What is Impact Materiality?
In a financial reporting context, materiality generally refers to a threshold upon which information is relevant and would influence the decision-making of stakeholders. For example, a company with $1 billion in revenue would not worry about whether uncollectible accounts receivable are $500 or $600 because the company is so big. However, that same company might be concerned if those uncollectible accounts receivable totaled $50 million. Materiality is unique to each company and requires significant judgment to determine what is material.
Similar to materiality in financial reporting, ESG disclosures also have thresholds upon which information is likely to influence investors' decisions. This concept is known as impact materiality. For example, Microsoft, a multinational corporation, would probably not report on installing a single "free little library" in Bellevue, Washington. However, Microsoft would likely report on its community initiative to teach 30,000 girls how to code. One of the key aspects of ESG reporting is determining and disclosing how a company's actions affect the world. In this article, we will discuss the importance of impact materiality, how it relates to current and proposed standards, and what companies are doing to disclose and report on impact material issues.
Why Does Impact Materiality Matter?
Together, materiality in financial reporting and impact materiality constitute double materiality. The concept of double materiality, which was first formally described by the European Commission in 2019, refers to the idea that corporate information can be significant for both its implications on a firm's financial value and its impact on the wider world. The Global Reporting Initiative (GRI) referred to these two concepts as “the only relevant forms of materiality” in this article. While all companies already consider financial materiality as a part of reporting, very few companies examine impact materiality. Impact materiality aligns with the goal of ESG reporting, which is to inform stakeholders how a company is ensuring proper governance and engaging with the environment and society. As a result, understanding impact materiality assists companies in determining what information is most relevant to stakeholders.
Impact materiality also encourages companies to broaden their definition of a stakeholder. While companies generally define stakeholders as investors, employees, suppliers, customers, and creditors, impact materiality widens this range to include communities, governments, non-governmental organizations (NGOs), academics, the media, and the overall environment. This expanded view forces companies to consider people and organizations affected by the companies’ actions, especially indirectly.
The Evolution of Corporate Social Responsibility
The concept of impact materiality is a big step towards the evolution of corporate social responsibility. In 1970, American economist Milton Friedman wrote, “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits”. This perception of the corporation has evolved over the past 50 years. In 2019, Business Roundtable released a statement titled "Statement on the Purpose of a Corporation," signed by 181 CEOs. The CEOs pledged a commitment to prioritize the well-being of all stakeholders, not just shareholders, while also increasing profits. The statement reads, "While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders." Additionally, the statement outlines the CEOs' commitments, including a pledge to prioritize sustainability by embracing environmentally sustainable practices and showing respect for the people in their communities.
CEOs representing businesses across various industries, including aviation, banking, construction, defense, and energy, have pledged to prioritize stakeholder well-being over shareholder profits. Contrary to Friedman’s words over 50 years ago, there may be more than one social responsibility of corporations.
Impact Materiality and Current/Proposed Standards
The Securities and Exchange Commission Proposed Rule
In the SEC’s proposed rule, the SEC does not mention impact materiality or double materiality. The Commission is “proposing to require disclosures about climate-related risks and metrics reflecting those risks because this information can have an impact on public companies’ financial performance or position and may be material to investors in making investment or voting decisions.” While this section of the proposed rule seems to put more focus on information affecting financial performance, the SEC does state that there are more factors to materiality. For example, materiality is a combination of magnitude and probability.
As defined by the Commission and consistent with Supreme Court precedent, a matter is material if there is a substantial likelihood that a reasonable investor would consider it important when determining whether to buy or sell securities or how to vote. As the Commission has previously indicated, the materiality determination is largely fact specific and one that requires both quantitative and qualitative considerations. Moreover, as the Supreme Court has articulated, the materiality determination with regard to potential future events requires an assessment of both the probability of the event occurring and its potential magnitude, or significance to the registrant.
The SEC also requires that registrants disclose the financial impacts of climate-related events and transition activities. However, the SEC’s proposed rule is more broad in what is considered material for climate-related events. Any climate-related event that would affect a line item of a company’s finances by more than 1% would be considered material. For more information on this topic, see our article on the 1% Aggregate Absolute Value Bright Line Materiality. Impact materiality is similarly broad, yet differs from this 1% aggregate value of materiality in that it is not quantitatively defined and focuses on the external impact of a company’s actions rather than the environment’s financial impact on a company. For more information on the proposed SEC rule, see our recent article.
European Financial Reporting Advisory Group
Under SEC requirements, companies would disclose potential financial risk to shareholders, yet some might argue that its disclosure does not appropriately discuss the impact on all company stakeholders. Other standard setters such as the European Financial Reporting Advisory Group (EFRAG) are looking for the impact on stakeholders of the company, thus leaning into the concept of impact materiality. EFRAG was mandated to draft European Sustainability Reporting Standards (ESRSs). The initial draft of the ESRSs defines impact materiality this way:
A sustainability matter is material from an impact perspective when it pertains to the undertaking’s material actual or potential, positive or negative impacts on people or the environment over the short-, medium- and long-term time horizons. Impacts include those caused or contributed to by the undertaking and those which are directly linked to the undertaking’s own operations, products, or services through its business relationships.
