Global challenges such as climate change, biodiversity loss and social issues are increasingly core issues for companies, and society at large. Conor Holland and Colm O'Se of our Sustainable Finance team discuss these challenges below.
The nature of these risks and the drivers of value for companies today mean that broader information – outside of solely financial metrics – is essential for resilient business and sustainable investment decisions. Companies are therefore responding to these risks and opportunities by providing more environmental, social and governance (ESG) information in their corporate reporting. While there have been significant enhancements in the nature and extent of ESG disclosures provided by companies in recent years, they are too often inconsistent and uncoordinated – owing to the difference in focus and targeted audience of the various reporting frameworks developed and adopted. The proliferation of sustainability reporting frameworks and standards developed in recent years is leading to confusion and the potential for ‘greenwashing’. For an effective response to the global challenges of our time, and to address stakeholder demands, sustainability reporting needs to be harmonised and interconnected with financial reporting. Investors are now calling for convergence and a single framework that will bring consistency and comparability.
Conceptual frameworks typically underpin the development of standards. The development of sustainability standards is likely to require a conceptual framework that may either derive from the coordination of current sustainability frameworks or be entirely new. Many stakeholders have argued that the principles of the existing financial reporting conceptual framework should be interconnected with a sustainability reporting conceptual framework. The conceptual framework for financial reporting (IFRS) achieves this for financial reporting.
Given the IFRS Foundation has existing standard-setting expertise, and recognising that IFRS incorporates many of the key concepts that would be relevant in the measurement of long-term company value – such as materiality and integrated reporting – some have suggested that the IFRS foundation could achieve greater consistency in global sustainability reporting. The IFRS Foundation has responded, and in October 2020 issued a public consultation on the need for a global set of internationally recognised sustainability standards, and to gauge support for its role in developing such standards.
Some readers may believe that financial reporting shares little in common with ESG or sustainability reporting; however, IFRS Standards already require companies to consider climate and other ESG risks and make judgements about providing disclosures on these issues in their financial statements. Sustainability information therefore seems to be a natural extension of its existing mission.
To develop a uniform set of sustainability standards, consistent with financial reporting standards, the IFRS foundation is exploring the merit of establishing a new Sustainability Standards Board (SSB) with an institutional and governance structure consistent with its financial reporting standard setter, the International Accounting Standards Board (IASB). Similar to the IASB, the new SSB could seek to establish a conceptual framework for sustainability reporting and provide clarity in key areas such as materiality and assurance on sustainability information.
Climate change affects businesses in various industries as global and local policy actions around climate change continue to evolve and given the growing demand by investors for climate-related information for their economic decision making. Climate-related events or conditions may impact an entity in terms of its business model, its operations and processes, and its ability to raise finance or attract investment and customers. Most, if not all entities, are likely to be impacted by climate change; directly or indirectly. Given the urgency associated with climate risk, the IFRS foundation has noted that developing global sustainability‑reporting standards for climate-related information would be their most pressing concern, and therefore any initial work to be undertaken by the SSB should address climate-related risks first. However, while the initial focus on sustainability standards is expected to be pivoted toward climate risk, it is envisaged that the SSB would ultimately broaden its remit over time to focus on other priorities beyond a specifically climate or environmental focus – for example into social and other related matters.
In November 2019, the IASB published a paper which clarified how the existing IFRS requirements may address material climate change risks (the IASB paper). It explained that as IFRS Standards are principles-based, climate change is not explicitly referred to in the requirements; however, despite this, IFRS standards do in fact address material climate change matters. According to IAS 1.7 “information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a reporting entity”. IAS 1.7 further clarifies that when assessing whether matters are material, judgement is required based on the nature or magnitude, or a combination of both. As such, an item of information could influence primary users’ decisions regardless of its size. In the context of climate-related matters, the IASB paper clarifies that stakeholders may expect disclosure in the financial statements. As a result, material climate-related matters may need to be reflected in the amounts recognised in a company’s financial statements and / or require disclosure in the relevant notes to the financial statements.
Similarly, auditors are increasingly considering the implications of climate-related matters as part of their own processes and professional responsibilities. The International Auditing and Assurance Standards Board (IAASB) has recently clarified how existing International Standards on Auditing require consideration and assessment of climate-related risks in an audit. As with other risks, if climate-related risks have a significant impact on a company, the auditor will consider whether the financial statements have appropriately reflected this in line with the relevant accounting standards. Equally, auditors will also read and consider other information presented in the front half for any material inconsistency with the financial statements.
Challenging as it may be, companies can no longer avoid considering, quantifying, and reporting on material climate-related matters. A range of forward-looking information is already embedded in financial reporting in areas such as fair value accounting, impairment testing, the measurement of provisions and the recognition of contingent liabilities. Such forward-looking information is a collection of judgements and estimates, based on the best information available to preparers. Climate risk is another matter that should be considered, like any other material risk to a business.
As outlined in this article, the growing recognition that stakeholders need to understand both financial and non-financial information together, for better insight into a company’s performance and dependencies, is expected to ensure we reach a point of more comprehensive form of corporate reporting in the near term. Climate change, the global pandemic and the increasingly clear connection between sustainability performance and financial risk and return are driving the urgency. The move toward a global interconnected solution is supported for many reasons, including:
Ultimately, the development of sustainability-related financial disclosure standards – which will likely come from the IFRS foundation – should enable stakeholders to understand how material sustainability matters create or erode value for a company. A connection between sustainability reporting and financial reporting should deliver a more coherent and comprehensive corporate reporting system in a way that meets the needs of all stakeholders.