Blog Post

Owning up to sustainability risks: the EU should champion international standards

To keep European Union capital markets open and integrated, new international standards should be reflected in future European law and accounting practice to provide further incentives for a reallocation of capital, reflecting in particular climate risks.

By: Date: April 26, 2022 Topic: Banking and capital markets

The publication in late March of proposals by the International Sustainability Standards Board (ISSB) put the European Union’s own agenda on corporate disclosures under the spotlight once again. The ISSB is part of the international accounting body IFRS (International Financial Reporting Standards), which has already defined a global standard for financial statements. The ISSB sustainability disclosure standards could similarly become a global benchmark. This could address financial stability risks, given that the impact of the climate emergency may not have been properly reflected in asset values.

A new EU model for corporate sustainability disclosures was published last year and will also be finalised in the coming months. The EU has promoted what seems a more ambitious concept of ‘double materiality’ which captures a firm’s impact on people and the planet, in addition to the risks to enterprise value. In order for EU capital markets to remain open, the just-announced international standards should be a building block of European standards to the greatest extent possible.

What gets measured gets managed

IFRS 9, the latest version of the global accounting standard, has been applied by in the EU since 2018. This seeks to provide a “true and fair” picture of a company’s finances. Yet, a company’s accounts are rarely sufficient to reflect risks from climate change and other sustainability risks. Comprehensive disclosure of such risks is needed alongside the published accounts. Numerous surveys have underlined that institutional investors, such as pension funds, still don’t have access to sufficiently clear and consistent information on such risks. Serious long-term investors are keen to understand how such risks are managed and what targets are set, in particular to reduce risks resulting from the low-carbon energy transition.

The IFRS 9 accounting standard introduced major changes in the form of forward-looking provisions, as firms need to anticipate losses. In reality, this is insufficient to capture sustainability risks companies face from the low-carbon energy transition, and companies and financial firms have had too much leeway. Three types of sustainability risk illustrate why financial accounts and disclosures do not capture climate risks well:

  • Firms should in principle explain future liabilities, even though the scale and timing of these liabilities are unclear. Decommissioning a coal plant ahead of its project lifetime or climate litigation could be significant expenses which will increasingly materialise over the coming years. IFRS guidance already requires such expenses to be shown if liabilities are more likely than not, while United States accounting rules only reflects such expenses if they are highly likely. In practice, there are few incentives to recognise provisions until liabilities are about to crystallise.
  • A related problem is the write down of assets that are exposed to the low-carbon transition. Stranded assets could emerge, for instance where proven oil reserves turn out to be un-burnable, or where residential property is exposed to floods or coastal erosion. Such ‘material’ information should in principle be disclosed in financial statements, though interpretations of this requirement vary widely. As a result, markets may be overvaluing assets significantly.
  • Finally, investors increasingly demand information on companies’ carbon exposures that arise in their upstream or downstream value chains, in particular in the emissions financed by banks or asset managers. Such indirect emissions could expose the reporting company or bank to risks arising in the climate transition. Computing these so-called ‘scope-3’ emissions is complicated by both lack of data and unclear methodologies.

Greater transparency through good disclosures and reporting should reveal material issues for a company’s future financial performance and hold boards to account in managing these future liabilities. In this way, markets may be spared abrupt re-pricing once the scale of the climate transition is revealed. Capital could be mobilised for those firms least exposed to risks, or for investment opportunities in which low-carbon technologies are deployed.

Together with a company’s accounts there should be a full disclosure of sustainability risks. Firms’ sustainability risk reports should be standardised as much as possible to facilitate cross-border investment and reports should also be independently audited.

As the scale of the climate challenge has sunk in, voluntary sustainability disclosure frameworks have proliferated. Detailed standards have been formulated by a number of private initiatives, including by the Global Reporting Initiative (GRI) since 1997, and by US-based SASB since 2011. In 2016, the Financial Stability Board, on the initiative of the G20, established the Task Force on Climate-Related Disclosures (TFCD). This defined some high-level principles to apply globally. The TFCD principles informed proposals issued in March by US securities market regulator SEC, for example.

