Don’t hold your breath for a global ESG standard
It’s almost a cliché to describe the progress towards globally consistent reporting by companies on environment, social and governance (ESG) as a journey. But that seems to be the most appropriate analogy for the process of developing ESG reporting standards. And, when it comes to this journey, our research indicates that asset managers agree on the destination but not on the route.
Asset managers’ views on proposed ESG reporting standards tend to differ depending on which side of the Atlantic they are on. But even then, officials in the same region often have very different opinions on important elements of these standards.
Consistency of destinations
Responding to investor demand for “high-quality, globally comparable sustainability information for capital markets”, the new International Sustainability Standards Council published two draft ESG reporting standards in March 2022. One focuses on general financial information related to sustainability; the other on climate-related disclosures.
The drafts were closed for public comment at the end of July. The ISSB aims to establish a “global baseline” – an internationally consistent minimum standard of disclosure required for sustainability reporting by companies to investors – which would also help companies meet the requirements of national regulators.
In our last article, we examine responses to draft standards from 20 US and European-based asset managers responsible for over $40 trillion in assets under management. This type of analysis helps us better understand the underlying thinking behind asset managers’ ESG approaches.
As Morningstar’s own response at the ISSB states:
“Asset managers invest globally; they absolutely need some international convergence to be able to communicate meaningful aggregate information to end users.
Overall, asset managers are very much on board with this. All of the comment letters we reviewed stated that they “supported”, “welcomed”, “applauded” or “agreed that there was a need” for the ISSB’s efforts in this regard.
Two key questions
Despite broad agreement on the end goal, asset managers’ opinions vary widely on the key areas addressed by the draft standards. In particular, opinions diverge on two key issues: the definition of “materiality” and the scope of mandatory information on greenhouse gas emissions. These were also the main dividing lines in the SEC’s earlier consultation on its proposed climate rule.
This divergence suggests that a “global baseline” will be difficult to achieve without major changes in approach from the ISSB or other standard setters, particularly the SEC and the European Commission, which have also recently consulted on its own climate and sustainability reporting standards.
1) How to define materiality?
According to the ISSB’s proposals, a company “would disclose material information about all material sustainability risks and opportunities to which it is exposed. […] in the context of the information needed by users of general purpose financial reporting to assess the value of the business.
This approach is often referred to as “single materiality” or “financial materiality” because it primarily considers the financial impacts of ESG risks and opportunities on a company. The SEC’s proposed climate rule also uses a single materiality approach.
This contrasts with the dual materiality approach proposed in the European Commission’s draft standards, which considers the financial impacts on the business and the impacts of the business on the environment and society at large.
Asset managers’ responses on this topic can be divided into three groups. Respondents commenting on materiality are generally either:
- agree with the ISSB’s proposal for a materiality approach that focuses on enterprise value;
- favor a flexible approach that uses a definition of materiality aligned with the local jurisdiction’s own definition; Where
- advocate for a “dual materiality” approach.
There is no clear and dominant opinion among the 20 respondents, but many seem to recognize the big difference in approach between US and European regulators on this issue and are aware that the single materiality approach used in the United States United is unlikely to change.
Several managers, mostly based in the United States, agree with the ISSB’s enterprise value approach, including Capital Group, Dimensional and Vanguard. Five of the largest US managers – BlackRock, Invesco, Northern Trust, State Street and T. Rowe Price – all advocate “a more flexible approach that would allow companies to apply the same standard of materiality that they apply today to financial reports”. as State Street says.
Most of the European managers in our selection support a dual materiality approach. One of them, DWS, believes that “without this, the needs of investors and other stakeholders will not be met”, and he is not alone in this view. Abrdn, Allianz, Amundi and Schroders, as well as PGIM in the US, all express similar views.
2) Greenhouse gas emissions: what should be disclosed?
The Greenhouse Gas Protocol, an existing voluntary reporting framework, separates greenhouse gas emissions into direct emissions (scope 1), indirect emissions related to electricity consumption (scope 2) and other indirect emissions related to goods and services that the reporting company produces or uses (scope 3).
The ISSB draft climate standard proposes that companies be required to report scope 1, 2 and 3 emissions. This differs significantly from the SEC proposal, which requires reporting only on scope 1 and 2. The SEC requires Scope 3 disclosures only in certain circumstances. This increases the risk of further discrepancies in reporting practices regarding Scope 3 emissions. This is also reflected in asset manager comments on the subject.
Most of the 20 respondents agree that disclosure of Scope 1 and 2 emissions is essential. The only exception is Dimensional, which believes companies should only provide greenhouse gas emissions reports if climate change is a material financial issue for the company.
Support for scope 3 reporting is lighter but still substantial. Eight of the 20 managers – including BNP Paribas, Capital Group, Legal & General and Northern Trust – indicate that they believe Scope 3 reporting is “necessary for investors to develop a complete picture of transition risk exposure and assess investment risks and opportunities,” as Wellington puts it.
Several other respondents – including BlackRock, Invesco, State Street, T. Rowe Price and Vanguard – believe that Scope 3 emissions disclosure methodologies are not mature enough to require mandatory disclosure by all companies to the actual hour.
Some of these companies suggest that Scope 3 disclosures should only be required when material; others suggest they should be postponed until more robust measurement methods are available.
What is the follow-up to the ISSB’s proposals?
Given this wide range of views, we can expect the ISSB to pay close attention to its next steps. Asset managers’ calls for the ISSB to expand its cooperation with other regulators and standard setters adds another dimension for this advice to consider.
The ISSB aims to finalize the new reporting standards by the end of this year. Hopefully by then we will have a much clearer view of how a global benchmark for ESG reporting might be achieved.
Lindsey Stewart is a CFA charterholder and director of investment stewardship at Morningstar