No Match Found
By Nadja Picard, Global Reporting Leader, PwC Germany
In recent years, a broad-based consensus has emerged that businesses must behave sustainably. Simply put, this means that investors, consumers, suppliers, and others expect businesses to focus on the long term and not to make the solutions of today the problems of tomorrow. And that matters in all contexts of what the business might touch, whether it’s the environment, the economy, its employees or its local communities. Businesses are expected to take a holistic approach to managing their operations, being mindful not only of commercial implications but also of the potential effect on their stakeholders, today and over time. Being a sustainable business is now an essential component of being a successful business.
And there is a growing opinion that in order for a business to demonstrate its success, it needs to provide its stakeholders with more than the financial statement measures our economy has traditionally used to assess corporate performance. The challenge today for businesses and their stakeholders alike is that the metrics and narrative that sit outside financial reporting need to produce information that is just as robust: they should be prepared, assured, engaged with, and used in a similarly robust way – or they will always play second fiddle to profit. Indeed, it could even be argued that the primary focus of company reporting should be on its sustainability – in a broad sense – with its financial performance forming one part of that, along with its performance in managing environmental, social and governance matters. And so the International Sustainability Standards Board’s (ISSB) sustainability disclosure proposals are an excellent starting point for giving that much needed, more holistic picture of corporate performance.
But beyond this, the consensus dissipates. Although much progress has been made in many jurisdictions around the globe to require companies to report information not only about financial performance but about how that performance was achieved and how sustainable it might be – what’s its business model, strategy, risks, governance and oversight. Yet there’s still no agreement on how to measure corporate performance beyond using financial metrics like share price returns and profit, how to determine what’s material to the business beyond using financial thresholds and how to determine which stakeholders matter most to the business beyond its shareholders. Many companies currently lack the systems and data needed to report on a broader definition of performance, even voluntarily; they also lack a robust and globally-aligned set of reporting standards to ensure they are reporting what investors and other stakeholders need to know, and in an understandable, clear and comparable way.
This lack of consensus has so far presented an enormous challenge to standard setters and policymakers keen to develop new reporting requirements. And it has challenged the companies trying to prepare and report on their sustainability performance as well as the investors trying to understand the information and base decisions on it. The result? Companies are reporting more and more information, yet investors are still asking for ‘more’. Standard setters have tried to answer that call, but the result until recently has been a proliferation of different reporting standards, each with their own agenda, angle and rules.
Finally, though, an opportunity for practical consensus on sustainability reporting standards has arrived. The body that oversees the largest accounting standard setter in the world, the International Financial Reporting Standards Foundation, has formed a new board for sustainability reporting, the ISSB. The ISSB’s recent proposals on sustainability and climate disclosures have the potential to bring together the financial performance measures that capital markets have traditionally relied on and the sustainability-related financial information that complements them. This is just the first step; the ISSB plans to move beyond climate reporting to encompass other areas of sustainability next year.
Given the magnitude and pervasiveness of the issues being discussed, the US Securities and Exchange Commission (SEC) and the European Financial Reporting Advisory Group (EFRAG) are developing their own rules for sustainability disclosures. Although it is positive to see an increasing focus on sustainability reporting around the world, there is a growing risk that multiple jurisdictions will develop their own sets of standards – some focused on information useful to investors and others also focused on information useful to a wider group of stakeholders. This could lead to different frameworks which will be costly and inefficient for companies to implement and difficult for investors and other stakeholders to interpret and act on. For those reasons, we need to do all we can to achieve global alignment of sustainability reporting standards, with the ISSB standards as a global baseline. Jurisdictions that have particular concerns or priorities can include their own local regulatory overlay as an addition to the baseline.
But there are two critical barriers to achieving the global alignment we need so badly because of differences in opinion on what should be reported and to whom: materiality and impact. We will explore each of these in more detail in future articles, but here we’d like to set out what the issues are and why they are so important.
The first barrier is agreement on what is material in the context of sustainability reporting. Assessing materiality is not always easy in a financial reporting context, but we’ve had years to come to grips with how to do it and to develop rules of thumb that make its application practical. It’s also more straightforward because, from a financial reporting perspective, materiality is assessed through the eyes of one stakeholder group: investors and creditors, the primary users of financial statements.
However, there is disagreement about how to define materiality in a sustainability context. This is a critical aspect of sustainability reporting because it determines what gets reported. For a variety of reasons, the three reporting proposals describe materiality in different ways:
The ISSB proposes assessing materiality in a financial (or monetary) context, relative to its potential effect on enterprise value, from the perspective of a company’s existing and potential investors, lenders and other creditors (that is, the same primary users of its financial statements).
