PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. 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. So, in practical terms, the gulf is no gulf, but a gap. What ISSB asks for. 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. Additionally, what is material and who is a stakeholder will likely change based on country and culture so evaluation of impact and consideration of materiality will require sifting, analysis, and assessing tradeoffs.
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. 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 is a really important decade for dealing with climate change, so asset owners have to decarbonise the real economy, says NZAOAs investment lead, The taskforce will support pension scheme trustees and the wider pensions industry with some of the key challenges around managing social factors, Alongside NNIP and PGGM, the investors that took the biggest tumble down the rankings since 2020s survey were State Street Global Advisors, PIMCO and Allianz Global Investors, The countrys reliance on Russian gas means its change of energy sources will carry alarger environmental cost. But as capital markets matured, investors began to contemplate a more active role, and after a divestment campaign helped end South African apartheid, the idea that investors could change bad corporate behavior, rather than simply avoiding it, developed a broader following. 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. 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. Additionally, EFRAGs draft European Sustainability Reporting Standards for the Corporate Sustainability Reporting Directive incorporate disclosure obligations that include entities impacts on nature, society and the climate. "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 . 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. Please see www.pwc.com/structure for further details. This is known as the single-materiality approach, as opposed to a double-materiality approach that considers impact both ways. 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 are some other areas that need ironing out too before standard setters finish their work. 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. 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. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). 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. However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. At a high level, the ISSB aims to help companies streamline their sustainability disclosures to facilitate an apples to apples comparison by investors. (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. As unlikely as this proposition seems, the Business Roundtable, an organization composed of most major U.S. corporations CEOs, promotes this idea under the moniker stakeholder capitalism, and claims that if a company treats all its stakeholders well (which can be another way of saying it optimizes its E/S impact), it will also maximize its return to its shareholders over the long term: While we acknowledge that different stakeholders may have competing interests in the short term, it is important to recognize that the interests of all stakeholders are inseparable in the long term. Business Roundtable, Redefined Purpose of a Corporation: Welcoming the Debate (August 2019). 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. 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. Socially responsible investing. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. Taking a market view adds an element of objectivity to the materiality assessment. Yet the scope of externalities is enormous. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. Tony Moller provided valuable research and drafting assistance in support of this Alert. Contributions to inequality also reduce GDP over time. 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. A concept often referred to as ' double materiality '. Firstly, the time element will force companies reporting under either the ISSBs and SECs rules to include outward impacts since, logically, the outward impact will eventually work its way inward. 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. 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. See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. 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. Because negative externalities burden the economy and beta. This is a critical moment. 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. 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. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. 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.. In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. 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. IFRS Advisory Council questions ISSB on future of SASB standards. Encourage the ISSB drafters to move to an express sesquimateriality standard. This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. If their content is aligned then the effect will be powerful. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. Finally, a number of prominent global financial regulators including the SEC, the UK Financial Conduct Authority, the European Commission, the European Financial Reporting Advisory Group (EFRAG), the Japanese Financial Services Authority, the Sustainability Standards Board of Japan Preparation Committee and the Chinese Ministry of Finance have agreed to join a working group focused on compatibility between the ISSBs standards and new regulations. Murphy suggests environmental impact and financial reporting can be integrated by using two provisions following the methodology in International Accounting Standard 37, which deals with provisions, contingent liabilities and contingent assets. Whats material depends on the issue, the context, the time frame and the stakeholder. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. 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. 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. The task of building a sustainable future is a shared responsibility for us all. Thats why we were created. union of two sets, not intersection) of impact materiality Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. 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. 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. 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. 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. 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 final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. 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. 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. But double materiality adds inside-out information, namely, information relevant to the companys impacts on society and the environment. 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. 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. 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. 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. Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality. '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 . 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. 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. 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. 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. Diversification is specifically intended to minimise idiosyncratic impacts on portfolio performance. 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. The last category of information is that which is relevant to stakeholders other than shareholders. 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. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. Thats why we were created. 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. However, for Andromeda Wood, vice president of regulatory strategy . 685 1784 92. This post is based on their recent paper. This means that companies have to report on both the financial and environmental implications of their sustainability efforts. 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. The logic for this is implicit within IAS 37. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. 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. 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). Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. The materiality principle chosen in the General Requirements seems to ignore the most important issue on the table without explanation. When the economy suffers, so do diversified shareholders. 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. 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). This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. 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. 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. 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. 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. 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. 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. The ISSB was announced in . 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. The CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". outside-in materiality - or ESG reporting as it is most commonly adopted today), to also disclose the impact of those same companies on society and the environment (i.e . - 2023 PwC. Sustainability and accounting specialist with a particular interest in assessing and quantifying sustainability risks and opportunities, and in particular climate-related risks and opportunities. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. A consultation paper on the SDR is expected in the second quarter of 2022.. This then helps create the business case for companies to take action on the priorities that their investors, customers and others really care about. 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. They both support a materiality assessment based on the potential effect on the companys enterprise value. 1. 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. Driven to assist organizations to elicit positive change.<br>TCFD | CDP | SBTs . [.] As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). If risks of this sort materialised, they would therefore damage the performance of a portfolio as a whole and all portfolios exposed to those systems. Disagreement over definitions is just one element of the materiality issue. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. 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. 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. The following chart sums up the four possible uses of data for which the ISSB might be optimized: As investors have become more cognizant of the importance of corporate impact on society and the environment, disclosure standards proliferated, making it difficult to compare the impact of companies that report on different standards. 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. Planetary forces much greater than cataclysmic weather events have decided that. 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. 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 will not move. 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. 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 of the biggest is that all three proposals define what is material in different ways. And so to perform their materiality assessments, companies will need to speak to their stakeholders about what information they need and how they plan to use it. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start. The EU can then "top up" these standards with those covering double materiality. Interest 61 (1971). 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. 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. 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. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). Take the example of an estimated sustainability cost of 66m (75m). Taking IAS 37 as a starting point is not as simple as it might seem. But the context for beta-relevant data is such that an enterprise value-based E/S disclosure regime may in many cases be very close to good enough for beta as well. 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. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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. Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. Since it cannot meet that essential accounting expectation of being a going concern unless reinvestment does take place, this provision must also be made upon the balance sheet, upfront, now. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. Financial materiality means that the activity has an effect on the companys cash flows or enterprise value (consistent with the SEC and ISSB). 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. The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. Welcome to IPE. 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