The ISSB Puts Portfolio Materiality on the Table
ISSB ADOPTS INITIAL STANDARDS WITH COMPANY-SPECIFIC MODEL OF MATERIALITY
In a prior post on this Forum, I discussed the need for the International Sustainability Standards Board (ISSB) to adopt a “sesquimateriality” approach to disclosure: one that would require reporting companies to disclose any sustainability information that was material to the performance of a diversified portfolio, rather than limiting mandatory disclosure to matters that would impact the prospects of the reporting company itself. At that time, the ISSB was just beginning its process. Now, more than two years later, it has adopted two standards, one on general requirements and one on climate, and more than 20 jurisdictions are using or taking steps to introduce the framework into their disclosure mandates.
Neither standard utilized the portfolio lens of sesquimateriality, but there are indications that could change, at least for future standards. As discussed below, the change would improve investor decision-making, fortify corporate accountability, and create more efficient capital markets, all in keeping with the tripartite mission of the IFRS.
ISSB TO CONSIDER PORTFOLIO MATERIALITY FOR NEW STANDARDS
The Staff of the IFRS Foundation (the international accounting standard setter that established the ISSB) is now in the process of investigating additional standards. They have developed a research plan regarding new standards for biodiversity, ecosystems, and ecosystem services (BEES) and human capital. These standards will cover matters such as human rights and forest degradation. That plan includes the following goal in paragraph 24:
The research will aim to understand whether BEES- and human capital-related financial implications arise from idiosyncratic versus systemic risks and opportunities and how they relate to investor portfolio versus entity-specific information.
This research goal specifically addresses the gap between the current standards (“idiosyncratic” and “entity-specific”) and the broader type of information the earlier post referred to as sesquimateriality (“portfolio” and “systemic.”)
Climate provides an example of the distinction. The current standard only requires a company to report greenhouse gas (GHG) metrics and targets that are reasonably likely to affect its own financial prospects. In contrast, a portfolio-cognizant standard would expressly require a company to report baseline data designed to show how its emissions impact the prospects of typical investment portfolios by contributing to climate change—whether or not the emissions were material to the prospects of the reporting company itself. A portfolio-cognizant disclosure standard would apply the same idea to human rights, biodiversity, and other systemic concerns, broadening the lens applied to sustainability issues well beyond the reporting company’s own cash flows and financing prospects.
THE IMPORTANCE OF SYSTEMIC VALUE TO INVESTORS
The vector of value from reporting company impact to investment portfolios begins with modern investing principles, which recognize that diversification allows investors to earn the superior financial returns that come from bearing risk while diversifying some of that risk away. Indeed, in many cases, the laws that govern investors who act in a fiduciary capacity require such diversification. Thus, for practical and legal reasons, modern investors are, by and large, diversified (or, in the case of intermediaries such as asset managers, owe allegiance to clients and beneficiaries who are diversified).
The return to diversified portfolios depends upon overall securities market returns (sometimes referred to as “beta”) more than the relative performance or cash flows and value of individual entities. (This relatively new usage can be confusing, as “beta” has an established meaning in finance, so this article will use “beta*” to refer to market returns.) As one work describes this, “[a]ccording to widely accepted research, alpha [over- or under-performance of individual securities] is about one-tenth as important as beta[* which] drives some 91 percent of the average portfolio’s return.”
Over long time periods, beta* is influenced chiefly by the performance of the economy itself, because the investable universe comprises the portion of the productive economy represented by investable companies and projects. Critically, the economy (and correspondingly, the investable portion) can be negatively impacted when companies act unsustainably. Such behavior degrades social, economic, and environmental systems; these negative externalities burden the entire economy.
As a result of these relationships, diversified investors internalize the collective costs of corporate externalities because they degrade the systems upon which economic growth, corporate financial returns, and diversified portfolios depend. Diversified investors absorb these costs even when they do not impact the prospects of the externalizing company. Returning to the climate example, one recent study suggests that the economy’s current greenhouse gas emissions trajectory may lead to a rerating of the entire equities market of 30-40% in comparison to a Paris-aligned economy. Another calculation suggests a 30% loss to the compound return on a typical 60/40 equity/debt portfolio over the next 40 years.
The following figure illustrates the path by which externalized costs impact diversified investors, regardless of the impact those costs may have on the prospects of the externalizing company.
This flow of value means that investors can use information about cost externalization by companies to decide how stewardship of corporate behavior might protect and enhance their financial returns. Stewardship may take the form of proxy voting, investment decisions, policy influence, and other actions. In other words, systemic impact information will allow investors to hold companies accountable for the manner in which they use investor capital, and the effect of such use on investment portfolios.
