Three big new sustainability reporting proposals from the US Securities and Exchange Commission (SEC), the European Financial Reporting Advisory Group (EFRAG), and the International Sustainability Standards Board (ISSB) promise to change how companies communicate sustainability information to their stakeholders. If their content is aligned then the effect will be powerful. Companies will finally have clear instructions on how to report on their sustainability impacts, risks, and opportunities, and investors and other stakeholders will be able to better track progress, compare performance, and hold companies to account. If their content is not aligned, then the status quo will continue: piecemeal reporting, inconsistencies, confusion, and limited progress towards understanding the effect of ESG matters. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions.
Central to the debate on global alignment is the concept of materiality, which is critical to determining what gets reported. What’s ‘material’ depends on the issue, the context, the time frame and the stakeholder. For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements.
While there are some obvious areas of agreement across the three sustainability reporting proposals – including their overall objectives to provide information about a company’s strategy, risks and targets for dealing with sustainability matters, and the need to look out over the short-, medium-, and long-term time horizons – there is also deep division. One of the biggest is that all three proposals define what is material in different ways. And, on the surface, this could threaten progress towards global alignment. However, there are nuances in the definitions which mean that companies may ultimately end up reporting broadly similar information under all three reporting frameworks.
In the one camp, broadly speaking, sit the SEC and the ISSB. They both support a materiality assessment based on the potential effect on the company’s enterprise value. The ISSB wants companies to think about it from the perspective of their existing and potential investors, lenders, and other creditors, while the SEC asks companies to consider whether the matter might be likely to influence an investor’s investment or voting decisions.
In the other camp sits EFRAG, which through the EU Corporate Sustainability Reporting Directive (CSRD) seeks to implement a double materiality approach, a concept which encompasses financial materiality and impact materiality. Financial materiality means that the activity has an effect on the company’s cash flows or enterprise value (consistent with the SEC and ISSB). Impact materiality means that the activity affects either people or the environment, whether directly via the company’s operations or indirectly in its value chain.
In this second article in our series on the sustainability reporting landscape, we aim to illustrate that this division needn’t be so deep, or at least needn’t derail progress towards achieving globally aligned standards.
Considering how each proposed standard might operate provides a window into their practical similarities and calls into question the notion that the materiality definitions of each of the different standard setters are irrevocably different, given the broad nature of what can affect enterprise value. Enterprise value is a global concept and is the market value of a company’s shares and the market value of its debt.
EFRAG’s definition of double materiality encompasses an ‘inward’ element (effects on the company from external sources) and an ‘outward’ element (effects the company has on externalities). If a sustainability issue is currently affecting a company’s business activities, it is likely to have an effect on the company’s cash flows over the short, medium or long term, and must be reported now. Equally, if a sustainability issue might at some point in the short, medium or long term have an effect on a company’s activities (even if it is not currently affecting the company’s cash flows), then it too must be reported now. So, for example, if a company is planning on extracting water at a rate that is not sustainable based on the volume of water available in the area, then this will certainly ultimately have an effect on their finances because in 15 years they will have run out of water to extract – or they will have to invest money sooner in exploring alternate sources of extraction. And if their rate of extraction is causing drought in a local area then in 15 years – or fewer – they must report this too, since their activities are having a negative impact on the environment.
This view of materiality doesn’t ask the company to have a crystal ball, only to think about likely future risks or events – such as resource shortages or environmental damage – that could change the way they structure their business model and, ultimately, do business. EFRAG’s proposed standard only asks that companies break the shackles of certainty and short-term thinking to report on the things that they are likely already – or should be – factoring into their business planning anyway.
The ISSB’s and SEC’s definitions of materiality are not far off from this. In practice, although worded differently (from each other and from EFRAG), they all could be expected largely to result in the same assessments of what’s material from an investor perspective – that is, factoring in what might lead to changes in future business activities and taking a long-term view. The ISSB and SEC do not, as EFRAG does, mention an ‘outward’ element: the effect the company might have on externalities such as the environment or local communities.
It is questionable whether this difference matters from a practical perspective, although arguably aligning terminology and definitions would help ensure consistent implementation and interpretation. Even without such alignment, in valuation terms enterprise value is typically determined by calculating the net present value of forecast future cash flows and takes a market perspective – which by nature encompasses all available information and takes a very long-term view (into perpetuity). Because the ISSB and SEC approaches focus solely on the effects to the future cash flows of the company, critics complain that it does not take into account certain negative impacts the company might have on the environment and society because those impacts have no calculable effect on its value. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour.
But, two subtle differences in how the ISSB and SEC both require the calculation of enterprise value mean that reporting entities using this standard would end up reporting broadly similar material information as those using the EFRAG standard.
Those subtle differences are time frame and taking a market (by definition, an outside) view.
The version of enterprise value we use in financial reporting today would consider the effect of many sustainability matters on long-term cash flows as hardly material – since they are inherently uncertain and typically have little effect on the business today. But enterprise value under the ISSB and SECs proposed sustainability standards say that what affects cash flows over the short, medium, and long term should be reported today. Thinking about the water usage example above, it’s clear that a company would end up reporting much the same information under the ISSB’s and SEC’s proposals as they would under EFRAG’s.
