Where would I start in talking about sustainability and corporate reporting? First, corporations all over the world identify and understand the key factors behind their success, and also identify and understand the key factors that are risks or obstacles to their success. Second, investors should have enough access to information about those factors to make informed individual investment decisions, which collectively should become the financial market’s capital allocation decisions. Some key factors are readily apparent in historical financial statements and other financial reporting. Others are less obvious but can represent potential red flags, such as quarter after quarter of net income accompanied by negative operating cash flow, quarter after quarter of negative current ratios, or topline growth that correlates entirely to acquisition activity.
However, many other key factors are not apparent from the financial statements or related financial reporting. Here are just a few examples: the risk of stranded assets for a company involved in resource extraction; the opportunity provided by assured access to a critical resource for a manufacturing company, especially where comparable access is problematic for other companies in the industry; the risk of disruption in supply chains that are critical to a product that’s material to a company; the opportunity for a regulatory breakthrough that will lead to a successful product or service that creates value, or conversely, the risk of regulatory action that would have a material negative impact on a company’s financial performance or operations.
The key factors that are not part of the financial statements or financial reporting, but that support value creation or constitute risks or obstacles to value creation, are the grist for the mill of ESG [environmental, social, and governance] reporting and for SASB [Sustainability Accounting Standards Board]. To paraphrase the first sentence of our current mission statement, SASB was established to set industry-specific standards for corporate sustainability disclosure, with a view towards ensuring that the information disclosed is financially material, comparable and decision-useful for investors.
SASB’s Governing Principles
Let’s parse the key elements. First, the standards are to be industry-specific. I think it’s axiomatic that the ESG factors that are important to value creation are different for a financial institution, or a beverage company, or for a chemical manufacturer, or a retail company. However, much of the ESG disclosure that is requested by stakeholders and provided by issuers in sustainability questionnaires and reports does not differentiate by industry. As a result, companies spend inordinate, unnecessary amounts of time amassing information that is beside the point. And the information that may make a difference in the performance or value creation of a company is buried in dozens of pages of information that probably makes no difference.
Second, SASB’s mission relates to disclosure, not the evaluation of results. Having said that, SASB would cheerfully admit, as would the SEC in its more candid moments, that disclosure requirements can drive behavior and outcomes. Moreover, the most meaningful disclosure regarding ESG topics follows from managing to those same topics. Having a company that engages in ESG disclosure because there is investor or other stakeholder demand for it, while not having a management system that measures performance of ESG topics that are important to the company’s performance, is suboptimal, if not irrational.
Third, the standards are designed by SASB to produce disclosure for the specific audience of investors. There are dozens, even hundreds of organizations that seek, receive, tabulate, evaluate, and give scores and ratings on ESG disclosure. They do so for a wide audience of different stakeholders, including investors, customers, employees, communities, voters, regulators, NGOs [nongovernmental organizations], and others. SASB respects and indeed supports other ESG disclosure regimes that are targeted to these wider audiences and considers them as complementary to SASB standards. But SASB standards are specifically designed for use by investors.
Fourth, not surprising given that the standards target an audience of investors, the ESG information to be disclosed under the SASB standards should be financially material. SASB’s determination of financial materiality begins with the U.S. federal securities law definition: “Information is material if there is a substantial likelihood that its disclosure would be viewed by the reasonable investor as significantly altering the total mix of information made available.”
The SASB approach leads to a less inclusive concept of materiality than that used by some other organizations seeking ESG disclosure, or used in some other jurisdictions’ regulatory regimes. The SASB approach also results in a higher likelihood that its standards will call for disclosure of globally relevant, financially material information. This is because the SASB approach will lead to disclosure that meets the test of relevance under regimes for which the standard of materiality is more inclusive. Moreover, U.S. registration and resulting adoption of U.S. material standards for disclosure by a large number of non-U.S. companies, including many of the world’s largest companies, already ensures that ESG disclosure under the SASB standards will be globally relevant.
Fifth, the standards should produce decision-useful disclosure. Specifically, and not surprising given that investors are the target audience, the disclosures produced by the standards should provide financially material information that is useful in the context of investment and voting decisions. Those decisions drive performance and value and collectively drive the allocation of capital.
Finally, disclosure under the SASB standards should be comparable. In particular, because of the industry-specific nature of the standards, disclosure by companies within an industry should be comparable to be most helpful to investors. In certain areas, SASB standards focus on metrics, and one reason is that metrics are more likely to lead to an increase in comparability of disclosures among companies.
There is a constant tension between investors’ desire for comparable information and each company’s desire for flexibility, and for the ability to tell its own story in its own way. There’s more comparability in financial reporting than in other disclosure because accounting standards provide the baseline for financial reporting. SASB in its standards setting is seeking to drive comparability by providing a similar baseline for ESG disclosure.
Determining what ESG disclosure is financially material is an important exercise in evaluating known future trends and uncertainties.
