When I was at the Oxford Sustainable Finance Summit a few weeks ago, I had the privilege of sitting on a panel moderated by Clara Barby (who spearheaded the creation of the International Sustainability Standards Board) along with, among others, Patrick de Cambourg who leads the EU standard setter, EFRAG. Clara asked Patrick and me to discuss the different approaches to materiality in the EU and the United States.
The EU follows a “double materiality” regime that requires companies to report both on matters that impact the company’s financial position, as well as the company’s impacts on society. In the US, we follow a “single” materiality framework focused on matters significant to the company and its shareholders. One might view the US as having an “outside in” approach to matters like climate change - evaluating how climate change impacts the company and its shareholders. The EU has both an “outside in” and an “inside out” approach that looks at the impacts of climate change on the company as well as the company’s impact on the broader world.
While there are important differences between the US and EU climate proposals, these are not so much driven by the single vs. double materiality distinction. In fact, I think a reasonable argument can be made that the single vs double materiality distinction in the context of climate change is frequently overblown.
Two factors account for the bridge between the US’ single materiality and the EU’s double materiality frameworks in the context of climate change. One is the Task Force on Climate-related Financial Disclosures (TCFD). The other is the steady drumbeat of proposed regulations, laws, and net zero commitments that are driving companies to account for their climate impacts. In economic terms, the phenomenon we were discussing is simply the internalization of what formerly have been economic externalities. Not long ago, companies did not bear the costs associated with their climate impacts. That has changed and companies are being held to account for their climate impacts, and are expected to be transparent with their shareholders and business partners about those climate impacts.
The TCFD framework facilitates an “outside in” analysis of the impact of climate change on a company. Its four main pillars guide companies to focus on their governance around climate change, their climate-related risk assessment, the development of strategies to address climate-related risks and opportunities, and metrics used to measure progress toward climate goals. Within the risk assessment pillar, companies are directed to evaluate their physical risks due to climate change as well as their transition risks. Transition risks are the bridge between single and double materiality in the context of climate change.
Transition risks include the risks (and opportunities) a company faces as a result of the transition to a lower carbon economy. These can be driven by a number of factors, including laws and regulations, taxation, tariffs, changing consumer preferences, employee demands, shareholder pressure, lender and investor expectations, and a host of other forces. Perhaps the most powerful force driving transition risks and opportunities is the financial sector.
Last Fall’s COP 26 in Glasgow highlighted the commitment by more than 450 financial institutions to join the Glasgow Financial Alliance for Net Zero (GFANZ). Those financial institutions pledged to become net zero across their Scopes 1, 2, and 3 emissions by 2050, and to set interim targets to demonstrate their progress. These financial institutions will necessarily drive reporting and decarbonization by companies to which they lend money or in which they make equity investments. This will be necessary as they work toward meeting their net zero commitments. Companies that fail to report on their GHG emissions and plans to address their climate-related risks are likely to have a higher cost of capital. This is a transition risk.
Similarly, the demand among investors for sustainable investment options creates opportunities for companies that report their decarbonization plans. It also creates risk for companies that fail to do so. The pressure on companies to report on their climate risks and transition plans is mounting, and extends well beyond the climate disclosure proposals currently under consideration by the US SEC and EU’s EFRAG. Some of the regulatory developments creating this pressure are summarized below.
Spotlight: California Climate Disclosure Law Moves Closer to Adoption
Status. California’s SB-260, also known as the Climate Corporate Accountability Act, continues to move closer to adoption. The bill was approved by a vote of 11-4 by the California Assembly Appropriations Committee on August 11 and next will be voted on by the full Assembly. If it passes in the full Assembly, it will go back to the California Senate for concurrence by the end of August. From there, it will go to Governor Newsom’s desk. The current text of the bill can be found here.
Who would be covered? The bill, if passed and signed into law, will apply to US partnerships, corporations, LLCs, and other business entities with total annual revenues over $1 billion that do business in California (“Reporting Entities”). According to an estimate by law firm Pillsbury Winthrop, this would cover some 5,200 private and public companies, including most of the country’s largest companies.
Mandatory Scopes 1, 2, and 3 reporting. The law would require Reporting Entities to publicly disclose to an emissions registry their Scopes 1, 2, and 3 GHG emissions from the prior calendar year in accordance with the GHG Protocol. The bill would require these disclosures to be presented in a manner that is easily understandable and accessible to residents of California.
Audit requirement. The public disclosures would have to be verified by the emissions registry or a third party auditor, approved by the California Air Resources Board (“State Board”), with appropriate expertise in GHG emissions accounting.
Implementation and timing. The State Board would be required by January 1, 2024, to adopt regulations to implement the law. Reporting Entities would be required to begin reporting annually in 2025 or by a date determined by the State Board.
