Explainer

Can Sustainability Standards Minimise Friction and Divergence?

Asset owners have welcomed draft sustainability reporting standards from ISSB and EFRAG, but also identified some rough edges. 

Clear, concise and standardised corporate disclosures on climate and wider sustainability themes are essential if investors are to understand the full scope of their portfolios’ positive or negative impact on the society and environment. 

However, the content of corporate sustainability disclosures still varies sharply according to the sector, jurisdiction and size of the company, resulting in a sea of data which may draw on estimates and methodologies very different from peers.  

“The current lack of [standardisation] poses a significant cost to asset owners and limits their ability to incorporate these issues into investment decision-making,” says the UN-convened Net Zero Asset Owner Alliance (NZAOA), a group of 74 institutional investors with US$10.6 trillion in assets. 

The need for a globalised baseline for climate and sustainability disclosures is therefore essential. 

With the consultation periods for both the International Sustainability Standards Board’s (ISSB) climate and general sustainability standards and the European sustainability reporting standards (ESRSs) now closed, this explainer touches on the sticking points which will need to be smoothed out ahead of their being finalised later this year.  

What are the main objectives of each standard? 

Launched last year at COP26, the ISSB aims to provide a reporting baseline for use in jurisdictions globally. Endorsed by IOSCO, its climate standard builds on the existing and widely adopted Task Force on Climate-related Financial Disclosure (TCFD) framework, whereas the general sustainability standard sets requirements for disclosures on other broader sustainability-related matters in corporates’ financial reports, including risks relating to biodiversity. 

Both standards will require companies to disclose how they are both directly and indirectly responding to risks and opportunities, how their subsequent strategy will be resourced, and what consequent changes they expect to financial position and performance over time.  

In comparison, the ESRSs support multiple pieces of EU sustainable investment legislation. 

Developed by the European Financial Reporting Advisory Group (EFRAG) in consultation with the Global Reporting Initiative (GRI), a voluntary sustainability reporting standards-setter, the ESRSs will apply to companies falling under the scope of the EU’s delayed Corporate Sustainability Reporting Directive (CSRD) 

Reporting requirements cover 13 themes across four categories: cross-cutting (general principles, strategy, governance and materiality assessments), environment (climate change, pollution, water and marine resources, biodiversity, resource use and circular economy), social (workforce, workers across the value chain, affected communities, consumers and end-users), and governance (risk management, internal control and business conduct).  

“The ISSB and EFRAG standards, while with different missions and objectives, are both very important to increase the availability and comparability of sustainability data,” Federica Casarsa, Policy Officer at the European Sustainable Investment Forum (Eurosif), tells ESG Investor. 

According to an NZAOA spokesperson, more granular and comparable data will “help investors implement effective stewardship and portfolio design strategies”.  

However, like two tectonic plates, too much friction or divergence in the approaches taken by the ISSB and EU could prove to be more disruptive than helpful, experts warn. 

Do the proposed reporting scopes meet asset owners’ expectations? 

The ongoing ‘enterprise value’ versus ‘double materiality’ debate is a prominent theme throughout consultation responses to the draft standards. 

The double materiality approach, which has been adopted by the ESRSs, requires organisations to outline how sustainability issues are impacting their business, as well as the organisations’ impact on sustainable development beyond their internal operations. The ISSB has a narrower focus on enterprise value, asking companies to disclose how environmental and social factors contribute to or erode a company’s total value. 

“Disclosure focused on enterprise value will not serve the needs of all investors, particularly those that are looking for a broader understanding of an entity’s sustainability performance and outcomes,” the NZAOA spokesperson argues. 

A number of asset owners have responded to the ISSB consultations calling for the adoption of the double materiality lens.  

Writing on behalf of the Church of England Pensions Board, Chief Responsible Investment Officer Adam Matthews noted that enterprise value is simply “too narrow”. 

He said: “In financial reporting, a factor is considered ‘financially material’ (and, therefore, as something that needs to be reported) if it has an impact on the decisions of primary users of an entity’s financial statements. This emphasis means that most companies will be required to report on very few, if any, environmental or social impacts. This is exacerbated by the effects of discounting (i.e., assigning less importance to impacts in the future than impacts today) and the tendency to downplay or even exclude probabilistic risks in many financial models.” 

The HSBC Bank (UK) Pension Scheme noted that enterprise value reporting is “backward-looking” and therefore of less use to pension funds. A forward-looking lens through double materiality is helpful from a risk management perspective, further informing how assets are subsequently managed across different generational cohorts of its members, the scheme said. 

“Sustainability risks may initially manifest themselves on the planet and society first and are only experienced by an entity over time. In our experience, it is only once such a risk is experienced by the entity, for example through a negative impact, that it becomes assessed and potentially disclosed by the entity,” HSBC added. 

