Post # 84
December 4, 2024
Claire Bodanis
Claire shares her ‘super insightful’ pointers for dealing with ESRS and IFRS S1 and S2, in a special bumper Christmas blog.
Last week, my lovely friends at City law firm, Ashurst, invited me to speak at their annual governance conference. As one FTSE 100 participant commented, Ashurst’s AGC is ‘always worth going to because the lawyers actually tell you useful things you need to know, and don’t just air their opinions!’ So I heartily recommend you get yourself an invitation for next year, if you’re not already on their guest list.
But a whole morning of only useful things would be a bit hard going, wouldn’t it? So they invited me along as the light relief in the sustainability reporting section, to give my opinion on how to deal with the ‘unintended consequences of sustainability reporting regulation’.
I managed to boil down to just 20 minutes my rant about the (unnecessarily) complicated European Sustainability Reporting Standards and their relationship with the (clear and well written) ISSB standards, and what to do about them without losing your mind or breaking your budget. And I even managed to tone it down, such that it was, to quote a different FTSE 100 participant, ‘super insightful’!
So I thought I’d share my five key points that I’d love you to remember, as our final blog of the year, and Falcon Windsor’s Christmas gift to all reporters.
We must think for ourselves how best to report, guided by the purpose of the standards
The double materiality analysis (DMA) is a strategic not a reporting exercise
Doing the DMA properly and reporting logically against ESRS will set us up well for the ISSB standards, IFRS S1 and S2
Tell the story in the strategic report, and provide the evidence in the sustainability statement
Make a virtue of the standards’ lack of clarity, and be brave in pursuit of the purpose of reporting – which brings me back to point 1: we must think for ourselves how best to report.
And here’s why I’d love you to remember them!
Point 1: We must think for ourselves how best to report, guided by the purpose of the standards
When I started thinking about how to deal with ESRS (the standards most of us will have to report against first), I assumed, in my naivety, that it would be like reporting against GRI, if a bit more involved. I.e., having done your materiality analysis and knowing what the issues are you need to report against, you would work through a nice tidy list of disclosures and fill in the boxes.
But unlike GRI, say, or the UK Corporate Governance Code, the ESRS disclosures are a complicated, convoluted, badly written set of cross-cutting, cross-referring requirements. They are not a nice tidy list of disclosures. So, once we get beyond the top-level headings, we must work out for ourselves a logical way of reporting against them – how to group them, under what subheadings and so on – in a manner that makes sense of the material and presents it intelligibly to our readers.
How do we do that? As with anything, it means being guided by the spirit and the purpose of the standards. Which is to get companies to properly understand and thus be able to account for their societal and environmental impacts – both risks and opportunities. Personally I find that quite inspiring, and I wholeheartedly support the EU in this endeavour. It’s just a pity that this good intention is bogged down in impenetrable verbiage – although looking on the bright side, I always love a good verbal challenge!
Point 2: The DMA is a strategic not a reporting exercise
The starting point for reporting, as mandated by ESRS, is the double materiality analysis. The words ‘double materiality analysis’, or DMA, often go hand-in-hand with a lot of f-ing and blinding, and, frankly, having seen the rubbish that comes out of many of these, I’m not surprised. But it would be a pity to disregard what could be a really valuable business exercise just because it’s done poorly – if expensively – by some.
I say valuable business exercise quite deliberately. Companies start going wrong with the standards at the very first hurdle in thinking that the DMA is a reporting exercise.
It isn’t.
Done properly, the DMA is an incredibly valuable strategic exercise that gives companies a more thorough understanding of potential risk and opportunity. It helps you think more widely and more strategically, in the longer term, about the future health and prosperity of your business.
But it has to be done properly. And that means getting the right partner to help you do it, and the right people at the right levels of seniority (i.e. very senior) inside the company to take part in it. (See the end of this blog for your stocking filler on the DMA.)
Point 3: Doing the DMA properly and reporting logically against ESRS will set us up well for the ISSB standards, IFRS S1 and S2
Another area much on UK reporters’ minds is the relationship between ESRS and the ISSB standards, IFRS S1 and S2. I’m often asked whether, if a company is reporting on ESRS, it will ‘count’ for IFRS S1 and S2 as well, seeing as we’re going to be reporting on the former first, and they are wider in scope, requiring ‘double’ as opposed to the ‘single’ materiality required by IFRS S1 and S2 (more in the stocking filler).