Yet, these initiatives have so far failed to create a comprehensive picture. Only about 2,600 firms globally support TCFD, the most recent and ambitious initiative. The different disclosures are rarely comparable, and verification through audits is patchy. One study suggests voluntary disclosures to date may have amounted to little more than “cheap talk”. A number of jurisdictions therefore seek to integrate sustainability reporting within their accounting frameworks and enforce this through local regulation. The announcement at last year’s COP26 climate summit conference that the IFRS would host a new sustainability framework, and that this would be supported by the five largest reporting initiatives, therefore represents a significant opportunity.

Corporate accountability and disclosures

ISSB could now set a global baseline in sustainability reporting. The roughly 140 countries which already apply IFRS accounting rules could require their companies to prepare additional sustainability disclosures to be published alongside the regular accounts. But the sustainability standards could also be applied independently, in countries or by firms that do not currently use the IFRS accounting standard.

In keeping with the nature of IFRS accounting standards, the new disclosure rules have been motivated by the relevance of risks to enterprise value (‘financial materiality’). Yet, the distinction between sustainability risks to a company, and risks posed by a company to the environment is often exaggerated. The latter can easily morph into the former. This would be the case, for instance, once externalities imposed by a firm, such as pollution, are priced in. Similarly, the increasingly numerous ESG investors are keen to understand a company’s own sustainability performance. Whether or not such ‘inside-out’ risks impact the bottom line at present, access to capital and financing costs may eventually reflect these risks. The ISSB standards rightly acknowledge this dynamic nature of what constitutes material information.

As in the TFCD, company reports based on ISSB would present their governance, strategy, risk management and metrics and targets used in addressing sustainability risks. Apart from climate this could include other risks, such as local environmental issues, or strife in labour markets. The second ISSB proposal on climate similarly goes beyond the TCFD in that it calls on comprehensive disclosures of emissions arising elsewhere in the value chain.

The European model

The European Commission’s own proposal (the Corporate Sustainability Reporting Directive, or CSRD) is more explicit in requiring this more expansive corporate disclosure. In the Commission’s view, companies should be providing information not just by investors but also by other stakeholders, including NGOs and labour unions, which require more extensive information. This concept of stakeholder capitalism may well be controversial. Yet, even the more limited objective of making EU capital markets function well suggests firms’ own sustainability performance is highly relevant.

In late March, the proposed CSRD entered the ‘trilogue’ phase of discussions between the European Parliament and the Council of the EU. About 50,000 EU companies, which are either listed on an EU market or deemed large, were supposed to present comprehensive and audited information on their impact on the environment alongside their 2023 accounts. Discussion in the European Parliament suggests SMEs may in fact be exempted and publication of sustainability disclosure may be delayed to 2025. This creates a risk of patchy and incongruent coverage of accounting and disclosure rules. In addition, for now, it would leave the ambitious disclosure requirements for financial market players without a sound basis in corporate reporting.

Compatible standards and open capital markets

To flesh out the proposed new EU disclosure rules, the Commission has promoted an as-yet little-known European accounting body, EFRAG (European Financial Reporting Advisory Group) which published its own proposal a week before that released by ISSB. Europe wants to conform with, though also at the same time shape, global disclosure rules. Even though EFRAG has conducted a number of consultations, and its governance has been reformed, there is a clear risk European accounting and sustainability disclosures will lose touch with what EU and international investors require. Implementation of the directive may diverge between different EU countries.

The future EU requirement to disclose the sustainability risks posed by companies to the environment and a range of other stakeholders is as yet unusual. Only a few other advanced markets, such as Singapore or Norway, or emerging markets, such as China or Morocco, have included this requirement in local regulations.

The EU could indeed be more ambitious than the ISSB standard in certain areas, for instance on emissions arising in the value chain, or the on credibility of companies’ net-zero plans. Yet, the implications of the CSRD for the openness of EU capital markets and for foreign direct investment linkages should be thought through carefully. Investors and EU companies should be able to rely on a single standard to judge the financial materiality of sustainability risks, including by using the SASB’s industry-specific metrics.

Standards defined through the ISSB and backed by the IFRS will have the required credibility, and could help to keep EU capital markets open and integrated.

Recommended citation:

Lehmann, A. (2022) ‘Owning up to sustainability risks: the EU should champion international standards’, Bruegel Blog, 26 April

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