In brief
- For a long time it was exceptionally difficult to compare financial statements between companies in different countries.
- However, an effort began to harmonise accounting standards between different countries.
- A similar evolution, finally, is under way in sustainability-related disclosures.
- It is important to remember what the new standards intend to do—and what they are not meant to do. They are framed as a “global baseline.”
Introduction
For a long time it was exceptionally difficult to compare financial statements between companies in different countries. In the UK companies could revalue their property and plant, but in America companies adhered to historical cost.1 In Japan it was perfectly legitimate for managers to pad their financial results by accumulating or releasing secret reserves.2 As late as the 1980s one observer noted that “limits on the availability of comparable information…diminish the effectiveness of investing decisions that involve evaluating alternative opportunities.”3
In the latter decades of the 20th century, however, an effort began to harmonise accounting standards between different countries. After many twists and turns, this culminated in the formation of the International Accounting Standards Board (IASB), responsible for developing the International Financial Reporting Standards (IFRS). All this made it easier for investors to make sense of financial statements in different countries.4 It is likely to have led to higher investment in equities, too.5
Sustainability-related disclosures
A similar evolution, finally, is under way in sustainability-related disclosures. Reporting of metrics related to climate impacts, governance and social issues is often a mess, as we have argued ourselves in the past.6 Different companies use different standards and practices for reporting sustainability-related information to investors—even for seemingly “objective” measures such as their use of renewable energy or their recycling.
All this makes it easier for unscrupulous companies, or even well-meaning ones, to “greenwash”: they may promise to behave in a sustainable way, but who knows what they are really doing? “The problem in today’s market is that companies can make claims that nobody can verify,” noted Emmanuel Faber, a former chief executive of food company Danone, earlier this year. “That makes it extremely difficult for people making capital-allocation decisions.”7
We at Generation have personal experience of what Mr Faber is talking about. One example, of an anonymous company, brings it to life. We wanted to find data on a large, listed company’s scope 1 and scope 2 emissions. It became much more difficult than we had anticipated. The company’s emissions for 2020 were close to 15 million tonnes, according to its own estimate. But one widely used data provider’s estimate was more than 55 million tonnes. Another analyst’s estimate was somewhat lower than the company’s. These differences, in part, reflect the fact that there is no agreed-upon methodology to calculate emissions. But a lot of the difference in numbers is, quite simply, impossible to explain.
Research backs up our frustration. A new study8 by a team of researchers assesses the reliability of greenhouse-gas disclosures. Focusing on oil-and-gas companies, the methodology has a simple intuition. Imagine if a company reported revenues by geography (Europe, Asia, Africa, etc.), as well as total revenues. You would expect the sum of regional revenues to equal total reported revenues. If it did not, you might be a bit suspicious of the data.
They do something similar for greenhouse-gas data. The authors look at companies where the total reported emissions do not equal the sum of emissions broken down by category. If it does not, it is hard to believe the data are very reliable. The results are shocking. At least one third of companies in the study do not produce reliable greenhouse-gas data—and there has been practically no progress in recent years.
Share of oil-and-gas companies reporting nonsensical climate data, 2010-19 (%)
Source: "Carbon disclosure quality: Oil & gas", by Sergio Garcia Vega, Andreas G. F. Hoepner, Joeri Rogelj & Frank Schiemann".
Hopefully, though, situations such as this should arise less frequently in the future. The world is moving towards equal prominence for sustainability-related disclosure and financial accounting. At COP26 last year, the International Sustainability Standards Board (ISSB) was established. It operates alongside, and is connected to, the IASB. The two boards share the governance of the IFRS Foundation, which itself is governed by a monitoring board of securities regulators from around the world. Mr Faber will chair the new board.
The idea is to create corporate sustainability disclosure standards that meet the needs of investors. Individual jurisdictions will decide whether to adopt such standards. But many governments seem keen.
