Responsible Investment Insights
In a nutshell:
- Last month, the International Sustainability Standards Board (ISSB), released their first draft on general sustainability and climate-related disclosures
- They both aim to provide investors with the information they need when assessing the potential impact of ESG risks and opportunities on enterprise value
The disclosure challenge
The integration of ESG and sustainability criteria into fundamental research is now the norm for leading asset managers. But despite the ongoing improvement in company disclosure, finding investment- relevant information can remain a challenge. For most investors, the lack of a universal taxonomy makes it difficult to assess the integrity of sustainable commitments - this creates avenues for ‘greenwashing’ which assessors now need to filter and identify.General and climate-related disclosures
According to the G&A Institute, 92 per cent of S&P 500 Companies and 70 per cent of Russell 1000 Companies published Sustainability Reports in 2020. This growth in sustainability reporting had been driven by regulators, coupled with increasing customer and investor demand for ESG information. This has however raised new challenges for both companies and investors in navigating and extracting material and comparable ESG information from the many ESG reporting frameworks and disclosures.
Look through a few ESG Reports and you will find glossy 100+ page documents detailing community and face-value environmental initiatives undertaken by the company. While this may help enhance brand value and employee engagement, it provides little information on how an issuer has strategically identified and prioritized ESG opportunities and risks. This is the core tenet of an effective ESG programme. Transparency in the management of key ESG risks remains a challenge.
Why the focus on ESG risks? ESG risks can impact a company’s enterprise value; affect the amount, timing and certainty of future cash flows; influence access to finance and determine the cost of capital. Compelling and meaningful ESG reporting happens when a company has outlined and identified relevant ESG risks and opportunities as they relate to the creation of long-term value. These are the opportunities the International Sustainability Standards Board (ISSB) seeks to address.
The ISSB was established by the IFRS Foundation at COP 26, and in March this year released their much awaited first draft on the General Requirements for Disclosure of Sustainability-related Financial Information (“the General Disclosures”), in addition to the IFRS S2 Climate-Related Disclosures (“Climate Disclosures”). Both the General and Climate Disclosures hope to address inconsistencies in disclosure, providing investors with the information they need to assess the impact of ESG risks and opportunities on enterprise value. The disclosures refer to and build on the frameworks established by the Climate Disclosure Standards Board, International Accounting Standards Board (IASB) , and the Task Force on Climate-related Financial Disclosures (“TCFD”) among others.
This is a very significant initiative, because once finalized, both documents will provide, for the first time and at a global level, much needed alignment and standardization in sustainability and climate reporting. Both the General Disclosures and Climate Disclosures are currently under consultation, with feedback due on 29 July 2022. The aim is for both documents to be finalized by December 2022.
Key items of note
The General Disclosures
- Similar in focus areas to the TCFD, the ISSB’s General Disclosures outline requirements on risks and opportunities relating to governance, strategy, risk management as well as metrics and targets. The framework also encourages material and industry-relevant metrics. The Sustainability Accounting Standards Board (SASB) and the Integrated Reporting Framework will soon be consolidated under the ISSB, with SASB disclosures transitioning into the IFRS Sustainability Disclosure Standards. Issuers who are currently reporting, or at minimum, mapping their existing disclosures to SASB, are likely to be a few steps ahead in aligning with these new requirements.
- Considering the uncertainties around determining emerging and long-term risks with accuracy, particularly concerning future events, the General Disclosures require an entity to disclose information on sources of information and outcome uncertainty. The ISSB notes that it is preferable to disclose this information, as this may have material impacts on a company’s financial position.
- The General Disclosures account for variations in and the evolution of methodologies in the calculation of key metrics – e.g. in human capital turnover, expecting that companies disclose assumptions and limitations of those methods, where such is made. This is also relevant to activities such as portfolio carbon foot printing, which at times relies on estimates and use of the proxies when emissions data is undisclosed. This transparency gives both issuers and investors some comfort when navigating through any challenges in sustainability accounting while providing flexibility in the use of any local methodologies or standards.
- As methodologies and assumptions continue to be refined, it is going to be the case that restatements will need to be made, whether it is due to an error in data, a refinement in methodology or a more accurate understanding of a future outcome. The General Disclosures outline a process for restating errors. This will be welcomed by companies who have sometimes grappled with how to meaningfully restate data or past disclosures in their reporting.
- New to the requirements is a statement of compliance. Where a company has complied with all the relevant requirements of the Disclosures, they are to produce an explicit and unqualified statement on its level of compliance.
