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. 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. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start. 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 . 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. 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. Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. Thus, while individual companies can profitably externalize costs, a diversified investor will pay these costs through lowered return on their diversified portfolios. Currently, companies and financial institutions utilize a variety of voluntary frameworks often referred to as the ESG alphabet soup to guide disclosure in sustainability reports and other corporate communications. 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. 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. CSRD explicitly requires double-materiality reporting and so vastly expands the scope of disclosure from considering only sustainability risks that companies face (i.e. Tony Moller provided valuable research and drafting assistance in support of this Alert. 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. 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. 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). These institutions cannot simply subordinate financial returns to concern for workers lives or the environment. 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. 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). Double materiality is an extension of the key accounting concept of materiality of financial information. 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. 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. 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. Double materiality is the union (in mathematical terms, i.e. 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. The draft standard also introduces the concept of dynamic materiality. As noted above, the GRIs disclosure standards adopt a broad, multi-stakeholder interpretation of materiality. 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. Pursuant to applicable rules of professional conduct, portions of this publication may constitute Attorney Advertising. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. 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. 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. Although there is no charge to the income statement, the reduction in shareholder equity arising from this proposal would reduce the amount of distributable reserve available to shareholders. It is likely that if companies begin to report accurately on their sustainability profile, the information they provide will be illuminatingly different from what the market thought it knew. 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. 685 1784 92. Such a standard, rising above a single focus on financial materiality but rooted in investor return, would not rise to the level of double materiality, and might best be described as sesquimateriality.. This change will not create a significant additional burden but will make the project more coherent and consistent with evolving fiduciary standards. A Three-Tiered Typology of Sustainable Development Performance Indicators (UNRISD 2019). So, in practical terms, the gulf is no gulf, but a gap. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. 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? Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. See Bill Baue, Compared to What? Businesses, regulators, and governments will have to convene and work together rapidly to develop them. They both support a materiality assessment based on the potential effect on the companys enterprise value. 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. However, for Andromeda Wood, vice president of regulatory strategy . 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. The ISSB agreed to fully align its description of materiality with IFRS Accounting Standards. All of this will edge companies closer towards a materiality assessment based on both the companys impact on the world around it as well as the potential effect on its enterprise value; in other words, and for all practical purposes, applying a double materiality concept. Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. 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. 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. Lastly, the fact that many companies will have to report new information and in large quantities could have the potential to cause a period of significant volatility in markets. 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. 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. But it does not tell shareholders how to use this data to value securities: the user provides that context. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. 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. In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. They threaten the functioning of the economic, financial and wider systems on which investment performance relies. IFRS 13 is one standard that does refer to future amounts when it talks about valuation techniques that convert future amounts (such as cash flows or income and expenses) to a single current (discounted) amount. 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 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. What ISSB asks for. Financial reporting standards have proven to be a driving force of stability and development in our global capital markets. Thats where we aregoing. Whatever the aim, they missed. 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. Sustainability materiality must be accepted as ever evolving, as it is for financial statement 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. They may find that for many issues their enterprise value and impact materiality assessments are so interlinked that for practical reasons it is not possible to split them apart. The logic for this is implicit within IAS 37. Financial materiality means that the activity has an effect on the companys cash flows or enterprise value (consistent with the SEC and ISSB). 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. 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. Global Consumer Insights Pulse Survey - June 2022, Ukraine: Tax, Legal and People considerations. Taking IAS 37 as a starting point is not as simple as it might seem. 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. 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. 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. This site uses cookies. This is similar to the architecture of the TCFD and ISSB. 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 . 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. But we are trying to. 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. Why? But the trade is inevitablethe only question is which type of investor it will favor. 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. See Thomas C. Schelling, On the Ecology of Micromotives, 25 Pub. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks. Corporate social responsibility. SASB's materiality map was so valued by the markets because it illuminated what mattered per industry. At a conceptual level, the General Requirements Standard attempts to unite multiple overlapping approaches to sustainability disclosure. 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). 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. 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. 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 focus should be on double materiality and not on enterprise value," the HSBC Bank (UK) Pension Scheme said in its submission to the ISSB. The ISSB standard could be of more limited value for certain jurisdictions. The General Requirements simply do not discuss or even acknowledge the existence of specifically beta-relevant information as pertinent to diversified investors economic decisions. 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. 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. 1. A concept often referred to as ' double materiality '. Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. TNFD's basis for adopting the 'enterprise value' approach doesn't appear to be evidence based. 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. In addition to interests in alpha and beta, shareholders may be otherwise affected by the E/S impact of companies in which they invest. 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. 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. 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). 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. 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. Double materiality can be a decision left to jurisdictions such as the EU, China or the US, which are currently working on their own systems of mandatory climate risk reporting. 24 February 2023 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. Below, we highlight three key takeaways from the draft General Requirements and Climate Standards. 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. The ISSBs and SECs definitions of materiality are not far off from this. 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. Companies and investors have, in the past and on other topics, risen to the challenge. 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. One such force is the International Organization of Securities Commissions (IOSCO), which sees the establishment of the ISSB and its shiny new climate-disclosure standard as key pillars of its overall sustainable-finance strategy. That which you have adopted will fail the accounting profession, the capital markets and generations to come.. 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. 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. 'The ISSB has a definition of materiality that could allow Europe to overlay double materiality, although more detail is needed, which hopefully will come from the . Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. 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