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. One example, Becker claims, is the understand of materiality. This means that companies have to report on both the financial and environmental implications of their sustainability efforts. A large percentage of securities markets beneficiaries are diversified, and the relative importance of beta compared to alpha should affect these investors calculus when considering the impact of a portfolio companys social and environmental externalities. The task of building a sustainable future is a shared responsibility for us all. 1. The logic for this is implicit within IAS 37. Diversified investors cannot avoid certain common risks almost all companies face. 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. But interests do not magically align. 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. Pause on that figure: prioritization of individual company financial return leads to one third of all listed companies around the globe destroying more value for society than they create for their own shareholders. Read our policy. It is unclear why the General Requirements present double materiality and ESG as the only choices. 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. 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. CSRD""Double MaterialityFinancial MaterialityImpact Materiality . 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. The net result for the [diversified] investor can be negative when the costs across the rest of the portfolio (or market/economy) outweigh the gains to the company; A company or sector securing regulation that favours its interests over others. 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. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. The ISSB drafters should recognize the risk that excluding beta could, at the margins, lead to the omission of decision-critical information for investors concerned with company impact on social and environmental systems that support other portfolio companies. However, sustainability reporting is not just about the sustainability-related impacts on the company (or its enterprise value) that can be material, but also the impacts of a company on the environment, climate or other sustainability issue so-called double materiality, Russell added. The ISSBs and SECs definitions of materiality are not far off from this. Diversified investors internalize the collective costs of such externalities (more than $2 trillion in 2018 according to the Schroders report cited above) because they degrade the systems upon which economic growth and corporate financial returns depend. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. USS welcomed the ISSBs decision to build on the structure of the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations in IFRS S1 and IFRS S2. Even if the ISSB wanted to include double materiality, it could well meet with opposition in jurisdictions still coming to terms with even basic sustainability reporting. 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. A business would create a sustainability reserve to represent the full compounded effect of decarbonising its operations. 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. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. And, in practice, a small one at that. These are the risks to the social and environmental systems in which the economy is embedded. Double, Sesqui, and "Regular" Materiality: Sustainability Disclosures and Different World Views - Responsible Investment Association Menu MENU En Fr RI Marketplace Membership About the RIA Intro to Responsible Investment Membership RI Marketplace Magazine Events Research & Policy Training & Certification Leadership Awards Contact Us He says: The first is a provision for the cost of closing the existing carbon-based business. 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. 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. 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. The absence of any discussion of this interest seems to be an important and unexplained omission from the analysis. On 3 November 2021, at COP26, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB). Take the example of an estimated sustainability cost of 66m (75m). 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. 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. Financial reporting standards have proven to be a driving force of stability and development in our global capital markets. 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. Frederick Alexander is Founder of The Shareholder Commons; Holly Ensign-Barstow is Director of Stakeholder Governance & Policy at B Lab. 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. This convergence is illustrated in Figure 1 below. PRI, an investor initiative whose members have $121 trillion in assets under management, recognizes this need. 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. 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. 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. 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. If risks of this sort materialised, they would therefore damage the performance of a portfolio as a whole and all portfolios exposed to those systems. 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. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. Diversification is specifically intended to minimise idiosyncratic impacts on portfolio performance. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. It . But while an individual investor is free to satisfy ethical goals without regard to financial consequences, many investors, such as retirement and mutual funds, have fiduciary obligations to prioritize the interests of their beneficiaries. 2017 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. Up until this point, we have discussed financial success in terms of single companies, but the returns of the institutional investors mentioned above depend much more on beta than on alpha. 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. There are some other areas that need ironing out too before standard setters finish their work. 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. 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. 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. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. 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. 3233596, VAT No. The following chart sums up the four possible uses of data for which the ISSB might be optimized: As investors have become more cognizant of the importance of corporate impact on society and the environment, disclosure standards proliferated, making it difficult to compare the impact of companies that report on different standards. 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. 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. What ISSB asks for. 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. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. 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. 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). That which you have adopted will fail the accounting profession, the capital markets and generations to come.. 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. 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. At a high level, the ISSB aims to help companies streamline their sustainability disclosures to facilitate an apples to apples comparison by investors. ESRSISSB . This is similar to the architecture of the TCFD and ISSB. Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. 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. 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. 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. 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. Disagreement over definitions is just one element of the materiality issue. But enterprise value under the ISSB and SECs proposed sustainability standards say that what affects cash flows over the short, medium, and long term should be reported today. 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. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. Last November, IOSCO chair Ashley Alder set out a five-point roadmap that securities watchdogs expect the IFRS Foundation to follow if they are to endorse the climate-change standard before the end of 2022 as the global baseline for climate disclosures. Figure 1: Convergence of Voluntary Sustainability Disclosure Standards. Impact materiality means that the activity affects either people or the environment, whether directly via the companys operations or indirectly in its value chain. 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. 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. 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. Although the ISSB does not provide specific guidance on where such disclosures must be made relative to general purpose financial reports, it emphasizes that sustainability-related information should be disclosed simultaneously with standard financial information and in as integrated a manner as possible. 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. 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. Corporate social responsibility. Double materiality is an extension of the key accounting concept of materiality of financial information. Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. 685 1784 92. 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. As noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of materiality. 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. Green Finance Institute director tells Chatham House while MP support double materiality approach. 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. They may find that for many issues their enterprise value and impact materiality assessments are so interlinked that for practical reasons it is not possible to split them apart. In the context of ESG, this is known as single materiality and means mainly environmental, social and governance factors that may pose a threat or opportunity to a business and its bottom line. Pursuant to applicable rules of professional conduct, portions of this publication may constitute Attorney Advertising. Registered Office: 1 Kentish Buildings, 125 Borough High Street, London SE1 1NP, UK pension risk transfer market set for bumper 2023. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. 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. 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. Changes in the reserve would flow into the statement of comprehensive income and then through the statement of changes in equity. 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 . Eight othersmostly based in Europe, and including Allianz, Amundi, BNP Paribas, DWS, and Schrodersencourage the ISSB to consider a double materiality approach, incorporating companies' impacts on the environment and wider society, in line with the European Commission's proposals. 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. 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. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . Double vs single vs dynamic materiality is one of the main pieces of contention between the ISSB and EFRAG in the design of their sustainability standards but what if this was only theoretical and in practice their thinking aligns? The focus of the General Requirements on ESG integration appears to reject the notion that information relevant to beta is important to shareholders. 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. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. 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. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). 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. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. 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. We will not move. On its face, the exclusive choice of enterprise value as the measuring stick for materiality means the standards will only be useful for investors who want to use environmental and social data to determine how a particular company will perform financially, in order to decide whether to buy or sell it, or perhaps to use their shareholder rights to push the company to change its practices to improve future cash flows. The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. "The focus should be on double materiality and not on enterprise value," the HSBC Bank (UK) Pension Scheme said in its submission to the ISSB. The UK government has gone a step further, signaling it intends to adopt the ISSBs standards as part of future mandatory sustainability reporting requirements under the Sustainability Disclosure Regulation (SDR).2. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. The materiality principle chosen in the General Requirements seems to ignore the most important issue on the table without explanation. 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. [.] However, for Andromeda Wood, vice president of regulatory strategy . In practice, this shifts the focus to the forward-looking or anticipatory aspects of double materiality. 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. Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. 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