This would appear as a balance sheet reserve, representing funds set aside to pay future obligations. ISSBs Proposed Framework Seeks to Unify Global Sustainability Disclosure Standards, Private Equity International Responsible Investment Forum, Kirkland Advises Greenbriar Equity Group on $3.475 Billion Fundraise for Oversubscribed Sixth Fund, Kirkland Advises Patient Square Capital on Record $3.9 Billion Inaugural Fundraise, General Requirements for Disclosure of Sustainability-Related Financial Information, European Sustainability Reporting Standards. Secondly, although climate science makes some environment-related sustainability information relatively simple to calculate and put a value on, companies will find it a great deal harder to quantify and set the bar for materiality for social and governance issues and other environmental issues like biodiversity. 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 failure to even address beta-oriented disclosure is surprising because there is a growing emphasis on the need for diversified investors to monitor and steward the beta impact of portfolio company activity. Thats where we aregoing. 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. 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. First, this is a rapidly evolving area and both science and social mores will mean that the items material to a business will constantly be shifting and changing. Economists have long recognized that profit-seeking firms in free-market economies will not account for negative externalities, and there are many profitable strategies that harm stakeholders, society, and the environment. Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. Three big new sustainability reporting proposals from the US Securities and Exchange Commission (SEC), the European Financial Reporting Advisory Group (EFRAG), and the International Sustainability Standards Board (ISSB) promise to change how companies communicate sustainability information to their stakeholders. This convergence is illustrated in Figure 1 below. 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. 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. Changes in the reserve would flow into the statement of comprehensive income and then through the statement of changes in equity. In the context of ESG, this is known as single materiality and means mainly environmental, social and governance factors that may pose a threat or opportunity to a business and its bottom line. IFRS 13 is one standard that does refer to future amounts when it talks about valuation techniques that convert future amounts (such as cash flows or income and expenses) to a single current (discounted) amount. IFRS Advisory Council questions ISSB on future of SASB standards. Were taking that all very, very seriously. But enterprise value under the ISSB and SECs proposed sustainability standards say that what affects cash flows over the short, medium, and long term should be reported today. Welcome to IPE. But from a disclosure perspective, investors should have the data that would allow them to understand the risk the company is taking by continuing to externalize costs. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. 24 February 2023 Pause on that figure: prioritization of individual company financial return leads to one third of all listed companies around the globe destroying more value for society than they create for their own shareholders. To make an assessment of materiality, the ISSB recommends that companies consult the industry-specific materiality factors outlined by the Sustainability Accounting Standards Board (SASB) Standards, as well as the most up-to-date topic-specific guidance of other standard-setting bodies, such as the Climate Disclosure Standards Boards (CDSB) guidance for water- and biodiversity-related disclosures. ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . According to Matthias Tger, a researcher at London School of Economics looking at the relationship between the environment and financial markets, the future of double . Consequently, an enterprise value materiality assessment would take into account a companys effect on the outside world to the extent that the market has knowledge of the issue and, therefore, prices it into the debt and equity securities of the company. 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. This recognition that change at one firm can affect the value of other firms in the portfolio implies a new goal for activism: namely, to engineer a net gain for the portfolio, possibly by reducing negative externalities that one firm is imposing on other firms in the investors portfolio. On 3 November 2021, at COP26, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB). But these standards do not provide for a grade or make a judgment as to whether the companys treatment of workers or fuel efficiency will in fact threaten its cash flows and enterprise value: that is generally left for investors to decide. PRI, an investor initiative whose members have $121 trillion in assets under management, recognizes this need. If their content is aligned then the effect will be powerful. He says: The first is a provision for the cost of closing the existing carbon-based business. The International Sustainability Standards Board (ISSB) is analysing feedback to its consultation on two proposed standards and will consider how to respond to stakeholder comments on topics such as enterprise value and materiality, the head of the IFRS Foundation said. The growing importance of this field is evident in the creation of the International Sustainability Standards Board (the ISSB) to establish uniform E/S disclosure standards that companies around the world will use to report to investors. Although the TCFDs recommendations are specific to climate-related risks and opportunities, the ISSBs General Requirements Standard advises that this approach be applied to all sustainability issues that could impact enterprise value, such as those posed by social or nature-related issues. Yet the scope of externalities is enormous. 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. Whats material depends on the issue, the context, the time frame and the stakeholder. get as much direction as quickly as possible to really build on momentum.. 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. Climate change denial has been a tough ask this summer. A new report from the law firm Freshfields Bruckhaus Deringer (the Freshfields Report) explains how externalized costs affect investment trustees fiduciary duties: System-wide risks are the sort of risks that cannot be mitigated simply by diversifying the investments in a portfolio. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start. The draft standard also introduces the concept of dynamic materiality. The Freshfields Report goes on to suggest that alpha-oriented strategies (e.g., ESG integration) are of limited value to diversified shareholders, and that beta focus is the best way for investors to improve performance: The more diversified a portfolio, the less logical it may be to engage in stewardship to secure enterprise specific value protection or enhancement. 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). 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 General Requirements Standard) and a Climate-Related Disclosures framework (the Climate Standard). 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). Taking IAS 37 as a starting point is not as simple as it might seem. Diversified investors cannot avoid certain common risks almost all companies face. 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. 