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. 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. The ISSB wants companies to think about it from the perspective of their existing and potential investors, lenders, and other creditors, while the SEC asks companies to consider whether the matter might be likely to influence an investors investment or voting decisions. The ISSB documentation expressly rejects "double materiality," the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. When the economy suffers, so do diversified shareholders. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. Please see www.pwc.com/structure for further details. Confirmation that climate change does not drive sustainability reporting came when the boards chairman, Emmanuel Faber, appeared at the IFRS Foundations World Standard Setters conference in September to rule out any shift to double materiality some call it impact reporting by the ISSB: We will not move. ESRS 2 General disclosures providing DRs on general reporting issues, governance, strategy and business model and the double materiality assessment process of sustainability impacts, risks and opportunities. 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). 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. This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. As noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of materiality. Thats where we aregoing. So how might this look on the financial statements? The Schroders Report calculated that one third of all listed companies around the world created net social costs that exceeded their profits. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. '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 . Last November, IOSCO chair Ashley Alder set out a five-point roadmap that securities watchdogs expect the IFRS Foundation to follow if they are to endorse the climate-change standard before the end of 2022 as the global baseline for climate disclosures. 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. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. Like the U.S. Securities and Exchange Commissions (SEC) recently proposed climate-related risk disclosure rule1, the ISSBs General Requirements and Climate Standards are based on the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD). In addition to potentially helping to drive convergence of voluntary sustainability disclosure standards, the ISSB could also play a role in the evolving regulatory shift from voluntary to mandatory sustainability reporting, again potentially helping to drive global compatibility among corporate disclosures. 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 . 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. The net result for the [diversified] investor can be negative when the costs across the rest of the portfolio (or market/economy) outweigh the gains to the company; A company or sector securing regulation that favours its interests over others. 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. What ISSB asks for. 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 Climate change denial has been a tough ask this summer. Climate change denial has been a tough ask this summer. This then helps create the business case for companies to take action on the priorities that their investors, customers and others really care about. 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. This would appear as a balance sheet reserve, representing funds set aside to pay future obligations. For example, if a company is using water at an unsustainable rate, this would have to be reported as a long-term risk to cash flows, just as it would be under EFRAGs approach. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. Of course, a company may make the judgment that it can get away with a certain amount of cost externalization, so that corporate managers may make business judgments that financial return can be maximized without optimizing social value. They may find that for many issues their enterprise value and impact materiality assessments are so interlinked that for practical reasons it is not possible to split them apart. This is similar to the architecture of the TCFD and ISSB. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. The ISSB was announced in . The PRI Report described the investor action necessary to manage social and environmental systems: Systemic issues require a deliberate focus on and prioritisation of outcomes at the economy or society-wide scale. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. Despite all the talk of urgency from IOSCO, the climate-change standard will not be in place until next year. 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. - 2023 PwC. The double-materiality concept as 'guiding principle' in the GRI Standards From climate change and biodiversity loss, to growing inequality, modern slavery, and scarcity of resources, our society and planet face the most significant challenges of all times. Swiss Re Institute, The Economics of Climate Change: No Action Not an Option (April 2021). Sustainability and accounting specialist with a particular interest in assessing and quantifying sustainability risks and opportunities, and in particular climate-related risks and opportunities. Financial reporting standards have proven to be a driving force of stability and development in our global capital markets. It recently issued a report (the PRI Report) that described a variety of corporate practices that can boost individual company returns while threatening the economy and diversified investor returns: A company strengthening its position by externalising costs onto others. Materiality: The First Step in ESG Management The easiest way to think of materiality is as a relevancy filter for the issues that matter most to an organization. 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. On March 24, 2022 the IFRS Foundation (the Foundation) and the Global Reporting Initiative (GRI) published a press release announcing "a collaboration agreement under which their respective. Yet diversified portfolios remain exposed to nondiversifiable risks, for example where declining environmental or social sustainability undermines the performance of whole markets or sectors Indeed, for investors who are likely to hold diversified portfolios in the long-term, the question is particularly pressing since these are likely to be the main ways in which they may be able to make a difference. The application of 'double materiality' has always been a central theme for GRI since its inception, largely due to the fact that its development is based on a multi-stakeholder approach, in which trade unions and civil society groups hold significant influence. The version of enterprise value we use in financial reporting today would consider the effect of many sustainability matters on long-term cash flows as hardly material since they are inherently uncertain and typically have little effect on the business today. 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. Encourage the ISSB drafters to move to an express sesquimateriality standard. The task of building a sustainable future is a shared responsibility for us all. In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to beta. The current plan for the ISSB expressly encompasses only data that implicate enterprise value (often called financial materiality), although a close read of the documentation produced to date leaves the door open for an expansion to information pertinent to beta information as well. 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. If their content is aligned then the effect will be powerful. Sustainability-related financial information is material if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports. 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. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. Posted by Frederick Alexander (The Shareholder Commons), on, Harvard Law School Forum on Corporate Governance, on One Small Step From Financial Materiality to Sesquimateriality: A Critical Conceptual Leap for the ISSB, Companies Should Maximize Shareholder Welfare Not Market Value, Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee. Double materiality can be a decision left to jurisdictions such as the EU, China or the US, which are currently working on their own systems of mandatory climate risk reporting. 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. ESRSISSB . 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. A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. Currently, companies and financial institutions utilize a variety of voluntary frameworks often referred to as the ESG alphabet soup to guide disclosure in sustainability reports and other corporate communications. These are the risks to the social and environmental systems in which the economy is embedded. