Putting businesses on the path to a low carbon economy will require access to funding throughout the transition. 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. ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . 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. This article addresses a fundamental debate over the purpose of the uniform standard and reaches the following conclusions: Four types of impact. Taking a market view adds an element of objectivity to the materiality assessment. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. E/S information that impacts the costs that companies externalize to the economy, which affect overall securities market returns (beta), and thus the returns of other companies in an investors portfolio. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. 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. 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. Companies and investors have, in the past and on other topics, risen to the challenge. 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. Climate change denial has been a tough ask this summer. In what follows, we'll break down the concepts of "materiality" and "double materiality" and share some key takeaways about their importance to ESG management. 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. 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. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. 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. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. 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. 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. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. Thinking about the water usage example above, its clear that a company would end up reporting much the same information under the ISSBs and SECs proposals as they would under EFRAGs. This time pressure leaves the board with little time to explore a draft sustainability-reporting standard drawn up by Prof Richard Murphy from Sheffield University Management School. ESRSISSB . Financial materiality is in line with current U.S. disclosure rules. For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. CSRD explicitly requires double-materiality reporting and so vastly expands the scope of disclosure from considering only sustainability risks that companies face (i.e. However, for Andromeda Wood, vice president of regulatory strategy . The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. But double materiality adds inside-out information, namely, information relevant to the companys impacts on society and the environment. To the extent such overlap exists, an investor can harmonize the desire for positive social and environmental impact and the desire (or obligation) to optimize financial returns. The law governing investment fiduciaries is evolving to make it clear that fiduciary obligations permitor even requirebeta management. However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. 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. 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.. 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. 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. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. Interest 61 (1971). This is a critical moment. Diversified investors cannot avoid certain common risks almost all companies face. By Stephen BouvierNovember 2022 (Magazine). 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). There have long been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example. Over long time periods, beta is influenced chiefly by the performance of the economy itself, because the value of the investable universe is equal to the percentage of the productive economy that the companies in the market represent. E/S information that involves the residue of E/S impacts that do not affect investment returns, but that impact on other matters that are important to individual investors (non-financial investor impacts). By Nadja Picard, Gilly Lord and Hilary Eastman. Diversification is specifically intended to minimise idiosyncratic impacts on portfolio performance. 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. The task of building a sustainable future is a shared responsibility for us all. Thats where we aregoing. - 2023 PwC. 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 ISSBs and SECs definitions of materiality are not far off from this. Impact materiality means that the activity affects either people or the environment, whether directly via the companys operations or indirectly in its value chain. We thank Paisley Ashton-Holt, Tom Beagent, Henry Daubeney, Will Evison, Alan McGill, Andreas Ohl, Atul Patel, Naomi Rigby and Katie Woods for their insightful contributions to this article. Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? 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 dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. Were taking that all very, very seriously. 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. 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. The ISSB was announced in . Even without such alignment, in valuation terms enterprise value is typically determined by calculating the net present value of forecast future cash flows and takes a market perspective which by nature encompasses all available information and takes a very long-term view (into perpetuity). 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 . This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. The focus of the General Requirements on ESG integration appears to reject the notion that information relevant to beta is important to shareholders. 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. There are some other areas that need ironing out too before standard setters finish their work. Key focus areas include the Task Force on Climate-related Financial Disclosures, Materiality, and Carbon management. 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. 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. The CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". And, on the surface, this could threaten progress towards global alignment. 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. 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. The logic for this is implicit within IAS 37. 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. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. 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. Corporate social responsibility. Disagreement over definitions is just one element of the materiality issue. But then we filter that with the financial materiality as defined by the accounting standards". 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. The ISSB documentation expressly rejects "double materiality," the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. None of these practical difficulties, however, ought to derail efforts to align. 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. SASB's materiality map was so valued by the markets because it illuminated what mattered per industry. 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. It is questionable whether this difference matters from a practical perspective, although arguably aligning terminology and definitions would help ensure consistent implementation and interpretation. 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 . PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. 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. What has the Net Zero Asset Owner Alliance actually said about carbon offsets? 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. 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. 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. 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. One of the biggest is that all three proposals define what is material in different ways. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). 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. Keep the distinction between ESG integration, beta management, and other sustainability purposes at the top of the discussion. Companies occasionally need to report new information and markets need to work out how to digest it. 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. 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. 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