Sustainability reporting and auditing Double Materiality Assessments (DMA)

What is the underlying difference between impact materiality and financial materiality?

As organizations are mandated to assess both impact materiality and financial materiality of potential sustainability topics, it is crucial to understand the differences between the two.

An impact materiality assessment determines material topics based on an organization’s actual or potential impacts on people and the environment, within the organization’s operations and value chain. It is important to note that material here is not defined in the traditional auditing sense, as determining materiality during a financial statement audit. Instead, material as defined by the CSRD is used to describe a sustainability topic that has significant impact of an organization’s activities or performance. Accordingly, the impact materiality perspective focuses on the effect an organization has on the world. A sustainability topic is assessed based on:

• Likelihood and severity of the topic’s impact on people and the environment.
• Whether the topic is actual or potential.
• Whether the impact of the topic is positive or negative on people and the environment.

An example of a material topic to consider for a software company could be to assess the impact of locating data centers in potentially water-scarce or water-dense regions of the world.

On the other hand, a financial materiality assessment determines whether a sustainability topic has potential financial risks or opportunities for an organization. The financial materiality perspective assesses whether a sustainability topic creates risks or opportunities that have a material impact on factors such as:

• An organization’s cash flow.
• Growth and development.
• Financial performance.
• Timespan of impact: short, medium, or long term.

One example of a material topic to consider as part of the assessment could be potential areas for loss of physical assets due to extreme weather conditions.

What is internal audit’s role in Double Materiality Assessments?

Internal audit can play a unique role in delivering assurance on the DMA, and there are numerous areas for value creation.

Because of internal audit’s independence within an organization, objective evaluation of the DMA can be provided. Evaluation of the DMA can help to validate the methodology used in the assessment and verify the accuracy and reliability of the data. Internal audit’s review can therefore assess the robustness of the DMA method and help to identify areas where efficiency and effectiveness may be improved.

Further, an additional set of eyes on the DMA can help verify that no sustainability topics — whether actual, potential, positive, or negative — have been omitted from the assessment, and can validate that no emerging risks and opportunities have been overlooked. Internal audit’s review of the DMA can therefore help to prevent errors or misrepresentations of material sustainability topics, and thereby improve overall compliance with the ESRS. 

Lastly, as the DMA will later be assessed by an external audit, internal audit’s review of the DMA can establish preliminary assurance of the process and overall outcome.

Key steps to auditing the Double Materiality Assessment (DMA)

Gain familiarity with relevant regulations and leverage expertise

To assess and review any organization’s double materiality assessment, foundational knowledge is crucial, such as the definitional background noted in the section above. To obtain this knowledge, and speaking in terms of firsthand experience, our team had to gain an understanding of current ESG trends and pressures, relevant regulations and standards, and leverage external sustainability expertise.

Firstly, our team took the time needed to learn more about the increasing relevance of ESG. This included participating in webinars and seminars focused on ESG topics provided by professional organizations and industry subject matter experts. Becoming thoroughly acquainted with the CSRD and the ESRS also meant learning and understanding why the European Union has proposed the CSRD and what it is trying to achieve. Similarly, we obtained a better understanding of the different ESRS on how to report sustainability information, and the metrics and methodologies that organizations are expected to use, especially as a guide to perform the double materiality assessment.

Once a comfortable understanding of the ESG space was obtained and we learned how the double materiality assessment was conducted by our organization, we leveraged the expertise of sustainability consultants. A session with subject matter experts was scheduled to clarify any doubts encountered while doing a deep dive of the ESRS and we were able to ask any outstanding practical questions relating to the requirements of the double materiality assessment. This type of expertise and service is regularly given by Big Four and boutique firm consultants.

The key takeaway here is that to gain the required knowledge to assess and audit the double materiality assessment, it is necessary to take advantage of the various resources and learning methods that are at your disposal.

Review, analyze and logically assess the DMA

The following list elaborates on five key checks performed that are necessary to audit the double materiality assessment. 

