In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. 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. 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. To accomplish this, the General Requirements Standard recommends that companies provide both quantitative data-based disclosures as well as qualitative narrative-driven disclosures. 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. It recently issued a report (the PRI Report) that described a variety of corporate practices that can boost individual company returns while threatening the economy and diversified investor returns: A company strengthening its position by externalising costs onto others. CSRD explicitly requires double-materiality reporting and so vastly expands the scope of disclosure from considering only sustainability risks that companies face (i.e. The ISSB consultation responses show there is also wide support for the approach within the financial sector. The Technical Readiness Working Group (the TRWG) recently released a set of recommendations for general requirements for the ISSB standards (the General Requirements) that addressed this question by defining what would be material for the standards overall. And, in practice, a small one at that. This includes activities that relate to other organisations in the value chain or in the sector if they could have potential consequences for the company itself. 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. Planetary forces much greater than cataclysmic weather events have decided that. Finally, from a rhetorical perspective, it is important that the final documentation of the ISSB standards acknowledge that investors have significant interests in beta impacts. Thats where we aregoing. 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. Companies and investors have, in the past and on other topics, risen to the challenge. Influential investors such as BlackRock have previously encouraged companies to voluntarily disclose in line with both TCFD and SASB, and companies that have already developed such procedures for sustainability reporting will find it easier to adapt to the ISSBs framework. 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. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. measuring and reporting carbon emissionsthat serve both purposes. The task of building a sustainable future is a shared responsibility for us all. Hard choices must be made. 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. Integration with Financial Reporting: Like the SECs proposed climate rule, the General Requirements Standard recommends that sustainability-related information be disclosed alongside an entitys general purpose financial reports as part of the ISSBs emphasis on the materiality of sustainability-related disclosures to investors. In Europe, double materiality - reporting on both sustainability factors affecting the company (financial materiality) and how the company impacts on society and the environment (outward materiality) - is already part of the European Commission's proposed Corporate Sustainability Reporting Directive (CSRD). 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. 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. 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. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. "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. None of these practical difficulties, however, ought to derail efforts to align. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. This convergence is illustrated in Figure 1 below. 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. 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. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). Investors need a reporting standard that accounts for all the costs a portfolio company imposes on them, even if the company itself avoids those costs. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. The ISSB will accept feedback on its General Requirements and Climate Standards until July 29, 2022, and will incorporate the comments it receives into its final sustainability reporting standards, expected by the end of 2022. See Bill Baue, Compared to What? Posted by Frederick Alexander (The Shareholder Commons), on, Harvard Law School Forum on Corporate Governance, on One Small Step From Financial Materiality to Sesquimateriality: A Critical Conceptual Leap for the ISSB, Companies Should Maximize Shareholder Welfare Not Market Value, Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. Thats why we were created. 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. 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. 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. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. 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. But interests do not magically align. ISSB releases draft definition of 'sustainability' for new reporting framework The decision does not, however, change the ISSB's decision to focus on single materiality as opposed to double materiality. Not that this in any way prejudges the issue. Before discussing the ISSB and the desirability of a sesquimateriality standard, we review several elements of E/S investing. 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. 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. A market price also factors in todays expectations about any potential implications that, at some future point in time, might affect a companys legal or regulatory situation (even if only by association). The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. Sustainability reporting standards promise to do the same. 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. By Stephen BouvierNovember 2022 (Magazine). 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 . Tony Moller provided valuable research and drafting assistance in support of this Alert. 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. The EU can then "top up" these standards with those covering double materiality. 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. 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. Thus, while individual companies can profitably externalize costs, a diversified investor will pay these costs through lowered return on their diversified portfolios. This is a critical moment. 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. 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? All topical standards have been changed to mirror the new four pillar structure. 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. Double materiality is the union (in mathematical terms, i.e. This cost was more than 50 percent of the profits those companies reported. For workers who are beneficiaries of many retirement plans, employment may be the most important financial asset. 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. As noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of materiality. Driven to assist organizations to elicit positive change.<br>TCFD | CDP | SBTs . The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. This would appear as a balance sheet reserve, representing funds set aside to pay future obligations. But, two subtle differences in how the ISSB and SEC both require the calculation of enterprise value mean that reporting entities using this standard would end up reporting broadly similar material information as those using the EFRAG standard. E/S information that involves the residue of E/S impacts that do not affect investment returns, but that impact on other matters that are important to individual investors (non-financial investor impacts). 