Be bold, brave but pragmatic. Above all, don’t become a navel gazing bureaucracy.
The ISSB (the International Sustainability Standards Board) has the potential to be a world leader in sustainability standards especially because the U.S. has been dragging its feet and the SEC is likely to face significant legal pushback should it come out with sustainability standards later in the year.
The conceptual need for an institution such as the ISSB is clear: whether we want to admit it or not, companies, because of their market-based transactions, generate harmful spillover effects such as pollution or products that affect local and global communities where these companies operate. Not all companies have voluntary incentives to provide such information to investors and society on account of short horizons, inertia or poor data availability in their own firms. One of the important ways to get companies to internalize the cost of these externalities is the production of transparent information about such spillovers. We have minimal information on accounting for externalities because the data to construct prices and quantities of non-market activities of the company such as pollution or worker safety are somewhat sparse to non-existent, as I discovered in my analysis of Coca Cola’s externalities. The ISSB can contribute by plugging this information gap.
The closest parallel comes from the world of reporting financial information. The FASB (Financial Accounting Standards Board) and the SEC (Securities Exchange Commission) are stellar standard setting and enforcement institutions in the U.S. They have had the benefit of evolving over several decades punctuated by financial crises, market booms and political interference from various stakeholders. The establishment of the ISSB is an especially important event because it is a “voluntary” standard setter, unlike the SEC and the FASB.
However, there are important differences between the world of financial and sustainability reporting. As I have written before, financial reporting is more focused on the first four factors of production in a business: materials, labor, capital and managerial talent. One could go further and argue that the financial reporting model covering these four factors is itself broken in the U.S. and the missing pieces therein such as absence of data on labor or human capital can be remedied by the ISSB. Moreover, the sustainability movement worries legitimately about the fifth factor, natural capital, that has been taken for granted or mostly ignored by the financial reporting system. The financial reporting system is also less interested in reporting on externalities that are unlikely to result in lawsuits or penalties in the short run.
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Having said that, the ISSB would do well to learn from the 100 year history of the FASB and the SEC. Here are 10 issues for the ISSB to consider.
1. Define your objective function and your audience carefully
The ISSB seems to have identified investors as its audience. At first blush, this sounds uncontroversial. However, at least four inconsistencies need to be managed: (i) conflict with other stakeholders; (ii) time horizon of the investor; (iii) covering negative externalities and positive ones such as consumer surplus; and (iv) associated measurement and verification challenges. Let me elaborate.
Sustainability, by definition, involves interactions between investors or shareholders with other stakeholders. Sustainability issues that are unimportant to investors even in the relatively long run are hugely relevant to stakeholders such as NGOs and social activists now. How will the ISSB adjudicate such conflicts among stakeholders? As a case in point, I have wondered why are U.S. shareholders not as aggressive as NGOs in bringing environmental or labor related lawsuits against companies? Do they care about the long-term reputational risks arising from these violations or is their investment horizon too short for these risks to bite?
A related point: most sustainability disclosures today focus on the company’s operations. Translating those disclosures to social impact of the product (the missing “P” in ESG) is a Herculean task for an investor. Consider a piece I wrote about Coca Cola. Coca Cola provides extensive disclosures on its ESG operations. I had to make several assumptions, that can be disputed, to translate those disclosures to the company’s social impact. I discovered that Coca Cola’s conventional financial accounting profits would be wiped out even if we assign modest social values to its carbon emissions, water usage and unrecycled plastic or the incremental diabetes cases potentially created by excess consumption of Coca Cola products.
When I discuss these findings with my colleagues, many shrug their shoulders. Some ask whether I am shorting Coca Cola’s stock and counsel me to not bet my pension money on that bet (I am not, for the record). Why? Partly because my colleagues believe, perhaps rightly, that Coca Cola’s investors will not have to internalize these social costs even in the medium or the long run.
One of three events needs to occur for that to happen: (i) regulation forces the company to internalize these costs; (ii) the investing community pulls capital out of Coke; or (iii) consumers defect in large numbers looking for an eco-friendly product. An investor has to forecast when one of all of these events may happen. That can be anywhere between say three years to a generation. Based on that investor’s horizon, this may or may not be relevant to an investor. How does the ISSB take such differing horizons into account if the effort is focused on investors?
Other colleagues rightly object that I have not accounted for all the positive externalities or benefits, especially the consumer surplus that Coca Cola creates. Consumer surplus is often defined as the price a customer is willing to pay for a can of Coke relative to what they are actually charged. I readily admit I do not know how to measure consumer surplus for Coca Cola as estimating demand curves, or the relation between price and quantity demanded for Coke, in local and global markets is essentially impossible for an outsider without access to private data confidential to Coke.
This may sound like an esoteric academic objection, but symmetry demands that sustainability disclosures should ideally cover both positive and negative externalities imposed by companies. Will the ISSB consider a proposal to make companies disclose the consumer surplus they create? Or the new knowledge created by its R&D that other entities exploit without paying for that knowledge? Or less controversial, the taxes they pay in their more important jurisdictions and their key suppliers? How does one verify such measures? The measurement and verification challenges associated with stakeholder issues for the ISSB are even more formidable than those for financial reporting issues.
2. Define what success looks like at the outset
Just like we publish student evaluations of our courses, have the ISSB publish an investor rating of its performance on an annual basis. A rule making institution rarely writes a rule saying that “it’s done.” Hence, it is important to make sure its primary audience, the investor, is allowed to rate its performance and the need for the ISSB’s continued existence.
3. Balance norms in practice with standards
The FASB appears to swear by the conceptual framework and, in effect, seems to think of writing standards as a deductive exercise from the conceptual framework document. A more inductive process based on codifying best practice from the field or norms used is a better approach. Accounting standards were first developed by essentially codifying diverse practice, hence the term “Generally Accepted Accounting Principles.” But the Conceptual Framework now has become a bit of a strait jacket.