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). It is questionable whether this difference matters from a practical perspective, although arguably aligning terminology and definitions would help ensure consistent implementation and interpretation. Information on a company is material and should therefore be disclosed if "a reasonable person would consider it [the information] important", according to the US Securities and Exchange Commission . 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.. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour. Related research from the Program on Corporate Governance includes Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and Exit vs. Voice by Eleonora Broccardo, Oliver Hart and Luigi Zingales (discussed on the Forum here). The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. This is known as the single-materiality approach, as opposed to a double-materiality approach that considers impact both ways. All of this will edge companies closer towards a materiality assessment based on both the companys impact on the world around it as well as the potential effect on its enterprise value; in other words, and for all practical purposes, applying a double materiality concept. 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. measuring and reporting carbon emissionsthat serve both purposes. One of the biggest is that all three proposals define what is material in different ways. 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 reason is that if a companys activities create the type of economic risk that threatens beta, it will almost surely be at risk for damaged reputation, increased regulation, and the increased costs that follow regulation. When a company saves costs with cheaper, carbon-intense energy, it trades away climate mitigation (which supports the intrinsic value of the economy) in exchange for more internal profit. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. IFRS Advisory Council questions ISSB on future of SASB standards. Not all investors are diversified, so if a company protects beta by accepting reduced enterprise value, it may be favoring diversified investors at the expense of concentrated investors. 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. 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. 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. This is a critical moment. These are difficult issues to report on, rife with judgement, and companies do not yet feel safe doing it especially when it comes to enforcement. Centrality of TCFD and SASB: As described above, the ISSBs General Requirements Standard centers on the four pillars of the TCFD framework, which are geared toward integrating sustainability risk assessment into the core processes of a companys business, as well as the industry-specific disclosures outlined by the SASB Standards. 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. This publication is distributed with the understanding that the author, publisher and distributor of this publication and/or any linked publication are not rendering legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. These phrases refer to the need for investors to pay more attention to the environmental and social (E/S) impacts of the businesses in which they invest. The ISSB consultation responses show there is also wide support for the approach within the financial sector. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. 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. Because the ISSB is a standard for disclosure, and not for action, it can be neutral on which side to take and simply provide beta-relevant information, in order to inform investors of the trades being made. The expectation is that this cost will be outweighed by the benefits to the market and companies of having more complete, transparent, comparable and reliable information on which to base resource allocation decisions. 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). Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. USS welcomed the ISSBs decision to build on the structure of the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations in IFRS S1 and IFRS S2. Modern investing principles obligate those institutions to diversify their investments, because diversification allows them to earn the higher financial returns that come from bearing risk while diversifying some of that risk away. 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. However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. 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. As we discuss in the next section, this will require beta-oriented disclosure. "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 . 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. One of the first parameters to be established must be the purpose of disclosure. The General Requirements Background section described inside-out and financial materiality in the following paragraphs (a) and (b): (a) disclosures to stakeholders about sustainability matters that have impacts on people, the environment and the economythese disclosures normally provide the broadest range of information because they aim to meet the needs of multiple stakeholders. Far from it, assured the ISSBs vice-chair, Sue Lloyd, during the ISSBs 21 September meeting: [F]or those listening, I think we need to be careful to be very clear that this isnt because we are not worrying about the comments that we received and the feedback that weve got. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. Figure 1: Convergence of Voluntary Sustainability Disclosure Standards. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. Shortly after the International Sustainability Standards Board (ISSB) tentatively confirmed that companies using its climate-reporting standard must disclose their Scope 3 greenhouse gas (GHG) emissions, board chair Emmanuel Faber took to Twitter, making the bold claim that the board was rewriting economics. This post is based on their recent paper. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. They must do so again. Disagreement over definitions is just one element of the materiality issue. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. ISSB releases draft definition of 'sustainability' for new reporting framework The decision does not, however, change the ISSB's decision to focus on single materiality as opposed to double materiality. In this second article in our series on the sustainability reporting landscape, we aim to illustrate that this division neednt be so deep, or at least neednt derail progress towards achieving globally aligned standards. Companies will finally have clear instructions on how to report on their sustainability impacts, risks, and opportunities, and investors and other stakeholders will be able to better track progress, compare performance, and hold companies to account. Why? Having given itself these two choices, the TRWG chose financial materiality: Sustainability matters that do not affect the reporting entitys enterprise value are outside the scope of general purpose financial reporting.. The ISSBs collaboration agreement with GRI further bridges the gap; a no gaps, no overlaps approach gives a holistic picture of sustainability performance on the basis of both impact and enterprise value. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. This view of materiality doesnt ask the company to have a crystal ball, only to think about likely future risks or events such as resource shortages or environmental damage that could change the way they structure their business model and, ultimately, do business. 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. Indeed, in another section of the General Requirements that discusses the materiality concept in more detail, the TRWG uses a definition that would certainly include beta information: General purpose financial reporting includes financial statements of and sustainability-related financial information about a specific reporting entity. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. 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. The General Requirements Standard creates an umbrella of disclosure expectations that will apply across all of the ISSBs forthcoming sustainability topic-specific standards, including the Climate Standard. 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. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). 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