The world is finally moving on sustainability-related reporting by businesses. Particularly, EU and international standards on companies’ disclosure are creating strong tailwinds for them to consider climate-related risks. While these standards have common objectives, they differ in their approach to the information that should be disclosed. This blog aims to help navigate this discussion by going beyond the political tensions between these two approaches.
Two parallel initiatives are currently underway to define these disclosure standards. One is from the European Financial Reporting Advisory Group (EFRAG) in the EU. The other one comes from the International Sustainability Standards Board (ISSB) at the international level. Both initiatives seek to provide investors and capital markets participants with transparent, reliable, and comparable information about companies’ sustainability risks and opportunities. However, a fundamental difference remains in their respective approaches to which information should be considered relevant – or “material” – to disclose. These differences reflect a wider political debate between the two approaches.
ISSB and EFRAG: diverging approaches to ‘materiality’
The major divergence between the ISSB and EFRAG approaches lies in what type of information they consider material, i.e. requiring disclosure to the public and impacting investors’ decisions.
- The ISSB adopts a financial materiality perspective. This considers that only information providing insights on climate-related financial risks affecting companies’ value is relevant to investors. For instance, how climate change can negatively impact a company.
- EFRAG follows a double materiality perspective. This also considers the impact of companies on, for instance, the environment to be material (“impact materiality”) and thus requiring disclosure to the general public.
ISSB as a baseline to build international coherence
This difference should not impede global cooperation and interoperability between both approaches. A global baseline for financial risks and opportunities reporting is critical to providing consistent, comparable, and reliable information that meets the needs of investors and serves the public interest. The “Financial Risk to Companies’ Value” is a widely understood concept against which companies could organize their sustainability reporting worldwide. This must stay the focus of this global baseline approach, as proposed by the ISSB.
What would this mean for the European approach? EU regulations already require double materiality disclosures via the EU Taxonomy Regulation, the Sustainable Finance Disclosure Regulation (SFDR) and the review of EU’s rules on sustainability reporting (CSRD). This creates a supportive legal environment to double materiality disclosures that is not shared or replicable internationally. With ISSB operating as an international baseline, EFRAG can align their financial materiality indicators so that both approaches become interoperable on this front. EFRAG can then build upon this basis to require additional disclosures in line with double materiality.
Beyond the opposition between financial materiality and impact materiality
However, ISSB standards as a global baseline can also incorporate aspects of impact materiality when relevant to assess risks on companies’ value. For that, it can draw inspiration from regional and international initiatives. Indeed, it is increasingly clear that companies’ activities that are harmful to the environment can lead to financial risks over the long term.
ISSB and EFRAG standards already share common indicators that could go beyond the debate on materiality and focus on the notion of impact on companies’ value. This is for example the case of greenhouse gas emissions indicators. These indicators show companies’ exposures to the risks related to greenhouse gas emissions across their value chain. They also inherently reflect these companies’ impact on the environment, which in turn also creates financial risks to companies’ value.
What is the way forward?
EFRAG and ISSB frameworks have more common approaches than initially meets the eye. This means that coordinating a coherent framework for sustainability disclosures is possible. However, it will need to go beyond the opposition between financial and impact materiality, which will necessarily take some time.
Both EFRAG and ISSB have ambitious timelines. They aim to publish their final standards by November 2022 and the end of the year respectively. However, EFRAG and ISSB representatives should continue their dialogue and align their work pace to bring coherence between their respective standards.
Coordination will be important to create a coherent reporting system avoiding both market fragmentation and double reporting in jurisdictions with higher standards.