Background

In recent years, there has been a growing awareness of sustainability-related risks and the potential impact which these may have on an entity’s current and future financial position, performance, and cash flows. Investors require high-quality information about these risks, as well as potential sustainability-related opportunities, when making investment decisions. Although sustainability reporting has become increasingly prominent, the proliferation of different, voluntary reporting standards and frameworks has caused fragmentation, and this has limited the usefulness of the information provided.

The IFRS Foundation believed that the information needs of investors were not being met. In response to this, they founded the International Sustainability Standards Board (ISSB), which has the aim of developing a global baseline of sustainability standards.

In 2023, the ISSB issued its first two sustainability disclosure standards. These are:

  • IFRS S1 General Requirements for Disclosure of Sustainability-Related Financial Information; and;
  • IFRS S2 Climate-related Disclosures.

These two standards are included on the list of Examinable Documents for Strategic Business Reporting (SBR) exams from September 2024 onwards.

General requirements

Entities apply IFRS S1 when preparing and reporting sustainability-related financial disclosures. IFRS S1 refers to four areas of core content that entities should provide in their sustainability-related financial information:

  • Governance – the governance processes used to monitor and manage sustainability-related risks and opportunities.
  • Strategy – the approach to managing sustainability-related risks and opportunities.
  • Risk management – the processes used to identify, assess, and monitor sustainability-related risks and opportunities.
  • Metrics and targets – the entity’s performance in relation to sustainability-related risks and opportunities, including progress towards any targets set.

As well as applying the principles in IFRS S1, entities must refer to other issued IFRS Sustainability Disclosure Standards when disclosing information about specific sustainability-related risks and opportunities. This means that entities must use IFRS S2 when preparing disclosures of climate-related risks and opportunities.

As no further IFRS Sustainability Disclosure Standards have yet been issued, sustainability-related disclosures related to non-climate issues must be prepared using the principles in IFRS S1 only. The ISSB will eventually draft, consult on, and issue a suite of other sustainability disclosure standards but, in the meantime, IFRS S1 requires users to consider the disclosure topics covered in standards issued by the Sustainability Accounting Standards Board (referred to as the SASB Standards) and to assess whether they are applicable.

IFRS S1 does permit entities to omit information about sustainability-related opportunities from sustainability-related financial disclosures if that information is commercially sensitive. However, the exemption does not apply to any information that is already publicly available, neither does it apply to sustainability-related risks.

Interconnectedness

There are several similarities between the principles and concepts in IFRS Sustainability Disclosure Standards and in IFRS Accounting Standards.

Both sets of standards use the same two fundamental characteristics of useful information (relevance and faithful representation), as well as the same four enhancing qualitative characteristics (comparability, verifiability, timeliness, and understandability).

The definition of materiality across the two sets of standards is also the same:

‘Information is material if omitting, misstating or obscuring that information could reasonably be expected to influence decisions that the primary users of general-purpose financial reports make on the basis of those reports.’

Both sets of standards identify the same primary user of financial reports: current and potential investors, lenders, and other creditors.

IFRS S1 specifies that sustainability-related financial disclosures must be reported at the same time as the related financial statements. The reporting period for the sustainability-related information must also be the same as for the financial statements. Both sets of standards require the disclosure of comparative information.

The treatment of material, prior period errors in sustainability-related financial information is also based on the same principle as in IFRS Accounting Standards: these errors must be corrected retrospectively by restating comparative amounts for the prior period, unless this is impractical.

Climate-related disclosures

Risks and opportunities
The SBR syllabus for exams from September 2024 onwards requires candidates to assess disclosures of climate-related risks and opportunities. Entities apply IFRS S2 when producing climate-related disclosures. The purpose of these disclosures is to provide information about climate-related risks and opportunities that the primary users of its financial reports would find useful.

Climate-related risks can be separated into two broad categories:

  • physical risks, and
  • transition risks.

Physical risks result from weather-related events, such as floods or droughts. They also result from longer term climatic changes; for example, rising temperatures may lead to rising sea levels as well as a loss of biodiversity.

Transition risks result from the move towards a lower-carbon economy.

Entities are required to provide disclosures about its governance, so that the users of its financial reports can understand how climate-related risks and opportunities are identified, monitored, and managed.

When identifying sustainability-related risks and opportunities, entities must use all reasonable and supportable information that is available to them without undue cost of effort. Data sources can be internal or external, and might include risk management processes, external reports or statistics, and industry experience. Assessments of what constitutes undue cost or effort will change over time and depend on the benefits of the information provided to the users.

The following is an example of a disclosure of some of the climate-related risks and opportunities facing an international restaurant business:

Physical risks
Our business model relies on large quantities of raw materials. Increased levels of flooding due to climate change has affected the quantity and quality of several key ingredients. This leads to price volatility, which reduces profit margins.

Restaurants in some locations are heavily impacted by water shortages and chronic weather events. These events may cause temporary closures but can also increase the costs of insurance premiums.