I wish I could say ‘yes’ – but there are technical differences, aside from the materiality point, and the IFRS and EFRAG have usefully published ‘interoperability guidance’ so that we can understand their relationship better. I imagine this will evolve, as companies start reporting in earnest and we see the standards playing out in practice.
Nonetheless, I firmly believe that doing the DMA properly and reporting logically against ESRS will set us up well for the IFRS S1 and S2. Why? On the first point, we know that through the DMA (done properly) we’ll have covered all the material issues relevant for ISSB as well. And on the second, since the purpose behind both sets of standards is similar, namely understanding the relationship between a company and the social and environmental issues in its orbit, then if we report logically, we’ll be on the right lines.
Point 4: Tell the story in the strategic report, and provide the evidence in the sustainability statement
I’ve mentioned the words ‘report logically’ a couple of times. What does that mean in practice? Let’s step back for a minute and think about the purpose of reporting. And I don’t mean sustainability reporting or specific regulations or disclosures. I mean why companies are required to report at all.
As many of you know, I describe the purpose of reporting as:
To build a relationship of trust with investors and other stakeholders through truthful, accurate reporting that people believe because it tells an honest, engaging story.
My practical response to this is to recognise that reporting serves its purpose of truth-telling by including and clearly distinguishing between two types of information. First, the annual report must tell a story – it must give a clear, engaging explanation of the business and its performance, as viewed by management and the Board. Which, by the way, must be fair, balanced and understandable, which means referencing all material issues, positive and negative. Second, it must provide the necessary disclosures – the evidence in the form of data and information that supports the story – in a manner that is easy for people to find, and easy to tag for machine reading.
In practice, this means structuring, designing, writing and producing reports with a much clearer distinction between these two types of information, guided by a good understanding of the standards and the principles behind them.
How do we apply this principle to incorporating reporting against the new standards?
The story – the insight part of the annual report – belongs in the strategic report (or EU equivalent). So you should be talking about the material issues not in some siloed section, but where they naturally occur, given that they are material to the business. In your business model, for example. And, if an issue is a material opportunity, you’d expect to see it referenced where you talk about strategy and opportunities; if it’s a material risk, you’d expect to see it talked about in the risk report.
That does not mean you have to overload the strategic report with all the disclosures required for each material issue, which are, in effect, the evidence behind your assertion of materiality. The place for that evidence is the sustainability statement itself – either an appendix in the annual report if you’re EU-listed, or if you’re not, in a standalone sustainability statement (see my recent news flash on this important subject). Either way, it should be structured as a disclosure index against the standards. This will apply equally to companies that only have to report against the ISSB standards by the way – the principle is the same.
A useful parallel for this story/evidence approach is the group financial review in the strategic report, compared with the financial statements at the back. The financial review is the story that explains what the disclosures in the back really mean.
Sounds so straightforward, doesn’t it? What’s different of course is that we already know how to structure the financial statements and notes. They follow a set form.
There is not – yet – a set form for creating the sustainability statement, structured around ESRS or the ISSB standards, because no one’s had to do it yet. And while some companies have published voluntarily in advance, none that I’ve seen have really cracked it yet – they tend to present what is disclosure information as if it were a story to be read. And, in doing so, they unbalance the annual report by making it difficult to distinguish between material and non-material information, and effectively make the whole thing feel like a sustainability report.
So what do we do?
We create our own!
As I noted at the start of this blog, this is not an easy thing to do, because the ESRS are unclear to the point of being contradictory in places. Which brings me to my final point that I’d like you to remember.
Point 5: Make a virtue of the standards’ lack of clarity, and be brave in pursuit of the purpose of reporting
Instead of wringing our hands at this challenge, I see this lack of clarity as an opportunity – an opportunity to think for ourselves about what makes most sense for the overall purpose of what we’re trying to achieve. I’m working on a first sustainability statement with a client right now, and believe me, the only way to make any sense of it is to think for yourself and constantly consider the purpose of reporting and how to ensure what you produce will be intelligible to the audience.
Because the requirements are unclear we have the opportunity to interpret them sensibly and in the spirit of the purpose of reporting.
A lot of companies are really worried about whether they’ll be able to comply and report everything they’re supposed to under each material issue by the time the reporting requirements hit them. This is often because the quality of some types of newly required data just isn’t up to scratch, or they just can’t collect it properly yet.
My response?
Don’t.
As long as you report truthfully and explain clearly where you comply, where you don’t, and why, then that’s good enough, at least in these early days. It makes no sense to report bad information that ends up being misleading because you’re racing to meet some poorly conceived deadline.