1. Review stakeholder mapping. A starting task for the DMA is to identify and map stakeholders that affect the organization and stakeholders that are affected by the organization. To check the completeness of the established stakeholder list, it is recommended to re-perform this mapping process. This exercise allows an evaluation of whether all relevant stakeholders of an organization have been identified.
2. Analyze the long list of material topics. To ensure material topic list completeness, review the sector-agnostic material topics identified and compare them to the topics outlined in the ESRS. Next, analyze the entity-specific topics that had been identified as unique to your organization’s industry, activities, and geographical reach. It is also important to make note not to forget potential material topics in the value chain. For each identified material topic, evaluate the reasoning and data for the topic as well as for the sake of consistency and how material topics are documented.
3. Review of the impact materiality assessment. For each identified material topic, evaluate the justification for the direction of the impact (positive or negative), the type of impact (actual or potential), and the time horizon (short, mid, or long-term). Furthermore, assess the supporting documentation of the ranking of the scale of the impact, the scope of impact, the irremediable character, and the likelihood of occurrence of each material topic. It is important to note that where qualitative reasoning is used as justification to rank material topics, clear and traceable documentation is crucial. Notably, quantitative data for topic ranking could be achieved through internal and external interviews and surveys.
4. Analyze the financial materiality assessment. The CSRD mandates that organizations investigate the financial impacts of material topics. Accordingly, for each identified material topic, it’s important to assess the justification for the type of effect (risk or opportunity), the value chain category (upstream and suppliers, own operations, customers, downstream beyond customers or across the value chain), and the allocated time horizon (short, mid or long-term), as well as review the effect of the material topic on the ability to continue to use or obtain resources, maintain relationships, the size of financial effect, and the probability of occurrence. A key takeaway from this check is to gauge whether organizational expertise has been utilized in the justification of the rankings. For example, were finance experts in the organization consulted when the size of financial effects was determined? How was this documented?
5. Critically evaluate the final short list of material topics. Once the material topics have been identified, justified, and ranked accordingly, make sure to have sufficient time allocated to assessing whether the final list of material topics are the most critical to your unique organization. Although there are strictly no limits, organizations tend to produce a short list of 8-15 material topics. Further, it is important to ensure that the identified material topics are intuitive and specific to your organization. A review such as this may force you to take a step back and ensure that the final list of topics is representative of what your organization does daily and evaluate what the organization needs to exist and function.

Key takeaways from auditing the DMA

1. Clear documentation and transparent choices are critical. Validate that any assumptions and justifications are documented as this will ensure traceability and reproducibility of the double materiality assessment.
2. To accurately account for the material topics relevant to an organization, consider all divisions and business units that an organization has. Different sectors, businesses, and geographical locations may expose an organization to various impacts, risks, and opportunities. These are all important to identify and consider as part of the DMA. It is here that internal audit can take advantage of its comprehensive understanding of the organization.
3. The double materiality assessment should be interdisciplinary. It is crucial to leverage an organization’s expertise to the fullest ability. Ensure collaboration with multiple departments such as compliance, procurement, risk, and finance to identify relevant topics and to assess associated risks and opportunities. A clear example would be that an organization’s finance team may have a very clear and concise understanding of the financial effects of risks-like revenue loss.
4. Review the impact materiality assessment holistically. Critically assess the material topics from an independent point-of-view and ask yourself questions such as whether it is reasonably justified to rank privacy higher on impact materiality than privacy. If the answer is yes, ensure that the reasons are clearly explained and documented. If the answer is no, then you may need to go back and re-assess the scoring of both topics.
5. Be mindful of a changing landscape and regulations. ESG regulations and standards are up and coming, new and dynamic. Guidance applied at the time of the writing of this article may have been updated. Staying up to date on regulations is crucial, specifically relevant to the double materiality assessment. It is important to note that the ESRS is in the process of developing sector-specific material topics that organizations will have to consider as part of the assessment.

In closing, while there is no single prescribed method for producing or assessing a double materiality assessment, our focus as internal auditors should be on ensuring the process is thorough, transparent, and aligned with the unique characteristics of our organizations. By doing so, we can help organizations comply with regulatory requirements and drive meaningful progress in ESG initiatives.