But we are trying to. If their content is aligned then the effect will be powerful. The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. 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. 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. 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. 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. One of the first parameters to be established must be the purpose of disclosure. Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. Companies occasionally need to report new information and markets need to work out how to digest it. 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. ESRSISSB . This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. For workers who are beneficiaries of many retirement plans, employment may be the most important financial asset. 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. As Hales explained: "Dual materiality and dynamic materiality are not new concepts, it's just that there's new language and an evolving understanding of these issues [that] helps to bring some clarity to frankly a concept that has been very challenging to communicate about for a long time." One key element of materiality is its specificity. This means that companies have to report on both the financial and environmental implications of their sustainability efforts. 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. Single MaterialityDouble Materiality Outside-in Perspective . 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. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. 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. But it does not tell shareholders how to use this data to value securities: the user provides that context. These are the risks to the social and environmental systems in which the economy is embedded. The General Requirements Standard specifies that potentially material sustainability-related considerations include activities and relationships related to an entitys value chain, which it defines as the full range of activities, resources and relationships related to a reporting entitys business model and the external environment in which it operates.. 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. 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. 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 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 expectation is that this cost will be outweighed by the benefits to the market and companies of having more complete, transparent, comparable and reliable information on which to base resource allocation decisions. The General Requirements propose two possibilities, which correspond to what disclosure specialists call financial materiality and double materiality. The first is disclosure designed for ESG integration. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. Because investors vote on directors and other matters, they have the power and responsibility to steward companies away from such practices. The Schroders Report calculated that one third of all listed companies around the world created net social costs that exceeded their profits. The law governing investment fiduciaries is evolving to make it clear that their fiduciary obligations permitor even requirebeta management. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. 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. 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. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. It means prioritising the long-term, absolute returns for universal owners, including real-term financial and welfare outcomes for beneficiaries more broadly. 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 The EU can then "top up" these standards with those covering double materiality. The ISSB's superpower may lie in illuminating issues that are emerging across the global markets for consideration by investors and the broader markets. 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. Having given itself these two choices, the TRWG chose financial materiality: Sustainability matters that do not affect the reporting entitys enterprise value are outside the scope of general purpose financial reporting.. We will not move. This convergence is illustrated in Figure 1 below. Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. The publication of these two draft standards represents a potentially significant step toward the coalescence of voluntary corporate sustainability reporting frameworks and could influence mandatory disclosure regimes that are evolving in the U.S., UK and EU. 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. Financial materiality is in line with current U.S. disclosure rules. This means stewardship that is less focused on the risks and returns of individual holdings, and more on addressing systemic or beta issues such as climate change and corruption. 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. These phrases refer to the need for investors to pay more attention to the environmental and social (E/S) impacts of the businesses in which they invest. 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. In the one camp, broadly speaking, sit the SEC and the ISSB. 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. If their content is not aligned, then the status quo will continue: piecemeal reporting, inconsistencies, confusion, and limited progress towards understanding the effect of ESG matters. Yet the scope of externalities is enormous. For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. 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. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour. Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. 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. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. A concept often referred to as ' double materiality '. Figure 1: Convergence of Voluntary Sustainability Disclosure Standards. "While the ISSB uses the so-called financial materiality as a basis, the European Financial Reporting Advisory Group (EFRAG) defines the double materiality, i.e., the effect of companies on society and the effect of society on companies in the Corporate Sustainability Reporting . 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. 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. Corporate social responsibility. Contributions to inequality also reduce GDP over time. Financial materiality means that the activity has an effect on the companys cash flows or enterprise value (consistent with the SEC and ISSB). The IFRSs accounting rules issued and maintained by the International Accounting Standards Board (IASB), on which the ISSB is modeled, have been adopted in over 100 countries, and the IFRS intends to co-develop the two independent sets of standards to ensure their connectivity, compatibility and relevancy to investors. 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. Socially responsible investing. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. 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. They both support a materiality assessment based on the potential effect on the companys enterprise value. union of two sets, not intersection) of impact materiality 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. 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. A recent study determined that in 2018, publicly listed companies around the world imposed net social and environmental costs on the economy with a value of $2.2 trillion annuallymore than 2.5 percent of global GDP. Climate change is an emergency that requires all hands on deck. 