By CPA Jeremy Riro
IFRS S1 — General Requirements for Disclosure of Sustainability-related Financial Information; became effective for annual reporting periods beginning on or after 1st January 2024. IFRS S1 requires an entity to disclose information about its sustainability-related risks and opportunities, which is helpful to the primary users of its general-purpose financial reports in making decisions relating to providing resources to the entity.
This sustainability disclosure standard connects a business entity’s general financial reporting with its Environmental, Social, and governance (ESG) strategy and reporting mechanisms. In addition, IFRS S1’s core objective is directly linked to the risk assessment and mitigation objectives of investors who provide capital to business entities.
Over the past decade, investors have increasingly realized that ESG factors directly impact company value; hence, they are now an integral part of their due diligence processes and investment decision-making. However, assessing all the ESG factors across the business value chain can lead to a rabbit hole with minimal value derived from the lengthy processes. To ensure efficient utilization of time and resources when conducting ESG compliance due diligence, investors narrow down to and prioritize material ESG issues (MEI).
From an investor perspective, IFRS S1 provides a standardized and practical framework that is comparable, understandable, and verifiable. It can be deployed quickly for timely assessment of ESG risk exposures for their current portfolios. Before IFRS S1 became effective, investors relied on different methods and frameworks to assess their portfolio companies’ ESG compliance and risk exposure. This made the ESG due diligence processes longer, cumbersome, and sometimes counter-productive. With the sustainability disclosure standards, investors can now apply harmonized processes to conduct deeper ESG analyses and interrogate the interactions of the business entity with its stakeholders, society, the economy and the natural environment throughout its value chain.
In general-purpose financial reporting, any information that would likely affect the share price of a business entity; or information that a rational investor would require before they make their investment decision is considered to be material. Under sustainability reporting, IFRS S1:17 provides that a business entity is required to disclose material information about the sustainability-related risks and opportunities that could reasonably be expected to affect the future prospects for the entity. IFRS S1:18 further defines material information as information that if it was omitted, misstated or obscured, it could reasonably be expected to influence the decisions the primary users of the general-purpose financial reports would make based on those reports; which include the financial statements and the sustainability related financial disclosures.
Different industries have different ESG compliance requirements. Hence, investors need to align the ESG due diligence by investors with the industry-specific disclosure requirements. The Sustainability Accounting Standards Board (SASB) Standards provide the standardized disclosure requirements for sustainability issues most relevant to investment decision-making across 77 industries. Through the SASB materiality finder online platform, investors can quickly find SASB disclosure topics relevant to their industries of interest and hasten their ESG due diligence processes.
Sector specificity notwithstanding, there are general material ESG issues that investors keenly consider in their due diligence processes before making their investment decisions. Social and governance material issues include corporate governance, stakeholders’ governance, access to essential services for employees, business ethics, community relations, data privacy and security, human rights within the organization and across its supply chain, occupational health and safety, product governance, ESG integration into the financials of the business as well as the overall human capital in the organization. On the other hand, environmental material issues include emissions, effluents and waste, carbon from own operations and the business’s products and services, environmental and social impacts of products and services, land use and biodiversity, water use for own operations and water use across the business’s supply chain as well as raw material use.
The above material ESG issues present real financial risks to businesses, hence investors need to understand and analyze them, as well as find ways to mitigate the risks they pose to their existing portfolios and future investments. In addition, investors are facing customer, reputational and regulatory pressures that their portfolio companies are going through as they adapt to the new requirements on ESG risk management. In some regions of the world such as the EU and the UK, investors are being mandated to gradually but steadily reduce their financed emissions, conduct investigations into supply chain human rights issues for their portfolio companies, adopt and adhere to broad based ESG management strategies and to report regularly in standardized formats on their progress in all ESG areas.
As investors incorporate ESG considerations in their investment decision-making processes, they face the challenge of finding reliable data. This challenge restricts their ability to optimize their sustainable portfolio construction strategies. However, with the disclosure requirements coming into force under IFRS S1, which became effective on 1 January 2024, more data is expected to be available in the future to provide investors with more insights into sustainability practices within businesses.
Availability of sustainability data from businesses will further define new ESG investment approaches from the screening stage to the portfolio management level. At the screening stage, qualitative and quantitative data will be used to exclude companies with characteristics that the investor wants to avoid, while including those that meet specific performance threshold for priority ESG metrics.
Thematic investing will also benefit from the availability of data; whereby investors in specific sectors such as clean energy and climate smart agriculture will be having deeper insights that will help them to conduct broader ESG related due diligence on their target investments. On the investment management front, investors will be able to provide oversight and sustainability stewardship more effectively through their representations in boards; since they will be equipped with actual ESG data and insights from the businesses they have invested in.
To undertake these ESG related investment risk analyses & sustainability integration changes in their portfolio companies, investors are obliged to invest significant amounts of time and resources internally or outsource the services to external professionals. The returns however outweigh the costs; since investors who fully integrate ESG considerations into their investment strategies and portfolios benefit from a reduction in their portfolio risk; and greater alignment with changing customer preferences. In African markets, compliance will be the leading factor for ESG considerations by investors in the medium term; since most local consumers are yet to fully link their purchasing decisions to products and services from companies that are keen on sustainability.
CPA Jeremy Riro is the Managing Partner at Fie-Consult; an Investment Advisory & Management Consulting firm with offices in Nairobi, Kenya and Kigali, Rwanda but working across Africa.
