The Biggest Change In Corporate Reporting Since The 1930s: How To Read IFRS Prototype Sustainability And Climate Standards

Public company reporting took a giant leap yesterday—the largest since the Great Depression. While the SEC is still contemplating its sustainability disclosure requirements, yesterday IFRS Foundation FFWM published prototype international climate sustainability reporting requirements.  

Following the stock market crash of 1929 and the Great Depression, the US government established the Securities and Exchange Commission (SEC) and gave it authority to set and enforce accounting practices to prevent the opaque and fraudulent public company reporting that contributed to the Great Depression. This represented a sea change in corporate reporting.  

As the pace of change in accelerated in the decades that followed, corporate reporting gradually untethered from the realities of business. Feng Gu and Baruch Lev explain that “today’s financial reports provide a trifling 5% of the information relevant to investors.” To illustrate, intangible assets—skilled workers, client relationships, patents, organizational processes, and brands—have come to represent 90% of the market value of the S&P500 and generate most corporate growth. Despite the growing dominance of intangible assets, many of them, such as people—ostensibly a company’s most important asset—are deemed expenses, rather than assets. Yesterday, investors moved one step closer to being able to accurately price intangibles and access information about material environmental and social factors that drive long-term value creation. 

More specifically, yesterday the International Financial Reporting Standards (IFRS) Foundation, which governs financial reporting in more than 140 countries, announced the formation of the International Sustainability Standards Board (ISSB) to develop a global baseline of sustainability disclosure and a commitment of leading investor-focused disclosure organizations to consolidate into the new board. The IFRS will complete the consolidation of Value Reporting Foundation — the recently merged entity uniting the Sustainability Accounting Standards Board (SASB) and International Integrated Reporting Council (IIRC) — and Climate Disclosure Standards Board (CDSB), an initiative of the Carbon Disclosure Project, by June 2022. The move to merge together the Value Reporting Foundation—until recently the two distinct entities SASB and IIRC—and the Climate Disclosure Standards Board within one sustainability standard-setter ensures that ISSB will have strong intellectual property and people right out of the gate and addresses investor and financial regulator demands for greater alignment among environmental, social and governance (ESG) frameworks. The new International Sustainability Standards Board is expected to develop and maintain a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.

The Shot Heard Round the World: IFRS Prototype Climate and General Disclosure Requirements

IFRS Foundation also published prototype climate and general disclosure requirements, a unified set of recommendations developed over six months by representatives of the CDSB, the International Accounting Standards Board (IASB), the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), the VRF and the World Economic Forum (Forum), supported by the International Organization of Securities Commissions (IOSCO) and its Technical Expert Group of securities regulators.

Value Reporting Foundation CEO Janine Guillot explains that the developments recognize “the vital importance of robust, credible, comparable information to enable efficient and resilient capital markets that support sustainable economic growth.” In the absence of SEC sustainability disclosure requirements, numerous nonprofits worked to fill the regulatory vacuum. The prototypes reflects their decades of careful work. Once the ISSB hones the prototype climate and general disclosure requirements into comprehensive sustainability disclosure standards for the global financial markets, these standards will impact US corporate ESG disclosure as US issuers seek to tap international capital markets. 

General Requirements for Disclosure of Sustainability-Related Financial Information Prototype

The prototype includes (i) an annual requirement to disclose a complete, neutral, and accurate depiction of an entity’s significant sustainability risks and opportunities as part of the entity’s general purpose financial reporting; (ii) a definition of material information, including an entity’s impacts on society and the environment that could reasonably be expected to affect the entity’s future cash flows and events considered to have low likelihood but high potential impact on the entity’s future cash flows; (iii) a consistent approach for disclosing significant sustainability-related risks and opportunities that consider an entity’s governance, strategy and risk management and supported by metrics and targets; and (iv) further requirements and guidance that support the provision of comparable and connected information.

