Understanding IFRS S1 and S2 for Sustainability Reporting

In the next update of the Sustainability Reporting Guideline (SRG Two), we will push for the Financial Reporting Council (FRC) to add a Sustainability Practices Framework or Policy as a required document. This Sustainability Practices Framework should outline a Sustainability Strategy, showing how a company responds to or plans to handle Sustainability Related Risks and Opportunities.

Implementing IFRS S1 and S2 should not be just about following rules. It should lead to better business behavior. For this to happen, sustainability practices must be a part of how a company runs its operations. Today, I want to clarify and provide some guidance on this.

One document in the Financial Reporting Council’s (FRC) Phase Two plan requires companies to identify all Sustainability Related Risks and Opportunities (SRROs) that could affect their future. They must also assess the importance of each identified SRRO. This assessment helps the company focus on the most relevant SRROs to prioritize. Materiality assessment is based on how likely these risks are to happen and their possible impact.

The impact relates to financial materiality, which means how SRROs can affect a company's financial performance, position, cash flow, and access to capital. Prioritization should focus on SRROs with the biggest financial impact, calculated by multiplying the likelihood of occurrence by its impact. I will not go into all the details about this, but in the end, the company will identify and prioritize the SRROs that could affect its future.

Next, integrating sustainability starts with the company figuring out which sustainability practices can address the identified and assessed SRROs. The company must then update its Risk Register to include all sustainability-related risks that have been identified. By doing this, they acknowledge that these risks are part of their responsibilities moving forward. If, after Phase Two, a company has not updated its Risk Register, they still have work to do. These risks must be included in the company’s broader Enterprise Risk Management (ERM) framework. The ERM is a Phase Three document, which we will discuss later.

Let’s now talk about the sustainability practices that address the identified and assessed sustainability-related risks. Implementing IFRS S1 and S2 should embed sustainability practices within a company’s operations, but this doesn’t always happen, especially when companies just focus on compliance. The first step to addressing sustainability-related risks is for the company to develop practices that can help manage these risks.

By setting up practices that address the SRRO, sustainability reports will focus on the company’s sustainability practices. These practices can be written in a document called the Sustainability Practices Framework or Policy. For instance, in a brewery, industry guidelines show that water is a sustainability risk. After identifying and assessing this risk, the company must determine what practices it will implement to manage water usage. This information should be part of the Sustainability Practices Framework or Policy.

Energy management is also a key sustainability risk in the hotel industry. The practices a hotel puts in place to manage energy use are part of its sustainability efforts. In finance, integrating environmental, social, and governance (ESG) factors into credit analysis is a sustainability risk. What measures a bank takes to tackle this is included in its Sustainability Practices Framework or Policy. This shows why identifying and assessing materiality is crucial for integrating sustainability practices into a company.

This brings us to why IFRS S2 needs certain industry-specific metrics for measuring performance in sustainability practices. For example, IFRS S2 requires a company in the food and beverage sector to report its energy management efforts with metrics like (1) operational energy consumed, (2) percentage of electricity from the grid, and (3) percentage of renewable energy. They must also disclose water management metrics like (1) total water withdrawn, (2) total water consumed, and the percentage of each in areas with high water stress. Sustainability practices help reduce energy and water use, which benefits the environment.

Real-world examples show that the idea of a Sustainability Practices Framework or Policy is faced with challenges. The first challenge is that the FRC does not require companies to submit a Sustainability Practices Framework or Policy. Instead, Phase Two requires a Sustainability Disclosure Policy, which makes sense since the FRC focuses on reporting and disclosures.

Some companies claim to have ESG or Sustainability Policies, but many contain vague statements like: "we believe the environment should be good for all" or "we will ensure we cause no damage to people and the environment and will work harmoniously with communities where we operate." While these companies have good intentions, they often lack actual practices that address the identified and assessed sustainability risks, relying instead on aspirational statements.

Another challenge is that existing ESG or Sustainability Frameworks serve different purposes and can mean different things to different companies. One company’s framework might include aspirational statements and its ERM, while another might focus on disclosure and risk governance. Thus, these frameworks do not always directly address the practices used to manage identified and assessed SRROs.

Nonetheless, some financial companies have done well in outlining how they integrate ESG into their credit analysis based on sustainable banking principles. But even they have limitations, as they do not fully cover financed emissions. Other sectors also have sustainability practices, but they do not always address all identified SRROs that IFRS S1 and S2 implementation will require.

When companies are asked to develop the right Sustainability Practices Framework or Policy according to IFRS S1 and S2, the challenge is that it is not part of what the FRC has required. This leaves it to the companies to create these as internal documents. Still, it is wise for companies to create Sustainability Practices Frameworks or Policies as if they were required by the FRC, even if they are internal, as this is the first step in embedding sustainability practices into their operations.

In the future, we will advocate for the FRC to include a Sustainability Practices Framework or Policy as a required document in the Sustainability Reporting Guideline (SRG Two). This Framework should outline a Sustainability Strategy, showing how a company responds to Sustainability Related Risks and Opportunities. This is the key to integrating sustainability practices into a company’s operations and changing business behavior, as practices can lead to changes in behavior. TO BE CONTINUED.