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. 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. 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. And so the fact that the ISSB and SEC have asked companies to see the long term as material today and in the context of a market perspective means that much of what a business considers to be its impact on the environment or society will be reflected in its consideration of enterprise value. Taking IAS 37 as a starting point is not as simple as it might seem. 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. Hard choices must be made. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. 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. But it does not tell shareholders how to use this data to value securities: the user provides that context. What ISSB asks for. The last category of information is that which is relevant to stakeholders other than shareholders. 1. The growing importance of this field is evident in the creation of the International Sustainability Standards Board (the ISSB) to establish uniform E/S disclosure standards that companies around the world will use to report to investors. Thus, diversified shareholders internalize E/S costs that individual companies can profitably externalize: This is a trade. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). 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. For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. 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 US Securities and Exchange Commission is also beavering away on its own climate-reporting proposals. 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. 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. 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. The ISSB documentation expressly rejects double materiality, the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. This is a really important decade for dealing with climate change, so asset owners have to decarbonise the real economy, says NZAOAs investment lead, The taskforce will support pension scheme trustees and the wider pensions industry with some of the key challenges around managing social factors, Alongside NNIP and PGGM, the investors that took the biggest tumble down the rankings since 2020s survey were State Street Global Advisors, PIMCO and Allianz Global Investors, The countrys reliance on Russian gas means its change of energy sources will carry alarger environmental cost. There are some other areas that need ironing out too before standard setters finish their work. 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. 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. The ISSB standard could be of more limited value for certain jurisdictions. 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 actual influence of certain behaviours on cash flows are still being understood and standard models for measurement in these areas are nascent, or missing altogether. The planned agenda consultation has also been pushed back into next year. This article addresses a fundamental debate over the purpose of the uniform standard and reaches the following conclusions: Four types of impact. Diversified investors internalize the collective costs of such externalities (more than $2 trillion in 2018 according to the Schroders report cited above) because they degrade the systems upon which economic growth and corporate financial returns depend. All topical standards have been changed to mirror the new four pillar structure. The ISSB will deliver a global baseline of sustainability disclosures to meet capital market needs. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . [.] Whatever the aim, they missed. Ruchir Agarwal and Gita Gopinath, A Proposal to End the COVID-19 Pandemic, IMF Staff Discussion Note (May 2021). This is a critical moment. A concept often referred to as ' double materiality '. The general understanding is that the ISSB will not incorporate what is called 'double materiality' - that is, it will focus largely on the impact of the changing climate on a company rather than on the impact of the company on the climate, as the assumption is this is what investors really care about. One of the biggest is that all three proposals define what is material in different ways. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. 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. 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). Read our policy. 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. Diversified investors cannot avoid certain common risks almost all companies face. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. 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 . In practice, this shifts the focus to the forward-looking or anticipatory aspects of double materiality. In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to beta. 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. EFRAGs proposed standard only asks that companies break the shackles of certainty and short-term thinking to report on the things that they are likely already or should be factoring into their business planning anyway. 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. And, on the surface, this could threaten progress towards global alignment. The ISSB consultation responses show there is also wide support for the approach within the financial sector. 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? 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. 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. Registered Office: 1 Kentish Buildings, 125 Borough High Street, London SE1 1NP, UK pension risk transfer market set for bumper 2023. Not that this in any way prejudges the issue. But interests do not magically align. As shown above, there is significant literature establishing that E/S disclosures that go beyond enterprise value may be of great importance to diversified investors economic decisions because of their financial interest in beta. 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. Contributions to inequality also reduce GDP over time. measuring and reporting carbon emissionsthat serve both purposes. 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. Pause on that figure: prioritization of individual company financial return leads to one third of all listed companies around the globe destroying more value for society than they create for their own shareholders. Though there are aspects of ISSBe.g. IFRS Advisory Council questions ISSB on future of SASB standards. 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. Continue the context-setting projects for beta-level impacts of E/S issues outside the ISSB process. 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. 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. 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 . 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. Because the ISSB is a standard for disclosure, and not for action, it can be neutral on which side to take and simply provide beta-relevant information, in order to inform investors of the trades being made. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. Nevertheless, portfolio theorys prescription of diversification certainly suggests that widely held entities should give strong consideration to diversified investors interests. 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). Despite all the talk of urgency from IOSCO, the climate-change standard will not be in place until next year. The message is clear: to optimize returns, investors must exercise their governance rights and other prerogatives to protect themselves and their beneficiaries from individual companies that threaten beta. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. Of course, there would be no need to decide between prioritizing E/S impact or financial return if business decisions that optimize one always optimized the other. Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). 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. Take the comment letter from David Russell, the UK Universities Superannuation Schemes head of responsible investment. Economists have long recognized that profit-seeking firms in free-market economies will not account for negative externalities, and there are many profitable strategies that harm stakeholders, society, and the environment. Sustainability-related financial information is material if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports. 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. Adding beta information to the ISSB reporting standard would not significantly enlarge the reporting requirement because any company conduct that threatens or benefits beta is likely to create corresponding regulatory and reputational risks and benefits to enterprise value, so that most beta information should be deemed material even under a putative ESG standard. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. And, in practice, a small one at that. 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. 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. The return to such diversified investors chiefly depends upon beta, not the performance of individual companies. This convergence is illustrated in Figure 1 below. Ironically, as E/S investing became popular, more capital moved into these constrained fiduciary institutions. He says: The first is a provision for the cost of closing the existing carbon-based business. 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. The doom loop was complete when falling river levels left Frances nuclear power plants battling to produce enough energy to meet the demand for cooling. 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. > ISSB 2023 . 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.. 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April 2
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