Commentary

A Step in the Right Direction

Andrew Probert, EMEA Head of ESG Advisory at Kroll, considers the headwinds that may hamper progress in setting global sustainability standards.

The formation of the International Sustainability Standards Board (ISSB), announced at the COP26 climate change conference, is a pivotal moment in the drive towards standardised ESG reporting. Neither its significance nor the spirit of collaboration that enabled its formation should be understated. At the start of last year, few would have expected the new body to be launched by COP26, but this should serve as a stark indicator of the urgency and demand  for a consistent set of metrics that can link sustainability to enterprise value.

Subsequently, the ISSB faces several potential headwinds that will need to be addressed. There are still pending issues that the body’s formation does not yet address either.

What is the ISSB’s remit?

The intention of the ISSB, according to the International Financial Reporting Standards Foundation (IFRS), is to “develop … a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs”. The ISSB has been created in response to the “growing and urgent demand for companies to provide globally consistent and comparable sustainability disclosures that meet the needs of investors and other financial market participants”.

By applying these clear guidelines, capital market participants will be able to understand a company’s underlying impact on sustainability matters relevant to assessing enterprise value and can use this information to inform their investment decision-making accordingly.

In theory, this meets the urgent requirement for a globally accepted set of standards, but in practice, there are potential issues that warrant further discussion.

Understanding disclosure

Whether capital market participants (or companies themselves) understand how the matters to be disclosed impact enterprise value is an issue that warrants consideration.

The connection between ESG-related matters and enterprise value creation is still up for debate, and it’s easy to understand why—this is considered a complex topic. A recent report issued by independent think tank Carbon Tracker underscores the complexities: over 70% of some of the world’s biggest corporate emitters failed to disclose the effects of climate risk in their 2020 financial statements. In fact, 80% of their auditors showed no evidence that they had assessed climate risk when reporting.

The hope is that with the development of the ISSB’s climate-related disclosure prototype, disclosures will become easier to articulate, which will enable companies, and their auditors, to make more meaningful statements. However, users of that information will need to understand how to leverage this information before pursuing investments.

A base set of standards

The second issue concerns capital market participants. Over time, flows of capital will likely change and be re-directed to companies that understand how their actions impact long-term sustainability. However, capital market participants are just one such stakeholder of a company.

Will this new set of standards respond to the concerns of other stakeholders, such as employees, customers and communities within which a company operates? Although the ISSB’s sustainable disclosure standards address some of their concerns, what many stakeholders consider to be material may differ from that which is set out in the ISSB’s standards, and that which is consequential to the firm itself. A solution could be for companies to use the ISSB’s sustainability disclosure standards as a base, and then build in additional disclosures that are material to their additional stakeholders.

However, this would only be on a voluntary basis, leading to further concerns. The ISSB and its pronouncements are purely guidance, with no legal authority. The adoption of its standards is, therefore, undertaken on a jurisdictional basis, and currently, the UK is the only country to have mandated its adoption. More countries will likely follow, but it does have its detractors, including some of the largest carbon emitters in the world.

In the US, for example, while the Securities and Exchange Commission (SEC) is yet to issue regulated requirements for climate and ESG disclosures, it has raised concerns around the ISSB’s broad approach to “fuzzy” topics and has questioned whether the ISSB has the right to set such standards for US investors.

This is not the first time we have seen such a challenge. The US did not adopt the IFRS, leading to a divergence in the way financial transactions are reported globally, although there has been a growing convergence over time. The hope is that if the SEC issues its guidelines on the topics covered by the ISSB, these will similarly converge over time.

Diverging standards could likely be an issue in the EU too. The EU has already proposed the creation of a separate set of sustainability standards, the Corporate Sustainability Reporting Standards (CSRD). In October 2021, 57 organisations sent an open letter to the EU, calling on it to align its own set of proposed reporting standards with globally consistent metrics and disclosures.

The UK’s approach

The UK government has proudly announced its adoption of international climate disclosures outlined by the Task Force on Climate Related Financial Disclosures (TCFD), one of the frameworks responsible for the formation of the ISSB into law and is the first G20 nation to do so. The requirements implemented will bring the UK’s largest firms in-line with ISSB guidelines, bringing in over 1,300 of the largest UK financial institutions into the realm of mandatory disclosures. As a result, firms will have to detail whether their disclosures are in line with requirements and if not, provide reasons for their lack of success.

The transition phase for UK firms is already underway as mandatory disclosures come into effect in April 2022. Accordingly, many firms will have to change their approach to annual reporting, importing processes which can collate operational data and present the findings required by the TCFD.

The motivation for legal enforcement of disclosures is more than just political, however. These measures aim to bring coherence between UK domestic standards and provide new visibility to the carbon footprint of corporations of interest for investors. When reporting becomes mandatory to a universal set of metrics, a big step is taken in standardisation which has been a major pitfall for ESG reporting so far. By giving investors and shareholders a transparent view of the ESG qualifications they can accurately compare ratings.

Intensive adoption

While mandatory requirements in the UK should bring cohesion, the next headwind for ISSB regards the implementation of these metrics on an international scale. The largest emitter for carbon emissions, the US, is yet to incorporate mandatory disclosures into law; the European Union is also another laggard in reporting standardisation.

In many ways, you could liken the adoption of the ISSB’s sustainable disclosure standards to other accounting change projects. Many will recall how labour and capital intensive the previous adoption of the financial instruments accounting standards was. The adoption of the new sustainability standards will likely present just as big, if not a bigger, challenges, yet success is possible.

Information will need to be collated from internal and external sources that do not form part of the existing infrastructure of financial reporting. People will need to be employed and processes must be created. Auditors will be required to provide assurance on the disclosures made. All of these processes will take time and likely cost money.

However, a singular focus on cost detracts from the original, overarching objective. Increasing disclosure on these topics creates transparency and re-enforces accountability over topics that companies have often long ignored. Investors may redeploy their capital in different ways, and likely away from companies that do not match their own beliefs and hopefully towards those that aim to make a difference. The UK’s adoption of mandatory reporting bodes well for the setting of an international benchmark but if the major emitters and economic zones fail to enforce standardisation, the practical results of the ISSB may be out of reach.

To Top
Newsletter SignupReceive all the latest stories from the ESG Investor editorial team

Subscribe to our free weekly newsletter below and never miss a story.

Share via
Copy link
Powered by Social Snap