Features

Stepping from Enterprise Value to Double Materiality

Policymakers and voluntary frameworks view sustainability reporting through different lenses, but asset owners are pursuing greater visibility. 

The UK announced this week that it is joining Europe in requiring investors and corporates to both report on their impact on the environment as well as the environment’s impact on them. This is also known as double materiality.

Applying to pension schemes, asset managers and asset owners, the Sustainability Disclosure Requirements (SDRs) aim to combat greenwashing by ensuring that sustainability claims are justified and, where appropriate, supported by credible net-zero transition plans.

The SDRs will be building on the UK’s existing climate disclosure framework, based on the Task Force on Climate-related Financial Disclosures (TCFD) guidelines, but will also require UK-based investors and companies to report in line with the UK’s planned Green Taxonomy. The scope and timing of the taxonomy will be decided following a consultation.

A double materiality approach to sustainability reporting is increasingly favoured by asset owners, as this will give them full visibility of investee companies’ exposure to and impact on environmental and social-related factors (both positive and negative), thus informing their investment decisions.

The HSBC Bank (UK) Pension Scheme “is interested in understanding not only the financial risks that companies are exposed to, but also what other risks and opportunities exist,” according to Russell Picot, Chair of its Trustee Board.

The scheme recently committed to achieving net-zero across its £36 billion of defined benefit (DB) and open defined contribution (DC) assets by 2050, halving its greenhouse gases (GHG) emissions by 2030 for its equity and corporate bond mandates.

“In the best-case scenario, we would have a complete double materiality framework that is fully supported by regulators, companies, civil society and investors on a global scale,” says Ole Buhl, Head of ESG at ATP, Europe’s fourth biggest pension fund (US$156 billion in assets under management).

Clear and consistent

However, reporting under a double materiality lens is challenging, requiring even more information from companies at a time when issues with the provision of reliable, comparable and relevant ESG-related data continue to present challenges.

Currently, a number of jurisdictions and voluntary frameworks are instead asking for enterprise value-focused sustainability reporting. These disclosures outline how environmental and social factors contribute to or erode a company’s total value.

Asset owners recognise that this more limited approach to sustainability reporting is more realistic in the short term.

But differing parameters for sustainability reporting requirements make it harder for global investors to secure consistent, standardised and comparable sustainability-related information on the assets in their portfolios.

“Above all, we need standardisation to ensure financial institutions are able to assess and manage the performance of sustainability-related factors. This requires corporate information to be presented in a clear and consistent manner,” says Monique Mathys-Graaff, Senior Sustainable Investment Strategist at investment consultants Willis Towers Watson.

Although the UK has centred its own approach in double materiality, its government is cognisant of this divide, noting that the country’s reporting requirements will be in line with other international standards, and “is preparing the ground to adopt international standards in this area (subject to consultation)”.

“The reality of today is that we have to approach disclosures more from a building block approach,” Buhl tells ESG Investor.

Diverging standards

As mitigating the risks posed by the climate crisis moves up the agendas of policymakers and investors, companies will be subject to an increasing number and variation of sustainability disclosure requirements.

The European Financial Reporting Advisory Group (EFRAG) has been tasked with co-constructing the European sustainability reporting standards (ESRSs) with the Global Reporting Initiative (GRI). Expected to be published by October next year, the ESRSs will embed a double materiality approach within the proposed Corporate Sustainability Reporting Directive (CSRD), which will replace the Non-Financial Reporting Directive (NFRD).

“Cold hard financial figures don’t tell the full story of a company’s performance in terms of its impact on the outside world,” said Mairead McGuinness, European Commissioner for Financial Stability, Financial Services and the Capital Markets Union, speaking at the UN-convened Principles for Responsible Investment (PRI) Digital Conference this week.

“CSRD will tell companies the information they need to supply around sustainability issues, and investors will be able to draw on clearer and more coherent information. The goal is for sustainability reporting to be on equal footing with financial reporting,” she said.

On the voluntary reporting front, sustainability disclosure platform CDP recently unveiled its 2021-2025 strategy, incorporating a focus on double materiality, according to Chief Impact Officer Nicolette Bartlett. Expanding its disclosure focus from climate to wider environmental issues, including biodiversity and waste management, CDP will develop “sector-specific double materiality-focused questions for companies”, identifying issues that are most relevant to the company in question, she says.

To support reaching net-zero emissions and full nature recovery by 2050, CDP will begin scoring all companies against scientific benchmarks reflecting their historic, current and projected impacts; their product portfolios; and their investment and transition plans.

Elsewhere, the US Securities and Exchange Commission (SEC) will be publishing its climate-related disclosure framework for publicly-listed companies this month. Partly because US-based investors and companies predominantly report to the Sustainability Accounting Standards Board (SASB), it is expected the mandatory framework will be built around enterprise value.