WHERE INTERESTS DIVERGE
As a result of the relationship between cost externalization and portfolio value, information regarding a company’s systemic impact has a particular importance to investors when it does not have a similar impact on the company itself. In such circumstances, company management may be incentivized to externalize costs if doing so can increase cash company flows, even if its investors absorb those costs through other entities in their portfolios.
Put more colloquially, from the company’s vantage point, profitably externalizing costs is a free lunch, while from a diversified investor’s vantage point, the lunch can be quite expensive. Accordingly, investors must be alert to the possibility that their capital is being used against their own interests by executives motivated to prioritize the value of their companies over the interests of broader portfolios. Disclosures regarding systemic impact are necessary to allow investors to protect their investments against such behavior.
EFFICIENT MARKETS NEED SYSTEMIC, PORTFOLIO LEVEL INFORMATION
To be clear, the company-specific modality of the first two ISSB standards is consistent with many financial disclosure systems and indeed, with most aspects of financial systems more generally. But this enterprise-level focus is arguably at the root of some of the globe’s most seemingly intractable problems. Broadening the ISSB standards’ focus could do more than improve the financial performance of investors in companies that use the framework for reporting; the expansion could be an important step towards rationalizing the financial system we use to allocate resources in a market economy.
Our markets rely upon profit signals to tell participants what to buy and sell throughout the supply chain. In theory, the companies make choices (i.e., allocate society’s resources) in a manner that maximizes value for investors as measured by the margin between their costs and revenue—their profit—and, as a byproduct, optimize society’s resource allocation. Market-based financial systems thus turn “private vice” into “public benefit” in Mandeville’s terminology.
But the vice in a financial system that only measures and manages economic success at the individual company level will miss the target of public benefit when it does not account for the significant systemic value that companies create or destroy outside their value chain. As discussed above, this is dangerous for investors, who rely upon social, environmental, and economic systems to support their diversified portfolios, but it also means that the economy’s reliance upon investors to allocate resources is inefficient, because markets will not account for the true cost that companies impose on social, environmental, and economic systems.
The effect of antibiotics in supply chains provides an important example. A restaurant company might increase its profits by using suppliers who overuse antibiotics in meat production, allowing them to reduce expenses by cramming animals into shockingly tight spaces, but thereby breeding pathogens that are resistant to live-saving antibiotics. All of the cost savings accrue to the company and its suppliers, while the cost of antibiotic overuse is paid by society as a whole, in the form of a growing global crisis of antimicrobial resistance, which will create an estimated USD100 trillion loss to global GDP by 2050—not to mention 10 million deaths per year. Of course, this 15-figure hit to the economy will be felt by long-term, diversified investors.
Yet our current financial system—including disclosure regimes, the design of equity incentives, and asset manager compensation based on alpha—is sharply attuned to the cost-saving achieved through antimicrobial abuse at individual companies but does nothing to account for the enormous corresponding social cost. Nothing in the current structure of ISSB standards is designed provide information that equips markets to address this cost, or the costs imposed when companies emit GHG, ignore human rights violations, or engage in a myriad of practices that increase their profits, but burden the broader economy.
This gap between value at the company level and systemic value is what Duncan Austin called the “dropped stitch of 20th century economics.” The IFRS research paper flags the existence of the gap by contrasting “idiosyncratic versus systemic risks,” pointing the way toward a remedy.
TIME FOR A CHANGE
Financial disclosure is not just a numbers game; the failure to address the true cost of corporate activity means that most current financial disclosure systems neither protect investors nor promote economic efficiency. Indeed, their company-specific focus encourages dangerous and inefficient resource allocation because it rewards companies that increase their enterprise value by externalizing social and environmental costs that undermine the economy and their investors’ portfolios. This upside down prioritization sits at the root of the climate crisis, biodiversity loss, growth-sapping inequality, and a myriad of other global threats generated by business practices that prioritize company profits over the critical systems that support the portfolios of investors (and our way of life).
It is past time to expand the aperture of the financial system, and ISSB has the scope to begin this work: the IFRS has a three-part mission to (1) improve investor decision-making, (2) strengthen accountability to capital providers, and (3) facilitate economic efficiency through improved capital allocation. Weaving the financial implications of reporting companies’ systemic impacts into the ISSB standards will fulfill this mission by meeting the needs of its investors, creating greater accountability on the part of corporate management, and ultimately leading to a better allocation of resources throughout the economy.
The IFRS paper signals that the international group most identified with financial disclosure is considering closing a critical gap. This could serve as a first step in recalibrating the financial system to account for the true cost of the goods and services produced in our economy. If financial disclosure were to clearly call out the threats that companies impose on investors’ portfolios, those investors would understand the imperative to steward companies away from such conduct, and to address other elements of the financial system that imperil their capital.
