing evidence that greenhouse emissions have a significant impact on the climate and therefore on society as well (the costs over the next two decades are estimated at between €250 billion and €41 trillion).

However, you can see that from the end of 2019 (i.e. including the pandemic year), the broad market has been doing a lot better than the entire oil sector. That is of course partly explained by the reduced demand for oil due to travel bans. But if you look further, an added factor is the accelerated sustainable transition ignited by the corona crisis. Investors are seeing the negative consequences of this accelerated transition on the oil sector.

In citing these two examples I would go so far as to say that the concept of double materiality would actually be partly superfluous if financial materiality were to be considered over a long time horizon. You can see that in many sustainability-related topics, including not only climate or healthcare but also diversity. A company that does not have diversity high on its agenda can suffer financially as a result of tightened rules, being less attractive to new talent or because of a "yes-man" culture that brooks no dissent. I do not believe that that will have an immediate financial impact, but it certainly would in the long term.

Implementing double materiality in practice will probably be difficult. Many parties will interpret the classification of sustainable materiality and financial materiality differently. However, everyone should be able to identify the most important topics. What we have yet to find out, is whether investors will then choose to continue supporting companies because they have more information or rather base their decisions simply on the latest quarterly figures if they happen to be disappointing.

Regards, Caspar