Rising climate-related material impacts mean now is the time to consider upgrading climate reporting and integrating it in risk management and strategy ahead of pending regulation.
Ahead of the Securities and Exchange Commission’s (SEC) highly anticipated final ruling on its proposed climate disclosure rules, many U.S. companies appear hesitant to fully implement steps to prepare to disclose greenhouse gas (GHG) emissions and climate-related risks through the annual financial reporting process. Controversy around the impending rules, which received a record 15,000 comments, followed by indications that proposed Scope 3 GHG emissions reporting requirements may be revised, has created uncertainty on the content of final climate disclosure rules. But according to Robert G. Eccles, Visiting Professor at Oxford University’s Saïd Business School and founding Chairman of the Sustainability Accounting Standards Board (SASB), companies should put aside the wait-and-see approach on enhancing their sustainability disclosure strategy because of the increasing financial materiality of their climate-related risks and actions.
“Climate-related impacts that can have a material impact on enterprise value should be the priority focus for companies in their decision-making about taking action to get ahead of final climate-related reporting standards,” says Eccles in a conversation with Kristen Sullivan, Audit & Assurance partner at Deloitte & Touche LLP and Global Audit & Assurance Sustainability and Climate Services leader.
They discuss the latest developments in climate reporting regulation affecting U.S. companies, market forces behind fast-evolving understanding of materiality in ESG issues, and how companies can use the market accountability mechanisms of sustainability reporting standards and assurance to integrate climate materiality considerations more systematically in their enterprise risk management (ERM), business strategy, and governance and controls environment.
Companies are having to sort through new and proposed climate reporting rules, guidance from multiple jurisdictions, and ongoing uncertainty over what will be included in the SEC’s proposed climate rule. What sustainability reporting developments do you consider to be most important for U.S. companies?
Eccles: I think it’s important for companies to understand the evolution in how the concept of materiality applies to ESG reporting and disclosure. And with the expected finalization of disclosure rules from the SEC and of the International Sustainability Standards Board (ISSB) standards, that understanding will likely be further enhanced. This trend has played a part in another important development, too: the politicization of ESG and what it means to use ESG as an investment criteria to evaluate company value.
ESG disclosure is about risks and opportunities that matter to investors, which is captured under the concept of “materiality.” ESG is about enterprise value creation, and is therefore important to investors, making it a focus of risk management. What is material is something that is determined by conversations between companies and investors, not by others. Of course, companies may be doing things that have a positive or negative impact on society, which may not be effectively captured from a value creation point of view. ESG materiality, which is about risks related to a company’s operations and activities, is different. In my view, it is the role of politicians to address these externalities when they are negative. How best to do this can be resolved through elections, laws, and regulations.
It’s important to note that the climate disclosure focus of both the SEC and the ISSB is grounded in materiality and how companies are managing the risks related to climate change and other sustainability issues.
Sullivan: There is a lot going on in the sustainability reporting space and more to come. To me, the main takeaway for U.S. companies is clear: global capital markets and regulators want enhanced disclosure of material ESG performance information that reflects how the company understands and acts on climate-related and other ESG issues impacting business risk and resilience. Standards drive adherence to criteria around materiality determination, but they can also drive trust and confidence in company disclosures. That helps drive a more efficient ESG data ecosystem.
Most of the S&P 500 and the Russell 1000 produce sustainability reports, but many investors don’t have confidence in them because the information varies so widely from one company to another. Investors are increasingly demanding sustainability reporting adhere to a common set of standards, just as it does with financial reporting. To Bob’s point, they want that standardized information from companies because climate change is recognized as being material to company performance.
