Bernard Peter Agulhas, the former audit regulator and chairman of the King Committee Subcommittee on Climate Change in South Africa, reflects on the auditability of the nascent sustainability standards, as without assurance those standards risk far more manipulation then their conventional financial counterparts.
Amidst the amplified enthusiasm around Environmental, Sustainability and Governance (ESG) disclosures, capital markets and investors have not yet erased the bad taste left by recent business and audit failures, which were not entirely unrelated to misleading disclosures and reporting.
This is simply because information is only as good as the comfort it gives to the parties relying thereon and the confidence it gives about the subject matter. The most commonly - known example of such subject matter would be an entity's Annual Financial Statements, which form the basis of many important decisions. If those decisions are based on incorrect information, it could carry grave financial consequences. And while the average human-being can be tolerant about many worldly things, one of them is not being out of pocket.
Fast forward from a universe in which decisions were informed only by financial results, affairs and cashflows of an entity, to one in which there are much more external impacts on the entity, and the entity has much more impact on the greater environment in which it operates. And with environment I mean not only the biophysical environment around us, but the society and economy - all of which are interconnected and interdependent and ultimately impacts human welfare.
Never has there been so much attention on our external environment – the air that we breathe, water, sustenance and security and less tangible elements such as the sense of belonging – than the present. Since all of these impacts our human welfare and continued existence, it comes as no surprise that deliberate action is needed when that welfare is threatened. By now everyone knows that the very environment on which we as well as future generations are so dependent, have been exploited beyond any tolerable threshold. We can therefore no longer ignore the impact of extreme weather conditions, amount of carbon oxide in the air, droughts, rising temperatures and diminishing coastlines on our lives. So, to demonstrate that we care, and take these issues seriously, we disclose and report thereon.
In the same manner that financial information is prepared and reported in terms of recognised criteria such as International Financial Reporting Standards (IFRS), any other reported information which relate to matters of the environment, society and governance, necessarily requires similar criteria. Such criteria, which have characteristics such as relevance, completeness, reliability, neutrality and understandability, should also be capable of being consistently applied across various industries and across many jurisdictions. And so, the IFRS Foundation saves the day by establishing an International Sustainability Standards Board (ISSB) which wastes no time to issue a framework in response to calls from investors, lenders and others for more consistent, comparable and (no surprise) verifiable information to assess the entity's overall value – information which relates to significant sustainability-related risks and opportunities. These risks and opportunities include those which will inform their economic decisions pertaining to that entity, and which arise from the entity's reliance and impact on resources, and ultimately enterprise value.
The first two exposure drafts which contain general requirements for sustainability-related financial information and disclosures related to climate change (which is drafted in the context of the general standard) respectively, recommend that entities disclose information regarding its strategy, governance, risk management and metrics and targets which pertain to such information. The questions which now arise (and are posed in the general exposure draft) include, inter alia:
- whether this highly sought-after information will indeed be produced as a consequence of the requirements in the proposed standards.
- whether the proposals can be applied when the financial statements are prepared on a basis of generally accepted accounting practice other than IFRS.
- whether it is reasonable to include requirements that the information should allow the user to make connections between sustainability-related information and general – purpose financial information.
- whether fair presentation can be achieved by referring to other frameworks in addition to the ISSB standards and that judgment can be used to identify disclosures where a specific ISSB standard does not exist.
- whether it is acceptable that materiality of sustainability – related disclosures can be based on judgement and be allowed to change from one period to the next.
- whether sustainability – related information can be included by cross-reference.
- and ultimately, whether these sustainability-related disclosures can form a global baseline for an assessment of enterprise value.
The general exposure draft states that, for sustainability-related financial information to be useful, it shall be 'relevant and faithfully represent what it purports to represent'. These are fundamental qualitative characteristics. Usefulness is enhanced if the information is comparable, verifiable, timely and understandable'. The exposure draft further requires that 'A complete set of sustainability-related financial disclosures shall present fairly the sustainability-related risks and opportunities to which an entity is exposed. Fair presentation requires the faithful representation of sustainability-related risks and opportunities in accordance with the principles set out in this [draft] Standard.'
Now, superimpose on the above the expectation that, in the same manner that financial information is prepared and reported in terms of recognised criteria such as IFRS, any reported sustainability-related information necessarily requires similar criteria which can be consistently applied across various industries and across many jurisdictions. Now we can attempt to respond to what appeared as relatively straightforward questions.
