We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. EFRAG's work is rooted in double materiality and Faber said the ISSB is "embracing [this approach] when it comes to looking at all the impacts, significant impact that companies are going to have on their ecosystem. This is a critically important public policy development, not simply because it will improve investment returns, but because it will lead to better social and environmental outcomes on the ground, as many of the most serious threats to beta are also the most serious threats to people and the planet on which we live. E/S Information that impacts future cash flows from the company to investors and thus the value of the enterprise (ESG integration or just ESG). In this Alert, we outline the contents of the draft standards focusing on the General Requirements Standard and situate them within the context of converging voluntary disclosure standards and increasing regulation. This includes activities that relate to other organisations in the value chain or in the sector if they could have potential consequences for the company itself. There will have to be a period of shared understanding between companies and their investors while companies seek to improve their sustainability credentials and refine their reporting. Sustainability reporting standards promise to do the same. All Climate Climate Risk CSRD Disclosure Disclosures Double Materiality Emissions ESG Management ESG Ratings ESG Strategy ESRS EU Financing Green Finance How To InsightsEN ISSB Materiality Net Zero Regulation Reporting Reporting Standards Risk Scope 3 Emissions Social Standards Sustainable Finance Taxonomy Uncategorized . For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. ISSB has so far produced drafts of two sets of standards: Socially responsible investing. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. The market must find a way to determine when this is important, and crucially, when it is not. Although the financial-materiality test articulated in the General Requirements seems inadequate to address the system level issues, the drafting implications may be more theoretical than practical, especially if the drafters understand the concern. TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. Environmental, social and governance (ESG) integration. It defines a liability as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. Double materiality should be included in global standards, says ESMA The European Securities and Markets Authority (ESMA) has called on the global financial standards body to capture climate and environmental impacts in its forthcoming sustainability standards. At a time when regulation alone seems increasingly inadequate to the task of addressing threats to the environment and our social fabric, an apparent retreat from a constructive market reform in a document as influential as the ISSB standards would be a serious setback. Key focus areas include the Task Force on Climate-related Financial Disclosures, Materiality, and Carbon management. If the company were degrading the environment by causing drought with over-extraction then clearly EFRAGs materiality definition would require this outward impact to be reported. It is quite different, for example, from the EU's more ambitious 'double materiality' approach in its proposal for a Corporate Sustainability Reporting Directive (CSRD) and the mandate given to expert body EFRAG to draft detailed reporting standards. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. But it does not tell shareholders how to use this data to value securities: the user provides that context. It means prioritising the long-term, absolute returns for universal owners, including real-term financial and welfare outcomes for beneficiaries more broadly. (b) disclosures to investors, lenders and other creditors about sustainability matters that affect their assessment of enterprise valuethese disclosures enable investors, lenders and other creditors to understand the impacts that sustainability-related risks and opportunities have on the value, timing and certainty of the entitys future cash flows, over the short, medium and long term and therefore users assessment of enterprise value. In the other camp sits EFRAG, which through the EU Corporate Sustainability Reporting Directive (CSRD) seeks to implement a double materiality approach, a concept which encompasses financial materiality and impact materiality. Though there are aspects of ISSBe.g. The ISSB standard could be of more limited value for certain jurisdictions. The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. [.] Single MaterialityDouble Materiality Outside-in Perspective . Given the real reputational and regulatory risk for companies that rely on externalized costs, those of us focused on beta impacts can do several things with the ISSB process. But this could also be reportable under the ISSBs and SECs rules, since community unrest might affect their licence to operate (and therefore their future cash flows) or injudicious extraction might lead to lawsuits for environmental degradation in 15 years time, again, affecting cash flows. Excluding beta information from the reporting standard does not reflect evolving recognition of the importance of beta. But, two subtle differences in how the ISSB and SEC both require the calculation of enterprise value mean that reporting entities using this standard would end up reporting broadly similar material information as those using the EFRAG standard. The dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. Equally, if a sustainability issue might at some point in the short, medium or long term have an effect on a companys activities (even if it is not currently affecting the companys cash