Posted by Frederick Alexander (The Shareholder Commons), on, Harvard Law School Forum on Corporate Governance, on One Small Step From Financial Materiality to Sesquimateriality: A Critical Conceptual Leap for the ISSB, Companies Should Maximize Shareholder Welfare Not Market Value, Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee. 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. The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. Socially responsible investing. 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. 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. 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. Thats why we were created. Double materiality is the union (in mathematical terms, i.e. 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. Changes in the reserve would flow into the statement of comprehensive income and then through the statement of changes in equity. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. 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 IFRSs accounting rules issued and maintained by the International Accounting Standards Board (IASB), on which the ISSB is modeled, have been adopted in over 100 countries, and the IFRS intends to co-develop the two independent sets of standards to ensure their connectivity, compatibility and relevancy to investors. 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. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. 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. Importantly, the inside-out concept as discussed in the General Requirements is not designed to address beta; instead, it is focused on how the E/S performance of a company affects society overall. But the context for beta-relevant data is such that an enterprise value-based E/S disclosure regime may in many cases be very close to good enough for beta as well. 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. 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). Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . 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 Nadja Picard, Gilly Lord and Hilary Eastman. 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 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. 24 February 2023 For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. 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. 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. It . Keep the distinction between ESG integration, beta management, and other sustainability purposes at the top of the discussion. 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. TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. As unlikely as this proposition seems, the Business Roundtable, an organization composed of most major U.S. corporations CEOs, promotes this idea under the moniker stakeholder capitalism, and claims that if a company treats all its stakeholders well (which can be another way of saying it optimizes its E/S impact), it will also maximize its return to its shareholders over the long term: While we acknowledge that different stakeholders may have competing interests in the short term, it is important to recognize that the interests of all stakeholders are inseparable in the long term. Business Roundtable, Redefined Purpose of a Corporation: Welcoming the Debate (August 2019). 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. 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 . 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. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. The materiality principle chosen in the General Requirements seems to ignore the most important issue on the table without explanation. Yet the scope of externalities is enormous. Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. There are some other areas that need ironing out too before standard setters finish their work. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). Their primary obligation is to protect the financial interests of their beneficiaries and clients by protecting and growing their investment portfolios. In 2021, SASB and the Integrated Reporting Framework combined to form the Value Reporting Foundation, which, alongside the CDSB, will fold into the ISSB by June 2022. Please see www.pwc.com/structure for further details. Hard choices must be made. 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. 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. Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. Double materiality. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. On March 24, 2022 the IFRS Foundation (the Foundation) and the Global Reporting Initiative (GRI) published a press release announcing "a collaboration agreement under which their respective. 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 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. 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. 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. Whats material depends on the issue, the context, the time frame and the stakeholder. Whatever the aim, they missed. 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. Thats where we aregoing. Companies and investors have, in the past and on other topics, risen to the challenge. 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. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour. 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. One of the first parameters to be established must be the purpose of disclosure. This is known as the single-materiality approach, as opposed to a double-materiality approach that considers impact both ways. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. The ISSB is the product of agreement among a critical mass of relevant industry participants to develop a uniform standard for disclosure of social and environmental impact. : More unites standard setters than divides them, Total Impact Measurement & Management (TIMM), ESG (Environmental, Social and Governance). 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. 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. 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. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. The ISSB standard could be of more limited value for certain jurisdictions. 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. But we are trying to. Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. 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. 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. See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. The ISSB agreed to fully align its description of materiality with IFRS Accounting Standards. Single MaterialityDouble Materiality Outside-in Perspective . 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. Take the example of an estimated sustainability cost of 66m (75m). Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. Centrality of TCFD and SASB: As described above, the ISSBs General Requirements Standard centers on the four pillars of the TCFD framework, which are geared toward integrating sustainability risk assessment into the core processes of a companys business, as well as the industry-specific disclosures outlined by the SASB Standards. The complex nature of the investment market, with some investors picking stocks for their portfolios and others being invested in index funds, means that companies have to cater to a massive array of information needs. Financial materiality means that the activity has an effect on the companys cash flows or enterprise value (consistent with the SEC and ISSB). 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. 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. All rights reserved. The ESRS focuses on "double materiality", which attempts to capture a company's impact on the environment and society, along with the sustainability impacts to the organization. Encourage the ISSB drafters to move to an express sesquimateriality standard. In the other camp sits EFRAG, which through the EU Corporate Sustainability Reporting Directive (CSRD) seeks to implement a double materiality approach, a concept which encompasses financial materiality and impact materiality. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. 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. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. CSRD""Double MaterialityFinancial MaterialityImpact Materiality . 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. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. The task of building a sustainable future is a shared responsibility for us all. 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. > ISSB 2023 . 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. Read our policy. 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. This convergence is illustrated in Figure 1 below. 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. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. Because the ISSB is a standard for disclosure, and not for action, it can be neutral on which side to take and simply provide beta-relevant information, in order to inform investors of the trades being made. The distance between the emerging definitions of materiality in sustainability reporting is smaller than you think and heres why it shouldnt prevent progress towards global alignment. 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. 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 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. 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. 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. Even without such alignment, in valuation terms enterprise value is typically determined by calculating the net present value of forecast future cash flows and takes a market perspective which by nature encompasses all available information and takes a very long-term view (into perpetuity). 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. Interest 61 (1971). Because the ISSB and SEC approaches focus solely on the effects to the future cash flows of the company, critics complain that it does not take into account certain negative impacts the company might have on the environment and society because those impacts have no calculable effect on its value. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. Investors need a reporting standard that accounts for all the costs a portfolio company imposes on them, even if the company itself avoids those costs. IFRS Advisory Council questions ISSB on future of SASB standards. measuring and reporting carbon emissionsthat serve both purposes. But interests do not magically align. 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. The dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? 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 . This cost was more than 50 percent of the profits those companies reported. 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 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. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. Climate change denial has been a tough ask this summer. 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. 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. 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. 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. If a sustainability issue is currently affecting a companys business activities, it is likely to have an effect on the companys cash flows over the short, medium or long term, and must be reported now. 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. 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. Why? 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