[Aanchal Kabra is a 5th year B.A. LLB (Hons.) student at the West Bengal National University of Juridical Sciences, Kolkata]
The concept of ‘materiality’ in financial disclosures was first introduced in the United States Securities Act of 1993. Thereafter, the United States Securities and Exchange Commission (‘SEC’) has maintained a consistent understanding of what information constitutes ‘material’ information as matters which an average, reasonable investor would likely attach importance to in determining whether to purchase a specified security. In 1999, the SEC further provided a list of non-exhaustive qualitative and quantitative considerations for determining materiality, indicating that even small misstatements or transgressions can be material if a reasonable investor would consider them significant. Presently, the SEC is considering the extension of the term to non-financial environmental, social, and governance (‘ESG’) disclosures, noting that even though ethical investors may consider this information significant, that does not automatically warrant mandatory disclosure of the same.
In contrast, the European Union (‘EU’) has expanded ‘materiality’ substantially and created extensive requirements for companies with regards to ESG disclosures. The EU sustainable finance framework acts in furtherance of the European Green Deal, which strives to make Europe the first climate-neutral continent by 2050, codified in European Climate Law. The framework consists of (i) the Taxonomy Regulation, which classifies economic activities indicating their sustainability; (ii) the Sustainable Finance Disclosure Regulation, which imposes ESG disclosure requirements on manufacturers of financial products and financial advisors; (iii) the Corporate Sustainability Reporting Directive (‘CSRD’), which establishes ESG disclosure requirements for certain types of companies; (iv) the Green Bond Standard, which underscores a voluntary standard for green bonds; and (v) the Climate Benchmark regulations, which make climate benchmark methodologies uniform and transparent.
The CSRD is a successor to earlier corporate disclosure requirements in the EU and is based on the ‘double materiality perspective’. In this post, the author explores the application of the double materiality perspective for ESG disclosures in India and the merits of such application.
Double & Dynamic Materiality
The concept of double materiality was first introduced by the European Commission in 2019 in the Guidelines on Non-financial Reporting, 2019. It is premised on the idea that materiality is two pronged – it is not only financial, but also environmental and social. In furtherance of this, companies must disclose not only how sustainability issues may affect the future of the company, “but also how the company affects society and the environment.” Disclosure of this information must be made to the extent necessary to understand the development, performance, position, and impact of a company’s activities. This is in view of the fact that as ESG becomes increasingly intertwined with corporate and public policy, the positive or negative impact of a company on ESG standards will become increasingly material to determine the company’s risk profile. A company’s impact on its external environment will rapidly translate into opportunities and risks, both of which may affect its valuation or an investor’s decision to invest.
This is further reiterated by the World Economic Forum, which established the concept of dynamic materiality in its 2020 white paper on the subject. Dynamic materiality argues that what is “financially immaterial to a company or industry today can become material tomorrow.” As transparency gains prominence, a company’s disclosures also grow in importance. The era of hyper-transparency has increased the rate at which seemingly immaterial issues (financially) are becoming material to investors. For instance, movements like #Metoo or #Blacklivesmatter can disseminate information rapidly and quickly become material to a company depending on its diversity policies. Thus, the ability to predict stakeholder reactions to emerging issues in sustainability is critical for businesses and their performance. Investors need access to this information to make informed decisions regarding their money.
The Need to Include Double Materiality
The perception of a company’s responsible behavior leads to less negative stock returns, even during a pandemic. Activist or government-led movements have a long history of materially affecting a company. For example, in India, after a campaign to boycott Chinese products, over 71% of Indians refused to purchase goods with a ‘made in China’ tag. Considering that China is India’s largest trading partner, this has negatively impacted several companies which depend on Chinese intermediaries.
Media pressure during activist movements can also significantly damage reputation on brand equity causing companies to frequently relent to public pressure. For instance, activist pressure has forced Nestle to previously stop marketing its baby formula in poor countries and recently suspend operations in Russia. Often, yielding to the public can come at a financial loss. More than 400 companies are facing similar pressure to exit from Russia. Shell, an Anglo Dutch oil company, has announced a gradual retreat from Russia at the cost of more than $5 billion. Similarly, social movements like the #Blacklivesmatter have previously led to nationwide consumer boycotts in the United States. Activism by ethical consumers can often lead to companies stopping sales of a particular product or terminating profitable partnerships.
Financial institutions may also refuse to invest in unethical or environmentally harmful projects. For instance, several international institutions refused to fund the environmentally harmful Rampal Power Plant, which is a joint venture between India and Bangladesh. Investors also divested from the Indian public undertaking NTPC, which is the co-owner of the project.
Frequently, in India, the judiciary has ruled against companies which harm the environment or act in contravention of public policy. In M. C. Mehta v. Union of India, the Supreme Court ordered more than 292 coal using industries, which were damaging the Taj Mahal, to switch to natural gas, relocate, or cease functioning. Similarly, in Sterlite Industries v. Union of India, the company had contravened provisions of the Air (Prevention and Control of Pollution) Act, 1981 due to lack of precautions and proper care while operating a plant in Tamil Nadu. While the company was allowed to operate the plant under certain conditions, it was liable to pay compensation amounting to INR 100 crores. Later, when it contravened the conditions imposed by the judgement, the plant was shut down. Pleas to reopen the same were denied as recently as 2020. The closure of the plant has significantly cost the parent company as it accounted for about two percent of its balance sheet.
In today’s age of ethical consumerism and stakeholder capitalism, increased transparency ensures that the footprint of a company can positively or negatively affect its sales or valuation. Thus, it is apparent that the impact of a company on its external environment can be significantly material to investors. It therefore remains critical for investors to be aware of this information to make an informed decision.
SEBI has mandated the top 1000 listed companies by market capitalization to make certain ESG disclosures by instituting the BRSR report. Presently, the BRSR report has limitations on the requirement for companies to disclose their impact upon society and the environment. However, it does possess certain indicators of the double materiality perspective. For instance, in Section C, under Principle C of the BRSR, businesses are mandated to disclose the percentage spend on R&D and capital expenditure investments in specific technologies to improve the environmental and social impacts of the company’s products and processes. Presumably, this might require the company to develop awareness of its impact upon its external environment. The company is also required to disclose whether it has procedures in place for sustainable sourcing as well as reclamation of products for reuse, recycling, and disposal.
The BRSR has certain guideline disclosures which a company may choose to undertake. Significantly, a company may voluntarily disclose whether it has conducted a ‘Life cycle Perspective/Assessment’ (‘LCA’) for any of its products or services and provide requisite details in relation to this. It may also voluntarily disclose significant social or environmental concerns identified in the LCA. An LCA is a method to evaluate the environmental impact of a product throughout its entire life cycle, inclusive of extraction and processing of raw materials, manufacturing, distribution, use, recycling, and disposal. For companies who choose to partake in such an assessment, this indicator would inform them and the involved stakeholders about the environmental impact of their functioning. Presently, there is no provision in the BRSR, voluntary or mandatory, requiring a company to investigate in the required detail its impact upon society similar to a double materiality assessment.
Thus, despite these provisions, there is still a need to mandatorily require companies to conduct a double materiality assessment, that is the inward and outward impact of a company and disclose the same to investors. Materiality assessments must seek to understand the effect of a company, dynamic materiality of issues, and the risks and opportunities faced due to sustainability issues. Such a disclosure requirement should not only calculate the impact of an organization on its external environment, but also the process of such calculation. The lack of disclosure and standardization of the process of materiality assessment reduces its credibility. This remains the only way to truly protect investors and future-proof Indian companies.
– Aanchal Kabra