In doing so, it has removed the existing definition of 'enterprise value' and the words 'to assess enterprise value' from the objective and description of materiality in the proposals. For an overview of the SECs proposed climate rule and its implications, please refer to our March 24 Alert., 2. 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). Driven to assist organizations to elicit positive change.<br>TCFD | CDP | SBTs . There are some other areas that need ironing out too before standard setters finish their work. Related research from the Program on Corporate Governance includes Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and Exit vs. Voice by Eleonora Broccardo, Oliver Hart and Luigi Zingales (discussed on the Forum here). Taking IAS 37 as a starting point is not as simple as it might seem. And, in practice, a small one at that. 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. The net result for the [diversified] investor can be negative when the costs across the rest of the portfolio (or market/economy) outweigh the gains to the company; A company or sector securing regulation that favours its interests over others. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. 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. The ISSB agreed to fully align its description of materiality with IFRS Accounting Standards. 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. Double materiality. Because negative externalities burden the economy and beta. Corporate social responsibility. 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. 1. 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). 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 noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of materiality. 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. Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. Whatever the aim, they missed. 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. 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. This site uses cookies. Companies occasionally need to report new information and markets need to work out how to digest it. These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. This is known as the single-materiality approach, as opposed to a double-materiality approach that considers impact both ways. 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 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. Changes in the reserve would flow into the statement of comprehensive income and then through the statement of changes in equity. 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. On 3 November 2021, at COP26, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB). 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. (b) disclosures to investors, lenders and other creditors about sustainability matters that affect their assessment of enterprise valuethese disclosures enable investors, lenders and other creditors to understand the impacts that sustainability-related risks and opportunities have on the value, timing and certainty of the entitys future cash flows, over the short, medium and long term and therefore users assessment of enterprise value. As such, we urge you to rethink your whole approach to this issue. Key focus areas include the Task Force on Climate-related Financial Disclosures, Materiality, and Carbon management. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. For example, if a company is using water at an unsustainable rate, this would have to be reported as a long-term risk to cash flows, just as it would be under EFRAGs approach. 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. One of the first parameters to be established must be the purpose of disclosure. The ISSB consultation responses show there is also wide support for the approach within the financial sector. (Of course, much data relevant to investors for beta purposes would overlap with these two categories, so that an expansion to beta-relevant information would add that value as well.). 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. Companies therefore may wish to consider the ISSBs standards a baseline for reporting, as opposed to an exhaustive set of disclosures. 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. 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. The logic for this is implicit within IAS 37. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. But we are trying to. 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 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. Though there are aspects of ISSBe.g. The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. 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 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. It . So how might this look on the financial statements? 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. 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. Single MaterialityDouble Materiality Outside-in Perspective . See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. 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. The last category of information is that which is relevant to stakeholders other than shareholders. 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 ISSB documentation expressly rejects "double materiality," the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. 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. Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? . The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. These are the risks to the social and environmental systems in which the economy is embedded. 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. Take the example of an estimated sustainability cost of 66m (75m). Interest 61 (1971). 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. 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. 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. Thats why we were created. This means that beta information is decision-useful, and thus comes within the broad parameters established in the General Requirements. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. 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. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. IFRS Advisory Council questions ISSB on future of SASB standards. It is important to understand that ESG data are often provided without much context. 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. The planned agenda consultation has also been pushed back into next year. Double materiality is an extension of the key accounting concept of materiality of financial information. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. The ISSBs collaboration agreement with GRI further bridges the gap; a no gaps, no overlaps approach gives a holistic picture of sustainability performance on the basis of both impact and enterprise value. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. 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. Yet the scope of externalities is enormous. Companies will finally have clear instructions on how to report on their sustainability impacts, risks, and opportunities, and investors and other stakeholders will be able to better track progress, compare performance, and hold companies to account. However, for Andromeda Wood, vice president of regulatory strategy . 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. We will not move. 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). 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. measuring and reporting carbon emissionsthat serve both purposes. 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. 3233596, VAT No. 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. 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. 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. Copyright 19972023 IPE International Publishers Limited, Registered in England, Reg No. They both support a materiality assessment based on the potential effect on the companys enterprise value. The market must find a way to determine when this is important, and crucially, when it is not. 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. Thats why we were created. One of the biggest is that all three proposals define what is material in different ways. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. In practice, this shifts the focus to the forward-looking or anticipatory aspects of double materiality. But it does not tell shareholders how to use this data to value securities: the user provides that context. 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. 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. When the economy suffers, so do diversified shareholders. 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. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. - 2023 PwC. Double materiality is the union (in mathematical terms, i.e. 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). 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 . Global Leader, Public Policy & Regulation, PwC United Kingdom, Director of Investor Engagement, PwC United Kingdom. Read our policy. Green Finance Institute director tells Chatham House while MP support double materiality approach. 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. 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. 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. 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. 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. 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. To accomplish this, the General Requirements Standard recommends that companies provide both quantitative data-based disclosures as well as qualitative narrative-driven disclosures. 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 dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . 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 ISSBs and SECs definitions of materiality are not far off from this. Impact materiality means that the activity affects either people or the environment, whether directly via the companys operations or indirectly in its value chain. Statement of comprehensive income and then through the economic harm the rest of their portfolios absorb adopt a broad multi-stakeholder! 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