The Climate Disclosures
- In regard to its Climate Disclosures, the ISSB expands on requirements in reference to the TCFD framework. Companies should disclose how their business model, strategy and cash flows are affected by climate change over the short, medium and longer term. The assessment should be in consideration of both physical and transitional climate impacts.
- Companies are expected to disclose whether they have sufficient finance to withstand climate-related risks and take advantage of related opportunities. While companies may already have in place board-level oversight of and governance around addressing climate impacts, these new requirements will see issuers place more emphasis on scenario analysis, and the creation of transition plans and strategies to achieve their targets. This would lead to a departure from high level disclosures on both physical and transitional risk to the more in-depth and descriptive analysis appreciated by investors.
- The Climate Disclosures also stipulate a requirement for absolute and intensity-based financed emissions to be disclosed, with emissions reported using the methodology from the Greenhouse Gas Protocol Corporate Value Chain (Scope 3) Accounting and Reporting Standard. This will greater harmonization of, and improve comparisons in regard to reporting of financed emissions.
Although the disclosures may evoke some initial anxiety among companies, they are an important step toward harmonizing disclosure frameworks and providing relevant information to investors. The company will be setting the foundation for meaningful reporting, and ultimately less work over the long-term.
Companies should take this opportunity to provide feedback to the ISSB and be active in relevant industry or peer-led consultations over the response period. They may also want to consider the following fundamentals in preparing for the new requirements:
- Ensure a clear internal understanding of material ESG risks and opportunities facing the business, particularly among senior management, with regular updates provided to the Board.
- Establish clear lines of accountability and ownership regarding the company’s ESG performance, particularly when identifying, addressing and/or managing relevant risks and opportunities.
- Conduct a gap analysis against the new requirements and the company’s current ESG disclosure.
- Assess the risk and/or costs of failing to meet any of these requirements, considering both reputational and possible compliance-related implications.
- Consider internal capacity, processes and/or systems to meet requirements for example data management and verification systems for the reporting of any metrics and targets.
- Assess the impact of climate change on the company’s value chain, conducting scenario analysis that aims to consider and quantify impacts on the company’s financial position.
- Where required, develop a pathway to adherence against the requirements, with clear milestones and targets.
Effective risk management is undoubtedly a value driver. It delivers resilience while allowing companies to navigate increasing uncertainty. However, ESG risks as they relate to a company’s enterprise value and financial position are not always properly assessed or understood. Asset owners and investment managers should consider the requirements an opportunity to engage with companies on their ESG journey, providing where this is needed, the overall context and rationale for why adherence to such requirements are necessary.
Investors should communicate the importance of addressing ESG risks and capitalising on opportunities in creating resilience and driving the creation of long-term value amidst sustainability challenges – whether from climate change, in ensuring business integrity, or in remaining an inclusive and just enterprise.
Investors may consider the following questions in engagements with their portfolio companies:
- Is there accountability and ownership from the board in identifying and addressing ESG risks? Is the board provided with regular updates on material ESG issues, whether through a board or management-led committee?
- Do companies have an adequate understanding of the ESG risks and opportunities they face? Have these risks been prioritized, and are they clearly articulated in the company’s ESG disclosure?
- Is the company’s sustainability strategy tied to addressing these risks and opportunities? If yes, is the management of these risks tied to senior management remuneration?
- Is the company’s ESG Report balanced and transparent in how it addresses material ESG risks and opportunities? Are disclosures comparable on a historic and sectoral basis?
- Has the company acknowledged and assessed the impacts of climate change on its business, reporting on its performance to best practice frameworks and guidance such as the TCFD?
While this is an exciting first step in the harmonization of reporting standards, there’s more work that needs to be done. It remains to be seen what alignments, if any, will be made among rating agencies and sustainability indices who often look for specific publicly available information in company ESG reports to determine ratings or index inclusion. These disclosures can result in a tick-box based approach to ESG reporting, making a company’s report appear contrived and adding to reporting complexity.
Following the finalization of the disclosures later this year, we will soon see which jurisdictions will adopt the requirements. Initial interest has been encouraging, with a statement published by the British government noting 38 jurisdictions that welcomed the proposed requirements, including China, Brazil, the European Commission and the United States.
It is now up to both companies and the investor community to express their feedback on these proposed requirements, which will be essential in ensuring the relevancy of these disclosures.
Overall, this is a momentous step and an exciting initiative that is set to provide much-needed clarity and a pathway toward effective ESG strategy and disclosure.