This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. 1. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. In the one camp, broadly speaking, sit the SEC and the ISSB. Of course, there would be no need to decide between prioritizing E/S impact or financial return if business decisions that optimize one always optimized the other. Sustainability and accounting specialist with a particular interest in assessing and quantifying sustainability risks and opportunities, and in particular climate-related risks and opportunities. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. The law governing investment fiduciaries is evolving to make it clear that their fiduciary obligations permitor even requirebeta management. 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. 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. 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. Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. 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. Faber predicts that Europes financial reporting adviser-turned-sustainability-standard-setter will finalise its technical advice to the Commission on sustainability reporting in the next couple of months. For similar reasons, Professor John Coffee predicted in a recent article that beta would surpass ESG integration as a motive for investor activism: This latter form of activism [beta focused] is less interested in whether the target firms stock price rises (or falls) than in whether the activist investors engagement with the target causes the total value of this investors portfolio to rise (which means that the gains to the other stocks in the portfolio exceed any loss to the target stock). SASB's materiality map was so valued by the markets because it illuminated what mattered per industry. Key focus areas include the Task Force on Climate-related Financial Disclosures, Materiality, and Carbon management. [.] 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. 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 . Thats why we were created. Registered Office: 1 Kentish Buildings, 125 Borough High Street, London SE1 1NP, UK pension risk transfer market set for bumper 2023. 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. 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. E/S information that does not affect investors, but is relevant to the impact companies have on civil society and stakeholders other than investors (stakeholder data). Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). Companies will finally have clear instructions on how to report on their sustainability impacts, risks, and opportunities, and investors and other stakeholders will be able to better track progress, compare performance, and hold companies to account. The absence of any discussion of this interest seems to be an important and unexplained omission from the analysis. While there are some obvious areas of agreement across the three sustainability reporting proposals including their overall objectives to provide information about a companys strategy, risks and targets for dealing with sustainability matters, and the need to look out over the short-, medium-, and long-term time horizons there is also deep division. 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. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. Take the example of an estimated sustainability cost of 66m (75m). See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). Climate change is an emergency that requires all hands on deck. 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. 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. However, sustainability reporting is not just about the sustainability-related impacts on the company (or its enterprise value) that can be material, but also the impacts of a company on the environment, climate or other sustainability issue so-called double materiality, Russell added. 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. 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. But double materiality adds inside-out information, namely, information relevant to the companys impacts on society and the environment. If the company were degrading the environment by causing drought with over-extraction then clearly EFRAGs materiality definition would require this outward impact to be reported. ISSB chair Emmanuel Faber has effectively ruled out the use of double materiality The board now expects to issue its climate-change standard next year Developments in the EU, US risk fragmenting the sustainability-reporting landscape Climate change denial has been a tough ask this summer. 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. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. 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. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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. This cost was more than 50 percent of the profits those companies reported. The Technical Readiness Working Group (the TRWG) recently released a set of recommendations for general requirements for the ISSB standards (the General Requirements) that addressed this question by defining what would be material for the standards overall. There have long been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example. The return to such diversified investors chiefly depends upon beta, not the performance of individual companies. 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. > ISSB 2023 . This convergence is illustrated in Figure 1 below. 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 . 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. Gulf or gap? This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. DWP sets up Taskforce on Social Factors for UK pensions industry, Threefold rise in asset managers holding board responsible for ESG, Accounting: Long-haul climate change reporting, Print advertising rates and specifications, Digital advertising technical specifications (pdf), Standard Terms and Conditions for Event Sponsors, ISSB chair Emmanuel Faber has effectively ruled out the use of double materiality, The board now expects to issue its climate-change standard next year, Developments in the EU, US risk fragmenting the sustainability-reporting landscape. What ISSB asks for. 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. For example, if climate change stays on the current trajectory, rather than aligning with the Paris Accords, GDP could be 10 percent less in 2050. 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. "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. But we are trying to. 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. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. Thus, to gather the E/S data that are material for company valuation purposes, the ISSB standard will have to include the same data that will be used to determine whether a company is externalizing costs to the detriment of people, planet, and other companies. 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. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. They both support a materiality assessment based on the potential effect on the companys enterprise value. Climate change denial has been a tough ask this summer. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. 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. : More unites standard setters than divides them, Total Impact Measurement & Management (TIMM), ESG (Environmental, Social and Governance). Double materiality 13 Double materiality is a concept which provides criteria for determination of whether a sustainability topic or information has to be included in the undertaking's sustainability report. Putting businesses on the path to a low carbon economy will require access to funding throughout the transition. The focus of the General Requirements on ESG integration appears to reject the notion that information relevant to beta is important to shareholders. Because negative externalities burden the economy and beta. Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. Corporate social responsibility. And, in practice, a small one at that. 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. 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. Double vs single vs dynamic materiality is one of the main pieces of contention between the ISSB and EFRAG in the design of their sustainability standards but what if this was only theoretical and in practice their thinking aligns? It . Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. 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. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. This reflected moral concern with profiting from suffering, rather than the use of investment to address a social issue. So how might this look on the financial statements? 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. They must do so again. 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. 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. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. These will include information that allows investors to draw conclusions as to whether the companys reputation is at risk, or whether it may be subject to regulation or increased costs when regulation is adopted to address currently unmitigated social or environmental costs. Unfortunately, the present obligation might not exist at the reporting date but could be a real future impact. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. Green Finance Institute director tells Chatham House while MP support double materiality approach. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour. 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. That is why we attempt to regulate companies: the choices that are best from an individual company financial perspective are not always best for society and the environment. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. 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. Impact materiality means that the activity affects either people or the environment, whether directly via the companys operations or indirectly in its value chain. 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. Taking a market view adds an element of objectivity to the materiality assessment. 24 February 2023 In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. PRI, an investor initiative whose members have $121 trillion in assets under management, recognizes this need. 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. 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. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. 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. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. 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. Swiss Re Institute, The Economics of Climate Change: No Action Not an Option (April 2021). Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. Finally, from a rhetorical perspective, it is important that the final documentation of the ISSB standards acknowledge that investors have significant interests in beta impacts. It is likely that if companies begin to report accurately on their sustainability profile, the information they provide will be illuminatingly different from what the market thought it knew. Such investors might prefer that companies in their portfolios make less money, i.e., that beta be reduced, if it were to lead to better employment opportunities. Adding beta information to the ISSB reporting standard would not significantly enlarge the reporting requirement because any company conduct that threatens or benefits beta is likely to create corresponding regulatory and reputational risks and benefits to enterprise value, so that most beta information should be deemed material even under a putative ESG standard. These projects help investors determine a companys fair share of a limited common resource or the proper social and environmental boundaries for individual companies that are necessary to preserve the systems upon which all companies rely. When the economy suffers, so do diversified shareholders. EFRAG's work is rooted in double materiality and Faber said the ISSB is "embracing [this approach] when it comes to looking at all the impacts, significant impact that companies are going to have on their ecosystem. Such a standard, rising above a single focus on financial materiality but rooted in investor return, would not rise to the level of double materiality, and might best be described as sesquimateriality.. 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. 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). 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 dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. 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. 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. 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. Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality. 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. Disagreement over definitions is just one element of the materiality issue. 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. 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 doom loop was complete when falling river levels left Frances nuclear power plants battling to produce enough energy to meet the demand for cooling. 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. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. Like the U.S. Securities and Exchange Commissions (SEC) recently proposed climate-related risk disclosure rule1, the ISSBs General Requirements and Climate Standards are based on the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD). The market must find a way to determine when this is important, and crucially, when it is not. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. The draft standard also introduces the concept of dynamic materiality. In practice, this shifts the focus to the forward-looking or anticipatory aspects of double materiality. Environmental, social and governance (ESG) integration. 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. This would appear as a balance sheet reserve, representing funds set aside to pay future obligations. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. 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. 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. Consequently, an enterprise value materiality assessment would take into account a companys effect on the outside world to the extent that the market has knowledge of the issue and, therefore, prices it into the debt and equity securities of the company. ESRS 2 General disclosures providing DRs on general reporting issues, governance, strategy and business model and the double materiality assessment process of sustainability impacts, risks and opportunities. Whats material depends on the issue, the context, the time frame and the stakeholder. The task of building a sustainable future is a shared responsibility for us all. Encourage the ISSB drafters to move to an express sesquimateriality standard. Were taking that all very, very seriously. Single MaterialityDouble Materiality Outside-in Perspective . 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. 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 ISSB consultation responses show there is also wide support for the approach within the financial sector. But these standards do not provide for a grade or make a judgment as to whether the companys treatment of workers or fuel efficiency will in fact threaten its cash flows and enterprise value: that is generally left for investors to decide. Interest 61 (1971). 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. 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). 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. 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