It is important to understand that ESG data are often provided without much context. The General Requirements Background section described inside-out and financial materiality in the following paragraphs (a) and (b): (a) disclosures to stakeholders about sustainability matters that have impacts on people, the environment and the economythese disclosures normally provide the broadest range of information because they aim to meet the needs of multiple stakeholders. This would be information of interest to NGOs, governments, and citizens who wanted to understand companies impact on the world. 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. A large percentage of securities markets beneficiaries are diversified, and the relative importance of beta compared to alpha should affect these investors calculus when considering the impact of a portfolio companys social and environmental externalities. There have long been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example. Thats why we were created. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. Single MaterialityDouble Materiality Outside-in Perspective . But as capital markets matured, investors began to contemplate a more active role, and after a divestment campaign helped end South African apartheid, the idea that investors could change bad corporate behavior, rather than simply avoiding it, developed a broader following. 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. 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. Alongside this conceptual harmonization, the ISSBs framework advances a general organizational convergence among some of the most widely used global standard-setting bodies. 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. Confirmation that climate change does not drive sustainability reporting came when the boards chairman, Emmanuel Faber, appeared at the IFRS Foundations World Standard Setters conference in September to rule out any shift to double materiality some call it impact reporting by the ISSB: We will not move. While this trade might financially benefit a shareholder with shares only in that company, it harms a diversified shareholder by threatening beta. 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 . Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. 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. If the company were degrading the environment by causing drought with over-extraction then clearly EFRAGs materiality definition would require this outward impact to be reported. Nevertheless, portfolio theorys prescription of diversification certainly suggests that widely held entities should give strong consideration to diversified investors interests. 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. So, in practical terms, the gulf is no gulf, but a gap. 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 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. One example, Becker claims, is the understand of materiality. Swiss Re Institute, The Economics of Climate Change: No Action Not an Option (April 2021). This is a critical moment. 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). Registered Office: 1 Kentish Buildings, 125 Borough High Street, London SE1 1NP, UK pension risk transfer market set for bumper 2023. 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. 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. We will not move. Socially responsible investing. This is the same way that traditional financial disclosures work: the purely financial data securities regulators require informs investors about items such as historical earnings data, sources of liquidity, and risk factors. 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. 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. But double materiality adds inside-out information, namely, information relevant to the companys impacts on society and the environment. He says: The first is a provision for the cost of closing the existing carbon-based business. This view of materiality doesnt ask the company to have a crystal ball, only to think about likely future risks or events such as resource shortages or environmental damage that could change the way they structure their business model and, ultimately, do business. Centrality of TCFD and SASB: As described above, the ISSBs General Requirements Standard centers on the four pillars of the TCFD framework, which are geared toward integrating sustainability risk assessment into the core processes of a companys business, as well as the industry-specific disclosures outlined by the SASB Standards. 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. "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. 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. The current plan for the ISSB expressly encompasses only data that implicate enterprise value (often called financial materiality), although a close read of the documentation produced to date leaves the door open for an expansion to information pertinent to beta information as well. Because negative externalities burden the economy and beta. - 2023 PwC. 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. As such, we urge you to rethink your whole approach to this issue. Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. Taking a market view adds an element of objectivity to the materiality assessment. E/S information that does not affect investors, but is relevant to the impact companies have on civil society and stakeholders other than investors (stakeholder data). ISSBs Proposed Framework Seeks to Unify Global Sustainability Disclosure Standards, Private Equity International Responsible Investment Forum, Kirkland Advises Greenbriar Equity Group on $3.475 Billion Fundraise for Oversubscribed Sixth Fund, Kirkland Advises Patient Square Capital on Record $3.9 Billion Inaugural Fundraise, General Requirements for Disclosure of Sustainability-Related Financial Information, European Sustainability Reporting Standards. 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. Challenges for the adoption of the ISSB standards; ISSB a driver for change or a compliance exercise? E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders: ISSB embraces a single type of data. Planetary forces much greater than cataclysmic weather events have decided that. Double materiality. Global Leader, Public Policy & Regulation, PwC United Kingdom, Director of Investor Engagement, PwC United Kingdom. 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. 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. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. All topical standards have been changed to mirror the new four pillar structure. TNFD has stated that it should align with the newly instituted International Sustainability Standards Board (ISSB) as part of efforts to consolidate sustainability standards. 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). 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. 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. There are some other areas that need ironing out too before standard setters finish their work. Companies are advised to monitor the continued development of the exposure drafts and may wish to consider aligning future sustainability reporting with key components of the General Requirements Standard, including relying on company- and industry-appropriate standards such as those of SASB. 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. The US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. Companies occasionally need to report new information and markets need to work out how to digest it. The Schroders Report calculated that one third of all listed companies around the world created net social costs that exceeded their profits. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. 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. The ISSB has the critical mass of support from established market participants necessary to bring the same uniformity (and thus utility) to sustainability reporting that now exists for standard financial reporting. 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. 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. But from a disclosure perspective, investors should have the data that would allow them to understand the risk the company is taking by continuing to externalize costs. This article addresses a fundamental debate over the purpose of the uniform standard and reaches the following conclusions: Four types of impact. The ISSB agreed to fully align its description of materiality with IFRS Accounting Standards. 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). This means that companies have to report on both the financial and environmental implications of their sustainability efforts. 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. 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. 1. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. Double materiality is an extension of the key accounting concept of materiality of financial information. At a conceptual level, the General Requirements Standard attempts to unite multiple overlapping approaches to sustainability disclosure. 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. They both support a materiality assessment based on the potential effect on the companys enterprise value. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. 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. Finally, a number of prominent global financial regulators including the SEC, the UK Financial Conduct Authority, the European Commission, the European Financial Reporting Advisory Group (EFRAG), the Japanese Financial Services Authority, the Sustainability Standards Board of Japan Preparation Committee and the Chinese Ministry of Finance have agreed to join a working group focused on compatibility between the ISSBs standards and new regulations. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. Diversified investors cannot avoid certain common risks almost all companies face. Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). This cost was more than 50 percent of the profits those companies reported. 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. 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. But then we filter that with the financial materiality as defined by the accounting standards". 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