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. Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality. The ISSB was announced in . 24 February 2023 Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. Encourage the ISSB drafters to move to an express sesquimateriality standard. Gulf or gap? The US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. This time pressure leaves the board with little time to explore a draft sustainability-reporting standard drawn up by Prof Richard Murphy from Sheffield University Management School. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. By Stephen BouvierNovember 2022 (Magazine). For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. Information on a company is material and should therefore be disclosed if "a reasonable person would consider it [the information] important", according to the US Securities and Exchange Commission . In its October 2022 board meeting, the ISSB . 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. 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. 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. 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. As discussed in the Freshfields Report and the PRI Report, decision-useful information extends beyond information that affects enterprise value; if a companys E/S impact has the potential to affect beta, diversified shareholders may well act on that information by, for example, voting against directors who fail to act to mitigate negative externalities. What ISSB asks for. 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 market-based solution in a document as influential as the ISSB standards would be a serious setback. Frederick Alexander is Founder of The Shareholder Commons; Holly Ensign-Barstow is Director of Stakeholder Governance & Policy at B Lab. By Nadja Picard, Gilly Lord and Hilary Eastman. 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. 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. Why? measuring and reporting carbon emissionsthat serve both purposes. There are some other areas that need ironing out too before standard setters finish their work. 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. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). Far from it, assured the ISSBs vice-chair, Sue Lloyd, during the ISSBs 21 September meeting: [F]or those listening, I think we need to be careful to be very clear that this isnt because we are not worrying about the comments that we received and the feedback that weve got. 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. ISSB has so far produced drafts of two sets of standards: CSRD""Double MaterialityFinancial MaterialityImpact Materiality . None of these practical difficulties, however, ought to derail efforts to align. We then share key takeaways for companies that are beginning or continuing to make sustainability-related disclosures. Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. Double materiality is the union (in mathematical terms, i.e. The last category of information is that which is relevant to stakeholders other than shareholders. However, for Andromeda Wood, vice president of regulatory strategy . Furthermore, the ISSB recommends that entities rely on industry-specific guidance for certain disclosures in addition to industry-agnostic general reporting guidance. 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 General Requirements Standard) and a Climate-Related Disclosures framework (the Climate Standard). This reflected moral concern with profiting from suffering, rather than the use of investment to address a social issue. 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. Despite all the talk of urgency from IOSCO, the climate-change standard will not be in place until next year. 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. 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. : More unites standard setters than divides them, Total Impact Measurement & Management (TIMM), ESG (Environmental, Social and Governance). Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. [.] 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. Another dynamic is the European Financial Reporting Advisory Group (EFRAG). The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. 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. Thats where we are going.. 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? 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. 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. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. One of the biggest is that all three proposals define what is material in different ways. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. And, in practice, a small one at that. For similar reasons, Professor John Coffee predicted in a recent article that beta would surpass ESG integration as a motive for investor activism: This latter form of activism [beta focused] is less interested in whether the target firms stock price rises (or falls) than in whether the activist investors engagement with the target causes the total value of this investors portfolio to rise (which means that the gains to the other stocks in the portfolio exceed any loss to the target stock). get as much direction as quickly as possible to really build on momentum.. Not that this in any way prejudges the issue. 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. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. What has the Net Zero Asset Owner Alliance actually said about carbon offsets? The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. 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. 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. The ISSB documentation expressly rejects "double materiality," the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. In addition to interests in alpha and beta, shareholders may be otherwise affected by the E/S impact of companies in which they invest. 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. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. The CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". 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. The logic for this is implicit within IAS 37. Since it cannot meet that essential accounting expectation of being a going concern unless reinvestment does take place, this provision must also be made upon the balance sheet, upfront, now. The focus of the General Requirements on ESG integration appears to reject the notion that information relevant to beta is important to shareholders. 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 article addresses a fundamental debate over the purpose of the uniform standard and reaches the following conclusions: Four types of impact. 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. The ISSB consultation responses show there is also wide support for the approach within the financial sector. Nevertheless, portfolio theorys prescription of diversification certainly suggests that widely held entities should give strong consideration to diversified investors interests. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. 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. 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. 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