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. This is similar to the architecture of the TCFD and ISSB. All rights reserved. The ISSBs and SECs definitions of materiality are not far off from this. There have long been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example. 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. 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). 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. 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. 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. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. It suggests that corporate activity that threatens critical systems is not material if that activity does not threaten enterprise value at the company in question. Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). 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. 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. 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. Frederick Alexander is Founder of The Shareholder Commons; Holly Ensign-Barstow is Director of Stakeholder Governance & Policy at B Lab. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. 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. And if their rate of extraction is causing drought in a local area then in 15 years or fewer they must report this too, since their activities are having a negative impact on the environment. 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. Eight othersmostly based in Europe, and including Allianz, Amundi, BNP Paribas, DWS, and Schrodersencourage the ISSB to consider a double materiality approach, incorporating companies' impacts on the environment and wider society, in line with the European Commission's proposals. Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. 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. See Bill Baue, Compared to What? Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. Disagreement over definitions is just one element of the materiality issue. 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. The ISSB and EU bodies are collaborating to create an interoperability mapping table to highlight the intersection.The key challenge here is to maximise the content in the intersection and avoid having similar requirements that are excluded from the intersection because they are subtly different. The gap between fiduciary and ethical obligations can be reduced in part if companies are able to implement responsible E/S practices that drive greater enterprise value. IFRS Advisory Council questions ISSB on future of SASB standards. 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. 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. The dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. Influential investors such as BlackRock have previously encouraged companies to voluntarily disclose in line with both TCFD and SASB, and companies that have already developed such procedures for sustainability reporting will find it easier to adapt to the ISSBs framework. For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. 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. Whats material depends on the issue, the context, the time frame and the stakeholder. Not that this in any way prejudges the issue. "The focus should be on double materiality and not on enterprise value," the HSBC Bank (UK) Pension Scheme said in its submission to the ISSB. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. 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. It means prioritising the long-term, absolute returns for universal owners, including real-term financial and welfare outcomes for beneficiaries more broadly. One of the biggest is that all three proposals define what is material in different ways. 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. 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. 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. Pursuant to applicable rules of professional conduct, portions of this publication may constitute Attorney Advertising. It is unclear why the General Requirements present double materiality and ESG as the only choices. Considering how each proposed standard might operate provides a window into their practical similarities and calls into question the notion that the materiality definitions of each of the different standard setters are irrevocably different, given the broad nature of what can affect enterprise value. 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. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. In 2021, SASB and the Integrated Reporting Framework combined to form the Value Reporting Foundation, which, alongside the CDSB, will fold into the ISSB by June 2022. The ISSB and SEC do not, as EFRAG does, mention an outward element: the effect the company might have on externalities such as the environment or local communities. This reflected moral concern with profiting from suffering, rather than the use of investment to address a social issue. 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. 24 February 2023 The doom loop was complete when falling river levels left Frances nuclear power plants battling to produce enough energy to meet the demand for cooling. Key focus areas include the Task Force on Climate-related Financial Disclosures, Materiality, and Carbon management. A consultation paper on the SDR is expected in the second quarter of 2022.. Were taking that all very, very seriously. 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. 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. 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. Double materiality is the union (in mathematical terms, i.e. 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. 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. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. Welcome to IPE. 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). The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. 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. 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 a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. In its October 2022 board meeting, the ISSB . Nevertheless, portfolio theorys prescription of diversification certainly suggests that widely held entities should give strong consideration to diversified investors interests. For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. Figure 1: Convergence of Voluntary Sustainability Disclosure Standards. Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. The UK government has gone a step further, signaling it intends to adopt the ISSBs standards as part of future mandatory sustainability reporting requirements under the Sustainability Disclosure Regulation (SDR).2. 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. In the one camp, broadly speaking, sit the SEC and the ISSB. 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. 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. ESRSISSB . Double materiality is an extension of the key accounting concept of materiality of financial information. Ultimately, investors and other stakeholders need access to information both financial and sustainability-related with sufficient transparency to be able to send the right market signals to companies about the kind of corporate behaviour they expect and will support. 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 . 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. The CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". 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 market-based solution in a document as influential as the ISSB standards would be a serious setback. But while an individual investor is free to satisfy ethical goals without regard to financial consequences, many investors, such as retirement and mutual funds, have fiduciary obligations to prioritize the interests of their beneficiaries. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. 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. 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.
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