UK-based pension fund Railpen pointed out that, by incorporating double materiality, ISSB would “be in good company”, as proposed transition planning frameworks, including those of the UK’s Transition Plan Taskforce and the Glasgow Financial Alliance for Net Zero (GFANZ), are considering the broader systemic impact of climate transition actions taken by companies on the environment.  

Other asset owners – notably based in jurisdictions that haven’t made as much progress in establishing sustainability reporting rules compared to Europe and the UK – are supportive of an enterprise value focus.  

“We support the approach that entities will be required to disclose information that is material and gives insight into an entity’s sustainability-related risks and opportunities that affect enterprise value,” said AustralianSuper, which has A$245 billion (c. US$168.3 billion) in AUM.  

IOSCO Chair Ashley Alder has previously argued that the ISSB’s proposed standards will provide more insight into environmental and other sustainability impacts as and when these become more financially material. 

The ISSB has said it is taking a ‘building blocks’ approach, first covering the most essential, foundational areas of sustainability reporting, allowing for additional layers to be added gradually as different jurisdictions develop their understanding of sustainability reporting. 

According to Secretary General Martin Moloney, IOSCO’s endorsement depends partly on whether ISSB’s standards can be “rigorously conformed” to across multiple jurisdictions.

“Stakeholders are raising really important questions around ‘how exactly do I read the text if I am operating in a compliance function or as an auditor?’ Some of the responses are about how do we get from aspiration to achievable reality in the short term.  We can’t put requirements in rules or standards if issuers of securities just cannot comply with them today,” he said.

The need to consider practical questions of implementation were also underlined by Eurosif. “Jurisdictions and stakeholders around the world are all subject to different rules and different interpretations of what ESG-related reporting means, so that is something to bear in mind when considering the scope of the ISSB standards,” says Casarsa. 

Moloney also welcomed responses endorsing IOSCO’s position on the ability of the ISSB standards to be challenging and to meet the evolving needs of investors.

“Some of the responses are about ensuring that we are on a progressive path so that the standards don’t become an inadequate resting point, but rather become part of a journey towards markets that really do differentiate the good sustainable investment from the better sustainable investment and the better from the best and price accordingly,” he said.

Railpen said the building blocks approach should allow the ISSB to propose the inclusion of double materiality – so-called ‘inside-out’ elements – over time. 

Are double materiality-focused reporting requirements too onerous? 

Double materiality, while increasingly favoured by asset owners, requires firms to disclose even more information at a time when they are already struggling to supply high-quality, relevant and comparable ESG-related data, some argue. Anticipation of future challenges coloured a number of responses to EFRAG’s consultation.  

As was previously identified by the GRI, the Institutional Investors Group on Climate Change (IIGCC) said “the breadth and depth of [EFRAG’s] proposed requirements could impose burdens and challenges for even the largest and most sophisticated entities in scope of the requirements”. This could then undermine investors’ ability to identify decision-useful information, IIGCC added, noting that some more detailed requirements could be framed as recommendations or guidance instead.  

Further, “an element of flexibility” should be introduced when companies are unable to source the relevant data, as approximations and estimates “could lead to misleading, inconsistent and inaccurate reporting that could negatively impact investment decisions and capital allocation”.  

IIGCC, the European membership body for investor collaboration on climate change, suggested EFRAG should allow for the omission of data (at least during the initial implementation phase) when the case for omission is “legitimate” – for example, if datasets are unavailable or incomplete.   

It qualified that a number of outlined topics in the ESRSs should nonetheless be maintained as mandatory disclosures, including measurable targets and action plans for climate change mitigation and adaptation. 

Does the fine print stand up to scrutiny? 

When reading the fine print of any new guidance, it’s vital that the terminology used is relevant and easy to understand. Both ISSB and EFRAG have been challenged to clarify their interpretations of sustainability-related terminology. 

Responding on behalf of the Asia Investor Group on Climate Change (AIGCC), CEO Rebecca Mikula Wright said the ISSB needs to explain the difference between the terms used in the draft when referring to the reporting scope as ‘significant’ or ‘material’. The Australian Council of Superannuation Investors (ACSI) also called for this clarification to be made.  

In the climate standard draft, the ISSB makes reference to entities identifying and disclosing significant climate-related risks and opportunities and how these will affect enterprise value over time, but doesn’t define ‘significant’. The draft is also open-ended about materiality, determining that “the responsibility for making materiality judgements and determinations rests with the reporting entity”. 

“Subjective interpretation of these terms could result in disclosure documents with varying levels of information, resulting ultimately in a failure to develop a standard that is able to elicit the required extent of essential information from reporting entities,” Mikula Wright said. 

If ‘significant’ cannot be more clearly defined, it should be removed, said the NZAOA. “Referring to ‘material’ instead of ‘significant’ would better guide decision-making on what should be disclosed,” the spokesperson adds. 