How the Standards Are Made
SASB’s process of setting standards in pursuit of its mission requires identification of the sectors and industries that would be used for SASB’s industry-specific approach; research to identify possible topics and metrics that the standards should address; development of a technical agenda of topics for consideration for the standards; an evidence-based approach that has been designed to be rigorous and to determine which topics and metrics are financially material, by which I mean you can see the impact of the ESG topics in the numbers, and decision useful for investors; and exposure of proposals for a public comment period and additional consultation with stakeholders to ensure that the standards enable disclosures that focus on material information for investors and that are cost-effective for preparers.
I want to revisit the financial materiality point for one more moment. SASB’s processes call for topics and metrics to be included in our standards only if there is a reasonably likely financial impact. When I say you can see it in the numbers, that means looking at both the past and the future. If there is evidence of financial materiality in the financial statements, such as could be the case with past supply chain disruption in the retail industry, one aspect of our analysis would be whether that is predictive for the industry going forward.
At the same time, determining what ESG disclosure is financially material is also an important exercise in evaluating known future trends and uncertainties. This involves an assessment of whether reasonably likely future impacts of an ESG topic are also reasonably likely to materially impact a company’s future financial performance or condition.
What is now SASB began setting standards back in 2012, with a Standards Council that was charged with internal responsibility for designing and promulgating provisional disclosure standards.
Those provisional standards were developed and promulgated sector-by-sector between 2012 and 2016. Following completion of the provisional standards, SASB restructured itself to ensure that it had the structure, and followed more closely the processes, for independent standards setting. The structure resembles that of GASB, FASB, IASB, and the International Financial Reporting Standards Foundation. An independent standards board—the current SASB—was established to set the standards; the pre-existing board on which I sit became the oversight and governance board of the SASB Foundation.
The Standards Board is charged with following the conceptual framework and rules of procedure, both available on our website, that had been established to turn the provisional standards into final standards and thereafter to monitor and update those standards. The Foundation Board is charged with appointing the members of the Standards Board and is responsible for oversight, governance, and funding, as well as with determining strategy in respect of various stakeholders and promulgating use of the standards. The Foundation Board is also charged with ensuring the Standards Board follows its due process procedures, and with resolving complaints regarding allegations that the Standards Board has failed to follow due process. The Foundation Board and its members are not involved in setting or assessing the substance of the standards.
The SASB standards-setting process identifies sustainability topics and metrics at an industry level that are designed to produce presumptively or likely to be material information for companies in the industry involved, depending on the company’s specific operating context. It is up to each company’s management—and I cannot emphasize this strongly enough—to determine whether a SASB standard in fact produces financially material information for that company. SASB standards are intended to provide guidance to company management, which is ultimately responsible for determining which information is financially material.
I would point out that the accounting standards developed by the SASB and IASB are in fact intended to operate similarly. Accounting standards carry a materiality filter that is too often disregarded, as you can all appreciate as you go through the hundreds of pages of immaterial financial disclosure and financial notes.
At the earliest stages of its work on establishing standards, SASB identified 11 different sectors that were further broken down into 79 industries. The Standards Board, working from the provisional standards, engaged in public out-reach and consultation, and in the fall of 2017 publicly promulgated an exposure draft of final standards for each of the 79 industries. Those standards included 247 proposed changes from the provisional standards and were accompanied by bases for conclusions for each of the proposed changes.
SASB standards are intended to provide guidance to company management, which is ultimately responsible for determining which information is financially material.
Let me give you a couple of examples. First, the provisional standards for the biotech/pharma industry included a metric measuring the average price increase of a company’s drug portfolio over the previous year. The Standards Board proposed an additional metric measuring the largest percentage increase in price of any drug in the portfolio. The conclusion, based on the evidence of recent financial impact of companies where there was a single drug with a very large percentage increase, convinced the Standards Board that that was a financially material, impactful potential metric, and so it proposed it for further comment.
Second, going in the other direction, the provisional standards included a metric for investment managers involving the CO2 emissions of issuers in the manager’s investment portfolio. The Standards Board proposed the elimination of this metric because it almost certainly is not workable, since the investment managers don’t have access to complete and consistent information regarding their portfolio companies’ emissions.
The Standards Board set a period, later extended to 120 days, for public comment on the exposure draft. There has also been additional outreach to stake-holders since the exposure draft was published. The Standards Board received 120 comment letters, many containing detailed comments on particular standards and industries. The comment letters are posted on the foundation’s website, as is a summary.
The Standards Board and staff have been working through the comments and other necessary steps and changes in producing final standards. There have been public meetings of the Standards Board with the public in person or via the Internet. Another public meeting is scheduled in July at Fordham’s Lincoln Center campus here in New York. The goal of the Standards Board is to codify and promulgate final standards by August 2018.
The Standards Board is also in the process of establishing and populating sector advisory groups—11 of them, one for each sector—to provide ongoing input in the process of assessing standards and changes going forward. Standards setting will be an ongoing process.