flows), then it too must be reported now. Lastly, the fact that many companies will have to report new information and in large quantities could have the potential to cause a period of significant volatility in markets. Sustainability and accounting specialist with a particular interest in assessing and quantifying sustainability risks and opportunities, and in particular climate-related risks and opportunities. However, the concept of double materiality, which includes environmental and social impacts of a companys operations even if not financially material to the company, has significant support outside of the ISSBs framework. The ISSB drafters should recognize the risk that excluding beta could, at the margins, lead to the omission of decision-critical information for investors concerned with company impact on social and environmental systems that support other portfolio companies. The ISSB documentation expressly rejects "double materiality," the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. Although the ISSB does not provide specific guidance on where such disclosures must be made relative to general purpose financial reports, it emphasizes that sustainability-related information should be disclosed simultaneously with standard financial information and in as integrated a manner as possible. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. It is likely that if companies begin to report accurately on their sustainability profile, the information they provide will be illuminatingly different from what the market thought it knew. Thus, to gather the E/S data that are material for company valuation purposes, the ISSB standard will have to include the same data that will be used to determine whether a company is externalizing costs to the detriment of people, planet, and other companies. Thus, while individual companies can profitably externalize costs, a diversified investor will pay these costs through lowered return on their diversified portfolios. Companies and investors have, in the past and on other topics, risen to the challenge. The distance between the emerging definitions of materiality in sustainability reporting is smaller than you think and heres why it shouldnt prevent progress towards global alignment. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). Once such a standard is established, failure to adhere will become a reputational and regulatory risk, so that the question of meeting that standard becomes financially material. Given the ISSBs potential to influence voluntary and mandatory sustainability reporting expectations, companies may wish to consider using its standards to help inform their sustainability disclosure strategy. This is the same way that traditional financial disclosures work: the purely financial data securities regulators require informs investors about items such as historical earnings data, sources of liquidity, and risk factors. Diversified investors internalize the collective costs of such externalities (more than $2 trillion in 2018 according to the Schroders report cited above) because they degrade the systems upon which economic growth and corporate financial returns depend. Contributions to inequality also reduce GDP over time. These will include information that allows investors to draw conclusions as to whether the companys reputation is at risk, or whether it may be subject to regulation or increased costs when regulation is adopted to address currently unmitigated social or environmental costs. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. ESRSISSB . While there are some obvious areas of agreement across the three sustainability reporting proposals including their overall objectives to provide information about a companys strategy, risks and targets for dealing with sustainability matters, and the need to look out over the short-, medium-, and long-term time horizons there is also deep division. A group of 86 global CFOs and institutional investors, representing 620bn in assets, criticised the ISSB for not adopting the double materiality approach which would require companies to report on the impact of their activities on the environment regardless of its relevance to enterprise value. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. The ISSB has the critical mass of support from established market participants necessary to bring the same uniformity (and thus utility) to sustainability reporting that now exists for standard financial reporting. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start. On March 31, 2022, the International Sustainability Standards Board (ISSB), an investor-focused initiative of the International Financial Reporting Standards (IFRS) Foundation, released long-anticipated drafts of its sustainability reporting standards: the General Requirements for Disclosure of Sustainability-Related Financial Information (the Integration with Financial Reporting: Like the SECs proposed climate rule, the General Requirements Standard recommends that sustainability-related information be disclosed alongside an entitys general purpose financial reports as part of the ISSBs emphasis on the materiality of sustainability-related disclosures to investors. As shown above, there is significant literature establishing that E/S disclosures that go beyond enterprise value may be of great importance to diversified investors economic decisions because of their financial interest in beta. ESG metrics will typically say something like, companies in X industry often hire low-wage workers in countries with poor regulatory schemes; this can expose them to reputational risk and cost increases over the long term and perhaps increased regulation and enforcement or fuel prices are subject to rapid change and efficiency measures