The Future of ESG comes into Focus

The Summit of Sustainability

Every year since 1995, barring a global pandemic, world leaders have gathered together for 2 weeks to discuss what’s to be done about the great scourge known as Climate Change. This “Conference of the Parties” (or COP) has most commonly passed with little notice or fanfare, but there have been a few notable instances. COP15, held in Copenhagen in 2009, set many ground rules for managing and mitigating the impacts of Climate Change, albeit in a non-binding agreement. It was here that governments agreed to limit warming to 2°C and begin sending billions annually to developing countries for necessary adaptation measures. 2015 saw the most significant results at COP21 in Paris, where the Paris Agreement made government's’ commitments legally binding. It set a target to limit warming to well below 2°C, achieve “climate neutrality” by 2050, provide $100 billion annually to developing nation adaptation funds, and each country must make a Nationally Determined Contribution (NDC) to their emissions reduction targets. Just last year at COP26 in Glasgow, countries were required to update their NDCs to reflect progress and increased ambition to more aggressively reduce emissions. But this COP was significant for a different reason. At COP26, the focus shifted from government action to what private industry should be contributing to help avert the worst impacts of Climate Change.

In the intervening years from the Paris to Glasgow, the imperative to address the menace of climate change had begun to weigh more heavily on the corporate world. Standards for corporate sustainability that had been around for years, like the Global Reporting Initiative, saw much wider adoption globally. Another significant development was the launch of the Michael Bloomberg-led Taskforce for Climate-related Financial Disclosure (TCFD) in 2017 which put forward a framework for businesses to investigate and report on the impacts of Climate Change on their enterprise value creation. These expanded forms of business accounting, which took into consideration non-financial aspects of an organization to understand holistic risks and opportunities, is now referred to as ESG (environment, social, and governance). The rapid ascent of ESG measurement and reporting among corporates came with it’s own barriers:

With several similar yet disparate ESG standards to follow, how do companies choose the best one?

If companies choose different ESG standards to report on, how do you make a meaningful comparison to the relative performance of each?

How do companies determine which ESG criteria are material to their unique operating circumstances?

The promising rise of ESG to deliver corporate contributions to the fight against Climate Change seemed to be at risk of fizzling out in its fledgling phase. Just as financial accounting had coalesced around a global standard of practice, so too did ESG need to firm up a consistent approach to simplify the practice for corporates and provide meaningful information to outside stakeholders. This all came to a head at COP26 in November 2021.

As a handful of ESG standards had differentiated themselves from the pack and developed strong participation in different jurisdictions, an old player in corporate accounting set out to solve the issue of competing interests. The International Financial Reporting Standards Foundation (IFRS), which oversees the global financial accounting standard known as IASB, had been working behind the scenes unify ESG reporting standards into a single, global format. At COP26 the International Sustainability Standards Board (ISSB) was announced as a body to bring together the many different sustainability standards into a simplified, streamlined, and united approach. Throughout 2022 the ISSB has achieved significant milestones:

• Aligned and/or consolidated sustainability standards including the GRI, Value Reporting Foundation, CDP, and TCFD.

• Determined preliminary approach to utilize the TCFD framework and SASB industry-specific standards of criteria

• Launched international inter-operability group to facilitate alignment with national regulators from different jurisdictions

• Received endorsement from both G7 and G20 for mandatory climate disclosures

With the final standard targeted for released in Q1 2023, the ISSB has made significant progress and already provided greater clarity to the expectations of ESG reporting moving forward. The most impactful announcements, however, have just been made at the 1-year anniversary of the ISSB at COP27 in Sharm El-Sheikh.

• In the lead up to COP27, the ISSB unanimously confirmed that Scope 3 GHG emissions disclosure will be required

• In line with recommendations of the TCFD, ISSB confirmed that climate-related scenario analysis will be required

• ISSB has closely worked to align with Europe’s EFRAG and the global IOSCO to align standards and receive their endorsement for the finalised standard

After the first year of the ISSB leading the charge of ESG reporting, we now have a clear picture of what to expect for the future of corporate sustainability management.

The ISSB Impact

Given what the ISSB has accomplished since 2021, the latest announcements, and the targeted release of a final standard in early 2023; there are several takeaways that corporate managers can utilize to prepare their organizations for the future of ESG.

1. The Value Chain is a Critical Driver

By announcing that Scope 3 emissions are mandatory (by a unanimous vote, no less), the ISSB has signaled to industry that their entire value chain will play a part in calculating their contribution to Climate Change. According to the Greenhouse Gas Protocol, there are three different scopes of emissions: Scope 1 covers direct emissions, those produced directly from business activity such as from facilities and fleets. Scope 2 covers indirect emissions produced from the production of purchased electricity, such as grid electricity produced from a fossil gas power station. Scope 3 covers indirect emissions from upstream and downstream activities, and for many businesses makes up the majority of their carbon footprint. Don’t be fooled by the greenwashing concept of Scope 4 emissions.

Not only are Scope 3 emissions important to capture the true impact of a business in contributing to Climate Change, but they are also the most difficult to calculate. Scope 3 emissions necessarily lie outside of the operations of the reporting business and therefore rely on external information to determine. For this reason, historically Scope 3 emissions have been excluded or optional for corporate emissions reporting. By making Scope 3 emissions disclosure mandatory, the ISSB is signaling that corporates must work together with their partners, suppliers, distributors, investors, and customers to fully understand their impact.