Investors ran into similar moments of confusion when perusing the ESRSs draft.  

The NZAOA called for EFRAG to clarify how the definition of value chain specifically applies to investors. 

The draft ESRSs describe the value chain as “the full range of activities or processes needed to create a product or service”. However, the alliance said this should be expanded to outline the key disclosures on value chains required of asset owners, “taking data availability from the financial sector into account”. 

In its consultation documents, EFRAG also proposes that entities report on their ‘locked-in emissions’, which it explains are “estimates of future greenhouse gas emissions that are likely to be caused by an undertaking’s key assets or sold products within their operating lifetime”. 

The IIGCC highlighted its concern that calculating these emissions and interpreting the results will be difficult in practice and therefore unlikely to be comparable or consistent across companies without further guidance.  

“EFRAG should develop a more precise definition of ‘locked-in’ emissions on this basis, and provide more detailed guidance on how to measure and disclose on these emissions (perhaps on a qualitative basis initially until methodologies mature),” the IIGCC noted in its response. 

Is greater alignment between the ISSB and Europe needed? 

Interoperability between the sustainability disclosure standards of the ISSB and the EU has long been cited as a priority, and will be partly achieved by aligning respective terminologies and definitions.  

In its response to the ESRSs consultation, the European Securities and Markets Authority (ESMA) emphasised the importance of further cooperation between the ISSB and GRI to achieve “better mutual alignment”. In March, the IFRS Foundation and GRI signed a memorandum of understanding, agreeing to adopt a ‘two pillar’ approach and coordinate their work programmes and standards-setting activities.  

ESMA said: “Alignment on terminology and definitions would be important for users consuming sustainability information under both EU and international standards, as this would enable them to more easily compare the information. Such alignment would also help preparers navigate the different sets of standards when compiling their reporting.” 

Laurence Caron-Habib, Head of Public Affairs at BNP Paribas Asset Management (BNPPAM) counters that, while alignment is of course preferable, “even if the definitions used by EFRAG and ISSB are not exactly the same on several aspects, we nonetheless consider that these differences should not create major issues”. 

Have the ESRSs strayed too far from TCFD?  

TCFD has been adopted globally and is recognised as a solid baseline from which to build climate reporting standards. Sustainability disclosures are far more wide-ranging, but some have argued for greater commonality.  

The ESRSs’ departure from the TCFD’s four-pillar guidance (governance, strategy, risk management, and metrics and targets) in favour of more “complex architecture” means that “reconciliation between ISSB standards and the ESRSs will not be seamless”, ESMA warned.  

The European securities watchdog has recommended that EFRAG should attempt to minimise these differences. ESMA nonetheless recognised that the TCFD structure was originally developed for disclosures on financially material climate-related issues, and therefore needed tailored adaptations to reflect “European specificities”.  

The ESRSs are designed to specify the information corporates will need to be disclosed under CSRD, providing an essential input to fuel Europe’s sustainable investment framework. 

The ESRSs will prompt a broader range of companies to report audited, tagged, and more comparable information on their sustainability-related risks, opportunities, and impacts, across a wider range of sustainability issues,” Susanne Draeger, Senior Specialist for Driving Meaningful Data at the UN-convened Principles for Responsible Investment (PRI), tells ESG Investor. 

This will then unlock much of the information necessary for asset managers to fulfil climate and broader sustainability reporting requirements under the Sustainable Finance Disclosure Regulation (SFDR), including the degree to which their investments align with the Taxonomy Regulation, Draeger adds. 

Asset owners and investor-led organisations have welcomed the ISSB’s close alignment with the TCFD framework, with AIGCC’s Mikula Wright pointing out this will make adoption across Asia easier, as TCFD has been accepted and mandated across several major Asian markets. 

However, HSBC Bank (UK) Pension Scheme noted that the ISSB hasn’t adopted a notable TCFD reporting requirement, introduced in 2021, which requires all companies to disclose their carbon emissions independently of a materiality assessment. The asset owner said that, as an example of double materiality at work, this kind of disclosure is important.  

“Ultimately, the objective [for the ISSB and ESRSs] should be to provide stakeholders with adequate tools to understand the differences between their standards so that they can use both and not duplicate information,” says Eurosif’s Casarsa. 

“The sooner the standards are finalised, the quicker companies will start reporting and investors will start using the data. Practices will improve over time.” 

Subject to feedback to its consultations, the ISSB standards will be finalised by the end of this year.  

EFRAG will deliver its final draft of the ESRSs to the European Commission by November, where they will then be subject to final discussions. If there are no delays, the ESRSs could be adopted into law by the Commission by the end of 2022. Companies falling under the scope of CSRD will then be expected to apply the standards to their 2023 sustainability reporting, publishing in 2024. 

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