EFRAGs proposed standard only asks that companies break the shackles of certainty and short-term thinking to report on the things that they are likely already or should be factoring into their business planning anyway. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour. One example, Becker claims, is the understand of materiality. 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. This is similar to the architecture of the TCFD and ISSB. 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. 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. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. CSRD""Double MaterialityFinancial MaterialityImpact Materiality . 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. 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). 'The ISSB has a definition of materiality that could allow Europe to overlay double materiality, although more detail is needed, which hopefully will come from the . This view of materiality doesnt ask the company to have a crystal ball, only to think about likely future risks or events such as resource shortages or environmental damage that could change the way they structure their business model and, ultimately, do business. Diversified investors cannot avoid certain common risks almost all companies face. Keep the distinction between ESG integration, beta management, and other sustainability purposes at the top of the discussion. The ISSB agreed to fully align its description of materiality with IFRS Accounting Standards. As such, we urge you to rethink your whole approach to this issue. This means that companies have to report on both the financial and environmental implications of their sustainability efforts. Excluding beta information from the reporting standard does not reflect evolving recognition of the importance of beta. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. In the one camp, broadly speaking, sit the SEC and the ISSB. Financial materiality is in line with current U.S. disclosure rules. See Bill Baue, Compared to What? The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. Tony Moller provided valuable research and drafting assistance in support of this Alert. 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. See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. 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. 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.. The International Sustainability Standards Board (ISSB) is analysing feedback to its consultation on two proposed standards and will consider how to respond to stakeholder comments on topics such as enterprise value and materiality, the head of the IFRS Foundation said. The Statement of Intent to Work Together Towards Comprehensive Corporate Reporting co-authored by five important standard setting organizations, was a 2020 document that was an important step towards the ISSB process; it describes inside-out information as being targeted at: various users with various objectives who want to understand the enterprises positive and negative contributions to sustainable development [in contrast to enterprise value information targeted] [s]pecifically to the sub-set of those users whose primary objective is to improve economic decisions. He says: The first is a provision for the cost of closing the existing carbon-based business. All rights reserved. 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. Taking a market view adds an element of objectivity to the materiality assessment. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. For ESG integration, the standard must call for disclosures of E/S matters that investors can use to model an enterprises value and future cash flows. 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. It is unclear why the General Requirements present double materiality and ESG as the only choices. It suggests that corporate activity that threatens critical systems is not material if that activity does not threaten enterprise value at the company in question. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. Single MaterialityDouble Materiality Outside-in Perspective . Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. Thus, while individual companies can profitably externalize costs, a diversified investor will pay these costs through lowered return on their diversified portfolios. Planetary forces much greater than cataclysmic weather events have decided that. The CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". Sustainability reporting standards promise to do the same. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. Hard choices must be made. 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. But double materiality adds inside-out information, namely, information relevant to the companys impacts on society and the environment. 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. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. 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. 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. Taking IAS 37 as a starting point is not as simple as it might seem. Environmental, social and governance (ESG) integration. Sustainability and accounting specialist with a particular interest in assessing and quantifying sustainability risks and opportunities, and in particular climate-related risks and opportunities. [.] 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. A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. The Schroders Report calculated that one third of all listed companies around the world created net social costs that exceeded their profits. This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. 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. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. 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. 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. 1. It . Encourage the ISSB drafters to move to an express sesquimateriality standard. Financial reporting standards have proven to be a driving force of stability and development in our global capital markets. 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. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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 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. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. Indeed, Institutional Shareholder Services, the worlds leading proxy adviser, recently announced it would do exactly that in its benchmark recommendation policy, treating a companys climate damage to the economy in parallel with damage to the enterprise. Interest 61 (1971). 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). 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. Companies occasionally need to report new information and markets need to work out how to digest it. The ISSB's superpower may lie in illuminating issues that are emerging across the global markets for consideration by investors and the broader markets. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. The ISSB and SEC do not, as EFRAG does, mention an outward element: the effect the company might have on externalities such as the environment or local communities. 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. