The implementation of IFRS S1 & S2 must not be approached strictly from a regulatory compliance perspective. Rather, it should lead to a change in responsible business behaviour. For there to be a change in responsible business behaviour, sustainability practices must be elevated and embedded in an entity’s business operation. Today I want to provide more clarification and guidance on this.
One of the documents in the Financial Reporting Council (FRC)’s Phase 2 implementation, requires an entity to identify all Sustainability Related Risks and Opportunities (SRROs) that could reasonably be expected to affect its prospect and carry out a materiality assessment of each identified SRRO. The materiality assessment enables the entity to zero in on those relevant SRROs for prioritisation. Materiality assessment is predicated on the likelihood/probability and magnitude of occurrence.
Magnitude of occurrence speaks directly to financial materiality i.e., SRRO’s effect on financial performance, position, cash flow and access to or costs of capital. Prioritisation should be predicated on the SRROs with the highest financial effect determined as likelihood/probability of occurrence multiplied by the magnitude. It is not my intention to go into the intricacies involved in the determination of this, but ultimately, the entity has identified and prioritised the SRROs that could affect its prospect.
The integration of sustainability begins with the entity identifying the sustainability practices that address the identified and materially assessed SRROs. First, the entity must update its Risk Register to include all those identified and materially assessed sustainability related risks. By updating the Risk Register, the entity now acknowledges that these are part of the risks that it will have to deal with and manage moving forward. If after Phase 2, an entity has not updated its Risk Register to include sustainability related risks, then know there is outstanding work to be done. These risks then form part of the risks to be integrated in the entity’s wider Enterprise Risk Management (ERM) framework. The ERM is a Phase 3 document and so will be covered in future series.
Let us now focus on the sustainability practices to address the identified and materially assessed sustainability related risks. The implementation of IFRS S1 & S2 should embed sustainability practices within the entity’s operation, but this is not always the case, especially when the implementation has been approached from a regulatory compliance perspective. The starting point in addressing the identified sustainability related risks is for the entity to institute sustainability practices that will help manage these risks.
By instituting practices that address the SRRO, sustainability disclosures will now be about disclosure of an entity’s sustainability practices. Such sustainability practices can be articulated in a document called Sustainability Practices Framework or Policy. The implementation of IFRS S1 & S2 should result in an entity producing its Sustainability Practices Framework or Policy. Let us take an example of a brewery company, where the industry guidance shows that water is a sustainability risk facing that industry. Having identified and materially assessed water as a sustainability risk, what practice is the entity putting in place to manage water. This practice should then form part of what is contained in the Sustainability Practices Framework or Policy.
Energy management is a material sustainability risk in the hotel business, what practices an entity in this industry puts in place to manage energy are sustainability practices. In the financial sector, integration of ESG in credit analysis and investment management is a sustainability risk. What practices the financial institution has put in place to address this, forms part of what is captured in Sustainability Practices Framework or Policy. We can go on and on. You can now understand why identification and materiality assessment holds the key to integration of sustainability practices in an entity’s operation.
The above explains why IFRS S2 requires the disclosure of certain industry specific metrics as a way of measuring performance on sustainability practices. Specifically, IFRS S2 will require an entity in the food and beverage industry to disclose energy management practices through metrics like (1) Operational energy consumed, (2) percentage grid electricity and (3) percentage renewable and water management practices through metrics like (1) Total water withdrawn, (2) total water consumed; percentage of each in regions with High or Extremely High Baseline Water Stress. Sustainability practices are what will lead to a reduction in energy and water consumption, thereby mitigating their impact on the environment.
Evidence from the field shows that what I have stated above about Sustainability Practices Framework or Policy is challenged and I want to dwell a little bit on this. The first challenge stems from the fact that the FRC documentation does not require an entity to submit Sustainability Practices Framework or Policy. Rather, what FRC requires in Phase 2 is Sustainability Disclosure Policy, and this is understandable since FRC’s focus is on reporting and disclosures, which is its mandate.
During implementation, some entities show they have ESG or Sustainability Policy or Framework, and when one looks at what they have, you discover that it is full of aspirational statements, ‘’we believe the environment should be good for all’’, we will ensure we cause no damage to people and the environment and will work harmoniously with communities where we operate’’. In all, we see genuine intention to evolve sustainability practices by these entities, but the missing link is evolving actual practices that address all the identified and materially assessed sustainability related risks as opposed to crafting aspirational statements.
Another challenge is that existing ESG or Sustainability Framework or Policy serves different purposes and does not always mean the same thing from one entity to another. In one entity, it may contain those aspirational statements and embed the entity’s ERM and list of operational and conventional risks the entity is managing. In others, it tends towards disclosure framework and risk governance structure. Thus, existing ESG or Sustainability Framework or Policy does not strictly address Sustainability Practices deployed to manage identified and materially assessed SRRO.
However, there are some entities in the financial sector that have done very well in articulating practices around how ESG has been integrated into their credit analysis following the sustainable banking principles, but limitations still exist as these do not address financed emission, which is understandable. Similarly in other sectors there are sustainability practices to manage sustainability risks. In all, they do not always address all the identified SRROs which IFRS S1 & S2 implementation will trigger.
Where the entity is now asked to produce the right Sustainability Practices Framework or Policy in line with the exigencies of IFRS S1 & S2 implementation, the challenge becomes the fact that it is not part of what FRC has specified, leaving it at the discretion of the entity to produce as an internal document. However, it is advisable for entities to still produce Sustainability Practices Framework or Policy as if it is part of what should be submitted to FRC, even if it is an internal document, as this marks the beginning of embedding sustainability practices within the operation of the entity.
In future amendments of the Sustainability Reporting Guideline (SRG 2), we will advocate for FRC to include Sustainability Practices Framework or Policy as additional documents to be submitted to it. Sustainability Practices should speak to Sustainability Strategy to present an overall picture of how the entity is responding to or plans to respond to Sustainability Related Risks and Opportunities. In this lies the integration of sustainability practices into an entity’s operation and a change in business behaviour, since practices are bound to change behaviour.
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