A Comparative Analysis Of Three Proposals For Climate-Related Disclosures

In January of last year I noted how the narrative on sustainability reporting had changed from the belief that market forces will determine the standards because there is no need for regulatory reporting requirements, to the obvious recognition that, as with accounting, we need regulators to create the standards and enforce their use. In this piece I would like to focus on just one aspect of sustainability reporting—standards for climate-related disclosures.

There are three significant new proposals now in the public domain for comment:

1. The U.S. Securities and Exchange Commission’s proposed rule for “The Enhancement and Standardization of Climate-Related Disclosures for Investors” with comments due by June 17, 2022.

2. The International Sustainability Standards Board’s (ISSB) “[Draft] IFRS S-2 Climate-related Disclosures” with comments due by July 22, 2022.

3. The European Sustainability Reporting Standards (ESRS) developed by the European Financial Reporting Advisory Group (EFRAG) “ESRS E1: Climate change” with comments due by August 8, 2022.

The obvious question to ask is “Are we going to get a global standard for climate-related reporting if three different organizations have just issued new proposals?” Maybe we’re just swapping out the past confusion created by multiple NGOs proposing standards for confusion stemming from regulatory bodies (the SEC and EU) and an organization backed by regulatory bodies (the ISSB)?” This question is fundamentally important. Climate change is a global issue and investors hold portfolios of companies all over the world.

The context for each standard-setting group is very different. The SEC is working in a highly politicized and polarized environment, with many (mostly Republicans) denying the existence of climate change, or denying that it’s a result of human activity, or whistling past the graveyard thinking that market forces and technological innovation will bail us out. In contrast, EFRAG is working in a political context where the EU sees addressing climate change as an opportunity for creating economic competitive advantage through the European Green Deal supported by the EU Taxonomy. Finally, the IFRS Foundation is an independent standard-setting organization which relies upon governments to mandate its standards. Most countries have endorsed the International Financial Reporting Standards (IFRS) of the International Accounting Standards Board (IASB); the U.S. is the obvious exception, replying instead upon U.S. Generally Accepted Accounting Principles (U.S. GAAP) developed by the Financial Accounting Standards Board (FASB).

All three proposals reflect the context in which they are created. All three are very thoughtful and contain a myriad of complicated issues and different views that need to be addressed. The nature of their implementation will also vary. We won’t know the details until the final standards are released after the comment periods close and each body reviews the feedback it has received, which itself will be a complex and time consuming process.

What do we know now? The good news is that all three proposals have a lot more in common than different. Some of the differences are important, but I am optimistic that the groundwork is being laid for a truly global standard for climate-related disclosures, with the necessary nuances to accommodate the laws, regulations, and customs of different jurisdictions. I reach this optimistic conclusion based on a recently released report, “The Evolution of Sustainability Disclosure: Comparing the 2022 SEC, ESRS, and ISSB Proposals,” by Persefoni (to whom I’m an advisor) and The SustainAbility Institute by ERM. This report is based on a careful comparative review of all three proposals.

The foundation for broad commonality relies on the fact the framework developed by the Task Force on Climate-related Financial Disclosures (TCFD) is foundational for all three proposals. All three build on the widely-used Greenhouse Gas (GHG) Protocol as well. These are good examples of how non-governmental initiatives can lay the groundwork for adoption by governments. Something similar is evident in how the work of the Value Reporting Foundation (the artist formerly known as the Sustainability Accounting Standards Board) for industry-specific standards has been incorporated into IFRS S-2.

The four elements of the TCFD framework are governance, strategy, risk management, and metrics and targets. “The Devil in the Detail” box summarizes how each proposal aligns with the TCFD.

The greatest degree of alignment between the three proposals and TCFD is with governance. The report notes that “Each of the three proposals fully aligns with the Governance guidance outlined by the TCFD, and additional components are minimal.” This is extremely important because it means that whatever proposal a company will be required to adopt, all of them will be grounded in reflecting the importance of addressing the risks and opportunities of climate change at the top of the organization, with its board of directors and executive management. This guidance will be very useful to boards of directors. The Commonwealth Climate and Law Initiative (CCLI) has done extensive work “examining the legal basis for directors and trustees to consider, manage, and report on climate change-related risk, and the circumstances in which they may be liable for failing to do so.” I have previously written about their recent report showing this even applies to directors of U.S. companies.