While it remains unclear whether the SEC will include Scope 3 GHG emissions disclosures in its final climate reporting rules, it is required under the recently finalized EU Corporate Sustainability Reporting Directive (CSRD), which is applicable to many U.S. companies with EU operations, and Scope 3 GHG emissions disclosure will be required under the second of ISSB’s two Climate Disclosure Standards (S1 and S2). ISSB’s voluntary standards will likely be highly valuable for companies because they have converged multiple sustainability reporting standards already in use by many companies and they are expected to be adopted through regulation in jurisdictions around the world
Another important development is the gradual merging of materiality and impact in ESG disclosure, which Bob noted. For example, the CSRD requires companies to report not only the financial impact of their climate risks and related actions but also their broader stakeholder impact. This concept is known as “double materiality” and considers both the financial impact of ESG topics on the company’s enterprise value and the impact on the environment, economy, and society of the company’s products and services. The impact materiality concept draws on the foundation of the Global Reporting Initiative, a widely adopted set of sustainability reporting standards used to help organizations communicate and demonstrate accountability for their impacts on the environment, economy, and people.
What are some implications of those developments for U.S. companies, especially those waiting to enhance their ESG disclosure strategy until the SEC issues its climate-related reporting standards and implementation deadlines?
Sullivan: ESG risk is business risk. It is evolving rapidly and should be considered in boardroom discussions because it ties in closely to strategy, especially as stakeholder expectations evolve to become regulatory requirements. Our recent Sustainability action report found that many companies are taking steps to prepare for additional disclosure requirements. For example, 89% of surveyed executives say their companies have enhanced internal goal-setting and accountability mechanisms to promote readiness for enhanced reporting standards.
Eccles: Company management should understand that reporting on material ESG risks is not simply about preparing to comply with upcoming regulations; existing SEC rules already direct companies to disclose any material impacts on their business. So, if a company makes statements about how it’s responding to climate change and a stakeholder relies on that information to evaluate the company, that introduces materiality. And that information becomes part of the accountability mechanism in the capital markets. In my view, what the SEC is doing is to simply provide greater clarity on how to make these material disclosures.
What can companies be doing ahead of the final SEC rules?
Eccles: First, understand the SEC’s proposed rules and ignore whatever ‘noise’ that may ensue once the final rules are issued, because it won’t matter to investors.
Second, CFOs, chief risk officers, chief sustainability officers, and others can familiarize themselves with and take steps to align to the initial ISSB Sustainability Disclosure Standards, S1 and S2, that will become effective in January 2024. Adopting those standards can help navigate complex ESG regulatory developments across multiple jurisdictions, including the proposed SEC climate disclosure requirements. ISSB provides an effective framework to help companies perform their materiality analysis. As part of that exercise, management should use the SASB Materiality Finder for guidance on the material issues particular to their industry.
Those two steps can enable companies to develop a point of view on their material climate-related considerations. They can review that materiality analysis with their board of directors and be able to demonstrate to shareholders and the market how they’re linking that analysis to strategy, capital allocation, and risk management. If U.S. companies do the work to build a point of view on their material ESG issues, implement rigorous processes for how they make that determination, including internal controls and measurement systems, and get signoff from their board of directors and input from their investors, they’ll likely be well-prepared.
Sullivan: U.S. companies should rapidly gain an understanding of the broad implications of E.U. regulation, too, because many will be impacted by it, whether through their E.U. operations or through disclosure demands from customers or investors impacted by the regulation. Understanding what steps they may need to take to comply with the CSRD, and the European Sustainability Reporting Standards, will also help them determine how to address the way financial materiality and impact materiality considerations are evaluated in ESG reporting and disclosure standards—and for investors.
It’s important for companies to open up and potentially revise their ERM process to understand how material climate-related and broader ESG risks relate to the business and to strategy and to assess whether they are prioritizing controls and data to evaluate impact and likelihood over different time horizons. Integrating material climate-related risks into ERM helps drive prioritization, visibility and engagement with the board and senior leaders on ESG. Additionally, internal audit and external assurance are important components of an effective governance structure and can be effective tools in driving strategic adherence to material ESG risk management and performance.
Integrating material climate-related and other ESG issues into ERM will also help drive the business case to invest in the systems, processes, and controls that may be necessary to measure, manage, and confidently communicate these material risks and drive trust with stakeholders.