Financial materiality

What is financial materiality?

Under the ESRS, a sustainability matter is material from a financial perspective if it triggers or could reasonably be expected to trigger material financial effects on the company: effects on its development, financial position, financial performance, cash flows, access to finance or cost of capital. IFRS S1 defines material information from the investor's point of view, and the ESRS financial perspective was designed to capture the same information, so one assessment can serve both. See double materiality explained and IFRS S1.

How is financial materiality assessed?

For each sustainability-related risk or opportunity, a company estimates the potential size of its financial effect and the likelihood that it occurs, over defined time horizons. It compares the result with thresholds it sets, usually linked to measures already used in risk management, such as a percentage of EBITDA, revenue or equity, and may also treat some matters as material for qualitative reasons, such as legal or reputational exposure. Enterprise risk management is the natural starting point, but it often has shorter horizons and needs extending for long-term climate and nature risks.

Financial materiality in practice: a manufacturer's assessment

A manufacturer with EBITDA of EUR 500 million sets its threshold at 2% of EBITDA, EUR 10 million of likely annual effect, and assesses four items over the medium term.

Carbon costs and demand for low-carbon products are material. The coastal warehouse flood has a large potential effect but low likelihood, giving a likely effect below the threshold; the company nevertheless treats it as material, because a single flood would halt deliveries for months and its insurers are reconsidering cover, a qualitative reason it documents. The water shortage falls below the threshold and is monitored. The material items are then reported, with their current and anticipated financial effects. See impacts, risks and opportunities.

Where do financial risks and opportunities come from?

Many arise from dependencies: a brewery depends on water, a farm on pollinators, a software company on skilled staff. Others arise from the company's own impacts, which can lead to regulation, litigation, lost customers or higher financing costs. Climate transition risks, such as carbon prices and changes in demand, and physical risks, such as floods and heat, are the most common, but social and governance matters, such as labour disputes in the supply chain, can be just as material. See climate scenario analysis.

What time horizons apply?

The ESRS define short term as the financial reporting period, medium term as up to five years after it, and long term as more than five years, and IFRS S1 asks companies to define and explain their own horizons. Climate and nature risks often only become financially significant in the long term, so a company should judge likelihood and size for each horizon, and an effect that is unlikely within five years may still be material over twenty. See ESRS 1 general requirements.

How does it differ from materiality in the financial statements?

Both are judged from the user's point of view, but financial statement materiality applies to amounts already recognised or disclosed for the period, while financial materiality for sustainability reporting looks forward over medium and long horizons, including effects not yet in the accounts. The two should connect: a risk judged financially material in the sustainability statement may also need disclosure as a key assumption or source of estimation uncertainty in the financial statements. See climate risk in the financial statements.

What is disclosed?

Companies describe the process and thresholds used and, for each material risk or opportunity, its nature, time horizon, effect on strategy and business model, and current and anticipated financial effects, using the phase-ins available. Under the revised ESRS these sit in ESRS 2. See ESRS 2 general disclosures and impact materiality.

This guide is general information. It is not tax or legal advice for your situation.