ESG accounting is a mess. Competing initiatives mean there’s no uniform set of standards for measuring a company’s progress on sustainability. The good news is that a new initiative, the International Sustainability Standards Board, promises to do for sustainability reporting what the International Accounting Standards Board (IASB) does for financial reporting — develop standards for companies to report their performance to investors. Though still fledgling, the ISSB’s ideal outcome would be if it becomes a global standard that integrates the work of all previous standards. Ideally, the SEC and EU can use its standards. Companies should give the ISSB their full support to make these standards the best they can be. Robert G. Eccles and Bhakti Mirchandani discuss the issues in an article on the Harvard Business Review website.
We Need Universal ESG Accounting Standards
Nearly every company today understands that sustainability must be made core to its strategy and capital allocation process but are often confused by how best to report on ESG progress in a way that will be credible to shareholders and other stakeholders. What is needed is a uniform set of standards for measurement and reporting — just as we have for financial performance. Imagine a world where each company had to decide for itself how to measure say, revenues, or depreciate its assets. Or to pick amongst three or four alternative ways of doing so suggested by NGOs. That is the situation companies have been living in when it comes to ESG — but there is hope on the horizon.
The world of sustainability reporting is a plethora of names and frameworks. Just to list a few of the more well-known ones: the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) (Eccles was one of the founders), the Sustainability Accounting Standards Board (SASB) (Eccles was the Founding Chairman), and the Task Force on Climate-related Financial Disclosures (TCFD).
The good news is that a forerunner has emerged that promises to offer a single source of truth of ESG reporting. It is called the International Sustainability Standards Board (ISSB). The ISSB will do for sustainability reporting what the International Accounting Standards Board (IASB) does for financial reporting — develop standards for companies to report their performance to investors. Both will be under the IFRS Foundation.
Created in November at the Cop 26 summit, ISSB will provide a “global baseline” for high-quality sustainability reporting that will support the work being done in the U.S. by the Securities and Exchange Commission (SEC) and the European Union (EU)’s “Corporate Sustainability Reporting Directive (CSRD).” The ISSB is focused on “single materiality” or the ESG information that drives valuation and matters to investors. This is also the focus of the SEC and so the mandates are consistent. In contrast, the CSRD has a broader “double materiality” mandate which means it will cover information of interest to stakeholders even if it is not of interest to investors. Linking the two is the concept of “dynamic materiality” — ESG issues that investors don’t care about today can become ones they care about in the future. The most striking current example is climate change.
The ideal outcome is that ISSB becomes a global standard that integrates the work of all previous standards and frameworks focused on investor needs. Ideally, the SEC and EU can use its standards. The EU can then “top up” these standards with those covering double materiality. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the standard setting process.
For a fledgling organization, the ISSB is off to a good start. On December 16, 2021, the IFRS Foundation Trustees announced the appointment of Emmanuel Faber, former CEO of Danone, as the first chair. This is a good choice because Faber understands the challenges of sustainability reporting from a corporate perspective and the opportunity created by having a global set of standards. On January 27, 2022, the Foundation announced the appointment of Sue Lloyd, current Vice-Chair of the International Accounting Standards Board, as ISSB Vice-Chair. In addition, Janine Guillot, CEO of the Value Reporting Foundation, has been appointed as Special Advisor to the ISSB Chair. These are also good choices. Faber explained to us the logic behind these two appointments, “Sue has a wealth of standard-setting experience that will be vital to the ISSB. Janine brings great connections to global investors and is key to the successful integration of the VRF into the IFRS Foundation.” A further Special Advisor to the ISSB Chair and the rest of the board will be named within the next several months.
Standard setting can be slow. Following the Great Depression, it took decades to standardize corporate accounting in the U.S. and globally. However, we need to move quickly. The threats from a changing climate and massive social pressures are urgent. Fortunately, we don’t have to start from scratch. Far from it. The quality of sustainability disclosure has been steadily improving in recent years. The consolidation of the Value Reporting Foundation, Climate Disclosure Standards Board, and TCFD frameworks provides ISSB with strong intellectual property and people right out of the gate. The ISSB can build on a strong foundation rather than start with blueprints and shovels.
The corporate community also has a key role to play in ensuring the success of the ISSB — and it is very much in its self-interest to do so. Investors are increasingly demanding information on a company’s performance on its material sustainability issues. At the same time, companies are increasingly being accused of “greenwashing” in their sustainability reporting. Having standards, with proper audits, addresses both issues. That said, it’s important to note that standards aren’t targets for issues like carbon emissions or diversity, equity, and inclusion (DEI). Rather, they provide credible information on the reporting done by a company on its progress in achieving whatever targets it decides to set (if any).
At the same time, companies have a legitimate concern about what the cost will be in implementing these standards. We note that standard setting always involves a cost/benefit analysis. From its inception the IASB has made a cost/benefit analysis a core element of its standard setting process and this experience will be useful to the ISSB. The ISSB will also be able to benefit from the experience of SASB since a cost/benefit analysis was integral to its work.
We also acknowledge that an initial investment will need to be made in order to have the same high-quality internal control and measurement systems to support this reporting. But the same is true for financial reporting, and experience and technology developments will lower the operating costs over time. Due to investor demand, audits on sustainability reporting are already a growing business.
There is one other major challenge that companies must address. To date, two conversations have been going on between companies and their investors and other stakeholders. One is about its financial performance, and this is a conversation between the CEO, CFO, and investor relations with portfolio managers. The other is about its sustainability performance, and this is a conversation between the company’s sustainability function and the sustainability and stewardship function in the investor. These two conversations are already starting to converge and must become one. Finance and sustainability people at both companies and investors must become bilingual. At companies, the finance and sustainability function need to be able to explain investments in sustainability and their contribution to financial performance. On the investor side, portfolio managers need to understand material sustainability issues, and the sustainability team needs to put their discussions in the context of financial performance.
So what can companies do to ensure the success of ISSB and with it their own long-term viability? Good news. Just two things.
The first is to actively participate in the standard setting process. As with financial standard setting, exposure drafts for proposed standards will be published in the public domain. Companies need to join investors in providing their input, including constructive input and critiques. If a company has an opportunity to participate in any advisory councils and working groups or share their views in comment letters, it should do so.
The second is to move aggressively to adopt these standards. There will be an inevitable lag time between when the standards are published and the country in which the company is headquartered in makes them mandatory (if it does), but those who wait will likely be those who lose. As some companies quickly adopt ISSB’s standards, investor pressure will mount for others to follow suit so they can compare companies’ performance and do their analysis. Failure to report won’t give a company the benefit of the doubt. Rather, investors will likely assume the worst — to the possible detriment of the company’s stock price.
When we asked him about his hopes from the corporate community, Faber said “Many companies are already doing good work which will help them prepare for when the standards are published. They should continue to do so and not wait. As we develop the standards feedback from companies is welcomed and will be essential.”
The ISSB will make life better for any company who cares about a sustainable long-term corporate strategy. Thus companies should give it their full support to make these standards the best they can be.
2 thoughts on “How to improve ESG accounting”
To combat climate change effectively, it is absolutely vital that the ISSB succeeds. To destroy ESG greenwashing once and for all, the rules it creates must be binding, rather than voluntary – and must be rigorously enforced. As this article states “Finance and sustainability people at both companies and investors must become bilingual”
You are absolutely right, Andrew