A new era of sustainability: IFRS S1 and S2

October 2023  |  COVER STORY | BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

October 2023 Issue

Sustainability is one of the defining issues of our time, particularly in a corporate context. Having a sustainable business requires companies to not only think about how their activities may impact the environment, but also how they impact employees, people working in supply chains and the communities in which they operate.

Companies also need to think about their longer-term human impact and whether they are contributing to a sustainable and inclusive global economy, as well as how they can best lead the way toward a more equitable, sustainable future alongside the input of governments and citizens.

However, leading the way is no easy task amid a mass of competing guidance. “There are some 600 sustainability reporting standards, frameworks and guidelines in existence today, many having been developed to serve different audiences and focus on different topics,” explains Fiona Donnelly, director of sustainability at The Institute of Chartered Accountants of Scotland (ICAS). “This can be a minefield for both report preparers and users, and there is a clear need to simplify and streamline reporting options.”

To that end, and following strong market demand for its establishment, in November 2021 the International Financial Reporting Standards (IFRS) Foundation formed the International Sustainability Standards Board (ISSB) – an independent, private-sector body – at COP26 in Glasgow.

From the outset, the IFRS set the ISSB four key objectives: (i) to develop standards for a global baseline of sustainability disclosures; (ii) to meet the information needs of investors; (iii) to enable companies to provide comprehensive sustainability information to global capital markets; and (iv) to facilitate interoperability with disclosures that are jurisdiction-specific or aimed at broader stakeholder groups.

“First supported by the G7 and G20 in early 2021, the ISSB was launched at COP26 with the task of creating a global baseline for sustainability and climate-related disclosure regimes,” says Sima Kammourieh, programme leader at E3G. “It demonstrated a shared understanding that the transition to a sustainable world requires information at the global level that is not only reliable, consistent and comparable across jurisdictions, but is also ambitious enough in its scope.

“Of course, prior to this, the Taskforce on Climate-related Financial Disclosures (TCFD) had deployed significant efforts in this space,” she continues. “The ISSB has built on this work, and raised its ambition, by requiring more granular information.”

Thus, on 26 June 2023, the ISSB published its inaugural global sustainability disclosure standards: the IFRS for General Requirements for Disclosure of Sustainability Related Financial Information (IFRS S1) and the IFRS for Climate Related Disclosures (IFRS S2).

“These standards are to be applied through a lens of financial materiality as the ISSB believes this will provide investors with the information they require,” attests Ms Donnelly. “They establish a global baseline for sustainability reporting and allow entities to also apply other reporting frameworks to enable a more holistic assessment to be provided to stakeholders.”

The aim of both IFRS S1 and IFRS S2 is to help improve the trust and confidence in company disclosures about sustainability to inform investment decisions – standards that will result in a high-quality, comprehensive global baseline of sustainability disclosures focused on the needs of investors and financial markets.

“The new standards set out disclosure requirements for companies on their governance, strategy, risk management and metrics, and targets related to sustainability,” affirms Pepijn Rijvers, executive vice president at the World Business Council for Sustainable Development (WBCSD). “The standards set out general requirements for disclosures in IFRS S1 and more specific requirements for climate-related disclosures in IFRS S2.”

Furthermore, the IFRS S1 standard is effective for annual reporting periods beginning on or after 1 January 2024 with earlier application permitted as long as IFRS S2 is also applied and vice versa.

IFRS S1

The objective of IFRS S1 is to require an entity to disclose information about its sustainability-related risks and opportunities that is useful to users of general purpose financial reports in making decisions relating to providing resources to the entity.

The standard requires an entity to disclose relevant information that 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 (collectively referred to as ‘sustainability-related risks and opportunities that could reasonably be expected to affect the entity’s prospects’).

IFRS S1 also prescribes how an entity prepares and reports its sustainability-related financial disclosures. It sets out general requirements for the content and presentation of those disclosures so that the information disclosed is useful to users in making decisions relating to providing resources to the entity.

Finally, IFRS S1 sets out the requirements for disclosing information about an entity’s sustainability-related risks and opportunities. In particular, an entity is required to provide disclosures about: (i) the governance processes, controls and procedures the entity uses to monitor, manage and oversee sustainability-related risks and opportunities; (ii) the entity’s strategy for managing sustainability-related risks and opportunities; (iii) the processes the entity uses to identify, assess, prioritise and monitor sustainability-related risks and opportunities; and (iv) the entity’s performance in relation to sustainability-related risks and opportunities, including progress toward any targets the entity has set or is required to meet by law or regulation.

IFRS S2

The objective of IFRS S2 is to require an entity to disclose information about its climate-related risks and opportunities that is useful to users of general purpose financial reports in making decisions relating to providing resources to the entity.

IFRS S2 requires an entity to disclose relevant information that 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 (collectively referred to as ‘climate-related risks and opportunities that could reasonably be expected to affect the entity’s prospects’).

The standard applies to climate-related risks to which the entity is exposed, which are climate-related physical risks, climate-related transition risks and climate-related opportunities available to the entity.

IFRS S2 sets out the requirements for disclosing information about an entity’s climate-related risks and opportunities.