Enforcement. The bill would authorize the California Attorney General to bring a civil action against a reporting entity seeking civil penalties for violations of the law. The penalty provision would be subject to legislative approval in the annual budget or other legislation.
Academic institution report. The bill would require the State Board to contract with the University of California, the California State University, a national laboratory, or other equivalent academic institution to prepare a report reflecting the disclosures made to the emissions registry. The report would consider the emissions in the context of California’s GHG emissions reduction goals.
Regulatory News
Australia
Australia advances net zero target
Climate Change Bill 2022 has passed the House of Representatives in Australia this month, with the intention of setting a reduction target of 43% reduction by 2030 (below 2005 levels) and net zero emissions by 2050. The country seeks a whole-of-government approach to meeting these targets, bringing together “business, industry, unions, farmers, community and conservation groups.” To provide accountability on meeting these targets, the law requires an annual update to Parliament on the progress being made towards net zero from the Climate Change Minister.
Prime Minister Anthony Albanese said, “This Bill records the Government’s ambition to take the country forward on climate action – and it reflects our determination to bring people with us. It will help open the way for new jobs, new industries, new technologies and a new era of prosperity for Australian manufacturing.” Before the bill is officially signed into law, it will be debated in the Senate in upcoming months.
Canada
Canadian government investment fund has doubts about EFRAG
Canada’s government-backed pension fund CPP has expressed skepticism about the need for a separate European climate reporting standard, given the existence of the ISSB’s reporting framework. A statement from CPP Investments argues that the European Sustainability Reporting Standards (ESRS) created by EFRAG seem “duplicative of efforts seeking to deliver a common global standard” for disclosure, like the newly released ISSB draft standards. While a key difference between the EFRAG and ISSB standards remains that the EFRAG rules are based on a double materiality standard, forcing companies to report on the ways their operations impact the environment, CPP claims that using both the ISSB and GRI standards for reporting will allow companies to produce both single- and double materiality-based disclosures.
China
China’s ministry of finance questions the need for global reporting standards
China expressed concern this week over the development of the ISSB global sustainability reporting standards, arguing that the baseline standards may be too rigorous for organizations in less developed economies to meet. The Chinese ministry of finance weighed in via comment letter to the ISSB, recommending that the board “re-examine” its metrics and criteria to take into account “differences in economic development levels of different countries and in sustainability disclosure regulatory capabilities.” The statement recommended that the ISSB stick with a taxonomy of green activities rather than the current slate of disclosure requirements detailed in the current exposure drafts.
EU
EFRAG ESRS comment period closed
Europe is one step closer to finalizing sustainability reporting standards for companies. The European Financial Reporting Advisory Group’s (EFRAG) draft European Sustainability Reporting Standards (ESRS) comment period closed Monday, August 8. Many responses follow a similar tone urging EFRAG to align disclosure drafts with the standards being developed by the International Sustainability Standards Board (ISSB).
The Net Zero Asset Owner Alliance, with 74 members representing $10.6 trillion in assets, wrote in their public comment that the “goal should clearly be that complying with the ESRS automatically means complying with the ISSB.” Similarly, the European Securities and Markets Authority (ESMA) commented that EFRAG should prioritize global comparability, while at the same time not “lowering the EU’s sustainability ambition.” On the topic of double materiality, ESMA writes that both the ISSB and EFRAG’s ESRS would benefit from including more clarification on the relationship between “impact materiality” and “financial materiality.”
The current divergence is why EFRAG’s ESRS appears to be more complex, argues ESMA. In their letter, they state, “while both EFRAG and the ISSB build on the TCFD structure, EFRAG has decided to depart from it and develop a more complex architecture.” They continue to urge EFRAG to work with the ISSB on reconciliation, as there is a fear that divergence will make reporting less “seamless,” resulting in disadvantages for users and preparers.
ESG ratings providers push back against EU regulators
In response to the European Commission’s consultation launched in April on whether or not ESG ratings providers should face regulation, top firms have deemed regulation of their industry unnecessary. MSCI and The London Stock Exchange Group have said a “code of conduct” would suffice in the face of EU-intervention. Morningstar, as well, said they had “no opinion” on regulation but saw “principles of good conduct” as an appropriate step forward.
Despite this rejection of regulatory action, the European Securities and Market Authority (ESMA) has applied pressure to pursue regulation by issuing a Call for Evidence after noting a growing momentum among regulatory bodies to address the issue.
India
India’s new energy conservation bill
In an effort to keep up with and adapt to the growing global demand for more green products, India recently passed new legislation to promote energy conservation and efficiency. The Energy Conservation Amendment Bill 2022 sets its focus on buildings, transportation, and industry, and enables the government to regulate fossil fuel-derived energy and set mandates for clean energy use.
