To date, ESG reporting has been largely voluntary, leaning heavily on non-financial data. However, new regulations due to come into force in 2024 will require businesses to disclose both the impact their activities have on ESG metrics, and how they are prepared to mitigate physical risks and transition risks related to climate change.
The summer months have seen rapid developments in sustainability reporting standards at UK, EU and international levels.
UK SDS to reflect IFRS standards
The UK government announced in August 2023 the creation of new sustainability reporting rules by July 2024. The UK Sustainability Disclosure Standards (SDS) will ‘form the basis of any future requirements’ related to corporate disclosure of sustainability issues, including climate change and will be likely to apply to all sizes of company and limited liability partnerships.
It is proposed that the Financial Conduct Authority will oversee disclosures from UK-listed companies, whilst the government will oversee disclosures for UK-registered companies and limited liability partnerships. It is not yet clear how this will operate in practice in the devolved administrations, whether this will be overseen by a Westminster government department or some newly established entity.
The UK SDS will replace a number of voluntary frameworks and private sector practices used for climate disclosures in the UK. The aim is to provide a more transparent and comparable framework for investors and stakeholders.
The UK SDS will be based on the International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards IFRS1 and IFRS2 published in June 2023. The IFRS standards aim to improve the disclosure and transparency of ESG information reported by companies.
The IFRS Standards have the objective of requiring an entity to disclose information about its “sustainability-related risks and opportunities” (IFRS S1) and its “climate-related risks and opportunities” (IFRS S2) which could “reasonably be expected to affect the entity’s cash flows, its access to finance or cost of capital over the short, medium or long term”.
What will the new SDS require businesses to do?
Whilst the UK SDS are at the early stages of development the UK Government has indicated that they will very closely follow the IFRS.
The core content of each IFRS standard includes disclosures relating to general sustainability and climate-specific risks and opportunities, respectively, including Governance, or the processes controls and procedures used to monitor and manage those risks and opportunities; Strategy, or the approach used to manage the risks and opportunities; Risk management, or the processes used to identify, assess prioritize and monitor the risks and opportunities, and; metrics and targets, including progress towards targets the company has set, or is required to meet by law or regulation.
Materiality
IFRS 1 is clear that only material information needs to be disclosed. IFRS states that the context of sustainability-related financial disclosures, information is material if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that primary users of general purpose financial reports make on the basis of those reports, which include financial statements and sustainability-related financial disclosures and which provide information about a specific reporting entity. One of the criticisms of the IFRS is that there is a lack of clarity around “materiality” and this may lead to companies “cherry picking” data.
On 31 July 2023, the European Commission adopted the first set of European Sustainability Reporting Standards (ESRS). These standards will be used by all companies under the Corporate Sustainability Reporting Directive (CSRD). The ESRS also rely on a materiality assessment to determine the information that companies must disclose. The ESRS currently lack detailed guidance on how to define scores and thresholds for materiality. This means that companies are left to self-determine which topics are material to a company, putting reliable and comparable results at risk.
It should be noted that both the International Sustainability Standards Board (ISSB) and European Commission are in the process of developing detailed guidance on the application and interpretation of materiality which will hopefully provide clarity.
The definition of materiality adopted in the UK SDS may well determine how burdensome (and some would say how useful) the new UK reporting requirements will be.
Time for Action
Businesses can expect both increasing pressure from investors and growing scrutiny on how they reflect climate-related matters in their financial statements. Businesses should begin to prepare now for the changes which will come into effect in 2024 and consider how climate change and regulatory changes associated with it will impact their business. For example, Climate-related matters may require an entity to direct its expenditure in ways not previously expected, this might include purchasing new, ‘greener’ assets or making alterations to existing assets. Businesses will also need to consider whether the useful economic life of assets and products have changed as a result of legislation, advancing technology or even a commitment to reaching net zero carbon emissions.
The UK SDS represents a significant step-change which will impact businesses at all levels, not just major PLCs. Under the emerging UK SDS it is likely that companies won’t be able to cherry pick the data that looks best for them. Rather, they will need to define specific, ESG-related metrics, follow through, and use robust and accurate data to measure their progress. ESG disclosures will need to shift from public relations, where ESG is often reported in glossy brochures produced by the marketing department, to the traditional mainstays of regulatory affairs: risk and finance.
While great care has been taken in the preparation of the content of this article, it does not purport to be a comprehensive statement of the relevant law and full professional advice should be taken before any action is taken in reliance on any item covered.