I understand that the ISSB will publish an exposure draft of its conceptual framework soon. It will have to deal with diverse practice, loosely defined as the frameworks already developed by the SASB, CDSB, GRI, TCFD, VRF. The ISSB might work well initially at codifying these social norms into standards. The danger lies down in the line when the urge to write standards, without considering emergent norms, can become more tempting.
4. Balance timeliness with due process
The FASB’s new standard to effectively capitalize operating leases took around 10 years to enact in the U.S. Writing an exposure draft and seeking feedback from constituents is a great idea. However, one has to solve business problems in a timely manner to serve a useful purpose. Failing that, due process eventually becomes an end into itself as opposed to a means to an end. The perfect can be the enemy of the good. Thankfully, there appears to be a great sense of urgency about transparency regarding sustainability issues in the investor community.
The ISSB should consider a mindset of “good enough” but more timely standards that will mandatorily be reviewed for relevance and usefulness after a specified number of years. Consider building in a sunset-provision for each standard so that we can review and discard irrelevant or ineffective standards in favor of better ones. That is, institutionalize continuous improvement to respond to market feedback.
5. Be responsive to emerging problems
A related point: inculcate the proactive entrepreneurial mindset of say a board level risk management committee. One of the dangers of standard setting bodies is functional obsolescence, usually created by rapid technology that makes the standard that solves yesterday’s problems somewhat irrelevant. A while back, I had written about how cheap alternate data is a biggest threat to regulatory standard setting.
In the world of financial reporting, the FASB has finally added reporting for crypto currency to their list of emerging issues that they intend to consider. Fixing intangibles reporting has been a pressing concern for years. As an example, Apple’s market cap of $3 trillion is now larger than the market cap of most exchanges in the world and its book value barely explains 2% of its market cap partly because of omitted intangibles from its balance sheet. The ISSB will do better to be more responsive to emerging problems and also have to coordinate with the E.U. to be timely and relevant.
6. Collect and use empirical evidence and run randomized tests if possible
The best ideas in the lab can sometimes fail in the field. Run randomized tests of new proposals to spot implementation issues and fix them before the standards are issued. Once standards are issued and implementation costs are incurred to change legacy systems to produce information asked for by the standards, companies are usually averse to change. Collect systematic data on how existing standards were implemented. Conduct post-mortems of rules that accomplished their objective and the collateral damage or unintended consequences, if any. Incorporate that learning into framing future rules.
7. Balance investor, preparer, NGO and auditor clout in the organization
Preparers and auditors have too much power at the FASB, not investors. Investors are relatively diverse and poorly organized. Also, at the risk of self-promotion, have an outsider such as an academic involved. They are likely to be evidence driven and less partisan. Should NGOs be part of the mix? There are pros and cons to that decision. NGOs might be the only party pushing for disclosures related to negative externalities that firms impose, in the absence of political consensus or regulatory capture. Of course, NGOs themselves are vastly diverse in their objective functions and might end up pushing for disclosures that may be only be tangentially relevant to investors. Hence, it might make sense to involve specialized NGOs as consultative members of specific task forces.
8. Balance uniformity with flexibility
Transactions and companies are inherently un-comparable in a sophisticated market because two identical companies cannot exist in equilibrium. Pepsi and Coca Cola sound like great comparable peers until you open their books and notice that they are very different companies. I once spent a week trying to recast Pepsi’s results using Coke’s accounting policies and vice versa. I failed miserably because there is not enough public data to accomplish this objective. At the same time, markets need some uniformity and standardization especially because quants and computerized data is used to run investment strategies. Recognize the tension between uniformity and flexibility while framing policies. Pushing for too much standardization and uniformity is likely to be counterproductive.
9. Think hard about enforcement
Standards without enforcement lack bite. Who will enforce the ISSB’s standards? The E.U.? What about the rest of the world? Is it the investor community or the big three institutional investors in the U.S.? Is it the ratings agencies such as MSCI or Sustainalytics? Can we expect anyone other than investors to be honest enforcers of the ISSB’s standards? To what extent will poor or biased enforcement affect the ISSB’s credibility and effectiveness?
10. Resist the culture of “clarifications” and complex rules
The SEC and FASB spend a lot of time “clarifying” their prior standards. These clarifications are usually sought by companies with large compliance budgets. Clarifications eventually create a culture of catering to these “clients” of the standard setter or the enforcement agency. It is better to have auditors and executives exercise professional judgement to apply the standards to their unique set of circumstances. Keep clarifications to a bare minimum. Otherwise, we will end up a dense rule book of clarifications that overwhelms the principles behind the standards.
Complex rules create their own perverse incentives: they disenfranchise the non-technical, uninformed investor and create a revolving door between standard setters or regulators and consulting firms. Too many clarifications, exceptions and rules also serve as an open invitation for the banking-consulting industrial complex to game around the standards. There are many such examples in financial accounting (structuring leases, derivatives, mortgage-backed securities etc.). Some of these are sadly doomed to repeat in the sustainability domain as published standards become the rule book around which greenwashing is engineered.
The IFRS’ formal launch of the ISSB is a huge step forward in equipping investors with transparent information about the externalities, both positive and negative, that companies invariably generate in the ordinary course of their business. Such information can ideally lead to more responsible individual actions, better laws and regulations, or nudge companies to take account of their harmful impacts on workers and customers or even encourage the creation of new products that reduce the impact of such externalities.
My two cents to the ISSB: be bold, brave but pragmatic. Above all, don’t become a navel gazing bureaucracy.