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. There are some other areas that need ironing out too before standard setters finish their work. Frederick Alexander is Founder of The Shareholder Commons; Holly Ensign-Barstow is Director of Stakeholder Governance & Policy at B Lab. What should be the role of investors when it is governments that have the most power to effect change? This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. EFRAG refers to impacts on people and the environment [that] may be considered pre-financial in the sense that they may become material for financial reporting purposes over time. Companies that prioritize their financial return to shareholders face a prisoners dilemma with respect to such resources, and unchecked market competition will inevitably lead to their depletion. Such a standard, rising above a single focus on financial materiality but rooted in investor return, would not rise to the level of double materiality, and might best be described as sesquimateriality.. However, Murphy has rejected this approach in favour of a model that compounds the future obligation because it is likely that the cost of deferring action to address environmental change will increase over time at a rate likely to significantly exceed any applicable discount rate that a reporting entity might choose. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). Double materiality is the union (in mathematical terms, i.e. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. 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. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. But investors wont give companies a free pass and their patience will wear thin quickly if companies do not appear to take this reporting seriously. Dig down to paragraph 85 of Agenda Paper 3B/4B from the ISSBs September meeting, and youll learn that the board will publish IFRS S1 and IFRS S2 as early as possible in 2023. This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. If a sustainability issue is currently affecting a companys business activities, it is likely to have an effect on the companys cash flows over the short, medium or long term, and must be reported now. A company cant consider only what it cares about; it has to take into account what others would consider when pricing the shares or debt, into perpetuity for shares and over the tenure of bonds or loans. 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. But we are trying to. Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. Companies occasionally need to report new information and markets need to work out how to digest it. 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. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. Socially responsible investing. 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. As with many new developments in reporting, companies will need to work out how to provide the right amount of information to the right stakeholders without overwhelming them with hundreds of pages of additional reporting. A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. As we discuss in the next section, this will require beta-oriented disclosure. In doing so, it has removed the existing definition of 'enterprise value' and the words 'to assess enterprise value' from the objective and description of materiality in the proposals. At a high level, the ISSB aims to help companies streamline their sustainability disclosures to facilitate an apples to apples comparison by investors. : More unites standard setters than divides them, Total Impact Measurement & Management (TIMM), ESG (Environmental, Social and Governance). 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. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. So, for example, if a company is planning on extracting water at a rate that is not sustainable based on the volume of water available in the area, then this will certainly ultimately have an effect on their finances because in 15 years they will have run out of water to extract or they will have to invest money sooner in exploring alternate sources of extraction. In practice, although worded differently (from each other and from EFRAG), they all could be expected largely to result in the same assessments of whats material from an investor perspective that is, factoring in what might lead to changes in future business activities and taking a long-term view. These include what might affect investment valuation, an investments contribution to systemic risk, how exposed it is, and what the implications of proxy voting might be. Thats why we were created. Corporate social responsibility. 'The ISSB has a definition of materiality that could allow Europe to overlay double materiality, although more detail is needed, which hopefully will come from the . 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. On its face, the exclusive choice of enterprise value as the measuring stick for materiality means the standards will only be useful for investors who want to use environmental and social data to determine how a particular company will perform financially, in order to decide whether to buy or sell it, or perhaps to use their shareholder rights to push the company to change its practices to improve future cash flows. For ESG integration, the standard must call for disclosures of E/S matters that investors can use to model an enterprises value and future cash flows. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. Sustainability reporting standards promise to do the same. Thats why we were created. Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. 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). Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. This article addresses a fundamental debate over the purpose of the uniform standard and reaches the following conclusions: Four types of impact. The EU can then "top up" these standards with those covering double materiality. Importantly, the inside-out concept as discussed in the General Requirements is not designed to address beta; instead, it is focused on how the E/S performance of a company affects society overall. Sustainable investing. The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. The US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. Similarly, they might be willing to sacrifice portfolio return if it meant a healthier environment in which to enjoy their retirement, or if doing so would relieve others suffering. The General Requirements propose two possibilities, which correspond to what disclosure specialists call financial materiality and double materiality. The first is disclosure designed for ESG integration. This reflected moral concern with profiting from suffering, rather than the use of investment to address a social issue. One of the first parameters to be established must be the purpose of disclosure. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. DWP sets up Taskforce on Social Factors for UK pensions industry, Threefold rise in asset managers holding board responsible for ESG, Accounting: Long-haul climate change reporting, Print advertising rates and specifications, Digital advertising technical specifications (pdf), Standard Terms and Conditions for Event Sponsors, ISSB chair Emmanuel Faber has effectively ruled out the use of double materiality, The board now expects to issue its climate-change standard next year, Developments in the EU, US risk fragmenting the sustainability-reporting landscape. In the alternative double-materiality rubric, financial materiality is referred to as outside-in information, because it addresses how social and environmental matters affect the company. 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. Tony Moller provided valuable research and drafting assistance in support of this Alert. Adding beta information to the ISSB reporting standard would not significantly enlarge the reporting requirement because any company conduct that threatens or benefits beta is likely to create corresponding regulatory and reputational risks and benefits to enterprise value, so that most beta information should be deemed material even under a putative ESG standard. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. 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