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Double Materiality: The Paradigm Shift in How We Value Companies and Invest

Double materiality is a concept that has gained significant attention in the financial world in recent years, and refers to the idea that the firm’s impact on the society and environment has direct, material impacts on the firm’s business and financial performance.

Why should we care?

This is crucial as attention on environmental-related issues will only increase in the coming years, where increased incorporation of ESG issues have translated into significant increases in climate change-related or circular economy-related M&A deals. Significant studies and empirical evidence have also shown an outperformance of environmentally friendly or green investments and deals as compared to traditional ones over long-term investment horizons. With the concept’s increased influence in legislation and regulatory frameworks, there is thus an urgent need to grasp this concept fast for investment decisions.

The significance of double materiality is not limited to how companies communicate sustainability information to stakeholders, but more importantly extends to how legislation would affect accounting standards and valuation methods. The European Financial Reporting Advisory Group’s (EFRAG) definition of double materiality encompasses both exogenous and endogenous elements. This means that not only is the company legally required to report the environmental risks on the firm’s business activities, but the firm also has to report on its impact on externalities and the environment too.

The SEC’s newest proposals to require companies to disclose Scope 1, 2 and 3 emissions drew much ire from certain industry groups, but raises an important question of whether ESG issues were material concerns for investors. The SEC’s definition of materiality in the context of financial statements meant that ESG issues could matter and that “an average prudent investor ought reasonably to be informed”. There is thus a paradigm shift in how we evaluate the value drivers for companies’ business activities, where ESG issues could become huge factors to consider in evaluating business risks and opportunities.

What would change?

With increasing focus on ESG issues and stakeholder governance amongst institutional investors, there could perhaps be a need to place even greater importance to such business risks during due diligence processes in mergers and acquisitions than before. This could also mean a further extension of such due diligence processes to businesses that do not seemingly interact with the environment directly, such as in terms of extracting resources or polluting with harmful manufacturing wastes.

Additionally, the changing regulatory environment could also present opportunities for investors. The SEC’s shift in position could signal a move in sustainability reporting and its influence on corporate behaviour. With more countries adopting regulations similar to those of the EU in ESG disclosure, investors find it increasingly easy to access the sustainability and long-term profitability of their investments. Breaking the status quo of inconsistent, piecemeal reporting could thus mean that investors may be better able to evaluate environment-related deals that they previously only had limited information on.

More robust ESG disclosures could also prevent greenwashing – a concern that remains prominent especially after the UK FCA’s warning to crack down on ESG claims and deals by private equity firms and hedge funds last year.

Of course, shifting regulatory environments could sometimes present uncertainty – especially given the confusion between various sustainability reporting standards and definitions. Nonetheless, new accounting standards and regulatory requirements are not uncharted territories for companies and companies seeking to survive in the long-term will surely be able to overcome these difficulties.

In summary, the concept of double materiality is certainly set to change the way we value companies and invest. M&A deals are no exception, and such ESG considerations will also grow in significance in due diligence processes in the near future since investors are more likely to invest in companies that are sustainable, responsible and better positioned for long-term financial success.

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