Overcoming challenges in materiality assessments under ESRS

Companies subject to the Corporate Sustainability Reporting Directive (CSRD) must determine their applicable disclosures through an assessment of the company’s material impacts and sustainability-related risks and opportunities (IRO). Eventually, the process and results may also be subject to a mandatory audit.

The European Sustainability Reporting Standards (ESRS) feature five environmental topics, four social topics and one governance topic, which may pose a significant challenge to companies with little previous sustainability engagement. Companies may lack knowledge about areas such ecology, climate sciences, or social effects, and therefore may miss and misjudge impacts, risks, and opportunities.

While this represents an opportunity for consultants to engage in capacity building, they should be wary of overtaxing their clients. Alternatively, auditors may provide significant input to the assessment to address blind spots, but should take care to maintain their mandated independence.

Exercising judgment to overcome constraints throughout the process

Throughout the assessment itself, a variety of challenges call for significant judgment from reporting companies as well as consulting and auditing firms. This need for judgment emerges from a lack of specificity in the ESRS about benchmarks and methods for IRO identification and assessment. A successful consulting or auditing engagement thus relies on gauging the existing expertise, ambition, data, and resources of the company to be able to determine appropriate methods.

The first specific challenge lies in the trade-off between the use of formal methods versus a subjective judgment of impact. For example, while a Life Cycle Assessment (LCA) is seen as the environmental gold standard, many smaller firms lack the capacity to conduct one, at least initially. Assumptions instead would be required, based on secondary data such as industry or product studies, media reports, and expert/stakeholder opinions. However, this reduces the accuracy of the assessment.

The second challenge concerns the involvement of stakeholders demanded by the ESRS. However, the timing, extent, and approach for this involvement are left open. Many companies lack a systematic stakeholder management approach. They have to work with existing stakeholder touchpoints, such as requests from representative banks or customers that reveal environmental, social, and governance (ESG) aspects. An internal survey of knowledgeable employees may help to systematically analyse these viewpoints, while business stakeholders may reveal their standpoints in their own ESG reports.

Such third-party ESG reports point toward the third challenge. While the ESRS call for an assessment of the upstream and downstream value chain, its extent is not mandated. Additionally, companies without significant leverage or goodwill will struggle to assess the specific impacts of their value chain partners. If these partners are also subject to the CSRD, their ESRS reports can be fed into the assessment. Otherwise, materiality must be judged subjectively, again based on generic secondary data.

Conclusion: working towards a gradual improvement of report quality

In conclusion, the key decision for companies, consultants and auditors is judging what constitutes reasonable effort and plausibility of conclusions. The resource- and ambition-based differences in these judgments may cause a significant spread in assessment and report quality. 

After uninitiated companies have grappled with first-time application of the ESRS, the consulting practice can try to increase the accuracy of the assessment through the gradual introduction of best practice methods such as life cycle assessment (LCA). With this approach, it is not unreasonable to expect stakeholders to begin factoring report quality into their evaluation of ESG considerations in the future.

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Boris Michels (CPA, CVA, Tax Advisor) is Senior Partner in the Audit Department of nbs partners in Hamburg and Global Chairperson of the GGI ARC Practice Group. With more than 20 years of experience, Boris is responsible for international assignments and quality control.

Dr Simon Norris advises large clients of nbs partners on the implementation of ESRS reporting and sustainability management approaches. He gained his expertise through his doctoral research at the Centre for Sustainability Management of the Leuphana University Lüneburg.