A recent study determined that in 2018, publicly listed companies around the world imposed net social and environmental costs on the economy with a value of $2.2 trillion annuallymore than 2.5 percent of global GDP. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. Companies are advised to monitor the continued development of the exposure drafts and may wish to consider aligning future sustainability reporting with key components of the General Requirements Standard, including relying on company- and industry-appropriate standards such as those of SASB. 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. 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. 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. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. Given the real reputational and regulatory risk for companies that rely on externalized costs, those of us focused on beta impacts can do several things with the ISSB process. These are the risks to the social and environmental systems in which the economy is embedded. 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. 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). 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. Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). 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. A market price also factors in todays expectations about any potential implications that, at some future point in time, might affect a companys legal or regulatory situation (even if only by association). Disagreement over definitions is just one element of the materiality issue. 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. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. 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. Taking IAS 37 as a starting point is not as simple as it might seem. 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. Companies that prioritize their financial return to shareholders face a prisoners dilemma with respect to such resources, and unchecked market competition will inevitably lead to their depletion. ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . In doing so, it has removed the existing definition of 'enterprise value' and the words 'to assess enterprise value' from the objective and description of materiality in the proposals. This includes activities that relate to other organisations in the value chain or in the sector if they could have potential consequences for the company itself. Thats why we were created. We then share key takeaways for companies that are beginning or continuing to make sustainability-related disclosures. This convergence is illustrated in Figure 1 below. 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. 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 . 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 CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". 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. If their content is aligned then the effect will be powerful. As one work describes this, [a]ccording to widely accepted research, alpha [over- or under-performance of individual securities] is about one-tenth as important as beta [and] drives some 91 percent of the average portfolios return. Stephen Davis, Jon Lukomnik, and David Pitt-Watson,What They Do with Your Money(2016). 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. 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. Tony Moller provided valuable research and drafting assistance in support of this Alert. Integration with Financial Reporting: Like the SECs proposed climate rule, the General Requirements Standard recommends that sustainability-related information be disclosed alongside an entitys general purpose financial reports as part of the ISSBs emphasis on the materiality of sustainability-related disclosures to investors. 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. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. 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. Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. 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. Despite all the talk of urgency from IOSCO, the climate-change standard will not be in place until next year. Global Leader, Public Policy & Regulation, PwC United Kingdom, Director of Investor Engagement, PwC United Kingdom. What has the Net Zero Asset Owner Alliance actually said about carbon offsets? If companies increase their own bottom line by emitting extra carbon, by refusing to share technology that will slow the pandemic, or by contributing to inequality, the financial benefits earned for their individual companies may be dwarfed by comparison to the costs the economy bears. The IFRSs accounting rules issued and maintained by the International Accounting Standards Board (IASB), on which the ISSB is modeled, have been adopted in over 100 countries, and the IFRS intends to co-develop the two independent sets of standards to ensure their connectivity, compatibility and relevancy to investors. What should be the role of investors when it is governments that have the most power to effect change? They both support a materiality assessment based on the potential effect on the companys enterprise value. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. 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. 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. > ISSB 2023 . 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. Even if the ISSB wanted to include double materiality, it could well meet with opposition in jurisdictions still coming to terms with even basic sustainability reporting. 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. 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. 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. Whatever the aim, they missed. The ISSB documentation expressly rejects "double materiality," the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. But from a disclosure perspective, investors should have the data that would allow them to understand the risk the company is taking by continuing to externalize costs. SASB's materiality map was so valued by the markets because it illuminated what mattered per industry. In the one camp, broadly speaking, sit the SEC and the ISSB. 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 ISSB standard could be of more limited value for certain jurisdictions. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. 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 dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. To accomplish this, the General Requirements Standard recommends that companies provide both quantitative data-based disclosures as well as qualitative narrative-driven disclosures. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. 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. As the process of sustainability reporting moves from voluntary to mandatory, companies with mature sustainability disclosure programs are likely to be well positioned to meet the evolving demands of stakeholders and regulators. IFRS Advisory Council questions ISSB on future of SASB standards. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. 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. On 3 November 2021, at COP26, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB). It is unclear why the General Requirements present double materiality and ESG as the only choices. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. So how might this look on the financial statements? This does not mean that disclosure standards drafters do not themselves need to understand the contextthat understanding is critical to eliciting the correct information for investors to use. 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. Standard-setting International Sustainability Standards Board Consolidated organisations But interests do not magically align. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. IFRS 13 is one standard that does refer to future amounts when it talks about valuation techniques that convert future amounts (such as cash flows or income and expenses) to a single current (discounted) amount. Not that this in any way prejudges the issue. As important as these two categories of impact may be, they are likely to be more heterogeneous than shareholder interests in beta, making them less likely to be good candidates for standardized disclosure. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. The EU can then "top up" these standards with those covering double materiality. 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. Thats why we were created. This means that companies have to report on both the financial and environmental implications of their sustainability efforts. The market must find a way to determine when this is important, and crucially, when it is not. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. Climate change denial has been a tough ask this summer. 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. It is questionable whether this difference matters from a practical perspective, although arguably aligning terminology and definitions would help ensure consistent implementation and interpretation. The ISSBs and SECs definitions of materiality are not far off from this. However, Murphy has rejected this approach in favour of a model that compounds the future obligation because it is likely that the cost of deferring action to address environmental change will increase over time at a rate likely to significantly exceed any applicable discount rate that a reporting entity might choose. This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. Take the example of an estimated sustainability cost of 66m (75m). The ESRS focuses on "double materiality", which attempts to capture a company's impact on the environment and society, along with the sustainability impacts to the organization. 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. In addition to interests in alpha and beta, shareholders may be otherwise affected by the E/S impact of companies in which they invest. 685 1784 92. 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 doom loop was complete when falling river levels left Frances nuclear power plants battling to produce enough energy to meet the demand for cooling. Discussion Note ( May 2021 ) next year is just one element the! 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