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. Climate change denial has been a tough ask this summer. 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. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. 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. Because negative externalities burden the economy and beta. 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. 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. 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. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. 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). 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. Climate change is an emergency that requires all hands on deck. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. 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. [.] 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. A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. See Bill Baue, Compared to What? So, in practical terms, the gulf is no gulf, but a gap. 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. The failure to even address beta-oriented disclosure is surprising because there is a growing emphasis on the need for diversified investors to monitor and steward the beta impact of portfolio company activity. Tony Moller provided valuable research and drafting assistance in support of this Alert. . 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. 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. 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. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. Encourage the ISSB drafters to move to an express sesquimateriality standard. The law governing investment fiduciaries is evolving to make it clear that fiduciary obligations permitor even requirebeta management. 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). 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. 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 . 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). 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. Impact materiality means that the activity affects either people or the environment, whether directly via the companys operations or indirectly in its value chain. 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. The ISSB intends to detail baseline requirements that ensure companies provide investors with a complete set of disclosures on sustainability risks and opportunities that could affect enterprise value, in order to complement the information provided in financial statements. 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. (Of course, much data relevant to investors for beta purposes would overlap with these two categories, so that an expansion to beta-relevant information would add that value as well.). 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. 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. 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. 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. 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. 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. 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. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. 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. IFRS Advisory Council questions ISSB on future of SASB standards. 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. 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 . 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. The ISSBs and SECs definitions of materiality are not far off from this. Financial reporting standards have proven to be a driving force of stability and development in our global capital markets. 1. This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. By the same token, a proper sesquimateriality standard would elicit the inside-out E/S data that was likely to impact the social and environmental systems that support beta. As noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of materiality. In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to beta. For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. 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. Global Leader, Public Policy & Regulation, PwC United Kingdom, Director of Investor Engagement, PwC United Kingdom. Companies occasionally need to report new information and markets need to work out how to digest it. But the trade is inevitablethe only question is which type of investor it will favor. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. At a high level, the ISSB aims to help companies streamline their sustainability disclosures to facilitate an apples to apples comparison by investors. The General Requirements Background section described inside-out and financial materiality in the following paragraphs (a) and (b): (a) disclosures to stakeholders about sustainability matters that have impacts on people, the environment and the economythese disclosures normally provide the broadest range of information because they aim to meet the needs of multiple stakeholders. These include what might affect investment valuation, an investments contribution to systemic risk, how exposed it is, and what the implications of proxy voting might be. This time pressure leaves the board with little time to explore a draft sustainability-reporting standard drawn up by Prof Richard Murphy from Sheffield University Management School. 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. Those subtle differences are time frame and taking a market (by definition, an outside) view. Thats where we are going.. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. 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. 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 draft standard also introduces the concept of dynamic materiality. 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. 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. These are the risks to the social and environmental systems in which the economy is embedded. 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. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. measuring and reporting carbon emissionsthat serve both purposes. 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. 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. Diversified investors cannot avoid certain common risks almost all companies face. They must do so again. In the one camp, broadly speaking, sit the SEC and the ISSB. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. 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. But while an individual investor is free to satisfy ethical goals without regard to financial consequences, many investors, such as retirement and mutual funds, have fiduciary obligations to prioritize the interests of their beneficiaries. The second is a provision for the capital cost of opening the new net-zero carbon-based business that must replace the existing carbon-based activity if the company is to be a going concern. 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. 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. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. 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. Standard-setting International Sustainability Standards Board Consolidated organisations 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. 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