If the response to most of the questions is a resounding 'yes', then we have created a truly universally accepted framework. But what if there are doubts that the proposed standards do not represent the characteristics of relevance, completeness, reliability, neutrality, understandability, comparability, consistency, auditability, and the fair presentation of sustainability-related risks and opportunities? In which case it would be useful and necessary to demonstrate that:
- By applying the requirements to information which is not prepared in terms of a common financial reporting framework, annual financial statements will still be comparable (although the question here is really whether reporting frameworks other than IFRS will accommodate the required disclosures. This does not appear to be insurmountable, but will it move us towards satisfying the needs of investors for global consistency and comparability?).
- Users will be in a position to effortlessly link sustainability-related information to other general-purpose financial information to create an overall picture of enterprise value and value creation. This could work if users have started to appreciate that enterprise value is also dependent on the entity's response to sustainability matters - and those who are already using Integrated Reporting Frameworks and integrated thinking will naturally be a few steps ahead.
- Deviation from an IFRS Framework (such as using industry-based standards, application guidance and industry practices) will not impact fair presentation. This might be a slippery slope if one of the objectives of a globally accepted reporting framework for sustainability information is comparability and consistency. And the last thing we need is a 'free-for-all' which will bring us right back to where we currently are.
- Application of judgment regarding what information to disclose and what information to disclose from one period to the next (which in turn is influenced by what is considered material) will not end up in precarious situations - situations in which judgments could be abused to present inconsistent and untrue information which will not be useful for holistic, comparable, and complete decision-making purposes.
- Including sustainability-related information by cross-referencing to other documents will not inadvertently (or not) detract from the importance thereof. I have never been a supporter of not making users' lives easier by having all the information at their fingertips instead of searching and not finding information which would be valuable to conclude on enterprise value.
Responses to the above might assist in determining whether the sustainability-related information has the characteristics described above. Kudos if it does. But there is still the burning question of its auditability, because if there is no independent verification, it does appear that this is the type of information which will lend itself to manipulation far more so than conventional financial information. And let us not forget that the providers of any assurance had better be qualified and trusted advisors as well (lest we compromise that much needed warm feelings). So somewhere someone has to reconsider competency frameworks, training and the many aspects to provide the comfort that there will be no negative fall-out from false assurance.
Which brings us to a further question: will the provision of assurance be reserved to the elite (also known as auditors), or is there a slight possibility that lesser human beings could also be capable of issuing the required level of assurance (also known as comfort)? At the risk of sounding like an economist, on the one hand auditors are well-qualified to express conclusions on subject matters in terms of specified criteria; on the other hand, are they the real experts on sustainability, the environment and climate change? One of my expectations would certainly include a requirement that, whoever is bestowed this privilege, should also have the privilege of oversight (one cannot have your apple pie and eat it). So, instead of considering which professions are regulated and granting them special rights, my take would be to first determine the required competencies and then ensure that competent providers are checked. After all, is ESG not really about equal opportunities as well? It is pleasing that the decision to build on the Recommendations from the Task Force on Climate-related Financial Disclosures (TCFD) includes transitioning disclosures to information which is verifiable (auditable) and therefore enforceable.
One would expect that holding role players to account for events which could inform our continued existence would, by now (but really, much sooner) have soared to the number 1 priority for the State which must deal with matters of policy to ensure transparency, accountability and sound financial controls in the management of public finances. In my country, South Africa, this would include financial stability to protect the economy and the people from major shocks to the financial establishment and building resilience through effectively managing all potential risks – not only those of a financial nature. We welcomed the new Climate Change Bill introduced in the South African National Assembly in October 2021, which recognises that a 'nationally driven, coordinated and cooperative legal and administrative response is required that acknowledges the significant role of the provincial and municipal spheres.' It further recognizes that 'climate change policy needs to be implemented in the context of sustainable development objectives and the achievement of national development goals, as well as the need to develop a legal and institutional framework for the implementation of the Republic's national climate change response.'
At least this will mean that regulators will have the wherewithal to enforce compliance and implementation of measures to slow down the demise of our valuable environment, although there can no certainty at this stage who would win the lucky draw.
Where does this leave us?
In terms of the ISSB, grateful for their prompt reaction to an identified need and ability to consolidate resources in record time to kick off awareness and urgency for entities to get on with it – as well as their decision to transition from an investor-focused approach to a broader stakeholder approach which will facilitate wider adoption. In terms of governments and legislatures, we can only hope that this crucial matter does not become the subject of different political agendas but a shared agenda in the interest of human welfare. In terms of business, the sooner the realisation crystalises that responding to sustainability matters is no longer optional, the more attractive their enterprise value will appear to investors and society.
But disclosures alone will not change the increasing challenges to the planet's survival. Divine intervention is also welcome.