The inverse consideration is that any organization that feels insulated from the requirements of ESG reporting must closely examine their own business relationships. If a significant portion of revenue relies on suppliers or buyers that will be affected by ESG mandates, even small, private companies will become liable for calculating their emissions to maintain profitable relationships. Beyond emissions calculations, the value chain should also be considered for alternative impacts of ESG, namely the “S” and “G”. Social impacts include relationships with employees, the communities where businesses operate, and broader society which considers diversity, equity, and inclusivity practices. Governance impacts include transparent and accountable management in line with legal compliance and covers remuneration, modern slavery, human trafficking, lobbying and tax obligations. It’s best to think of Scope 3 emissions as the first step toward more thorough vetting of professional relationships that seeks to minimize risk for corporates throughout their value chain.

2. Risk is the Name of the Game

By reaffirming the TCFD’s inclusion of Climate-related Scenario Analysis, the ISSB has put an emphasis on the risks that Climate Change poses to business-as-usual. Scenario Analysis is a tool meant to provide business managers with a means to consider futures where current assumptions may not be applicable. One of the leading causes of climate inaction is that Climate Change impacts lag behind the inputs driving the change. If the moment a molecule of greenhouse gas was added to the atmosphere there was an instantaneous, equally-weighted reaction that altered human activity, the debate around the need for action or the mere existence of Climate Change at all likely would not have drug on for decades. Even now we can observe the increased physical impacts of Climate Change have driven greater strides toward collective action that were, in turn, immediately shifted to the backburner with the energy crisis resulting from the Russian invasion of Ukraine. This bias toward near-term thinking highlights the necessity of Scenario Analysis.

Structured Climate-related Scenario Analysis provides pre-determined scenario criteria that is based on possible futures for different outcomes of Climate Change. Scenarios based on best case outcomes of limiting warming to 1.5°C allow for greater latitude in considering physical risks of Climate Change while placing greater emphasis on the transition risks, such as high carbon taxes. Scenarios with more dire circumstances, such as 4°C of warming, magnify the physical risks of climate change and may require business managers to reconsider if their current business plan remains viable in a world with disrupted supply chains, resource scarcity, and mass migration. In line with the TCFD, Scenario Analysis should include two types of scenarios on different ends of the spectrum of Climate Change outcomes. In this way, businesses are able to gain better appreciation of relative risks that would otherwise be outside the realm of consideration to current business-as-usual practices.

This approach to keeping risk at the center of decision-making is a key theme of ESG as a philosophy. The beginnings of incorporating non-financial aspects into public disclosures was driven by investors and outside stakeholders seeking greater understanding of the risks an organization faces that are not accurately captured on a balance sheet. High profile scandals, such as Volkswagen’s emissions cheating practices or the Boeing 737-Max groundings for faulty software, served as head-on-a-pike warnings to shareholders that financial disclosures are insufficient to understand holistic enterprise risk. That approach is kept central with the mandate of Climate-related Scenario Analysis.

3. A Question of Materiality

One of the key challenges faced by corporates seeking to stay at the forefront of sustainability by undertaking ESG management has been the question of determining what applies to their business. Different standards and regulations have provided differing guidance depending on where a company operates. This inconsistency, even within a single industry, has been the source of consistent ire within the ESG world for a number of years. From the first announcements of the ISSB, it seemed as though they sought to align with a classical “enterprise value” materiality. In line with the demands of investors, enterprise value materiality limits the consideration of ESG impacts to those that directly affect the enterprise value creation of the company. This stands in contrast to the more broad “double materiality” that saw widespread adoption by ESG standards. Double materiality includes enterprise value, but adds consideration for impacts on the natural environment and broader society. In this way, private industry is meant to also benefit more than just its shareholders, but also the landscapes and communities where it operates.

With these latest announcements, it seems that ISSB is willing to consider and incorporate double materiality. Over the last year, a major barrier to the ISSB achieving a globally applicable standard was the difference of material definition to the European Union. The EU has been the most advanced jurisdiction for sustainability reporting among world governments. Their progress with Taxonomy for Sustainable Activities, Sustainable Finance Disclosure Regulation, and Corporate Sustainability Reporting Directive has been spearheaded by the European Financial Reporting Advisory Group (EFRAG). The publication of the EU’s Green Taxonomy confirmed that EFRAG would use double materiality as its basis for non-financial reporting. If the ISSB and EFRAG could not find alignment on the most fundamental consideration for ESG reporting, it posed the potential for a new global ESG standard to be excluded from the most advanced ESG-aligned economy.

The latest announcement from the ISSB signifies that double materiality will be a consideration for the final standard. This means that business managers should base their ESG materiality assessments with a consideration for impacts on the environment and society. A key component of ESG reporting is to maintain consistency over time. Nothing would undermine consistency more than reassessing materiality for ESG impacts year-over-year. While materiality should be dynamic, this is most accurate in response to changes in operational circumstances and the concerns of stakeholders.

Conclusion

The global sustainability summit of COP26 is currently underway. World leaders are gathered in Egypt to affirm their commitments to collective action meant to avoid the worst impacts of Climate Change, and importantly this year, support developing countries in their efforts to adapt to the impacts already being felt. At the same time, the corporate world is also making strides to strengthen their contributions to reducing emissions and improving sustainability.

The latest announcements by the ISSB have significant impacts for business managers seeking to stay on top of the evolving world of ESG. We now know that emissions will be considered up and down the value chain with the mandate for reporting Scope 3 emissions. Additionally, by requiring Climate-related Scenario Analysis, the ISSB is keeping risk at the heart of ESG management. Finally, to ensure that there is a single, global ESG standard the ISSB is aligning with important jurisdictions to support double materiality for ESG impacts.

Armed with this knowledge, business managers can feel empowered in setting their sustainability strategy into the future. This approach to ESG management underpins the advisory services of Impact Cooperative.

Get in contact with Impact Cooperative today to begin your sustainability journey and solidify your ESG strategy: Contact@ImpactCooperative.com