Transition risks
Climate-related laws and regulations are regularly changing. Our restaurants operate in more than 90 countries around the world. Compliance costs are high. Moreover, increased regulation can result in higher operational costs, such as in relation to the cost of energy.

Many of our customers pay close attention to our climate-related strategies and targets. If these are deemed insufficient, then our brand value will decline. Reputational damage will impact our market share and our share price.

Opportunities
To achieve our goals, we are pursuing more efficient operations through investment in new technologies. In the long-term, we expect a significant decline in energy-usage, with a resulting increase in reported profit margins.

With regards to identified risks and opportunities, the entity would need to disclose the impact on its strategy and decision making. It must also outline the effect of the risks and opportunities on its financial position, financial performance, and cash flows in the current reporting period, as well as the anticipated effect in the short, medium, and long term. To help users assess the adaptability of the entity, information must also be provided about the resilience of the entity’s strategy and business model to climate-related changes. This includes providing information about climate-related scenario analysis that the entity has carried out.

Metrics
Entities are required to disclose metrics and targets that will help the primary users understand its performance in relation to climate-related risks and opportunities. IFRS S2 states that this involves providing information about any climate-related targets that the entity has set, as well as information about its greenhouse gas (GHG) emissions.

Greenhouse gas emissions
In accordance with IFRS S2, entities are required to disclose gross GHG gas emissions. This disclosure must be broken down into Scope 1, Scope 2, and Scope 3 emissions. These are defined as follows:

  • Scope 1 – direct GHG emissions that occur from sources that are owned or controlled by an entity.
  • Scope 2 – indirect GHG gas emissions from the generation of purchased or acquired electricity, steam, heating, or cooling consumed by an entity.
  • Scope 3 – indirect GHG emissions (not included in Scope 2) that occur in the value chain of an entity.

An example disclosure of gross GHG emissions is provided below:

Swipe to view table

GHG emissions (metric ton CO2e) 20X6 20X5
Scope 1 GHG Emissions 1,153,352 1,045,243
Scope 2 GHG Emissions 4,534,212 4,734,243
Scope 3 GHG Emissions 7,432,435 7,875,432

This disclosure is important because it helps users of the sustainability-related financial information assess the entity’s exposure to climate-related risks and opportunities. Entities with higher GHG emissions are potentially more exposed to climate-related transition risk because they will be more heavily impacted by legal, technological, market and reputational risks. In particular, shifting consumer demands could lead to severe reputational damage for entities that do not make sufficient progress in reducing their GHG emissions.

For some industries, Scope 3 emissions can account for almost 90% of total GHG emissions. For this reason, Scope 3 emissions are sometimes perceived as a hidden risk – especially if undisclosed. The requirement in IFRS S2 to disclose Scope 3 GHG emissions therefore gives a more complete picture of an entity’s overall carbon impact, and it also enables investors to compare the carbon-impact of entities with different business models (such as those which heavily outsource activities and those that do not).

It can be difficult to measure GHG emissions, particularly those falling into Scope 3, and many different methodologies exist. For this reason, IFRS S2 requires entities to measure GHG emissions in accordance with Greenhouse Gas Protocol: A Corporate Accounting and Reporting Standard (2004), unless an entity is legally required to use a different method. This consistent approach reduces the risk of bias, helping to ensure a faithful representation of the underlying phenomena. There are also some exemptions and simplifications for entities in the first year of applying IFRS S2.

Targets
IFRS S2 requires entities to provide information about the climate-related targets it has set. Below is an example of an extract from a disclosure note for an international hotel business:

The company aims to reduce water consumption per occupied room by 20% from a 20X0 baseline by the end of 20X9. By the end of 20X6, the reduction in water consumption per occupied room since 20X0 was 8.4%. We are behind schedule on this goal but continue to explore opportunities to reduce water consumption.

The company plans to reduce net carbon dioxide emissions by 30% from a 20X0 baseline by the end of 20X9. To achieve this, we will reduce gross emissions by 10%, while also making use of carbon credits. These credits are generated from projects that use technology to capture carbon dioxide from the atmosphere before storing it safely underground. The carbon credits have been independently verified by the Global Carbon Council. By the end of 20X6, net and gross carbon dioxide emissions had reduced by 24% and 2% respectively. We are behind schedule on our gross target but have implemented a new executive management share-based payment scheme which will vest if the goal is achieved.

If entities disclose a net GHG emissions target, IFRS S2 also requires disclosure of the gross target. This is because a reduction in net GHG emissions can be achieved without making changes to the entity’s business model, for instance, through the purchase of carbon credits.

IFRS S2 defines a carbon credit as ‘an emissions unit that is issued by a carbon crediting programme and represents an emission reduction or removal of greenhouse gases.’ IFRS S2 requires entities to disclose their planned use of carbon credits to achieve any net greenhouse gas emissions target. Disclosure of the planned use of carbon credits in achieving climate-related goals is important because some carbon capture technologies may prove ineffective, or there might be a change in regulations that ban entities from using certain schemes. The prices of carbon credits may also change significantly, which will impact these plans and, therefore, the entity’s ability to meet its targets.