The SEC also proposes assessing materiality in a financial (or monetary) context on the basis of whether the matter is likely to influence an investor's investment or voting decisions.
EFRAG proposes assessing it from two perspectives (‘double materiality’): financial or impact (or both). Financial materiality means that the activity has a financial effect on the company, generating risks or opportunities that can influence its future cash flows, and therefore its enterprise value. Impact materiality means that the activity has an effect on people or the environment, whether by the company’s own operations or in its value chain.
Although they all describe materiality differently, there is significant overlap between them, particularly because they all refer to assessing materiality in the context of a sustainability issue’s effect in the short, medium and long term. The three proposals also acknowledge that some of these issues are intertwined: an issue that negatively affects local communities or the planet can damage a company’s brand and thus have a negative financial impact. So they aren’t actually miles apart. Because of this, we believe that the debate over materiality definitions and concepts should not be a reason for not achieving global alignment.
The second roadblock is with regard to assessing a company’s impact on the world around it. Given that its impact can have financial implications on the business, a company’s impact on people and planet is critical information for investors. But not all impacts have estimable cash flow outcomes and therefore won't all be material from a financial or traditional enterprise value perspective. For example, there is little if any direct cost of enhancing the diversity of the board of directors. That doesn’t make the information, or issue, unimportant; in some cases society or the environment pays the price, even if companies, their investors and some other stakeholders don’t.
There are two reasons why information about a company’s impact is important:
Assessing the aggregate impact of an investment portfolio. This helps providers of capital to assess what they are providing finance for and steering it away from where they don’t want it to go.
Understanding the financial implications of actions companies take now and in the future. By considering how today’s externalities (such as pollution or noise) may become internalised tomorrow (whether through regulation, stakeholder pressure or changing business conditions), businesses and investors alike can make more informed decisions.
Taking climate change as just one example, an enormous amount of capital is needed to fund the transition to net zero – by businesses, investors, governments and others – and users of sustainability reporting will need to be able to assess the impact that their association with a business is having. Such information would help businesses attract capital, customers and talent. So far, investors, customers and employees – and indeed, many companies – have been making these decisions on the basis of incomplete knowledge. But that won’t last. In the future, capital and talent will rather flow to companies that can demonstrate both financial success as well as positive ESG impact, and one way to do that is through credible corporate reporting.
The barrier is that impact is often assessed qualitatively and is in some cases in the eye of the beholder. A negative impact to one stakeholder group can be beneficial to another and vice versa. For example, the tension between closing a mine and protecting the livelihood of the workers. Practically, it’s difficult to ascribe a value to a company’s impact on the world around it until there is a perceptible effect on cash flows or discount rates. This doesn’t fit into our traditional valuation models, although some academics and others are looking to revise some elements of finance theory to accommodate it. Opinions may differ, but what’s certain is that, to talk about sustainability, including impact, we need a common language that business understands.
Being able to measure a company’s negative and positive impact on the world around it in financial terms would allow like-for-like comparison across sustainability issues and across companies. But while working out a price or value for a company’s impact has conceptual merit, there are a number of practical issues that will need to be worked out before it can be considered a useful and trustworthy basis for making business, investment and other decisions. If the ISSB, along with the Global Reporting Initiative (GRI), can work toward how to report on a company’s impact more consistently, this could be the baseline for incorporating impact into sustainability reporting globally. The ISSB and GRI cooperation agreement would create a ‘no gaps, no overlaps’ approach, giving a holistic picture of sustainability performance on the basis of impact and enterprise value, including explaining how these can converge over time as externalities become internalised.
We are at a critical point in the evolution of corporate reporting. Sustainability disclosures need to be in a common language that business and investors understand – a language that describes company performance holistically. Investors and other stakeholders need access to information 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 investors really care about. If we miss this opportunity to achieve global alignment in reporting, resulting in corporate reports that don’t meet the needs of the market, our collective efforts will be abandoned – the consequences of which would be dire. Clearly this isn’t easy but that doesn’t mean we shouldn't try.
The ISSB’s proposals are an excellent starting point on the road towards a common language of sustainability for business, and we need to ensure they are understandable, practical and give the information investors and companies need to work towards solving the world’s biggest problems. We finally have the impetus, the technology, and a fragile consensus to help codify the means and method of disclosure – but this will only work if everyone gets involved and supports global alignment. Because we all have a part to play in this, and we can’t let this moment pass us by – stakeholders need to make their voices heard, and help the ISSB get it right, the first time.
I thank Henry Daubeney, Hilary Eastman, Andreas Ohl, Susanne Stormer and Katie Woods for their insightful contributions to this article.