If our approach is logical, appropriate and makes sense in light of the overall purpose of what we’re all here to do, then we should do it!
When you get bored of The Great Escape – here’s a Christmas short!
If you get tired of Christmas telly, I can heartily recommend spending 45 minutes or so watching October’s webinar on today’s blog subject. I was lucky to have as panellists the wonderful Jonathan Labrey from the IFRS; Harriet Cullum from Diageo, who’s also on the UK TAC advising the government on endorsing the ISSB standards; and Janice Lingwood, an independent governance expert and about the most experienced, pragmatic and sensible person you can hope to hear from on anything regulation-related.
I am indebted to them all for much of my thinking on this subject, although all opinions expressed in this blog are entirely my own.
Happy watching!
On behalf of everyone at Falcon Windsor, I wish you all a very peaceful and happy Christmas.
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Your DMA stocking filler
A common mistake people make is thinking that the DMA is an extension of the old stakeholder engagement analysis so beloved of sustainability consultants, where you ask your internal and external stakeholders what they think is important, and then plot those points on a graph, with the cross-over determining what the material issues are.
This doesn’t work for two reasons. First – the two axes of double materiality are not internal and external stakeholder opinions. Instead they are the impacts of environmental and social issues on a company (called ‘financial’ materiality by ESRS), and the impacts of the company on those issues (not very helpfully called ‘impact’ materiality by ESRS!). Second – what makes any one of these issues material is not the interrelationship between financial and impact materiality.
Financial materiality OR impact materiality OR both
Rather, an issue can be material from a financial perspective, or from an impact perspective or both. When it comes to reporting, we have to report on all of them, not just those that are material in both respects. And so plotting them on a matrix that implies an interrelationship is misleading.
As an aside, the distinction between impact and financial materiality made by ESRS is, in my mind, a bit of a blunt instrument for political purposes: after all, they’re not mutually exclusive. A company’s impact on the social and environmental issues around it tend to give rise to indirect risks and opportunities that may then become financially material at some point in the future, even if they aren’t technically financially material right now.
For example – treatment of employees. Treat your employees poorly (impact materiality) may not be financially material and thus need reporting in that respect right now, but it might become so in the longer term, as you become known for being a poor employer, and you find it difficult to attract and retain the right people. And so your cost of hiring goes up and perhaps your ability to do business effectively reduces.
Group level with sub-sub-topic detail is easiest
A question for many companies with subsidiaries in Europe caught in the net is whether they should report at Group or subsidiary level. From everything I’ve seen so far, reporting at Group level is easiest, for two main reasons. First, because the financial materiality threshold is so much higher, and second because the related systems tend to be set up to report externally at Group level. (Although some companies, who are perhaps nervous about doing a Group materiality analysis straight off, are doing a ‘pilot’ with a subsidiary to see how it works in practice – reckoning that no one’s going to read what’s purely a compliance filing anyway!)
The other mistake people make with the DMA is thinking that it’s easier to conduct a materiality analysis at a high, superficial level when considering the detail. Aside from it being a waste of money since it tells you little you don’t already know, it gets you into all sorts of trouble with ESRS reporting.
Why? ESRS has 10 topic standards, 37 sub-topics, and 73 sub-sub-topics. (With all the disclosures that sit behind them.) For example – one of the topic standards, ‘own workforce’, has three subtopics, and 17 sub-sub-topics. If you stick to the high level and conclude that ‘own workforce’ is material, then you bring in – and have to report on – all the three subtopics, and the 17 sub-sub-topics and all their related disclosures. Much better to go to the detailed level, because by doing so you can then rule out all the ones that sit above it. And you will have a far more useful analysis since you’ll properly understand what specific issues are material to your business.
The relationship between ESRS and IFRS S1 and S2
One of the main differences between ESRS and the ISSB standards is that the ISSB doesn’t distinguish between different types of materiality, and instead uses the materiality definition used in the accounting standards, which is broadly equivalent to the ‘financial materiality’ aspect of ESRS. So under IFRS S1 and S2, we need report only on those issues that are financially material now.
But the ISSB, no doubt with an eye to Europe, also requires us to distinguish between material and non-material issues in our reporting. It’ll therefore be important to be absolutely clear what is financially material and what is only impact material to comply with IFRS S1 and S2, since the latter will not be deemed material at all. All the more important, then, that we don’t confuse our readers by plotting the material issues on one of those stakeholder matrix type graphs referred to above.
And that’s it – time for my tangerine and chocolate money…