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start. The last category of information is that which is relevant to stakeholders other than shareholders. Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. 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. 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 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. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. 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. 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. 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. 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. Murphy suggests environmental impact and financial reporting can be integrated by using two provisions following the methodology in International Accounting Standard 37, which deals with provisions, contingent liabilities and contingent assets. But then we filter that with the financial materiality as defined by the accounting standards". The absence of any discussion of this interest seems to be an important and unexplained omission from the analysis. PRI, an investor initiative whose members have $121 trillion in assets under management, recognizes this need. 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. 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. 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. The General Requirements Standard recommends that companies disclose material sustainability-related information, defined as information that could reasonably be expected to influence primary users assessments of an entitys enterprise value, with the responsibility for the materiality assessment resting on the reporting entity. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. 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. All of this will edge companies closer towards a materiality assessment based on both the companys impact on the world around it as well as the potential effect on its enterprise value; in other words, and for all practical purposes, applying a double materiality concept. 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. 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. Ultimately, investors and other stakeholders need access to information both financial and sustainability-related with sufficient transparency to be able to send the right market signals to companies about the kind of corporate behaviour they expect and will support. Unfortunately, the present obligation might not exist at the reporting date but could be a real future impact. Double materiality is the union (in mathematical terms, i.e. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. 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. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. 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. 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. So how might this look on the financial statements? Double materiality. So, for example, if a company is planning on extracting water at a rate that is not sustainable based on the volume of water available in the area, then this will certainly ultimately have an effect on their finances because in 15 years they will have run out of water to extract or they will have to invest money sooner in exploring alternate sources of extraction. 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. There will have to be a period of shared understanding between companies and their investors while companies seek to improve their sustainability credentials and refine their reporting. IFRS Advisory Council questions ISSB on future of SASB standards. In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. In his workplan briefing in March, Faber said the board aim[ed] to issue the new Standards by the end of the year, subject to the feedback. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. 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. 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). 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. Frederick Alexander is Founder of The Shareholder Commons; Holly Ensign-Barstow is Director of Stakeholder Governance & Policy at B Lab. This reflected moral concern with profiting from suffering, rather than the use of investment to address a social issue. A concept often referred to as ' double materiality '. The task of building a sustainable future is a shared responsibility for us all. Gulf or gap? 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. 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). This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. 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. Their primary obligation is to protect the financial interests of their beneficiaries and clients by protecting and growing their investment portfolios. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). 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. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. Additionally, what is material and who is a stakeholder will likely change based on country and culture so evaluation of impact and consideration of materiality will require sifting, analysis, and assessing tradeoffs. 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. Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? Ensure that the drafters of the ISSB keep front of mind the fact that most of the investors for whom ISSB is being created are diversified. Secondly, although climate science makes some environment-related sustainability information relatively simple to calculate and put a value on, companies will find it a great deal harder to quantify and set the bar for materiality for social and governance issues and other environmental issues like biodiversity. 24 February 2023 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. 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. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. For all the reasons discussed in Section A.4, diversified investors have a financial need to know whether portfolio companies are externalizing social and environmental costs. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. For workers who are beneficiaries of many retirement plans, employment may be the most important financial asset. Influential investors such as BlackRock have previously encouraged companies to voluntarily disclose in line with both TCFD and SASB, and companies that have already developed such procedures for sustainability reporting will find it easier to adapt to the ISSBs framework. The growing importance of this field is evident in the creation of the International Sustainability Standards Board (the ISSB) to establish uniform E/S disclosure standards that companies around the world will use to report to investors. A market price also factors in todays expectations about any potential implications that, at some future point in time, might affect a companys legal or regulatory situation (even if only by association). Climate change is an emergency that requires all hands on deck. 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. The context-setting projects for beta-level impacts of E/S investing became popular, more capital moved into constrained... Returns to concern for workers lives or the environment that requires all hands deck! 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