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. Interest 61 (1971). However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. Considering how each proposed standard might operate provides a window into their practical similarities and calls into question the notion that the materiality definitions of each of the different standard setters are irrevocably different, given the broad nature of what can affect enterprise value. 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. The logic for this is implicit within IAS 37. This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. In light of the diversification mandate of Modern Portfolio Theory, and the importance of beta to diversified investors, this anachronistic hyper-focus on enterprise value is troubling. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. Companies occasionally need to report new information and markets need to work out how to digest it. 1. 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. 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. 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 . They both support a materiality assessment based on the potential effect on the companys enterprise value. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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. Taking a market view adds an element of objectivity to the materiality assessment. 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. Though there are aspects of ISSBe.g. "Enterprise value is a backward-looking, lagging indicator," it said, adding that . Companies therefore may wish to consider the ISSBs standards a baseline for reporting, as opposed to an exhaustive set of disclosures. Standard-setting International Sustainability Standards Board Consolidated organisations 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. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. It . Were taking that all very, very seriously. Please see www.pwc.com/structure for further details. 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. The version of enterprise value we use in financial reporting today would consider the effect of many sustainability matters on long-term cash flows as hardly material since they are inherently uncertain and typically have little effect on the business today. This does not mean that disclosure standards drafters do not themselves need to understand the contextthat understanding is critical to eliciting the correct information for investors to use. 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. Green Finance Institute director tells Chatham House while MP support double materiality approach. The ISSBs and SECs definitions of materiality are not far off from this. 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. 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. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. 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. 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. 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. get as much direction as quickly as possible to really build on momentum.. Swiss Re Institute, The Economics of Climate Change: No Action Not an Option (April 2021). By Nadja Picard, Gilly Lord and Hilary Eastman. This idea extended beyond security selection and included influencing corporate behavior by voting shares and engaging with management. Even without such alignment, in valuation terms enterprise value is typically determined by calculating the net present value of forecast future cash flows and takes a market perspective which by nature encompasses all available information and takes a very long-term view (into perpetuity). At a conceptual level, the General Requirements Standard attempts to unite multiple overlapping approaches to sustainability disclosure. 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. 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. 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. Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. 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 decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. This site uses cookies. Whatever the aim, they missed. 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. But we are trying to. It means prioritising the long-term, absolute returns for universal owners, including real-term financial and welfare outcomes for beneficiaries more broadly. The ISSB is the product of agreement among a critical mass of relevant industry participants to develop a uniform standard for disclosure of social and environmental impact. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. One of the biggest is that all three proposals define what is material in different ways. 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. 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. 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 CSRD takes a more comprehensive approach than the ISSB, adopting what it calls a "double materiality perspective". 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 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. PRI, an investor initiative whose members have $121 trillion in assets under management, recognizes this need. 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. The ISSB's superpower may lie in illuminating issues that are emerging across the global markets for consideration by investors and the broader markets. The absence of any discussion of this interest seems to be an important and unexplained omission from the analysis. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. In practice, this shifts the focus to the forward-looking or anticipatory aspects of double materiality. 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. 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. outside-in materiality - or ESG reporting as it is most commonly adopted today), to also disclose the impact of those same companies on society and the environment (i.e . 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. The reason is that if a companys activities create the type of economic risk that threatens beta, it will almost surely be at risk for damaged reputation, increased regulation, and the increased costs that follow regulation. 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. Thats why we were created. 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 Standard creates an umbrella of disclosure expectations that will apply across all of the ISSBs forthcoming sustainability topic-specific standards, including the Climate Standard. So, in practical terms, the gulf is no gulf, but a gap. 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. The law governing investment fiduciaries is evolving to make it clear that their fiduciary obligations permitor even requirebeta management. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. The US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. The market must find a way to determine when this is important, and crucially, when it is not. 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