In terms of strategy, all three proposals note the utility of scenario analysis, described in the report as “an analytical tool that helps companies develop climate plans and assess their resilience to climate-related risks by charting out business implications and potential consequences in a number of different climate scenarios.” Scenario analysis is not required by the SEC, but it is for the ISSB and EFRS, both of which have strategy reporting requirements that go beyond the TCFD.

All three proposals are also largely aligned with the risk management component. The biggest difference, according to the report, is that “the EFRS proposal includes the concept of double materiality as the union of impact and financial materiality.” Financial (i.e., single) materiality concerns the sustainability issues important to enterprise value creation. Impact (i.e., double) materiality is about how a company affects society in environmental and social terms regardless of the importance to enterprise value creation.

Finally, for metrics and targets, all three proposals regarding GHG emissions require disclosure regarding Scope 1 (emissions from a company’s operations) and Scope 2 (emissions from purchased electricity). The SEC and ISSB require Scope 1 and 2 disclosures in both absolute and intensity terms. EFRS requires absolute GHG emissions supplemented by share of Scope 1 under regulated emission trading schemes and both market-based and location-based Scope 2 emissions.

The largest differences are for Scope 3 (emissions throughout the company’s value chain, both upstream and downstream). These are much more difficult to measure. In general, investors want them, while companies are concerned about their ability to generate accurate Scope 3 information and the cost of doing so. The SEC’s requirement is the most parsimonious, only requiring Scope 3 disclosures if financially material or where a company has set Scope 3 reduction targets. Scope 3 is mandatory for both EFRS and ISSB but with some technical differences. In my view, getting global alignment on Scope 3 disclosures will be especially challenging. We should wait and see what the requirements are in the final standards. I also note that companies can choose, or be pressured to by investors, to disclose more on Scope 3 than the standard may require.

The “Eight Takeaways” box below summarizes the major conclusions drawn from the Persefoni and ERM analysis. I have already discussed the first two. The SEC and EFRS both require third-party assurance, although neither is prescriptive about who should provide this assurance, or the qualifications required for doing so. Since the ISSB itself cannot mandate the use of its standards, it will be up to the jurisdictions that require them to determine what, if any, the assurance requirements will be.

The proposals differ in terms of how prescriptive they are and the scope they cover. EFRS is the most prescriptive and the SEC the most principles-based, although it is quite prescriptive in some ways. Right now the SEC is only focused on climate. EFRS has issued a large number of standards. ISSB has also issued a general requirements standard (IFRS S-1) that will be the basis for future standards on different sustainability topics. In terms of the number of companies that will be subject to these standards, in the U.S. it is around 11,000 listed companies. In the EU it is 49,000 companies, both listed and unlisted, based on size criteria in terms of number of employees and revenues. For the ISSB, it will depend on which jurisdictions mandate their standards.

While this high degree of commonality provides some realistic hope for a global baseline on climate-related disclosures, the elephant in the room is how jurisdictions will deal with the standards set by others. Will the SEC allow companies to use ISSB? It has solicited public comment on this. Similarly, ESRS has stated that “other reporting standards can be used in addition [emphasis mine] to the EFRS.” This begs the question as to whether EFRS will acknowledge the ISSB on sustainability topics covered by both standards. This is obviously a fundamental question for EU companies since they all use IFRS. Non-EU companies that use IFRS will either choose to adopt ISSB or something similar (as some do with IFRS) or, highly unlikely in my view, come up with their own set of standards.

While the proposals implementation timelines vary by calendar and according to type of company, the general time frame looks to be 2023 at the earliest and, more reasonable in my view, 2024 or maybe 2025 for smaller companies.

I do not know how long it will take each body to review their comment letters and issue their final standards, which can always be adjusted in the future based on what is learned from their implementation. I’m guessing we’ll have all three by the end of the year. I’m also guessing that a similar comparative analysis done then wouldn’t turn up anything significantly different.

The key point is that great progress is being made developing a global baseline for climate-related disclosures. This bodes well for standards for other sustainability issues. My dream is that within five to 10 years we have a solid set of sustainability reporting standards on which high-quality assurance can be done, just as we have for financial reporting. Today it’s hard to imagine a world without required financial reporting based on a set of standards about a company’s financial performance. Another dream is that 10 years from now it will be hard to imagine a world without the same being true for a company’s sustainability performance.

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