Global Sustainability Standards — a World of Difference
The founder and former CEO of the SASB opines on the promise and perils of achieving a global standard for disclosure of sustainability impacts
As the Greek philosopher, Heraclitus, said: “change is the only constant.” Heraclitus asserted that the world exists as a coherent system in which a change in one direction is ultimately balanced by a corresponding change in another. Well, Heraclitus would have been amazed at the recent movement at COP26 toward a coherent system of global sustainability standards, were he a sustainable investor today. The fundamental question is, what will be the corresponding change in corporate behavior? More reporting? Or better performance?
This week, the IFRS (International Financial Reporting Standards) Foundation made good on its promise to create an International Sustainability Standards Board (“ISSB”) with the purpose of standardizing sustainability information that affects enterprise value creation. The IFRS Foundation was established to develop a single set of global accounting and sustainability disclosure standards, ultimately to bring transparency, accountability and efficiency to the global financial markets. The announcement at COP26 in Glasgow also further consolidated sustainability standards setters CDSB, IIRC and SASB into the ISSB. A debt of gratitude is owed to these first-generation standards setters, who contributed greatly to awareness about the importance of climate change to the financial system, the necessity of integrated thinking in corporate strategy, the materiality of sustainability factors to investors and, most importantly, that corporate sustainability efforts could be measured and communicated effectively. But change we must, and the ISSB is a welcome consolidation of these pioneering efforts, if not bittersweet for me personally.
As the founder and former CEO of SASB (2010–2018), I’m delighted to see the industry maturing and professionalizing at a time when climate-related disclosures are on the cusp of evolving from voluntary to mandatory. I applaud the commitment of the IFRS Foundation to take on the challenge of creating an ISSB. Standards setting is not for the faint of heart. In order to be successful, the ISSB will need to blaze its own trail, rather than mimic well-established financial standards-setting processes, because sustainability issues are inherently different from all other threats and opportunities facing investors, businesses and the markets — in scope, scale, measurement, timing and, ultimately, consequence.
Sustainability issues are inherently different from all other threats and opportunities facing investors, businesses and the markets — in scope, scale, measurement, timing and, ultimately, consequence.
I’m proud of SASB’s industry-based standards, the work product of more than eight intense years of research and collaboration with US market participants. The SASB standards were the first evidence-based sustainability standards. SASB’s research advanced the market’s understanding of materiality and enabled financial analysts and investors to see that sustainability issues can and do affect value creation, and they do so differently by sector.
That said, no one should be under any illusions that SASB’s first-generation standards are fit for the global capital markets of 2021 and beyond. They were a grand experiment, based on concepts developed more than a decade ago designed explicitly for use in the US capital markets, and they have not been substantially updated since they were released in 2018. So much has changed since then and, for this reason, I believe that it’s the lessons learned from the SASB initiative that are important to the ISSB, not the standards themselves. I truly hope that the ISSB will be the next generation sustainability standards setter. With that in mind, allow me to share some lessons learned from that grand experiment.
The Conceptual Framework is the North Star.
In 2011, after toiling away on setting up SASB.org in my basement for close to year, I received the first grant for the organization and was off to the races. Intending to follow the sector-based model developed with my colleagues Steve Lydenberg and David Wood at the Initiative for Responsible Investment at Harvard University, all that was needed was to select the first sector. Eureka! Health care! Why? Because my husband, an economist for Kaiser Permanente, could tell me all the “right answers” about what was material in the industry. That was my “jump start” on the standards. My next task was to set up a process to address all other industries. No problem. On a family vacation, I began to read everything I could find about the Financial Accounting Standards Board (FASB) and the history of accounting, and came across a delightful book entitled “A Conceptual Framework for Financial Accounting and Reporting: Vision, Tool or Threat?” I was hooked. I remember calling Bob Herz, by then the former Chair of FASB, from the beach to ask “Bob, what is this “Conceptual Framework”? Do we need one for SASB?” The answer came back, deadpan… “I don’t know how you can set standards without one.” And the rest is history.
In standards setting, form really does follow function. In 2011, when SASB was just beginning to develop standards for the US capital markets, we applied design thinking to understand the issuers and investors and the complex set of securities laws that govern public disclosure for SEC reporting companies. The design criteria were set out in SASB’s Conceptual Framework. The principles and assumptions guiding development of the standards provided the essential boundaries within which to innovate, and a critical touchpoint to guide SASB through inevitable differences of opinion and pressure for scope creep.
