The EU, the ISSB and the quest for better sustainability data: substance and materiality are more important than international alignment
Eurosif head Victor van Hoorn on why current plans for global ESG reporting standards won’t move the market in the right direction fast enough
Imagine you want to understand the sustainability profile of food companies: do you compare companies’ financial resilience to extreme weather events? Or do you look at the company with the least negative impact on biodiversity, for example relying on diverse crop rotation rather than monocultures? In the case of a manufacturing company: do you want to know the financial impact of a carbon price on its operations? Or do you want to understand the extent of its absolute emissions, so you can fully understand its impact on climate as well as the impact of future carbon price hikes? Ideally, the answer to all these questions which allow you to understand the company’s resilience to environmental, social and governance (ESG) risks and its impact on the environment and society.
As COP26 drew to a close with cautious optimism, it is clear that a significant gap exists between actions, promises and what is actually needed. To ensure that these actions are taken rapidly enough, we urgently need decision-useful information to steer the right types of public and private investments. Currently, this is lacking in terms of quality, quantity and comparability. An internationally coherent set of reporting requirements which helps producing comparable, decision-useful sustainability information across jurisdictions and companies is therefore vital.
A globally harmonised standard will by default only be at best a consensus driven minimum common denominator found at international level.
On 3 November, the IFRS Foundation announced the formation of the International Sustainability Standards Board (ISSB) to develop “a comprehensive global baseline of high-quality sustainability disclosure standards”. While Eurosif applauds efforts towards internationally more coordinated and coherent sustainability reporting, it is worth having a thorough look at the ISSB’s approach.
A focus on enterprise value is too narrow - only a double materiality approach will provide the forward-looking, decision-useful information
For a start, the standards produced by the ISSB will focus on enterprise value, looking at the impact of sustainability factors on the financial health of a company. This means that information reported pursuant to this standard will only answer your questions regarding the agri-food and manufacturing company related to the financial health of the company, while leaving the other questions wanting for an answer.
An enterprise value approach risks omitting information on impact and important negative externalities that might be caused by the company but are financially immaterial as they are incorrectly priced. Only a sustainability reporting system based on ‘double materiality’ – providing information on how sustainability issues affect the company (financial materiality), as well as on how the company impacts the environment and society (environmental and societal materiality) – will provide the information and level of transparency necessary for stakeholders to fully understand a company’s sustainability performance. The ISSB therefore is too muted in its ambitions.
Disclosure of the right information should be our aim, not global harmonisation
As with any global initiative, a key question is always how the ISSB standards will interact with local or regional initiatives that are different in scope, focus or subject matters. A globally harmonised standard will by default only be at best a consensus driven minimum common denominator found at international level. This may explain the initial focus on enterprise value: it would be currently impossible to reach a similar consensus on impact materiality. And negotiations to expand the scope to cover biodiversity, nature and social issues may rapidly result in a deadlock.
The ISSB standard could be of more limited value for certain jurisdictions. It is quite different, for example, from the EU’s more ambitious ‘double materiality’ approach in its proposal for a Corporate Sustainability Reporting Directive (CSRD) and the mandate given to expert body EFRAG to draft detailed reporting standards.
In the EU, the Taxonomy Regulation and EU Sustainable Finance Disclosure Regulation (SFDR) introduced absolute sustainability performance measurement for sectors through Technical Screening Criteria and Principal Adverse Impact indicators, which apply regardless of whether they are financial material. Companies and investors facing these reporting requirements will need more information than the ISSB standard is likely to provide. Therefore, they will have to use the standards produced by the EFRAG, which in turn are will likely draw more on those produced by the Global Reporting Initiative - whose perspective is more closely aligned.
We urge the EU co-legislators to accelerate the negotiations of the CSRD proposal
If a hierarchy must be made between full international harmonisation around enterprise value and fragmentation following some jurisdictions’ more ambitious push for double materiality, it is clear to us that the substance of the reporting requirement is more important than full harmonisation and alignment.
Moving urgently from voluntary reporting to mandatory reporting, by law
The current landscape of voluntary reporting, combined with an increasing number of private reporting initiatives has resulted in the generation of incomplete, unverified and incomparable information that is not decision-useful to investors and financial markets. As the ISSB announcement notes “Voluntary reporting frameworks and guidance have prompted innovation and action, although fragmentation has also increased cost and complexity for investors, companies and regulators.”
This forms the very reason for policymakers and regulators to intervene in proposing mandatory sustainability disclosures enshrined in public law. Evolving reporting requirements from voluntary requirements, with a certain discretion is implicit, towards mandatory requirements, whose infringement might result in fines, is likely to dramatically improve the quality of reporting.
And here the ISSB standards may face a challenge. The standards will only become law once their adoption is mandated in the local legislation of each jurisdiction. If the adoption of ISSB standards follows the same endorsement as with IFRS IASB standards, it can reasonably be expected that implementation of any ISSB standards in binding local legislation will take several years in some cases. When dealing with pressing sustainability challenges such as climate change, excess time is unfortunately a luxury we do not have. And differing timetables for implementation across jurisdiction may yet result in fragmentation rather than harmonisation.
The EU needs to speed up the CSRD process, now
What should the implication of the ISSB announcement be for the EU? The EU should continue to direct its attention to the adoption of an ambitious CSRD proposal, complemented by a robust set of sustainability reporting standards developed by EFRAG which have the right objective and scope: double materiality across a holistic view of sustainability, including climate change, biodiversity and social indicators. It should then use this to push the ISSB to gradually raise its ambition level in the years ahead.
And here accelerating progress is key. The European Commission has done its part of the work, publishing its proposal in April of this year, underlining the importance of this work, also to smoothen the implementation of the EU Sustainable Finance Action Plan. We are now in mid-November and we still do not have a clear timetable from the EU co-legislators, the European Parliament and the EU Member States in the Council to accelerate their work. Therefore, we urge the EU co-legislators to accelerate the negotiations of the CSRD proposal. Seeking to end on a positive note following COP26, building a reporting framework that generates high-quality decision-useful sustainability information should be a relative quick win for policymakers, compared to some of the profound structural changes to our economies that will be required to successfully tackle climate change.
Victor van Hoorn is the Executive Director of Eurosif, Europe’s sustainable investment forum.