can limit future costs. Accordingly, the disclosure line items will require the company to describe the programs and standards in place to assure workers are not being abused, its record in meeting such standards and relevant legal requirements, its plans to reduce fuel use, etc. In their 2021 book, Moving beyond Modern Portfolio Theory: Investing that Matters, Jon Lukomnik and James Hawley explained that these systematic risks inevitably swamp any alpha strategy: It is not that alpha does not matter to an investor (although investors only want positive alpha, which is impossible on a total market basis), but that the impact of the market return driven by systematic risk swamps virtually any possible scenario created by skillful analysis or trading or portfolio construction. However, sustainability reporting is not just about the sustainability-related impacts on the company (or its enterprise value) that can be material, but also the impacts of a company on the environment, climate or other sustainability issue so-called double materiality, Russell added. - 2023 PwC. The materiality principle chosen in the General Requirements seems to ignore the most important issue on the table without explanation. Up until this point, we have discussed financial success in terms of single companies, but the returns of the institutional investors mentioned above depend much more on beta than on alpha. The ISSB issued International Financial Reporting Standard S1, General Requirements for Disclosure of Sustainability-related Financial Information, and IFRS S2, Climate-related disclosures, in March. Companies are advised to monitor the continued development of the exposure drafts and may wish to consider aligning future sustainability reporting with key components of the General Requirements Standard, including relying on company- and industry-appropriate standards such as those of SASB. This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. In its October 2022 board meeting, the ISSB . The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. These projects help investors determine a companys fair share of a limited common resource or the proper social and environmental boundaries for individual companies that are necessary to preserve the systems upon which all companies rely. The logic for this is implicit within IAS 37. "While the ISSB uses the so-called financial materiality as a basis, the European Financial Reporting Advisory Group (EFRAG) defines the double materiality, i.e., the effect of companies on society and the effect of society on companies in the Corporate Sustainability Reporting . Take the example of an estimated sustainability cost of 66m (75m). Ensure that the drafters of the ISSB keep front of mind the fact that most of the investors for whom ISSB is being created are diversified. The publication of these two draft standards represents a potentially significant step toward the coalescence of voluntary corporate sustainability reporting frameworks and could influence mandatory disclosure regimes that are evolving in the U.S., UK and EU. In the one camp, broadly speaking, sit the SEC and the ISSB. As Hales explained: "Dual materiality and dynamic materiality are not new concepts, it's just that there's new language and an evolving understanding of these issues [that] helps to bring some clarity to frankly a concept that has been very challenging to communicate about for a long time." One key element of materiality is its specificity. EFRAGs proposed standard only asks that companies break the shackles of certainty and short-term thinking to report on the things that they are likely already or should be factoring into their business planning anyway. E/S information that does not affect investors, but is relevant to the impact companies have on civil society and stakeholders other than investors (stakeholder data). Pursuant to applicable rules of professional conduct, portions of this publication may constitute Attorney Advertising. The Technical Readiness Working Group (the TRWG) recently released a set of recommendations for general requirements for the ISSB standards (the General Requirements) that addressed this question by defining what would be material for the standards overall. This means stewardship that is less focused on the risks and returns of individual holdings, and more on addressing systemic or beta issues such as climate change and corruption. EFRAGs definition of double materiality encompasses an inward element (effects on the company from external sources) and an outward element (effects the company has on externalities). This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. Double vs single vs dynamic materiality is one of the main pieces of contention between the ISSB and EFRAG in the design of their sustainability standards but what if this was only theoretical and in practice their thinking aligns? 3233596, VAT No. And, in practice, a small one at that. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. It explains the approaches of the GRI Standards ( impact materiality), the IFRS' International Sustainability Standards Board (ISSB) ( financial materiality) and the incoming European Sustainability Reporting Standards ( double materiality), and how they interconnect. The Statement of Intent to Work Together Towards Comprehensive Corporate Reporting co-authored by five important standard setting organizations, was a 2020 document that was an important step towards the ISSB process; it describes inside-out information as being targeted at: various users with various objectives who want to understand the enterprises positive and negative contributions to sustainable development [in contrast to enterprise value information targeted] [s]pecifically to the sub-set of those users whose primary objective is to improve economic decisions. If their content is not aligned, then the status quo will continue: piecemeal reporting, inconsistencies, confusion, and limited progress towards understanding the effect of ESG matters. Their primary obligation is to protect the financial interests of their beneficiaries and clients by protecting and growing their investment portfolios. The General Requirements Standard recommends that companies disclose material sustainability-related information, defined as information that could reasonably be expected to influence primary users assessments of an entitys enterprise value, with the responsibility for the materiality assessment resting on the reporting entity. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. The general understanding is that the ISSB will not incorporate what is called 'double materiality' - that is, it will focus largely on the impact of the changing climate on a company rather than on the impact of the company on the climate, as the assumption is this is what investors really care about. Planetary forces much greater than cataclysmic weather events have decided that. This site uses cookies. As the process of sustainability reporting moves from voluntary to mandatory, companies with mature sustainability disclosure programs are likely to be well positioned to meet the evolving demands of stakeholders and regulators. Putting businesses on the path to a low carbon economy will require access to funding throughout the transition. There have long been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example. A market price also factors in todays expectations about any potential implications that, at some future point in time, might affect a companys legal or regulatory situation (even if only by association). In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to beta. In Europe, double materiality - reporting on both sustainability factors affecting the company (financial materiality) and how the company impacts on society and the environment (outward materiality) - is already part of the European Commission's proposed Corporate Sustainability Reporting Directive (CSRD). And so the fact that the ISSB and SEC have asked companies to see the long term as material today and in the context of a market perspective means that much of what a business considers to be its impact on the environment or society will be reflected in its consideration of enterprise value. The ISSB is the product of agreement among a critical mass of relevant industry participants to develop a uniform standard for disclosure of social and environmental impact. It is important to understand that ESG data are often provided without much context. A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. Those subtle differences are time frame and taking a market (by definition, an outside) view. As discussed in the Freshfields Report and the PRI Report, decision-useful information extends beyond information that affects enterprise value; if a companys E/S impact has the potential to affect beta, diversified shareholders may well act on that information by, for example, voting against directors who fail to act to mitigate negative externalities. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). As we discuss in the next section, this will require beta-oriented disclosure. For similar reasons, Professor John Coffee predicted in a recent article that beta would surpass ESG integration as a motive for investor activism: This latter form of activism [beta focused] is less interested in whether the target firms stock price rises (or falls) than in whether the activist investors engagement with the target causes the total value of this investors portfolio to rise (which means that the gains to the other stocks in the portfolio exceed any loss to the target stock). Steering clear of this risk is likely to require, at most, minor adjustments in methodology; moreover, the initial ISSB documentation, while ambiguous, does not preclude such considerations. The General Requirements Standard specifies that potentially material sustainability-related considerations include activities and relationships related to an entitys value chain, which it defines as the full range of activities, resources and relationships related to a reporting entitys business model and the external environment in which it operates.. For all the reasons discussed in Section A.4, diversified investors have a financial need to know whether portfolio companies are externalizing social and environmental costs. One such force is the International Organization of Securities Commissions (IOSCO), which sees the establishment of the ISSB and its shiny new climate-disclosure standard as key pillars of its overall sustainable-finance strategy. Financial materiality is in line with current U.S. disclosure rules. This post is based on their recent paper. This divergence of interests arises in many cases from the unpriced availability of finite common resources, such as the earths carbon sink or the capacity of society to absorb growing inequality. What should be the role of investors when it is governments that have the most power to effect change? Just like any issue that can factor into the market price for a debt or equity security, sustainability issues can affect the likelihood, timing and amounts of potential cash inflows and outflows resulting from a companys activities over any time horizon. In light of the diversification mandate of Modern Portfolio Theory, and the importance of beta to diversified investors, this anachronistic hyper-focus on enterprise value is troubling. Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. It . 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