Governance. Sustainability-related financial disclosures on governance facilitates understanding of governance processes, controls and procedures used to monitor and manage sustainability-related risks and opportunities. This includes a description of the body or bodies with oversight of existing and emerging sustainability-related risks and opportunities, and of management’s role with respect to existing and emerging sustainability-related risks and opportunities.

Strategy. Entities are required to communicate their strategy to address significant sustainability-related risks and opportunities. Disclosure requirements include the sustainability-related risks and opportunities that entities reasonably could affect its business model, strategy, and cash flows over the short, medium, or long term; the impact of significant sustainability-related risks and opportunities on business models, on management’s strategy and decision-making, and on its financial position, performance, and cash flows at the reporting period end and anticipated over the short, medium, and long term; and the resilience of the entity’s strategy to significant sustainability-related risks.    

Risk Management. These disclosures reveal how an entity’s existing and emerging sustainability-related risks are identified, assessed, managed, and mitigated and whether those processes are integrated into existing risk management processes. Disclosures include the process by which sustainability-related risks are identified and assessed; clarity on how each significant risk is being monitored, managed and mitigated; and how these sustainability-related risk identification, assessment and management processes are integrated into the entity’s overall risk management process.

Metrics and Targets. Metrics and targets explain how an entity measures and monitors its significant sustainability-related financial risks and opportunities. Entities are required to disclose cross-industry, industry-based, and activity metrics; targets set by its governance body or bodies; and other key performance indicators used to measure progress toward targets. Cross-industry metrics are relevant regardless of industry and business model, industry-based metrics are relevant to entities within an industry, and activity metrics facilitate normalization of cross-industry and industry-based metrics and facilitate comparison. Activity metrics include number of employees, amount of product sold, and retail space. Metrics, key performance indicators, and targets are required to be clearly labeled and their definitions and methodologies to be consistent over time.  

Climate-Related Disclosures Prototype

IFRS uses the recommendations by the Task Force on Climate-related Financial Disclosures as its starting point for its Climate-Related Disclosures Prototype. It includes the same governance, strategy, risk management, and metrics and targets sections as in its General Requirements for Disclosure of Sustainability-Related Financial Information Prototype with similar language. The metrics and targets section contains much more granular detail. 

Cross-Industry Metrics Disclosure Requirements.     

·      Greenhouse gas emissions: absolute gross Scope 1, Scope 2 and Scope 3, expressed as metric tons of CO2 equivalent, according to the Greenhouse Gas Protocol, and emissions intensity

·      Transition risks: the amount and percentage of assets or business activities vulnerable to transition risks

·      Physical risks: the amount and percentage of assets or business activities vulnerable to physical risks

·      Climate-related opportunities: the proportion of revenue, assets or other business activities aligned with climate-related opportunities, expressed as an amount or as a percentage

·      Capital deployment: the amount of capital expenditure, financing or investment deployed toward climate-related risks and opportunities, expressed in the reporting currency

·      Internal carbon prices: the price for each metric ton of greenhouse gas emissions used internally by an entity, including how the entity is applying the carbon price in decision-making

·      Remuneration: the proportion of executive management remuneration affected by climate-related considerations in the current period

Climate-Related Targets. Entities are required to disclose their climate-related targets; the objectives of the targets; and whether the targets are absolute or intensity-based, science-based and validated by a third party, and derived using a sectoral decarbonization approach; the timeframe over which the target applies; the base year from which progress is measured; any milestones or interim targets, and metrics used to assess progress. 

Conclusion

IFRS Foundation’s formal launch of the International Sustainability Standards Board, consolidation with leading sustainability standard setters, and publication of the prototype climate and general disclosure requirements are important steps along the road to comprehensive sustainability disclosure standards for the global financial markets. Rigorous due process, including public consultations, will follow, and the EU’s reaction to ISSB-driven standards will be important. The standards remain a space to watch and to commit time to publicly comment on.