The ISSB must resist the temptation to “jumpstart” its process by hastily adopting outdated standards, but rather, must begin by developing its own Conceptual Framework, as its constitution requires. The Conceptual Framework for ISSB must thoughtfully consider what it means to bring transparency, accountability and efficiency to financial markets around the world in the context of sustainability issues and their interpretation by users.
The Conceptual Framework will establish the ground rules for threshold concepts such as the purpose of the standards, the definition of sustainability, the materiality orientation, methods of measurement, the importance of context in interpreting data, the differences in priorities and concerns of countries that use IFRS (as well as those that do not, namely the United States), and ultimately how success of the standards- setting effort will be evaluated. Rules of procedure and representation of global stakeholders in the process must also be outlined in detail. The Conceptual Framework is the North Star that defines the agenda and decision-making activities of the new board. Without it, ISSB will be adrift in a sea of hundreds of potential (and often conflicting) criticisms raised by thousands of stakeholders, with no way to prioritize. There is a danger of capture by self-interested parties in the ESG industrial complex who benefit from more and more standards, not better and better performance on the things that matter. A Conceptual Framework will provide guardrails and must precede standards setting activities in order to maximize the potential for success. Take it from Bob.
Think Global, Act Local.
Efforts to develop and roll out international financial reporting standards (by the IASB, accounting standards setting body of the IFRS Foundation) have professionalized capital markets around the world now in over 120 jurisdictions. However, regrettably, there is no global standard — each jurisdiction adapts and adopts IFRS to varying degrees, and there was no buy-in from the United States, which continues follow US GAAP. Much like globalization of trade, global standards are a myth. Celebrating the creation of ISSB as a victory for a single unified global sustainability standard is naïve, and misses the true advantage of ISSB. The IASB has created the perfect structure for supporting global jurisdictions, while allowing adaptation to specific market use cases. It operates essentially as a clearinghouse, establishing a principles-based framework which is then tailored, translated and adopted to varying degrees in different jurisdictions based on local conditions and their underlying legal structures. The opportunity for ISSB is not to achieve global standardization, but to align global markets around an approach to sustainability standards setting and core principles, while allowing for jurisdictional differences in implementation.
The opportunity for ISSB is not to achieve global standardization, but to align global markets around an approach to sustainability standards setting and core principles, while allowing for jurisdictional differences in implementation.
Among the 120 jurisdictions that currently use IFRS, the EU is notable due to its lack of support for the ISSB. The EU has regulatory (namely, enforcement) authority (which the ISSB will not) and is by far the global leader in developing mandatory sustainability disclosure standards. Unfortunately, the ISSB and EU approaches are not harmonized. The EU is focused on principal adverse impacts that affect capital flows to a green and just economy. They are working closely with the European Financial Reporting Advisory Group (EFRAG) and the Global Reporting Initiative (GRI). The absence of GRI from the ISSB amalgamation of standards setters is the proverbial elephant in the room, and in reality, it will mean continued fragmentation of ESG standards. Over 1/3 of IFRS jurisdictions currently recommend or mandate GRI’s sustainability standards, and are unlikely to switch to ISSB if the approaches are not harmonized.
When I was leading SASB, the media loved to play up the rivalry between GRI and SASB. In reality, I learned the ropes from the first CEO of GRI, the late Ernst Ligteringen — an amazing human being and great mentor to me. I worked with GRI when they were just eight people in Amsterdam and I was a young sustainability consultant at Arup helping them with their business model pro bono. When I later founded SASB, it was to develop a materiality-based approach that would work for the US capital markets, which was lagging far behind Europe in reporting. SASB was intentionally focused on identifying material ESG issues, such that companies would drive performance on those issues, thereby improving financial performance and investors would reward them — a win-win financially, with impact as icing. It was a kind of ESG Trojan horse, if you will. At the time, most US investors couldn’t wrap their heads around the relevance of ESG directly to investing. Our job was to convince financial analysts of the merit of these issues, not regulators. SASB worked within the SEC definition of materiality for disclosure purposes, which created a de facto mandatory reporting environment — thereby allowing those enlightened analysts to access relevant information directly from the filings — without changing the law — because disclosure of material information was already compelled. We were just suggesting what some of those modern material issues might be, and providing a simple way to talk about them. SASB’s strict adherence to financial materiality in standards setting was not so much a choice, but a necessity for mainstreaming ESG in the largest capital market in the world, given the securities laws that govern information flows in the U.S. capital markets. GRI, a more mature and globally networked organization, took a broader stakeholder view of impacts (now known as “double” materiality), an approach much more aligned with European views on the purpose of the corporation. They intentionally set out to give a voice to those stakeholders that could not vote with their money, in the way that investors can. Because GRI created guidelines for the preparation sustainability reports, their efforts were unimpeded by regulatory constraints. The different approaches of the two organizations worked for their respective constituents and regions at that time.
