Towards a global sustainability disclosure standard
Raising awareness about sustainability-related risks and opportunities has increased the demand for global sustainability reporting standards, since they have been recognised as pillars to solving the coming climate disaster.1 The central assumption behind disclosure is that exposing companies' risks and opportunities to scrutiny will shift capital from carbon-intensive assets to low-carbon ones. To some extent, these expectations are rooted in the efficient market's hypothesis, which might be over-valued due to disclosure requirements' voluntary nature and the deficient comparable information across sectors and regions. Hence, the need for a global standard is decisive to reduce greenwashing and align finance with ambitious sustainability targets.
In the light of the urgent need to improve the global consistency and comparability of entities’ sustainability disclosure, the International Financial Reporting Standards (IFRS) Foundation, which rules financial reporting in more than 140 jurisdictions, announced at COP26 the creation of the International Sustainability Standards Board (ISSB). This declaration has been considered a significant step forward since the new organisation aims to consolidate ESG reporting standards suitable to support regional and national regulations.
Notwithstanding the priority given to climate disclosure standards, the IFRS is also paving the way for guidance related to general sustainability information. In this regard, the IFRS released the prototype of General Requirements for Disclosure of Sustainability-related Financial Information (IFRS Prototype). The document outlines a set of guidelines for providing decision-useful information about entities’ exposure to sustainability-related risks and opportunities influencing the valuation of entities.
The forthcoming ISSB standards have been praised as a cutting-edge tool to curb global warming and accelerate a sustainability transition towards a net-zero economy. The IFRS Prototype defines three critical concepts concerning sustainability-related risks and opportunities: materiality, reporting entity’s boundary, and connectivity. It also builds on the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations on features such as governance, strategy, risk management, and metrics and targets.
Enterprise value and sustainability
The landmark declaration of the IFRS is also a response to the IMF Global Financial Stability Report 2021, which urged policymakers to consolidate the climate information architecture to reinforce the alignment of capital flows with climate goals. Moreover, the ISSB has been received with optimism by stakeholders from capital markets once the Glasgow Climate Pact reaffirmed the global commitment to limit global temperature rise to well below 2ºC.
Evidence points that one of the most significant challenges of the ISSB is the identification of material data since it is the bedrock of sustainability corporate reporting. To approach this issue, the IFRS Prototype suggests that material information refers to insights into factors that could influence the entities’ enterprise value from an integrated thinking viewpoint that considers the creation, preservation, or erosion of value over the short, medium, and¡ long term. However, from a legal perspective, US courts have argued that materiality must be decided on a case-by-case basis since the corporation itself determines it.10 Therefore, the ISSB should assume the dynamic nature of materiality, which can be addressed by local adaptation and supplementary standards.
The IFRS's pragmatic approach focuses on enterprise value, which reflects the investors' assessments of future cash flows. Hence, the IFRS emphasises that not all sustainability matters necessarily affect the entities' business models. The reporting should only consider the drivers of enterprise value, including impacts from the entities' supply chains. The type of information covers factors such as climate change, water and land use, or biodiversity. Furthermore, the connectivity between the sustainability-related financial disclosures and the general-purpose financial reports has been remarked as essential to identify dependencies and trade-offs that affect the business model.
Improving accountability of transition financing products
Any transition plan requires a set of measurements to determine the possible pathways towards a sustainability transition. Therefore, the ISSB standards arrive at a critical time to boost the emerging transition financing products and services. Over the last decade, the link between disclosure initiatives and the reallocation of capital into low-carbon investments has appeared weak. Even though transition finance recognises the importance of robust, credible, and comparable information, the issuance of assets such as sustainable fixed-income instruments has not been relevant to accelerate a sustainability transition, especially in emerging markets.
The ISSB work can support the expansion of the transition finance markets. Remarkably, sustainability-linked financing instruments such as bonds and loans can take advantage of the global sustainability disclosure standards in two ways. Firstly, these new asset classes tie the interest rate with sustainability performance targets at the entity level. To improve the pricing mechanism, issuers should integrate ISSB guidelines about the material information from a catalogue of cross-industry and industry-based metrics. Secondly, the ISSB standards can join a framework to report transition plans based on key performance indicators associated with the enterprise value. As a result, short- and medium-term targets could be aligned with long-term ones. In this regard, the IFRS Prototype already recognises the interrelations between capital providers and counterparties that influence the creation or loss of entities’ value and the financial returns to capital providers.
Nowadays, there is a significant concern about the proper channels to allocate the necessary capital, who should receive it, and most importantly, how to ensure it will be used effectively. It seems that the labelling is not sufficient to count green bonds or loans as transition finance. Consequently, the sustainable debt market should evolve beyond labels and give more importance to the incentive structures between capital providers and counterparties as well as the right key performance indicators that will deliver ambitious sustainability outcomes aligned with a just transition.
The standards’ harmonisation progress should be reflected in the financial engineering of the deals in transition financing products. The gradual adjustment is possible in sustainability-linked bonds and loans arrangements since they require annual reassessments of metrics and targets tied to margin or coupon ratchet. Entities that did not establish transition plans from the beginning can easily correct their financing framework according to the ISSB standards in addition to the principles from the Loan Market Association and the International Capital Market Association.
Additionally, the ISSB standards may improve the transparency of private markets such as loans and leverage finance since the market participants will need to comply with accountable metrics and targets to address sustainability-related risks and opportunities to access credits with lower interest rates. Deals will be subject to greater scrutiny, but companies can take advantage of funding options from financial providers of capital that are integrating ESG standards. Furthermore, sustainability-related risk and opportunities can trigger sustainability-oriented innovations and become a competitive attribute for corporations, as demonstrated in a rising number of sectors.
One of the major challenges for the ISSB will be the way sustainability is addressed and connected with financial reporting standards since the concept of sustainability is not universally agreed upon and is not consistent over time. For instance, what would be the time frame over which sustainability risks will materialise compared with the traditional horizon of fixed income securities? Even by the fact that assets such as credit facilities can extend over more than ten years, evidence show that investors rank sustainability risks low in comparison with other investment risks, even though they consider them as financially material. This situation reflects the investors’ uncertainty of the time horizon and that might be one of the weak aspects of the ISSB approach. The ISSB should be careful in the way sustainability standards will influence the confidence in the accuracy and quality of financial reporting standards, according to the former SEC Chief Accountant Wes Bricker. There is a latent risk that sustainability standard-setting can shift the flow of capital in ways that might undermine the sustainability transition.