18 October 2023
In June 2023, the International Sustainability Standards Board (ISSB), issued its inaugural standards — IFRS(1) S1 and IFRS S2. The Standards provide a framework for reporting sustainability data alongside related risks and opportunities. The goal is to provide investors with a global baseline that can be adopted by regulators and implemented by companies around the world. In other words, the accuracy and comparability of sustainability reporting will now become as important as financial reporting for companies.
The effective date of implementation of these standards, as set by the IFRS Foundation and ISSB is January 2024. However, voluntary adoption has also been allowed. These standards will not be mandatory for IFRS accounting standard reporting companies until capital markets and securities commissions formally adopt and require the standards. However, given IOSCO’s(2) endorsement of the standards and a global push by investors for a comparative sustainability framework, a quick response by regulatory bodies across the world is anticipated. It is important to note that all six GCC countries are members of the IOSCO. There is a substantial overlap of these new standards with the already existing IFRS-aligned frameworks across different jurisdictions, including the GCC(3) (e.g., SASB(4) and TCFD(5) ), and hence it would be a natural fit for many companies.
IFRS S1 deals with the general requirements for the disclosure of sustainability-related Financial Information. The Standard requires companies to disclose all information about sustainability-related risks and opportunities that could reasonably be expected to affect a company’s prospects. For example, if an entity’s business model depends on a natural resource — such as oil — the entity could both affect and be affected by the quality, availability, and affordability of that resource. Specifically, degradation or depletion of that resource—including resulting from the entity’s own activities and from other factors—could create a risk of disruption to the entity’s operations and affect the entity’s business model or strategy and could ultimately negatively affect the entity’s financial performance and financial position.
IFRS S2 deals with climate-related Disclosures. The standard requires companies to disclose all information about climate-related risks and opportunities that could reasonably be expected to affect the company’s prospects. Other than the general requirement to disclose governance processes, strategy, and risk management processes towards identifying and tackling climate-related risks, companies are also required to disclose specific cross-industry metrics such as greenhouse gas emissions.
An October 2022 KPMG study found that while 96% of the world’s 250 largest firms published sustainability reports, in the Middle East and Africa, only 56% of the region’s top 392 companies released such information in 2021, down from 59% a year earlier. That compared with 89% in Asia Pacific, 82% in Europe and 74% in the Americas. The majorly hydrocarbon-dependent GCC economies have pledged net zero targets through their respective vision statements through diversification away from oil. Net-zero targets and diversification goals can be practically achieved only with frequent tracking of progress and performance. The sustainability standards help companies with that precisely, therefore adding macro-economic importance to the adoption of these standards.
2. Business Impact
The ISSB has acknowledged the possibility of market shifts due to the burden of increased sustainability disclosures arising from these new standards. However, IFRS S1 and IFRS S2 are intended to improve the alignment and interoperability of global ESG standards, reducing the reporting burden for preparers and enhancing the usefulness of sustainability disclosures for investors in making decisions.
The costs of initially applying IFRS S1 and IFRS S2 are likely to be substantial, including the one-time costs of developing and implementing systems for reporting and internal controls on data, and personnel costs to source the appropriate talent to manage data collection and disclosure processes. These costs might be new for many first-time preparers of sustainability-related financial disclosures. With the currently low levels of reporting across GCC, companies in the region would be forced to commit significant resources, both financial and human, to meet the minimum reporting requirements of the sustainability standards. However, the associated costs would likely decrease over time, as preparers set up systems and become familiar with the disclosure requirements. It hence becomes competitively relevant for the GCC companies to prepare a proper framework and hire appropriate human resources to ensure that the costs of complying with the new requirement do not outweigh the potential benefits.
When a company’s business model depends on a natural resource, like oil, it might be affected by changes in the quality, availability, or pricing of that resource. When a company’s activities result in adverse impacts on those resources, like spillage, it might be subject to reputational damage, fines, penalties, or stricter government regulation. When a company’s business partners and suppliers face sustainability‑related risks and opportunities, the company itself might be exposed to related consequences. Such dependencies, relationships and impacts can create or erode the company’s financial performance and financial position. The standards require the companies to study the above and disclose the same. Such studies can reveal the areas in which companies need to improve and hence commit resources accordingly. Further, with the global comparability of these standards, companies can understand where they stand on a global level and take steps to improve that position. It also presents an opportunity for companies to improve the confidence among investors and therefore improve their public reputation.
Improved data quality is expected to have a positive effect on areas such as governance, strategy, access to capital, cost of capital, reputation, and employee and stakeholder engagement. The core content of both standards involves a section on governance. The goal of governance-related disclosures is to outline the governance processes and procedures companies implement to monitor and manage sustainability and climate-related risks. Disclosures include the reporting of the steps taken by the governance body in the assessment of the risks and the decisions on major transactions and their risk management processes and related policies. An improving corporate governance landscape bodes well for the GCC region, which is currently marketing itself as the catalyst for global economic growth and attracting huge foreign investments.
Investors are likely to benefit from the application of IFRS S1 and IFRS S2 by avoiding costs, such as the inefficiencies of manual data collection, management, and analysis of sustainability-related financial disclosures. Many of these benefits for investors stem from the greater consistency, comparability, and verifiability of disclosures when IFRS S1 and IFRS S2 are applied. The global baseline of sustainability-related information required by IFRS S1 and IFRS S2 can facilitate investors’ understanding of the risks and opportunities of companies with different business models, exposure to climate risks based on locations of operations, and supply-chain dependencies. If investors have an improved understanding of the sustainability-related risks and opportunities of a company and its peers, it will be easier for them to predict future cash flows and the uncertainties associated with future cash flows, leading to lower risk of owning the company, and, as a result, lower cost of capital. A lower cost of capital leads to better valuations for the company which will ultimately reflect in the share price.
The new sustainability standards issued by the IFRS board are yet to be adopted by the GCC countries and have not indicated any specific dates about the adoption of the sustainability standards. However, major economies including UK and China are committed to the adoption of the IFRS standard. For the GCC, the new reporting requirements will likely lead to companies spending significant costs and resources for the transition. This will lead to an initial phase of market shifts as the effectiveness with which the companies make the transition varies and companies that already have a proper system in place have an advantage. However, over a period, as companies attain familiarity, the costs will reduce and the benefits of adopting such standards will outweigh the costs. The benefits include improved business processes, efficient utilization of resources, improved corporate governance, and share price discovery for investors. With the GCC economies vying for foreign investments and sustainability reporting gathering increasing importance across the globe, the adoption of the standards is relevant for the GCC companies.
(1) IFRS – International Financial reporting Standards
(2) IOSCO – International Organization of Securities Commission
(3) GCC – Gulf Co-operation council
(4) SASB – Sustainability Accounting Standards Board
(5) TCFD – Task Force on Climate-related Financial Disclosures
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