Currently, the implementation timeline for the EFRAG’s proposed standard is still unclear. In the meantime, other regulatory agencies are unsure whether they will move forward with the double materiality standard. In its most recent exposure draft, the IFRS refrained from committing to an impact approach for defining materiality. Instead, “[each] entity would be required to use judgment to identify what is material, and materiality judgments are reassessed at each reporting date.” Proponents of double materiality have submitted comment letters, suggesting that “sustainability without double materiality is not true sustainability.”
Standard setters, organizations, and companies are clearly considering and redefining what materiality means. While companies must comply with the appropriate regulatory authorities and their respective definitions of materiality, there is also room for companies to voluntarily disclose what they deem to be material.
How Companies are Disclosing Material Impacts
Impact materiality is a relatively new concept, and few companies are addressing impact materiality in financial statements or other public filings. Many companies address impact materiality in auxiliary filings, such as sustainability reports.
Chilean Cobalt Corporation
Chilean Cobalt Corporation (C3) is a Pennsylvanian mining company that is working to develop cobalt mines in Chile. In C3’s S-1 registration statement, the company describes challenges that it is currently facing, including “changing laws, regulations and standards relating to corporate governance and public disclosure.” The rapidly changing regulatory environment makes it difficult for C3 to know how to properly address areas of increasing stakeholder interest, such as ESG. The company included the following regarding the challenges the company faces in addressing impact materiality:
The concept of impact materiality, related to a company’s reporting for impacts on the economy, environment and people, will eventually create a double materiality standard, when combined with financial materiality, which could cause risks emanating from the level of overall required disclosures, for which C3 would expect to mitigate based on its proactive approach to ESG and its alignment with emerging leading global standards. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.
Uncertainty regarding the role of impact materiality in reporting may be a concern for companies that issue financial statements. Understanding impact materiality and the role it can play in disclosing information can help companies avoid this dilemma.
3M is a multinational conglomerate that operates in various industries, including health care and consumer goods. In 3M’s 2022 Sustainability Report, the company outlined its approach to assessing impact materiality. 3M worked with an outside consulting firm to gather data on stakeholder’s perspectives regarding 3M’s sustainability strategy. 3M took a wide approach to define stakeholders, including “customers, suppliers, NGOs, corporate/private sector, academics, consultants, government, media, finance, trade associations, and think tanks.” By considering a wider range of stakeholders, 3M was able to receive direct feedback on how its sustainability strategy affected people, communities, and the environment. After gathering this data, 3M analyzed it to determine what issues were material to those surveyed. 3M found 18 areas to measure impact materiality and reported on those areas.
An example of an area of impact materiality reported by 3M is water quality and usage. This was identified as a critical area by stakeholders. In 3M’s sustainability report, the company explained that they had hit their 2022 goal of reducing water usage by 10%. The company also outlined their plan to improve the quality of wastewater returned to the environment through investments in water purification.
Walmart, the largest publicly traded company in the world by revenue as of 2022, publishes an ESG report each year. In the 2020 edition of Walmart’s report, the company published the following note on materiality:
Materiality, as used in this report, and sometimes referenced as “ESG materiality,” and our materiality review process, is different than the definition used in the context of filings with the SEC. Issues deemed material for purposes of this report and for purposes of determining our ESG strategies may not be considered material for SEC reporting purposes.
Walmart outlines the clear gap between impact and financial materiality. As discussed previously, the SEC’s definition of materiality is focused on and measured by financial metrics. Companies such as Walmart are bringing impact materiality to light by making voluntary disclosures that are beyond the scope of SEC requirements.
General Motors Company (GM)
GM is the largest automobile manufacturer located within the United States as of the end of 2022. In its 2021 Sustainability Report, GM outlined its four-step process for determining impact materiality:
- Identify a list of sustainability topics relevant to GM and the automotive industry
- Understand stakeholder perspectives and priorities through an internal survey of more than 100 GM employees as well as 40 interviews with internal and external stakeholders
- Score the topics based on quantitative and qualitative inputs
- Prioritize the topics through the development of a tiered matrix as shown [in the report]
GM reported that there were six topics identified by stakeholders as being in the “highest priority.” These topics fit neatly into the different aspects of ESG:
- Environmental: Climate Risk & Resilience, Product GHG Emissions, and EV Infrastructure
- Social: Diversity, Equity & Inclusion, and Vehicle Safety
- Governance: Business Ethics
In the report, GM detailed its efforts in each of those categories and described its future goals. For example, in the section about Diversity, Equity & Inclusion, GM reported that 31.9% of top management were women, and that the company engaged in a “rigorous annual process” to ensure that there was no pay discrimination amongst female employees.
Impact materiality helps companies determine which ESG efforts are important to stakeholders, and thus should be disclosed. While it is not currently a part of any standards or regulations in the United States, companies can use it to enhance voluntary disclosures relating to ESG issues. Understanding what impact materiality is and how it may be utilized by a company can be an important step in improving ESG-related disclosures.