In addition, IFRS S2 requires an entity to disclose information that enables users of general purpose financial reports to understand: (i) the governance processes, controls and procedures the entity uses to monitor, manage and oversee climate-related risks and opportunities; (ii) the entity’s strategy for managing climate-related risks and opportunities; (iii) the processes the entity uses to identify, assess, prioritise and monitor climate-related risks and opportunities, including whether and how those processes are integrated into and inform the entity’s overall risk management process; and (iv) the entity’s performance in relation to its climate-related risks and opportunities, including progress toward any climate-related targets it has set, and any targets it is required to meet by law or regulation.

Comprehensive reporting

“The ISSB standards respond to demand from capital markets for sustainability-related disclosure standards that are comprehensive and consistent,” says Caroline May, a partner and co-head of ESG at Norton Rose Fulbright LLP. “IFRS S1 and IFRS S2 represent the ISSB’s first step toward fulfilling that mandate.

“It is hoped that the standards lead to increased trust and confidence in company disclosures in sustainability and climate-related risks and opportunities,” she continues. “This, in turn, should lead to greater market knowledge and assurance in respect of these matters.”

With IFRS S1 and IFRS S2 disclosure requirements comprehensive, companies face a significant challenge collecting and aggregating different types of data for sustainability reporting – challenges that, if met, may see sustainability-related financial reporting reach the same level of maturity as financial reporting.

“It is important to understand that the rules governing financial reporting have been developed over 200 years, whereas the systems for sustainability-related financial reporting are only just beginning,” says Mr Rijvers. “Collecting and aggregating different types of data for sustainability reporting is a unique challenge.”

In order to meet this challenge, Mr Rijvers advises companies to ask themselves the following three basic questions to ensure their sustainability reporting meets the needs of all their stakeholders.

First, who needs this information and what do they need it for? This should help a company develop an integrated system to manage and report relevant sustainability information to different stakeholders.

Second, are my current systems and processes to collect, analyse, manage and report on sustainability information adequate to meet these different reporting needs? This should help companies identify where changes to their data systems, analytical processes and information are needed to respond to diverse reporting needs.

Third, am I using my sustainability data adequately to inform internal decision making and produce credible reporting on our management of sustainability-related risks and opportunities? This should help companies identify where to strengthen their systems and processes to govern, manage and use sustainability data to set strategy and measure performance against it.

“The real key to comprehensive sustainability reporting is to ensure the company has comprehensive governance and management systems to identify and respond to sustainability related risks and opportunities, and that these are linked to financial planning processes that can translate actions taken into value for the company,” adds Mr Rijvers.

As well as disclosure requirements, companies also need to evidence how they will assess and manage the sustainability and climate-related risks they face. In time such analysis should elevate sustainability and climate-related issues to sit alongside purely financial information as key issues in annual reports and statements.

Extensions

Given the fundamental changes in reporting that IFRS S1 and IFRS S2 introduce, the ISSB is well aware that it needs to do a significant amount of work to ensure the success and effective implementation of the standards – work that it believes is essential to the creation of the global baseline of sustainability-related financial disclosures to meet the needs of capital markets.

To that end, on 4 May 2023 the ISSB published its ‘Request for Information: Consultation Agenda Priorities’ to obtain feedback on its priorities over the next two years, with proposed topics of interest including biodiversity, ecosystems, ecosystems services, human capital and human rights. Feedback was requested by 1 September 2023.

“The ISSB is looking to develop further standards that will relate specifically to the risks and opportunities companies face in respect of broader environmental issues and social issues,” says Ms May. “This should lead to an increasingly broad range of environmental, social and governance (ESG) matters becoming an integral part of reporting requirements within capital markets.”

According to Ms Donnelly, at present the ISSB takes a narrow view of the needs of investors and should consider developing standards to meet the needs of those that are seeking impact returns in addition to financial returns. “In doing so, we believe such standards would produce more comprehensive reports that would better serve more investors and would also meet the needs of other stakeholders,” she adds.

Double materiality and interoperability

Currently voluntary, the passage to IFRS S1 and IFRS S2 becoming mandatory depends on their adoption into law, as well as how successfully they can be combined and interoperate with relevant local laws and regulations – an evolutionary process toward an end goal of double materiality.

“There is a high degree of confidence the ISSB standards will form a common global disclosure baseline,” opines Ms Kammourieh. “Nigeria, Ghana and Zambia have been early adopters, and Japan, Canada, the UK and Australia are consulting on ISSB standards adoption, as are Hong Kong and Singapore. European and ISSB standards were also designed to be interoperable. The greatest unknown is how close standards issued by the US Securities and Exchange Commission (SEC) will align with the ISSB.

“The ISSB standards already open the door to wider interpretations of what constitutes materially relevant information to investors,” she continues. “With time and ever-increasing relevance of climate and sustainability concerns, it is very likely that information deemed materially relevant will systematically cover wider firm impact concerns.”

Certainly, ensuring the interoperability of the ISSB standards, which is key to ensuring that companies can efficiently report on a double materiality basis, is a key issue. Additionally, regular engagement between bodies in addition to the ISSB, such as the Global Reporting Initiative (GRI) and the European Financial Reporting Advisory Group (EFRAG), is essential if the information needs of key stakeholders are to be met.

“We would expect to see increasing interoperability between the ISSB standards and other global and jurisdictionally-based standards as investor information requirements widen and financial valuation practices adapt,” concludes Mr Rijvers. “The increasing pressure faced by companies to demonstrate to multiple stakeholders how they are transitioning to a net zero, nature positive, more equitable economy and society will also drive swift change in the disclosure landscape in the coming years.”

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Fraser Tennant