Firstly, the time element will force companies reporting under either the ISSB’s and SEC’s rules to include ‘outward’ impacts since, logically, the outward impact will eventually work its way inward. For example, if a company is using water at an unsustainable rate, this would have to be reported as a long-term risk to cash flows, just as it would be under EFRAG’s approach. If the company were degrading the environment by causing drought with over-extraction then clearly EFRAG’s materiality definition would require this ‘outward’ impact to be reported. But this could also be reportable under the ISSB’s and SEC’s rules, since community unrest might affect their licence to operate (and therefore their future cash flows) or injudicious extraction might lead to lawsuits for environmental degradation in 15 years’ time, again, affecting cash flows. The ISSB’s collaboration agreement with GRI further bridges the gap; a ‘no gaps, no overlaps’ approach gives a holistic picture of sustainability performance on the basis of both impact and enterprise value.
Secondly, enterprise value, by definition, takes a market view and has a long-term perspective. Taking a market view adds an element of objectivity to the materiality assessment. A company can’t consider only what it cares about; it has to take into account what others would consider when pricing the shares or debt, into perpetuity for shares and over the tenure of bonds or loans. Just like any issue that can factor into the market price for a debt or equity security, sustainability issues can affect the likelihood, timing and amounts of potential cash inflows and outflows resulting from a company’s activities over any time horizon. This includes activities that relate to other organisations in the value chain or in the sector if they could have potential consequences for the company itself. A market price also factors in today’s expectations about any potential implications that, at some future point in time, might affect a company’s legal or regulatory situation (even if only by association). Consequently, an enterprise value materiality assessment would take into account a company’s effect on the outside world to the extent that the market has knowledge of the issue and, therefore, prices it into the debt and equity securities of the company.
And so the fact that the ISSB and SEC have asked companies to see the long term as material today and in the context of a market perspective means that much of what a business considers to be its impact on the environment or society will be reflected in its consideration of enterprise value. So, in practical terms, the gulf is no gulf, but a gap. And, in practice, a small one at that.
Disagreement over definitions is just one element of the materiality issue. There are some other areas that need ironing out too before standard setters finish their work.
First, this is a rapidly evolving area and both science and social mores will mean that the items material to a business will constantly be shifting and changing. No business has a crystal ball and the provision of forward-looking information will inevitably mean that certain items, incidents and events are missed. The market must find a way to determine when this is important, and crucially, when it is not. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality.
Secondly, although climate science makes some environment-related sustainability information relatively simple to calculate and put a value on, companies will find it a great deal harder to quantify and set the bar for materiality for social and governance issues and other environmental issues like biodiversity. The actual influence of certain behaviours on cash flows are still being understood and standard models for measurement in these areas are nascent, or missing altogether. Businesses, regulators, and governments will have to convene and work together rapidly to develop them. Additionally, what is material and who is a stakeholder will likely change based on country and culture – so evaluation of impact and consideration of materiality will require sifting, analysis, and assessing tradeoffs.
Thirdly, it is the case that companies will not always know exactly who their shareholders or investors are and what they care about. The complex nature of the investment market, with some investors picking stocks for their portfolios and others being invested in index funds, means that companies have to cater to a massive array of information needs. These include what might affect investment valuation, an investment’s contribution to systemic risk, how exposed it is, and what the implications of proxy voting might be.
All of this will edge companies closer towards a materiality assessment based on both the company’s impact on the world around it as well as the potential effect on its enterprise value; in other words, and for all practical purposes, applying a double materiality concept. Consequently, this low bar for materiality will mean that the initial volume of information companies may feel under pressure to report will be massive. As with many new developments in reporting, companies will need to work out how to provide the right amount of information to the right stakeholders without overwhelming them with hundreds of pages of additional reporting. The compliance burden for companies will be high but for investors with multiple companies to monitor, the information burden will be even higher. The expectation is that this cost will be outweighed by the benefits to the market – and companies – of having more complete, transparent, comparable and reliable information on which to base resource allocation decisions.
Lastly, the fact that many companies will have to report new information and in large quantities could have the potential to cause a period of significant volatility in markets. It is likely that if companies begin to report accurately on their sustainability profile, the information they provide will be illuminatingly different from what the market thought it knew. These are difficult issues to report on, rife with judgement, and companies do not yet feel safe doing it – especially when it comes to enforcement. There will have to be a period of shared understanding between companies and their investors while companies seek to improve their sustainability credentials and refine their reporting. But investors won’t give companies a free pass and their patience will wear thin quickly if companies do not appear to take this reporting seriously.
None of these practical difficulties, however, ought to derail efforts to align. Financial reporting standards have proven to be a driving force of stability and development in our global capital markets. Sustainability reporting standards promise to do the same. Ultimately, investors and other stakeholders need access to information – both financial and sustainability-related – with sufficient transparency to be able to send the right market signals to companies about the kind of corporate behaviour they expect and will support. This then helps create the business case for companies to take action on the priorities that their investors, customers and others really care about.
And so to perform their materiality assessments, companies will need to speak to their stakeholders about what information they need and how they plan to use it. Companies need to articulate the value drivers for their business to see if they and their stakeholders are on the same page. They may find that for many issues their enterprise value and impact materiality assessments are so interlinked that for practical reasons it is not possible to split them apart.
This is a critical moment. We must focus on what unites us in agreement and we cannot afford for minor differences to get in the way of progress. Companies occasionally need to report new information and markets need to work out how to digest it. This is not unfamiliar territory – new accounting standards and regulatory reporting requirements come up from time to time. Companies and investors have, in the past and on other topics, risen to the challenge. They must do so again.
We thank Paisley Ashton-Holt, Tom Beagent, Henry Daubeney, Will Evison, Alan McGill, Andreas Ohl, Atul Patel, Naomi Rigby and Katie Woods for their insightful contributions to this article.