Fast forward to 2021, with the SASB incorporated into ISSB, and GRI working with the EU, financial materiality and “double” materiality are clashing on the global disclosure stage. However, these concepts are more aligned than one would think. Stakeholders are essential to long-term value creation. In the age of social media, stakeholders create financially material conditions for companies and are able to change corporate behavior by tweeting. The environment, also a stakeholder, has finite limits and is expressing its concern with overreach through extreme weather related events. No company will perform well over the long term without stakeholder alignment. SASB considered stakeholders one of the most important catalysts in determining whether or not an issue was likely to become material in its early research. The philosophical differences over approaches to materiality are overblown, and surmountable, in the global markets. Efforts by the ISSB to harmonize with GRI and the EU now will ultimately enhance the likelihood of adoption of ISSB standards across IFRS jurisdictions.
Separate the Enduring from the Emerging.
As I learned the hard way at SASB, not everything that can be standardized should be standardized, and knowing the difference is essential. Developing standards for 80 industries in eight years was a huge undertaking. It was great for financial analysts, who could focus only on the issues important to the industry they covered. But it was terrible for regulators, who didn’t have the capacity and could not develop competency to enforce standards of that scope and complexity. It has also proven impossible to maintain current — by the time a standard is issued, it’s already obsolete. Science-based targets keep moving, and so do awareness, industry norms and stakeholder concerns. The ISSB’s super power may not necessarily lie in hard-wiring standards for global markets, but in identifying patterns and illuminating issues that are emerging across the global markets for consideration by investors and the broader markets.
The ISSB’s super power may not necessarily lie in hard-wiring standards for global markets, but in identifying patterns and illuminating issues that are emerging across the global markets for consideration by investors and the broader markets.
We are living in a time of unknown unknowns, with new sustainability issues frequently emerging as our society and environment grapple with unprecedented levels of population, pollution, extreme weather events and unrest. The pace at which credible and rigorous sustainability standards setting can proceed (when modelled after traditional financial standards-setting processes) is ill-suited to the dynamic nature of the vast and evolving landscape of climate and other ESG issues. Covid, for example, emerged quickly in early 2020 and is still gripping our markets. Global pandemics were not contemplated in SASB’s — or anyone else’s — standards. The SEC gets credit for swift guidance on disclosure considerations — released in June of 2020, and together with a variety of public statements between March and June 2020 as to SEC expectations. Neither a standard, nor mandatory, the guidance and related public statements provided SEC reporting companies in effect with a dashboard of disclosure considerations that would increase the likelihood that investors would receive decision-useful information in the context of unprecedented developments. Because the SEC did not follow the traditional rule-making process, it was not delayed by proposed rulemaking and lengthy comment processes.
The ISSB will need to differentiate those issues that are enduring from those that are emerging, and to develop different processes to deal with them. Ideally, IFRS jurisdictions will provide important intelligence on ESG issues that can allow the ISSB to be responsive and act as an early warning system. Sustainability information is pre-financial, not non-financial. But by the time it is standardized, it’s less valuable to the markets. Attempting to set out a five-year agenda of sustainability themes to be addressed will likely prove futile. The ISSB has the opportunity to set up a different kind of process that is flexible and responsive. Speed is more important than structure, especially now that artificial intelligence (AI) can be deployed at scale. Natural language processing (NLP) of ESG information allows unstructured data to be structured and served up to investors, making standards moot, as long as you know what you are looking for. Rather than trying to compete with technology, the ISSB should lean into it to identify the emerging issues that are most likely to evolve from an idiosyncratic risk to a sectoral, regional or systemic risk. The ISSB’s global perch is a huge asset, allowing them to recognize and map global patterns of sustainability issues and communicate them to investors early on. This is one of the most important contributions the ISSB can make to the field, because action can be taken to abate an emerging issue well before a standard for disclosure can be produced. In sustainability, time is of the essence.
Pattern recognition through application of AI is one of the most important contributions the ISSB can make to the field of ESG, because action can be taken to abate an emerging issue well before a standard for disclosure can be produced. In sustainability, time is of the essence.
Climate Risk is a Systemic Risk.
