Double Materiality: A Comprehensive Approach to Assessing Sustainability
In recent years, ESG considerations have gained significant standing in the corporate and investment spheres, reflecting a growing concern for sustainability challenges and how companies impact the planet and its people. ESG criteria, aimed at evaluating companies based on their environmental, social, and governance practices, have played a crucial role in defining corporate responsibility and accountability. More recently, however, ESG has experienced a backlash. Leaving politics aside, one key constructive criticism that was raised is that this ESG assessment predominantly focuses on how climate and social issues affect the company’s operations – in other words, an "outside-in" perspective. While this perspective is useful in acknowledging and managing such risks, it tends to fall short of addressing how an organization can create positive change for the planet and society at large (“inside-out”). In other words, ESG tends to emphasize "how you do it," but lacks a comprehensive view including “what you do”, which accounts for the net impact of a company's products and services on society.
To address these challenges, we at Sustainable Market Strategies apply the concept of “Double Materiality”, offering a distinct and more comprehensive approach to evaluating sustainability. In addition to the “outside-in” perspective of ESG, Double Materiality also has an "inside-out" perspective, recognizing that a sustainability assessment must not only account for the impact of external risks on a company's activities but also the transformative potential of a company’s products and services.
What is Double Materiality?
To understand the concept of double materiality, one must consider its two distinct components: Operational Performance and Product Impact.
Operational Performance
Operational performance focuses on a company’s ability to run its business in alignment with robust sustainability principles. This aspect centers on how well a company manages its “material” ESG risks. It addresses concerns related to environmental impacts, labor practices, and ethical governance, depending on the industry the company operates in. For instance, GHG emissions is a really important metric for a cement producer, whereas it may not be as relevant as a metric for a software company. Reversely, a key metric for that software company might be data privacy, which would be irrelevant for the cement producer. Operational performance assesses the "how you do it" dimension of a company. Essentially, it examines the company's compliance with ESG standards.
Examination of a company's operational performance has potential for effective engagement. After identifying areas of weakness, engagement strategies can be tailored to target areas where a company's operational performance falls short of sustainability standards. Investors can influence the company to change specific practices to improve its operational sustainability.
Product/Service Impact
Product Impact is focused on the "what you do" dimension, emphasizing the impact of a company's products and services. This aspect accounts for the "inside-out" perspective. It assesses the positive or negative influence of a company's products and/or services on sustainability and society.
Considering the impact of a company's products and services, it can be challenging when a company's core product or service offering is misaligned with sustainability goals (see the example with tobacco company Philip Morris below). For these companies, opportunities for improvement are limited as the company is unlikely to change products. However, this can help investors identify areas of exclusions for their portfolios.
Examples
The following examples illustrate the importance of considering both aspects of double materiality: operational performance and product impact.
Schneider Electric:
Operational Performance: Schneider Electric demonstrates leadership, notably through its substantial renewable energy use and sustainable procurement policies.
Product Impact: Schneider Electric’s main activity is to produce energy efficiency solutions through digital energy management. The company’s products are essential in our cities and infrastructure to make the transition to a lower carbon economy.
Schneider excels in both aspects of materiality.
Philip Morris:
Operational Performance: Philip Morris receives high praise from ESG rating agencies for its exemplary operational performance, including robust sustainability practices and effective management of ESG risks.
Product Impact: The company's core product, cigarettes, is widely recognized as harmful to health.
Philip Morris is strong operationally, but the company's product offsets some of this impact.
Operational Performance: Tesla faces significant operational performance challenges, including governance issues and employee treatment concerns.
Product Impact: As a pioneer in the electric vehicle industry and a key player in energy generation and storage systems, Tesla is at the forefront of the energy transition.
While Tesla’s products have a positive impact on the energy transition, this impact is somewhat mitigated by governance issues within its operations.
Monster Beverage:
Operational Performance: The company's transparency is limited, lacking details on risk information from suppliers, and manufacturing is outsourced with a vague Supplier Code of Conduct.
Product Impact: Monster Beverage's energy drinks have poor nutritional value, high sugar content, and synthetic caffeine, contributing to adverse health effects like high blood pressure and obesity.
Monster Beverage has challenges in both product and operations. Overall improvement is difficult because even with engagement strategies, operational enhancements won't resolve the fundamental health concerns associated with Monster Beverage products.
The matrix chart below provides a visual representation, positioning these companies based on their operational performance (horizontal axis) and their impact (vertical axis).
Utilizing the double materiality framework aids in the comprehensive evaluation of a company's overall contribution to society, effectively distinguishing between those excelling in both operational performance and product impact and those that may fall short in one or both dimensions. It is possible for companies to shift towards the right by improving operational performance thanks to engagement strategies, but impact remains relatively stable.
FINAL THOUGHTS
The principles of Double Materiality account for both the "outside-in" and "inside-out" implications of how companies influence sustainability objectives. By evaluating both a company's operational performance and the impact of its products and services, investors and stakeholders gain a more comprehensive view of its sustainability contributions and challenges. This approach opens the door for effective engagement and ensuring that investments genuinely contribute to the betterment of the planet and society. The double materiality assessment is a vital step in the evolution of sustainability considerations and standards.
Check out the Company Double Materiality section for more company specific analysis.
A full Double Materiality analysis for Tesla is available here.