Just like any issue that can factor into the market price for a debt or equity security, sustainability issues can affect the likelihood, timing and amounts of potential cash inflows and outflows resulting from a companys activities over any time horizon. 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. The return to such diversified investors chiefly depends upon beta, not the performance of individual companies. The law governing investment fiduciaries is evolving to make it clear that their fiduciary obligations permitor even requirebeta management. 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. As unlikely as this proposition seems, the Business Roundtable, an organization composed of most major U.S. corporations CEOs, promotes this idea under the moniker stakeholder capitalism, and claims that if a company treats all its stakeholders well (which can be another way of saying it optimizes its E/S impact), it will also maximize its return to its shareholders over the long term: While we acknowledge that different stakeholders may have competing interests in the short term, it is important to recognize that the interests of all stakeholders are inseparable in the long term. Business Roundtable, Redefined Purpose of a Corporation: Welcoming the Debate (August 2019). In what follows, we'll break down the concepts of "materiality" and "double materiality" and share some key takeaways about their importance to ESG management. This cost was more than 50 percent of the profits those companies reported. Read our policy. The ISSB intends to detail baseline requirements that ensure companies provide investors with a complete set of disclosures on sustainability risks and opportunities that could affect enterprise value, in order to complement the information provided in financial statements. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. 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 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. Taking a market view adds an element of objectivity to the materiality assessment. 1. A consultation paper on the SDR is expected in the second quarter of 2022.. 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. 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. 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. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. 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. They both support a materiality assessment based on the potential effect on the companys enterprise value. 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. As important as these two categories of impact may be, they are likely to be more heterogeneous than shareholder interests in beta, making them less likely to be good candidates for standardized disclosure. 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. 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. In the one camp, broadly speaking, sit the SEC and the ISSB. 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. 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? There are some other areas that need ironing out too before standard setters finish their work. > ISSB 2023 . The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. 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.. As we discuss in the next section, this will require beta-oriented disclosure. Frederick Alexander is Founder of The Shareholder Commons; Holly Ensign-Barstow is Director of Stakeholder Governance & Policy at B Lab. 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. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. 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. 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. Indeed, in another section of the General Requirements that discusses the materiality concept in more detail, the TRWG uses a definition that would certainly include beta information: General purpose financial reporting includes financial statements of and sustainability-related financial information about a specific reporting entity. 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. Similarly, they might be willing to sacrifice portfolio return if it meant a healthier environment in which to enjoy their retirement, or if doing so would relieve others suffering. See Bill Baue, Compared to What? Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality. 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 . 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. For example, an investor might conclude that a company can avoid reputational, regulatory, and supply chain risks by adopting better labor and energy practices. 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. The ISSB documentation does not addressor even acknowledgethe possibility of providing beta or non-financial investor information. 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). 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. So, in practical terms, the gulf is no gulf, but a gap. However, the concept of double materiality, which includes environmental and social impacts of a companys operations even if not financially material to the company, has significant support outside of the ISSBs framework. 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. As noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of 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. The ISSBs and SECs definitions of materiality are not far off from this. On 3 November 2021, at COP26, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB). 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. This publication is distributed with the understanding that the author, publisher and distributor of this publication and/or any linked publication are not rendering legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. But 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. 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. 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. 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. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. By the same token, a proper sesquimateriality standard would elicit the inside-out E/S data that was likely to impact the social and environmental systems that support beta. It explains the approaches of the GRI Standards ( impact materiality), the IFRS' International Sustainability Standards Board (ISSB) ( financial materiality) and the incoming European Sustainability Reporting Standards ( double materiality), and how they interconnect. Encourage the ISSB drafters to move to an express sesquimateriality standard. Thats why we were created. However, Murphy has rejected this approach in favour of a model that compounds the future obligation because it is likely that the cost of deferring action to address environmental change will increase over time at a rate likely to significantly exceed any applicable discount rate that a reporting entity might choose. Standard-setting International Sustainability Standards Board Consolidated organisations Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. We then share key takeaways for companies that are beginning or continuing to make sustainability-related disclosures. 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. Companies therefore may wish to consider the ISSBs standards a baseline for reporting, as opposed to an exhaustive set of disclosures. But we are trying to. 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. 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. What has the Net Zero Asset Owner Alliance actually said about carbon offsets? 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. All rights reserved. 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. Thats where we aregoing. 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 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. "Enterprise value is a backward-looking, lagging indicator," it said, adding that . The ISSB agreed to fully align its description of materiality with IFRS Accounting Standards. 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. 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. 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). 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