The ISSB has rightly established climate risk (from the broader universe of ESG risks) as its first priority. Climate risk is indeed urgent, and enduring, and investors rightly crave consistent, comparable and reliable disclosure that provides fundamentally important transparency around the systemic risk posed by the effects of climate change. And therein lies the problem. Climate risk is a macro-economic risk, demanding global solutions to global risks. Corporate disclosure, however, by its nature, illuminates idiosyncratic risks. Aggregating individual disclosures from tens of thousands of companies is unlikely to give investors an adequate view of the climate-related risks they are facing in a portfolio. Strategies for dealing with macro risks favor allocation to different sectors, regions and other asset classes, not picking among individual stocks. Macro-economic risks cannot be diversified, rendering corporate disclosures of lesser value to the types of strategies that investors typically employ in response to macro risks.
The ISSB should again leverage its vantage point at the center of 120 jurisdictions to gather meta-data on climate-related financial risks, and provide insight about the effectiveness of regional solutions such as carbon pricing mechanisms, trading schemes, taxes, and sector- or technology-based incentives, towards abating corporate carbon emissions. This meta-data will be more helpful to global investors facing systemic climate risks in their portfolios than more and more detailed and complex corporate disclosures. Factor analysis tells us that in globally diversified portfolios, sector and regional contributions to risks and returns far outweigh company-specific contributions.
So, as we seek to compel better corporate climate disclosures, which helps to price idiosyncratic risk, let’s not forget the need for better macro-economic climate data, to help understand systemic risk.
Keep it Simple.
Above all, keep carbon disclosures simple. Many jurisdictions around the world already require greenhouse gas (GHG) emissions reporting for public companies in high emitting industries… in other words, where it is material. The templates that have been developed by collaborating NGOs for adoption by ISSB represent the extraordinary efforts of many talented specialists with extensive carbon reporting expertise. But the templates do not reflect the rudimentary skills and scarce corporate resources of many smaller and medium-sized companies that need to report. A wonderful, simple, alternative proposed here by Stefan Reichelstein at the University of Mannheim cuts straight to the chase and is far more cost effective to implement. Gross and net carbon emissions, with a year-over-year trajectory. This is all that’s needed. Why? Because that enables carbon emissions to be priced, and without market pricing, this externality will be continue to be measured, and disclosed, but not managed.
The ISSB must focus initially on the information that is needed to enable regional market pricing schemes — not hypothetical, internal shadow pricing or complex disclosures about long-term strategies well beyond management’s tenure. Keep the signal clear and timely, and the market can react. Currently there is a price on carbon for only 13% of the world’s capital markets. The price on carbon is what will drive efficient strategies to achieve net zero by 2050, and give public companies that are actively investing in decarbonization cover from the unrelenting short-term profit seeking capital markets.
There is another unintended consequence of enhanced climate disclosures that ISSB needs to consider. The burden of reporting against a global standard is often viewed as the price for access to capital. But what if better GHG emissions data causes investors to flee from the hard-to-abate industries? In the EU and the US, this phenomenon is already occurring. Asset owners and managers, in an attempt to decarbonize their portfolios, actively invest in low carbon intensity sectors, or passively invest in index tracking low carbon vehicles that overweight technology and underweight industrials and extractives. Their portfolio carbon numbers go down, while carbon in the atmosphere goes dangerously up. Companies that need capital to decarbonize are denied entry to indices. In effect, well-meaning climate disclosures to date have effectively driven capital away from the companies that need it most. One need only to look at the trend in atmospheric carbon concentrations to see that sustainable investing is not (yet) working, and may even be exacerbating the problem. ISSB must evaluate the full cost-benefit equation of implementing new standards, including unintended consequences for the companies in jurisdictions that adopt the standards.
A World of Difference.
Decades of work by sustainability standards setters will be useful in informing the efforts of the newly formed ISSB. The most important contributions that the first generation of ESG standards setters will make to the effort is not their work products, but their lessons learned. What gets measured doesn’t necessarily get managed, unless it is also incentivized. Focusing on standardizing the minimum information needed to price risk, incentivize change and drive capital is what will move global markets most quickly.
Sustainability considerations, once thought fringe, are now central to adequate evaluation of risks by investors and other stakeholders. Capital markets would not have the depth and liquidity they do today without high quality and comparable information on financial performance. For the markets to continue to generate wealth and ensure that the state of the world enables them to continue to do so, there is a need for concise and relevant sustainability information of equal quality for enduring issues, and an early warning system for emerging issues.
While standards setting for the global capital markets is a serious business, we should also not imbue it with too much importance. It is not a panacea, nor a prerequisite for action. And we are running out of time. With every change, comes a reaction, as Heraclitus wisely observed. What investors and the markets, and more broadly society, really need is not just better reporting, but better companies, that are built to be resilient in the 21st century. One can only hope that the ISSB’s efforts will enhance, and not impede, the efforts of global companies and their investors to meet the extreme environmental and social challenges our communities, our markets, our societies face. This could mean a world of difference.