Wendy Walford outlines the need for consistent and comparable sustainability disclosures, and discusses why two new standards from the International Sustainability Standards Board are a step in the right direction
During the past decade we have seen increasing evidence of the scale and impact of climate change and the demands we have placed on nature.
Alongside this is increasing recognition of the systemic change that is needed to avoid accelerating these changes. A successful transition to a decarbonised economy will require substantial change in the way actuaries value and assess these risks.
In the same period, the financial industry’s understanding of the risks and opportunities associated with climate change has also grown. This has been driven by several factors, from increased understanding of physical impacts to improved modelling of their economic consequences.
As the world has experienced more frequent and severe extreme weather events, the scientific community has reached a consensus that global warming has been driven by anthropological greenhouse gas emissions. Alongside this, we have grown our understanding of the actions that the global economy needs to take to avoid the worst possible outcomes.
In 2021, for example, the International Energy Agency (IEA), an influential intergovernmental organisation that advises on energy policies, published Net Zero by 2050: A Roadmap for the Global Energy Sector, the world’s first comprehensive study on how to transition to a net-zero energy system by 2050. This seminal report set out the sheer scale of the necessary transition by presenting the IEA’s understanding of a pathway that is compatible with a 50% probability of limiting average global temperature rise to 1.5°C above pre-industrial levels.
This IEA net-zero scenario aims to be consistent with the Intergovernmental Panel on Climate Change’s climate change Assessment Reports, and sets out just how difficult and expensive this scenario is. For example, in order to meet net-zero by 2050, there can be no new unabated coal plants or oil and gas fields approved for development, and no new coal mines or mine extensions. Investing in these assets will therefore carry significant additional risks on returns, which will need to be incorporated into investment decision-making.
IEA scenario modelling and analysis in collaboration with the International Monetary Fund has estimated that several trillion dollars of incremental capital a year will need to be invested into low-carbon energy, energy infrastructure and energy efficiency. The radical transformation of the global energy system required to achieve net‐zero CO2 emissions in 2050 hinges on both expansion in investment and a shift in what capital is allocated to. For this capital allocation to occur, a financial services industry that is aligned with net-zero outcomes will be crucial. To support the required change and expansion of investments, it is essential for us to have robust credible data on how capital will be deployed.
A global baseline for non-financial disclosures
Investors increasingly seek to understand the risks and opportunities that investee companies see in climate change, and how they are adjusting their strategies to prepare for these changes. Accordingly, companies increasingly aim to show that they are responding to the challenges they will face and seeking out opportunities while managing their changing risk profile.
Financial reports focusing on last year’s progress against profit targets do not provide a full picture of a business’s exposure to and management of non-financial risks. This limitation has led to a wide range of different standard-setting bodies, all bringing slightly different expectations and requirements for entities’ non-financial disclosures.
While these non-financial disclosures are an improvement, global investors seek transparent, robust and, importantly, comparable information. Having a single international baseline for these standards will help both investees and investors.
In 2021, to help meet this demand, the IFRS Foundation Trustees announced the creation of a new standard-setting board: the International Sustainability Standards Board (ISSB). The intention is that ISSB will deliver a comprehensive global baseline of sustainability-related disclosure standards that give investors and other capital market participants information about companies’ sustainability-related risks and opportunities, to help them make informed decisions.
The ISSB launched a consultation on its first two proposed standards on 31 March 2022. One sets out general sustainability-related disclosure requirements, the other specifies climate-related disclosure requirements. These exposure drafts consolidate content from five different disclosure frameworks, including the Task Force on Climate-Related Financial Disclosures (TCFD), the Climate Disclosure Standards Board and the Sustainability Accounting Standards Board (SASB).
The first proposed standard, Exposure Draft IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information (General Requirements Exposure Draft), sets out the overall requirements for an entity to disclose information on its significant sustainability-related risks and opportunities. This standard extends existing climate disclosures to all significant sustainability risks that an entity is exposed to, such as biodiversity and its interaction with climate, and social issues such as modern slavery or diversity and inclusion.
“Companies increasingly aim to show that they are responding to the challenges they will face while managing their changing risk profile”
The standard aims to provide a complete set of sustainability-related financial disclosures that will be useful to the primary users of general purpose financial reporting when they assess enterprise value and decide whether to provide resources to the entity. It requires entities to disclose, for each significant sustainability risk, information on:
- The governance processes, controls and procedures the entity uses to monitor and manage sustainability-related risks and opportunities
- The actual and potential impacts on its business strategy and financial planning
- The processes the entity used to identify, assess and manage sustainability-related risks
- The metrics and targets used to assess and manage the relevant risks and opportunities over time.
The proposed standard is an ambitious disclosure programme. Entities have taken a long time to develop and adopt climate reporting. Building out broader sustainability disclosures to the same level of quality will take time and will be challenging.
Although entities have already been producing sustainability reports, this shift to integrating them with the financial reporting process and meeting additional requirements set out in the standards will be a significant but beneficial exercise. These sustainability disclosures could give investors the robust information that is needed to assess how aligned an entity’s purpose and its profit drivers are.
The second standard, Climate Exposure Draft (IFRS S2), builds on TCFD recommendations and incorporates industry-based disclosure requirements derived from the SASB standards. Reflecting the greater development of climate-related financial disclosures, the requirements in the proposed standard are relatively close to existing standards.
As with the draft sustainability standard, there are additional disclosure requirements compared to the existing voluntary frameworks. This relates in part to a drive for increased standardisation, but the exposure drafts also include additional data requests. For example, the level of granularity for asset reporting from asset owners is significantly greater than that currently adopted. Some areas, such as the reporting of a carbon footprint for derivative assets, will require significant developments, as there are currently no industry standards for how to calculate these metrics.
A step in the right direction
Good disclosures should meet a broad range of users’ needs and enable them to draw out the information that is useful for decision-making, while identifying the limitations of the reporting for any conclusions that they may draw. The two standards proposed by the ISSB are a step in the right direction.
The new standards will help users of financial reports to explain and measure the risks faced by entities. This information can then be used to supplement a financial-based risk assessment, to understand future risks and exposures that their investments may be exposed to.
Combining individual disclosures and a greater understanding of the interaction with the system-wide risks, can provide rich sources of information that may be used to inform risk-return decision-making and support risk management outcomes for the entities that actuaries work for.
Wendy Walford is head of climate risk at Legal & General and a policy co-lead on the IFoA Sustainability Board