See Bill Baue, Compared to What? 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. 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. In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to beta. 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. 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. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. 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. These are the risks to the social and environmental systems in which the economy is embedded. 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. 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. The law governing investment fiduciaries is evolving to make it clear that their fiduciary obligations permitor even requirebeta management. 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. 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. Read our policy. Disagreement over definitions is just one element of the materiality issue. Information on a company is material and should therefore be disclosed if "a reasonable person would consider it [the information] important", according to the US Securities and Exchange Commission . And, in practice, a small one at that. As such, we urge you to rethink your whole approach to this issue. EFRAG refers to impacts on people and the environment [that] may be considered pre-financial in the sense that they may become material for financial reporting purposes over time. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. 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. 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. Those subtle differences are time frame and taking a market (by definition, an outside) view. Financial materiality is in line with current U.S. disclosure rules. The US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. 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. 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. 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. One example, Becker claims, is the understand of materiality. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). Nevertheless, portfolio theorys prescription of diversification certainly suggests that widely held entities should give strong consideration to diversified investors interests. They must do so again. 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 agreed to fully align its description of materiality with IFRS Accounting Standards. Not all investors are diversified, so if a company protects beta by accepting reduced enterprise value, it may be favoring diversified investors at the expense of concentrated investors. 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. 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. 685 1784 92. 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. None of these practical difficulties, however, ought to derail efforts to align. One of the biggest is that all three proposals define what is material in different ways. 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. 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. 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. Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. 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). Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. 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. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. 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. 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 . 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. 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. In the one camp, broadly speaking, sit the SEC and the ISSB. But the trade is inevitablethe only question is which type of investor it will favor. 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. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. 2017 By Nadja Picard, Gilly Lord and Hilary Eastman. 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. 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. The planned agenda consultation has also been pushed back into next year. 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. In Europe, double materiality - reporting on both sustainability factors affecting the company (financial materiality) and how the company impacts on society and the environment (outward materiality) - is already part of the European Commission's proposed Corporate Sustainability Reporting Directive (CSRD). Tony Moller provided valuable research and drafting assistance in support of this Alert. 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. 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). TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. Changes in the reserve would flow into the statement of comprehensive income and then through the statement of changes in equity. 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. Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. 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. Companies and investors have, in the past and on other topics, risen to the challenge. 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. 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. 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 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. 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 In addition to interests in alpha and beta, shareholders may be otherwise affected by the E/S impact of companies in which they invest. 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. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. 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. 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. This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. One of the first parameters to be established must be the purpose of disclosure. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. 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. get as much direction as quickly as possible to really build on momentum.. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. These phrases refer to the need for investors to pay more attention to the environmental and social (E/S) impacts of the businesses in which they invest. 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. 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. Hard choices must be made. 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. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. Swiss Re Institute, The Economics of Climate Change: No Action Not an Option (April 2021). Environmental, social and governance (ESG) integration. 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. Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. 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. 1. The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. Corporate social responsibility. Excluding beta information from the reporting standard does not reflect evolving recognition of the importance of beta. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. 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. 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). A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. 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. 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