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. Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? Keep the distinction between ESG integration, beta management, and other sustainability purposes at the top of the discussion. These are the risks to the social and environmental systems in which the economy is embedded. Many of the comment letters on both standards are broadly supportive, but there were some niggles among the praise. But double materiality adds inside-out information, namely, information relevant to the companys impacts on society and the environment. The EU can then "top up" these standards with those covering double materiality. 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. The Freshfields Report goes on to suggest that alpha-oriented strategies (e.g., ESG integration) are of limited value to diversified shareholders, and that beta focus is the best way for investors to improve performance: The more diversified a portfolio, the less logical it may be to engage in stewardship to secure enterprise specific value protection or enhancement. 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. 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. Yet diversified portfolios remain exposed to nondiversifiable risks, for example where declining environmental or social sustainability undermines the performance of whole markets or sectors Indeed, for investors who are likely to hold diversified portfolios in the long-term, the question is particularly pressing since these are likely to be the main ways in which they may be able to make a difference. 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. 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. 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. Companies are advised to monitor the continued development of the exposure drafts and may wish to consider aligning future sustainability reporting with key components of the General Requirements Standard, including relying on company- and industry-appropriate standards such as those of SASB. 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. 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. 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. For workers who are beneficiaries of many retirement plans, employment may be the most important financial asset. 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. But then we filter that with the financial materiality as defined by the accounting standards". 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. In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to 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). 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. But it does not tell shareholders how to use this data to value securities: the user provides that context. 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. Importantly, however, to the extent that E/S impact and enterprise value at a company are not correlatedi.e., to the extent that value and values do not aligninvestors and companies will have to choose between optimizing enterprise value and optimizing E/S impact, or make some compromise between the two. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. 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. This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . Sustainability-related financial information is material if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports. 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. Double materiality can be a decision left to jurisdictions such as the EU, China or the US, which are currently working on their own systems of mandatory climate risk reporting. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. 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. 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. 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 suggests that corporate activity that threatens critical systems is not material if that activity does not threaten enterprise value at the company in question. 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. 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. 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. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. 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. Not that this in any way prejudges the issue. 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). 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. To accomplish this, the General Requirements Standard recommends that companies provide both quantitative data-based disclosures as well as qualitative narrative-driven disclosures. 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. Although the TCFDs recommendations are specific to climate-related risks and opportunities, the ISSBs General Requirements Standard advises that this approach be applied to all sustainability issues that could impact enterprise value, such as those posed by social or nature-related issues. 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. Hard choices must be made. A consultation paper on the SDR is expected in the second quarter of 2022.. The law governing investment fiduciaries is evolving to make it clear that fiduciary obligations permitor even requirebeta management. This site uses cookies. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. 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. 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. This then helps create the business case for companies to take action on the priorities that their investors, customers and others really care about. One example, Becker claims, is the understand of materiality. This is similar to the architecture of the TCFD and ISSB. 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. Double materiality is an extension of the key accounting concept of materiality of financial information. 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. 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. 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. 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. Gulf or gap? 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. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. Sustainable investing. 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. 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. 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. It means prioritising the long-term, absolute returns for universal owners, including real-term financial and welfare outcomes for beneficiaries more broadly. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. Single MaterialityDouble Materiality Outside-in Perspective . 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. 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. Tony Moller provided valuable research and drafting assistance in support of this Alert. 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 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. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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. 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. 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. 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. 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. 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. 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. The market must find a way to determine when this is important, and crucially, when it is not. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. 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. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. 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 Thats why we were created. The ISSB consultation responses show there is also wide support for the approach within the financial sector. 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. 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