One Small Step From Financial Materiality to Sesquimateriality: A Critical Conceptual Leap for the ISSB
13 Pages Posted: 1 Apr 2022
Date Written: March 13, 2022
Corporate social responsibility. Socially responsible investing. Environmental, social and governance (ESG) integration. Sustainable investing. These phrases refer to the need for investors to pay more attention to the environmental and social (“E/S”) impacts of the businesses in which they invest.
The growing importance of this field is evident in the creation of the International Sustainability Standards Board (the “ISSB”) to establish uniform E/S disclosure standards that companies around the world will use to report to investors. The ISSB has the critical mass of support from established market participants necessary to bring the same uniformity (and thus utility) to sustainability reporting that now exists for standard financial reporting.
This article addresses a fundamental debate over the purpose of the uniform standard and reaches the following conclusions:
Four types of impact. E/S information can travel three pathways to affect investors and a fourth to affect other stakeholders:
1. E/S Information that impacts on future cash flows from the company to investors and thus the value of the enterprise (“ESG integration” or just “ESG”).
2. E/S information that impacts on the costs that companies externalize to the economy, which affect overall securities market returns (“beta” ), and thus the returns of other companies in an investor’s portfolio.
3. E/S information that involves the residue of E/S impacts that do not affect investment returns, but that impact on other matters that are important to individual investors (“non-financial investor impacts”).
4. E/S information that does not affect investors, but is relevant to the impact companies have on civil society and stakeholders other than investors (“stakeholder data”).
Of course, there is much overlap among these four types of information. Data that impacts on enterprise value may also affect investors through the other pathways, or have impacts on other stakeholders. The extent of this overlap is likely to be a subject of debate.
ISSB embraces a single type of data. The current plan for the ISSB expressly encompasses only data that implicate enterprise value (often called “financial materiality”), although a close read of the documentation produced to date leaves the door open for an expansion to information pertinent to beta information as well. The ISSB documentation expressly rejects “double materiality,” the standard European regulators embrace, which couples financial materiality with information designed to inform other stakeholder data. The ISSB documentation does not address—or even acknowledge—the possibility of providing beta or non-financial investor information. The failure to even address beta-oriented disclosure is surprising because there is a growing emphasis on the need for diversified investors to monitor and steward the beta impact of portfolio company activity.
Expanding the ISSB definition of materiality to include beta information would not significantly expand the reporting burden. Adding beta information to the ISSB reporting standard would not significantly enlarge the reporting requirement because any company conduct that threatens or benefits beta is likely to create corresponding regulatory and reputational risks and benefits to enterprise value, so that most beta information should be deemed material even under a putative ESG standard. Such a standard, rising above a single focus on financial materiality but rooted in investor return, would not rise to the level of double materiality, and might best be described as “sesquimateriality.”
Excluding beta information from the reporting standard does not reflect evolving recognition of the importance of beta. The ISSB drafters should recognize the risk that excluding beta could, at the margins, lead to the omission of decision-critical information for investors concerned with company impact on social and environmental systems that support other portfolio companies. The increasing recognition of the importance of beta to investors could make a beta-free ISSB standard obsolete from the start. Steering clear of this risk is likely to require, at most, minor adjustments in methodology; moreover, the initial ISSB documentation, while ambiguous, does not preclude such considerations.
Finally, from a rhetorical perspective, it is important that the final documentation of the ISSB standards acknowledge that investors have significant interests in beta impacts. The law governing investment fiduciaries is evolving to make it clear that their fiduciary obligations permit—or even require—beta management. This is a critically important public policy development, not simply because it will improve investment returns, but because it will lead to better social and environmental outcomes on the ground, as many of the most serious threats to beta are also the most serious threats to people and the planet on which we live. At a time when regulation alone seems increasingly inadequate to the task of addressing threats to the environment and our social fabric, an apparent retreat from a constructive market reform in a document as influential as the ISSB standards would be a serious setback.
Keywords: Disclosure, Sustainability, Materiality, Double Materiality
JEL Classification: G30, G18, M48
Suggested Citation: Suggested Citation