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. 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. They both support a materiality assessment based on the potential effect on the companys enterprise value. One example, Becker claims, is the understand of materiality. Sustainability reporting standards promise to do the same. 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. In their 2021 book, Moving beyond Modern Portfolio Theory: Investing that Matters, Jon Lukomnik and James Hawley explained that these systematic risks inevitably swamp any alpha strategy: It is not that alpha does not matter to an investor (although investors only want positive alpha, which is impossible on a total market basis), but that the impact of the market return driven by systematic risk swamps virtually any possible scenario created by skillful analysis or trading or portfolio construction. 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. At a high level, the ISSB aims to help companies streamline their sustainability disclosures to facilitate an apples to apples comparison by investors. Yet the scope of externalities is enormous. 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. 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. 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. Hard choices must be made. 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. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). Sustainable investing. Because negative externalities burden the economy and beta. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. 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. At a conceptual level, the General Requirements Standard attempts to unite multiple overlapping approaches to sustainability disclosure. 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. 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. 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. If their content is aligned then the effect will be powerful. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. 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. As shown above, there is significant literature establishing that E/S disclosures that go beyond enterprise value may be of great importance to diversified investors economic decisions because of their financial interest in beta. 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. 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. 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. 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. A company cant consider only what it cares about; it has to take into account what others would consider when pricing the shares or debt, into perpetuity for shares and over the tenure of bonds or loans. These projects help investors determine a companys fair share of a limited common resource or the proper social and environmental boundaries for individual companies that are necessary to preserve the systems upon which all companies rely. 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. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. They must do so again. The last category of information is that which is relevant to stakeholders other than shareholders. 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. This reflected moral concern with profiting from suffering, rather than the use of investment to address a social issue. 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. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. And if their rate of extraction is causing drought in a local area then in 15 years or fewer they must report this too, since their activities are having a negative impact on the environment. 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. Thus, to gather the E/S data that are material for company valuation purposes, the ISSB standard will have to include the same data that will be used to determine whether a company is externalizing costs to the detriment of people, planet, and other companies. 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. 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. A group of 86 global CFOs and institutional investors, representing 620bn in assets, criticised the ISSB for not adopting the double materiality approach which would require companies to report on the impact of their activities on the environment regardless of its relevance to enterprise value. In addition to potentially helping to drive convergence of voluntary sustainability disclosure standards, the ISSB could also play a role in the evolving regulatory shift from voluntary to mandatory sustainability reporting, again potentially helping to drive global compatibility among corporate disclosures. 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. Diversified investors cannot avoid certain common risks almost all companies face. A consultation paper on the SDR is expected in the second quarter of 2022.. 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. E/S Information that impacts future cash flows from the company to investors and thus the value of the enterprise (ESG integration or just ESG). 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. A new report from the law firm Freshfields Bruckhaus Deringer (the Freshfields Report) explains how externalized costs affect investment trustees fiduciary duties: System-wide risks are the sort of risks that cannot be mitigated simply by diversifying the investments in a portfolio. 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. 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. But the trade is inevitablethe only question is which type of investor it will favor. 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. 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. 2017 The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. In the alternative double-materiality rubric, financial materiality is referred to as outside-in information, because it addresses how social and environmental matters affect the company. 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. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. 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. "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. 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. In its October 2022 board meeting, the ISSB . At a time when regulation alone seems increasingly inadequate to the task of addressing threats to the environment and our social fabric, an apparent retreat from a constructive market reform in a document as influential as the ISSB standards would be a serious setback. 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. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. IFRS Advisory Council questions ISSB on future of SASB standards. This means that companies have to report on both the financial and environmental implications of their sustainability efforts. Registered Office: 1 Kentish Buildings, 125 Borough High Street, London SE1 1NP, UK pension risk transfer market set for bumper 2023. union of two sets, not intersection) of impact materiality Although there is no charge to the income statement, the reduction in shareholder equity arising from this proposal would reduce the amount of distributable reserve available to shareholders. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. 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. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. All topical standards have been changed to mirror the new four pillar structure. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. Climate change is an emergency that requires all hands on deck. 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. 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. 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. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). By Stephen BouvierNovember 2022 (Magazine). More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. The doom loop was complete when falling river levels left Frances nuclear power plants battling to produce enough energy to meet the demand for cooling. 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. 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. 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). Taking IAS 37 as a starting point is not as simple as it might seem. 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. What has the Net Zero Asset Owner Alliance actually said about carbon offsets? Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. The double-materiality concept as 'guiding principle' in the GRI Standards From climate change and biodiversity loss, to growing inequality, modern slavery, and scarcity of resources, our society and planet face the most significant challenges of all times. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. According to Matthias Tger, a researcher at London School of Economics looking at the relationship between the environment and financial markets, the future of double . Companies and investors have, in the past and on other topics, risen to the challenge. 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. 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. For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. 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. 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. 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. These are difficult issues to report on, rife with judgement, and companies do not yet feel safe doing it especially when it comes to enforcement. What ISSB asks for. 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. Climate change denial has been a tough ask this summer. 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. 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. 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. 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. Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. 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. In this Alert, we outline the contents of the draft standards focusing on the General Requirements Standard and situate them within the context of converging voluntary disclosure standards and increasing regulation. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . 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 failure to even address beta-oriented disclosure is surprising because there is a growing emphasis on the need for diversified investors to monitor and steward the beta impact of portfolio company activity. 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. 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. 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 . 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. 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. Thats where we are going.. 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