Given investor demand for high-quality sustainability-related information, the ISSB has been quick to publish its first proposals. It has led with a climate standard. Disclosure of “scope 3” emissions—i.e., those all the way along a company’s supply chain, not just the emissions it directly produces—is being tackled. There are also likely to be specific requirements for each individual industry. For instance, the proposals suggest that homebuilders disclose the share of new homes that are built in areas with high water stress. Packaging companies would need to disclose recycling rates. And airlines would need to say how much fuel they are using, and what percentage of that fuel is renewable.
It is important to remember what the new standards intend to do—and what they are not meant to do. They are framed as a “global baseline.” After being implemented, many stakeholders, including certain investors, may nonetheless demand more sustainability-related information from companies. The proposals also leave plenty of room for governments to make more stringent requirements themselves. As Erkki Liikanen, the chair of the IFRS Foundation Trustees, argued in a recent speech, “disclosure standards do not set the policy objectives, but they can be a valuable instrument to support the delivery of those policy objectives.”9
Conclusion
The proposals are just a start. The development of international financial accounting standards took decades—but given the urgency and scale of climate and other sustainability challenges, we argue for much quicker progress here. A consultation period on the proposals ended in July 2022. Many hope, however, that some countries will actually implement the new standards before the end of the year. Slowly but surely, the relevance of high quality sustainability-related information for optimal capital allocation decisions is being put on the same level as financial accounting.
Key terms
IFRS: International Financial Reporting Standards. Accounting standards which govern how different types of transactions and events are reported in financial statements.
ISSB: International Sustainability Standards Board. An independent body charged with developing IFRS Sustainability Disclosure Standards.
IASB: International Accounting Standards Board. Responsible for developing the IFRS.
COP26: Conference of the Parties. The 26th United Nations Climate Change conference was held in Scotland in 2021.
Scope 1 emissions: greenhouse-gas emissions from sources which an organisation controls directly.
Scope 2 emissions: greenhouse-gas emissions from sources which an organisation controls indirectly (such as the emissions associated with electricity generation that power a factory).
Scope 3 emissions: emissions that are not produced by the company itself (such as those in its supply chain).
- https://www.ruf.rice.edu/~sazeff/Evolution%20The%20Accounting%20Review.pdf
- https://www.jstor.org/stable/43294812
- http://archives.cpajournal.com/old/08033850.htm
- Accounting standards between countries remain less than fully comparable. However the situation as it stands is not bad. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1585404
- https://archivo.alde.es/encuentros.alde.es/anteriores/xiiieea/trabajos/pdf/046.pdf
- https://www.generationim.com/our-thinking/insights/the-future-of-esg-data/
- https://www.ifrs.org/news-and-events/news/2022/02/interview-with-new-ISSB-Chair-Emmanuel-Faber/
- https://www.wiso.uni-hamburg.de/fachbereich-sozoek/professuren/schiemann/archiv/praesentation-konsistenz-treibhausgasemissionen.pdf
- https://www.ifrs.org/news-and-events/news/2021/06/is-there-a-path-to-global-sustainability-standards/ emphasis added
Important Information
The ‘Insights 13: A Primer for the Harmonisation of Sustainability Standards for Investors' is a report prepared by Generation Investment Management LLP (“Generation”) for discussion purposes only. It reflects the views of Generation as at August 2022. It is not to be reproduced or copied or made available to others without the consent of Generation. The information presented herein is intended to reflect Generation’s present thoughts on sustainable investment and related topics and should not be construed as investment research, advice or the making of any recommendation in respect of any particular company. It is not marketing material or a financial promotion. Certain companies may be referenced as illustrative of a particular field of economic endeavour and will not have been subject to Generation’s investment process. References to any companies must not be construed as a recommendation to buy or sell securities of such companies. To the extent such companies are investments undertaken by Generation, they will form part of a broader portfolio of companies and are discussed solely to be illustrative of Generation’s broader investment thesis. There is no warranty investment in these companies have been profitable or will be profitable. While the data is from sources Generation believes to be reliable, Generation makes no representation as to the completeness or accuracy of the data. We shall not be responsible for amending, correcting, or updating any information or opinions contained herein, and we accept no liability for loss arising from the use of the material.