What Comes Next
I want to close by spending a few minutes on the manner of disclosure. SASB’s processes will produce a globally relevant set of industry-specific ESG standards. I say that notwithstanding the fact that the starting point for SASB’s standards setting has been the concept of materiality under the U.S. securities laws. This starting point, however, does not dictate the manner of disclosure of information that is responsive to the SASB standards. SASB’s work in analyzing current disclosures has convincingly demonstrated that companies include information that ties to a significant majority of SASB’s provisional standards in the U.S. reports. The number is well over 50%.
Unfortunately, much of the disclosure in regulatory filings is generic boilerplate. Interestingly, non-U.S. companies are more responsive to the topics covered by the SASB standards than their U.S. counterparts. However, with the communications revolution of the Internet and social media, companies today have a vast array of options available to them in deciding how to communicate with their investors.
Optimal ESG disclosure will depend on companies and investors reaching an understanding as to both what information should be disclosed and how it should be disclosed. I’ve talked already a good deal about the “what.” An understanding as to how to disclose will require a market-driven solution. Regulatory filings will play a role, and ideally an increasing role. As ESG disclosures become more widespread, the processes for producing and verifying reliability of information become more mature, and there is greater agreement as to what information should be disclosed.
In both the short and long term, however, better disclosure will be produced by market-driven solutions and understandings between companies and investors more than by legal requirements. Just to take the U.S. rules for a moment, regulatory filings do not require the disclosure of all material information. I repeat, there’s no requirement that all material information be disclosed in an SEC filing.
Information is required to be disclosed if it falls into one of the following three categories: One, it’s responsive to a line item disclosure requirement. Two, it has to be disclosed to keep the rest of what is being disclosed from being misleading. Three, it is forward-looking information as to a known trend or uncertainty that is reasonably likely to occur and to have a material impact on financial performance or condition.
Optimal ESG disclosure will depend on companies and investors reaching an understanding as to both what information should be disclosed and how it should be disclosed.
That last requirement is very important to ESG disclosure, because thinking about ESG matters is inherently a forward-looking exercise. However, companies often seek to satisfy this last requirement through generic boilerplate—risk factors, for example, or other disclosures that would not be fully responsive to what investors seek or to the Auditing Standards Board standards and metrics.
The SEC issued a concept release in 2016 seeking input on how to improve its disclosure regime. Most of the responses that were not form letters addressed ESG disclosure, and there was considerable discussion of both additional and more focused disclosure. Significantly, SASB’s comment letter stated that additional rules were unnecessary, principally because SASB believes that the existing requirement as to forward-looking disclosure referred to above provides an adequate basis for, and a correct way to think about, ESG disclosure. It must also be noted that advocating line item requirements dictating disclosure regarding 79 separate specific industries is unrealistic, without regard to the political environment.
Companies have made clear their resistance to providing ESG disclosure beyond the legally required minimum in regulatory filings, at least currently. There is a wide variety of other avenues for disclosure available, including sustainability reports, annual reports, integrated reporting documents, website disclosure, CEO or chair letters to investors, investor presentations, and others.
As for investors, they have increasingly made clear that getting good ESG disclosure is more important to them than where it appears, so long as it is readily accessible, and the company resistance to disclosure in regulatory filings has developed into an unnecessary distraction and an obstacle to ESG disclosure. For me, what is important is that ESG disclosure operates within a robust governance framework with management involvement, including financial, legal, and investor relations, and under a strong control environment to assure reliability of disclosures that follow the same basic principles that are followed for financial reporting.
In addition, more attention should be paid to assurance covering the material accuracy and completeness of ESG disclosures. I believe that the proposition that liability risk for companies for ESG disclosure in regulatory filings is significantly greater than the risk for disclosure otherwise is significantly overstated.
I also hope that, over time, more ESG disclosure will be included in regulatory filings. But for the moment, I favor a process of not insisting on disclosure in regulatory filings, except of course as to matters where disclosure is legally required, and seeking an understanding between companies and investors as to the best manner of disclosing ESG information.
I’m going to close with a couple of suggestions for those of you who want to learn more and get more involved in this area. We are at an important inflection point in SASB’s life and in ESG disclosure with the upcoming codification of our standards. This is a journey that will continue. In the next stages of the journey, I would hope there would be further engagement by issuers and investors.
In particular, I would note the following. In the next few months, the Standards Board, as I said, is going to promulgate the standards for 79 industries. We want engagement and feedback—formal, informal, however you would be willing to give it.
In that vein, SASB is in the process of establishing the 11 sector advisory groups as I described. This will be a key point of engagement, especially for issuers who are interested in providing technical input. I urge folks to consider joining a sector advisory group or getting their company to join a sector advisory group.
Finally, SASB offers a certificate for those who wish to get up to speed on the bases and nuances of ESG standards and disclosure, and SASB’s role in that universe. But the certificate, while it’s a SASB certificate, actually covers ESG much more generally. Those who might be interested in seeking out more information about this, I would refer you to the SASB website. We’d love to give you all certificates if you’re willing to put in the effort.