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. In the one camp, broadly speaking, sit the SEC and the ISSB. Economists have long recognized that profit-seeking firms in free-market economies will not account for negative externalities, and there are many profitable strategies that harm stakeholders, society, and the environment. This is known as the single-materiality approach, as opposed to a double-materiality approach that considers impact both ways. 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. 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. 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. PRI, an investor initiative whose members have $121 trillion in assets under management, recognizes this need. Whats material depends on the issue, the context, the time frame and the stakeholder. 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. 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 . 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. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. 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. However, for Andromeda Wood, vice president of regulatory strategy . See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). 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. Thus, while individual companies can profitably externalize costs, a diversified investor will pay these costs through lowered return on their diversified portfolios. Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. 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. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. Climate change denial has been a tough ask this summer. On 3 November 2021, at COP26, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB). These are the risks to the social and environmental systems in which the economy is embedded. They both support a materiality assessment based on the potential effect on the companys enterprise value. CSRD explicitly requires double-materiality reporting and so vastly expands the scope of disclosure from considering only sustainability risks that companies face (i.e. Steering clear of this risk is likely to require, at most, minor adjustments in methodology; moreover, the initial ISSB documentation, while ambiguous, does not preclude such considerations. Sustainability reporting standards promise to do the same. We then share key takeaways for companies that are beginning or continuing to make sustainability-related disclosures. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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. A consultation paper on the SDR is expected in the second quarter of 2022.. 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. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. 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. Many of the comment letters on both standards are broadly supportive, but there were some niggles among the praise. '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 . 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. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. 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 . Diversification is specifically intended to minimise idiosyncratic impacts on portfolio performance. 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. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). But interests do not magically align. Although the financial-materiality test articulated in the General Requirements seems inadequate to address the system level issues, the drafting implications may be more theoretical than practical, especially if the drafters understand the concern. 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. 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. 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. The planned agenda consultation has also been pushed back into next year. 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. 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. What should be the role of investors when it is governments that have the most power to effect change? One example, Becker claims, is the understand of materiality. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. Standard-setting International Sustainability Standards Board Consolidated organisations For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. 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. Furthermore, the Global Reporting Initiative (GRI) which provides standards for companies to disclose their environmental and social impacts to a broader set of stakeholders than investors and is the most widely used disclosure system globally has pledged to coordinate its future standard-setting activities with those of the ISSB to provide two pillars of international sustainability reporting. 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. 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. This would appear as a balance sheet reserve, representing funds set aside to pay future obligations. 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 focus should be on double materiality and not on enterprise value," the HSBC Bank (UK) Pension Scheme said in its submission to the ISSB. To accomplish this, the General Requirements Standard recommends that companies provide both quantitative data-based disclosures as well as qualitative narrative-driven disclosures. This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. We will not move. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). 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. 3233596, VAT No. 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. 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. 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. Despite all the talk of urgency from IOSCO, the climate-change standard will not be in place until next year. The ISSB will accept feedback on its General Requirements and Climate Standards until July 29, 2022, and will incorporate the comments it receives into its final sustainability reporting standards, expected by the end of 2022. Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. 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. The actual influence of certain behaviours on cash flows are still being understood and standard models for measurement in these areas are nascent, or missing altogether. 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. Whatever the aim, they missed. Interest 61 (1971). 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. Single MaterialityDouble Materiality Outside-in Perspective . Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. 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. 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). 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. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. Planetary forces much greater than cataclysmic weather events have decided that. 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. Sustainable investing. What ISSB asks for. 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. 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. 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. Diversified investors cannot avoid certain common risks almost all companies face. TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. 24 February 2023 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. 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. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. 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. 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. 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. By Stephen BouvierNovember 2022 (Magazine). 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. In its October 2022 board meeting, the ISSB . 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. 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 recommendations of both the ISSB and the TCFD fall into four broad pillars governance, strategy, risk management, and metrics and targets corresponding to how the disclosing company approaches these four practices in the context of a given sustainability topic. 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. 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 . Financial materiality is in line with current U.S. disclosure rules. union of two sets, not intersection) of impact materiality Registered Office: 1 Kentish Buildings, 125 Borough High Street, London SE1 1NP, UK pension risk transfer market set for bumper 2023. 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. As such, we urge you to rethink your whole approach to this issue. It is questionable whether this difference matters from a practical perspective, although arguably aligning terminology and definitions would help ensure consistent implementation and interpretation. IFRS Advisory Council questions ISSB on future of SASB standards. Environmental, social and governance (ESG) integration. "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 ISSB's superpower may lie in illuminating issues that are emerging across the global markets for consideration by investors and the broader markets. 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. The ISSB was announced in . None of these practical difficulties, however, ought to derail efforts to align. Were taking that all very, very seriously. Companies therefore may wish to consider the ISSBs standards a baseline for reporting, as opposed to an exhaustive set of disclosures. The US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. 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. On March 31, 2022, the International Sustainability Standards Board (ISSB), an investor-focused initiative of the International Financial Reporting Standards (IFRS) Foundation, released long-anticipated drafts of its sustainability reporting standards: the General Requirements for Disclosure of Sustainability-Related Financial Information (the General Requirements Standard) and a Climate-Related Disclosures framework (the Climate Standard). 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. 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. 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. Welcome to IPE. Similarly, they might be willing to sacrifice portfolio return if it meant a healthier environment in which to enjoy their retirement, or if doing so would relieve others suffering. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. 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. 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. 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. 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. The absence of any discussion of this interest seems to be an important and unexplained omission from the analysis. 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. A company cant consider only what it cares about; it has to take into account what others would consider when pricing the shares or debt, into perpetuity for shares and over the tenure of bonds or loans. 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. Because negative externalities burden the economy and beta. 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. 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. Keep the distinction between ESG integration, beta management, and other sustainability purposes at the top of the discussion. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. 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. The message is clear: to optimize returns, investors must exercise their governance rights and other prerogatives to protect themselves and their beneficiaries from individual companies that threaten beta. And, on the surface, this could threaten progress towards global alignment. 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. The ISSB indicated that its aim is for the complete set of ISSB Standards, once finalized, to provide a comprehensive global baseline of sustainability disclosures for investors in global capital markets to use when assessing the value of companies. The EU can then "top up" these standards with those covering double materiality. 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. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. In this Alert, we outline the contents of the draft standards focusing on the General Requirements Standard and situate them within the context of converging voluntary disclosure standards and increasing regulation. 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. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . 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. SASB's materiality map was so valued by the markets because it illuminated what mattered per industry. 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. See Bill Baue, Compared to What? 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. 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. And, in practice, a small one at that. 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. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. 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