Driving real-world change 

Carol Adams, Professor of Accounting at Durham University Business School, previously wrote that enterprise value-focused reporting does not prioritise sustainable development or stimulate action at the pace required by climate change and related crises. For asset owners looking to ensure that they are having a maximum positive impact on society and the environment, it is vital to have clear visibility of all the sustainability-related risks and impacts to which their investee companies expose them, she noted.

To an extent, a double materiality perspective is already possible when assessing climate-related risks and impacts, argues Bartlett.

“It is fairly obvious that the higher your carbon emissions, the higher your transition risk and overall impact on the environment,” she says.

This is reflected in the TCFD’s recent update to its implementation guidance. While the framework remains predominantly focused on enterprise value, the revised annex has slightly broadened its parameters, noting that all Scope 1 and 2 GHG emissions should be reported “independent of a materiality assessment” and that Scope 3 is encouraged, albeit still subject to a materiality assessment. This will give investors more visibility of the impact of a company’s value chain in terms of carbon emissions.

Earlier this year, Eric Usher, the Head of the UN Environment Programme Finance Initiative (UNEP FI), said that the TCFD’s materiality definition is insufficient for driving real-world change, calling instead for a focus on double materiality.

HSBC’s Picot highlights a “time lag” between an environmental or societal issue becoming important to investors and “subsequently becoming material within the enterprise value concept”. Through double materiality, investors are able to ask for that information more quickly.

For complex topics, such as biodiversity risks, it is understandable why some frameworks are backing an enterprise value focus, experts say. It will be easier to build out the double materiality lens from an existing foundation over time, expanding into specific issues as confidence in corporate data grows.

Furthermore, if companies do not fall under double materiality reporting requirements, investors can still “put pressure on companies in the most vulnerable sectors”, asking them to provide information on their impact on environmental and social factors, according to Picot.

It’s not a competition

Although different countries and frameworks are choosing to prioritise enterprise value or double materiality, this does not mean that these standards cannot align with one another to ensure comparability.

Double materiality and enterprise value “are not in conflict with each other”, says Bartlett. “One just asks for more from the company than the other.”

An integral element of the GRI and EFRAG’s focus when developing the ESRSs will be on ensuring collaboration with other developing global standards, such as the International Financial Reporting Standards (IFRS) Foundation’s International Sustainability Standards Board (ISSB), to ensure that the different standards are as aligned as possible.

That is not to say the process is without friction, with GRI Chair Eric Hespenheide noting recently that the IFRS Foundation is only developing its sustainability standards and reporting “in a narrow sense”.

Asset owners appear willing to support both strands as they continue to evolve.

“At ATP, we see ourselves as a double materiality investor. Therefore, we are looking for information from companies that is both material from a financial viewpoint and a societal viewpoint,” says Buhl.

Nonetheless, ATP is also supportive of enterprise value-focused reporting becoming the global standard under the IFRS Foundation’s ISSB, notes Buhl, who is a member of SASB’s Investor Advisory Group (IAG).

“But, as a European pension fund, we continue to follow and support the development of the EU’s double materiality reporting regulation,” he says.

Double materiality-focused disclosure requirements can be layered on top of enterprise value reporting over time, says Bartlett. “They are two sides of the same coin,” she notes.

Building blocks

Ultimately, asset owners want access to comprehensive and decision-useful information from investee companies that will aid their own transitions to net-zero portfolios.

In the longer term, this will require the depth of information offered by double materiality, experts say. But they also recognise that the impact of environmental and social factors on enterprise value is, and will continue to be, a core component of their assessments and investment decisions. It is not a bad place to start.

The global sustainability standard developed by the IFRS Foundation will need to serve as a “sophisticated baseline” for all policies and frameworks to build from, regardless of focus, said Ashley Alder, Chair of the Board for the International Organisation of Securities Commissions (IOSCO), also speaking at the PRI’s Digital Conference this week.

“Once the ISSB is established, there needs to be continued dialogue to ensure the standard is accounting for developments in Europe, the US and elsewhere,” he said.

Despite current divergence, experts predict that the global standard will evolve over time, eventually incorporating double materiality-focused disclosure requirements.

“There has been some pragmatism in the development of the ISSB and global sustainability standards by focusing only on enterprise value. There is considerable hope and expectation within the investor community that this lens will broaden over time once it’s formally established,” Picot adds.

But asset owners need to exercise patience as they wait for the two reporting paths to connect.

“There is no world where ultimately double materiality is not seen as a critical component to include in all sustainability reporting across the finance sector. It’s just a matter of time,” says Bartlett.

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