The legislation also opens the door for a carbon market to exist in the country, where entities will be able to buy and sell carbon credit certificates that they receive from the government, based on whether or not they meet the clean energy or energy efficiency threshold. Until the country fulfills its 2030 climate commitments by reducing GHG emissions by 45% and achieving 50% clean energy, the market will remain domestic. This move will be key to ensuring India can keep up with competitors in the global industrial market.
International - ISSB
Summary of the latest meeting of the ISSB Jurisdictional Working Group
On July 18th, the ISSB Jurisdictional Working Group, consisting of ISSB representatives, China, Europe, Japan, UK and the US, with IOSCO as an observer, met to continue their mission of achieving greater interoperability among proposals. During the meeting, the ISSB acknowledged the consistency in the feedback received on their Exposure Drafts and the US, EU and ISSB updated participants on the status of their work together to align their approaches in what will become finalized standards, though we do not know the details of this cooperation.
Still, a main takeaway from the meeting is the importance of establishing a global baseline for jurisdictions and market participants to reduce costs to reporting companies and investors and to enhance the consistency of reported information. The ISSB and the European Union are keen to achieve alignment as soon as possible due to the timeline for implementation of the EU’s Corporate Sustainability Reporting Directive (CSRD). The group will be meeting again in September 2022.
Japan
Tech solutions to help comply with climate disclosure
IBM Japan Sumitomo Mitsui Banking Corporation (SMBC), and my company, Persefoni AI, are partnering to provide a carbon accounting and decarbonization solution for Japanese customers. The partnership will help customers satisfy new climate disclosure requirements put forth by the Tokyo Stock Exchange that require complex and granular data about companies’ emissions. IBM’s data input tools will help automate data entry into Persefoni’s carbon accounting platform, while SMBC will provide customers with climate risk and opportunity analysis services to round out the decarbonization solution.
New Zealand
First climate adaptation plan
New Zealand’s first climate adaptation plan has been released with the goals of reducing vulnerability, building adaptive capacity and strengthening resilience. To get started, between 2022-28, the country plans to produce strategies, policies and proposals to help understand and respond to climate change risks, make risk-informed decisions, build climate-resilient development and embed this resilience across government functions. The plan stresses the need to get the foundation right first. You can find New Zealand’s table of actions here.
UK
FCA issues letter on PE and hedge fund ESG mislabelling
The Financial Conduct Authority (FCA) has issued a warning that it will be cracking down on ESG claims made by private equity firms and hedge funds in a letter this week. The FCA said, “Firms offering [ESG] products should expect to be subject to review to ensure marketing materials accurately describe their product, with funds offering clear and consistent disclosure.”
Last year, the FCA issued guiding principles on the design, delivery and disclosure of ESG and sustainable investment funds. Now, with ESG-related funds on the rise, the FCA is saying that they will annually review any such claims to combat greenwashing concerns.
US
IRA Impacts on US Regulatory Environment
This week, President Biden signed into law the Inflation Reduction Act, which contains a historic amount of funding for climate change programs, amongst other things. My colleagues at Persefoni have written a great piece this week in Fast Company summarizing the bill’s top takeaways for corporations and financial institutions, and more analysis has come out this week about the impacts of the IRA on US regulatory agencies.
E&E News reporting finds that the IRA could aid the EPA in defending new rules advancing climate-related emerging technologies like carbon capture storage (CCS) since the bill makes this tech more cost-effective. This is significant because the EPA plans to propose climate rules on existing fossil fuel power plants early next year, taking into account the learnings from the Supreme Court’s ruling on the Clean Power Plan. While we don’t yet know for sure what these rules will look like, some expect the EPA to base them on CCS. Often, the cost of new rules are used as ammo against it. However, if the funding from the IRA makes CCS cheaper, this could benefit the EPA’s rule-making agenda.
California’s ambitious offshore wind goals
Last week, the California Energy Commission (CEC) announced its intentions to expand its clean energy through offshore wind. This is a major step forward in the state's journey towards carbon neutrality and achieving 100% clean electricity, with an expected 2,000-5,000 megawatts (MW) by 2030 and an ambitious goal of 25,000 MW - enough to power 25 million homes - by 2045. The CEC hopes to harvest enough energy from offshore wind, in tandem with solar, to supply a reliable power grid, favoring clean energy over fossil fuels.
While this is a significant step, it is the first of many as the CEC continues to research and develop a solid plan, which the Legislature must receive by June of 2023. Sites for offshore wind activities will include areas near Morro Bay and Humboldt, the latter of which has already begun seeing preparatory renovations. This project is currently funded by the $10.5 million the CEC approved in March of 2022, and could see continued support from the state, as Governor Newsom proposes an additional $45 million in funding to continue preparations at waterfront facilities.
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