How to Set Thresholds in Double Materiality Assessment

The use of thresholds is a key practice in the European Sustainability Reporting Standards’ (ESRS) double materiality assessment. In this article, we look at what it is and how to apply thresholds accurately.

What are thresholds and why are they important?

Thresholds are criteria for determining materiality as defined by the ESRS. If certain thresholds are met, an impact can be considered to be material to the business and/or its stakeholders. It is useful for ensuring relevance in sustainability reporting, and also enables the prioritisation of material matters in order of significance. This helps a reporting organisation to focus on and manage areas that have a greater impact.

To understand the thresholds deployed by the ESRS, a distinction must first be made between actual impacts and potential impacts. Actual impacts are those that already occur within an entity’s value chain, while potential impacts are those that could occur. This distinction is made mainly for prevention and supports the ESRS general principle of due diligence. 

In ESRS 1 2.0 Applying CSRD Concepts, due diligence is “the process that undertakings carry out to identify, assess, prevent, mitigate and remediate the actual and potential adverse impacts connected with its operations, products or services through its own activities and its business relationships”. This approach asserts that companies should take every precaution to avoid foreseeable impacts. 

With this in mind, the ESRS uses four key thresholds for determining materiality:

1. Scale - the extent of an impact
2. Scope - the coverage of an impact
3. Irremediability - the ability or possibility to reverse and/or remediate a negative impact
4. Likelihood - the probability of an impact occurring 

The first three criteria above collectively determine the severity of an impact. Severity is considered when assessing actual impacts while severity and likelihood (all four criteria) are considered for potential impacts. A distinction should also be made between positive impacts and negative impacts, both of which are relevant for reporting. Positive impacts are assessed by scale and scope and negative impacts by severity.

How to use thresholds in materiality assessment?

It should be noted that the ESRS does not set hard and fast rules regarding the application of thresholds beyond the basic definitions and core criteria. If a company already has a due diligence process in place or other risk management approaches, it may use these to inform threshold-setting such as the common practice of risk identification, assessment, and prioritisation. Otherwise, the following approach is recommended by the ESRS. 

For actual impacts, a simple column approach may be used to measure an impact against the three criteria for severity. This is presented in the table below as one possible example. 

Reporting organisations are not limited to this format of presentation. Whatever the approach, companies are required to explain the thresholds used for each criterion. For example, what scale is considered low for a given impact, which could be qualitative or quantitative in nature?

For potential impacts, since four criteria are involved, the severity assessment as a combined unit may be plotted against likelihood in a matrix such as the one below. 

In this case, companies may use the column format to explain severity followed by the matrix that includes likelihood. There are multiple ways to define likelihood including qualitative measures such as unlikely, likely or highly likely, or quantitatively in percentage terms or numerical scale, or even its frequency over a period of time. Companies should determine the most relevant likelihood definitions for each impact but ensure comparability between all of them so that it can be simply understood as unlikely to highly likely in the matrix.

Special care should be paid to the relationship between severity and likelihood, as a low probability event with severity of exaggerated proportions may still be considered material, as can be the case with disastrous environmental events that are irremediable.

The approach to financial materiality is slightly different. Two factors are considered for financial materiality: the likelihood of risks and opportunities and the potential magnitude of financial implications. The financial impact of risks and opportunities should be considered for the short, medium, and long term, despite financial reporting being shorter in the cycle than sustainability reporting. If the financial impact of a risk or opportunity is not definable, it can still be considered material based on qualitative factors such as loss of investor confidence which could lead to significant asset devaluation or capital depreciation.