Chapter 1
Introduction

Financial performance has long been at the heart of corporate reporting. It will remain so. Investors and others will always want to know how profitable a reporting entity is, how much cash flow it is generating and what are its assets and liabilities. Yet, in a world increasingly challenged by issues of sustainability, the need is growing for information that complements the financial statements, giving insight into the risks and opportunities that affect an entity's financial prospects.

Take the obvious example of climate change, which can affect corporate financial performance either by creating physical risks to an entity's business operations, transition risks to its business model, or opportunities to create economic value in novel ways. Physical risks might arise in the short term from the effects of extreme weather events, for example, floods that force closure of an operating facility or that disrupt supply chains. In the long term, rising sea levels might render business in a coastal region unviable. Transition risks might manifest in a variety of ways, depending upon how the entity's various stakeholders respond to climate change. Customers might demand lower-carbon products and services, while competitors might disrupt the market with new offers that meet this demand. Governments and regulators might impose tighter restrictions on greenhouse gas emissions, perhaps by introducing a carbon tax. Banks, seeking to enhance their own sustainability credentials, might either refuse loans, or charge higher interest rates, for clients with a high carbon footprint. Potential employees, especially those in the early stages of their careers, might choose to avoid the stigma of working for a business with poor environmental performance. Meanwhile, any of these risks can also be turned around and understood as opportunities, as possible new sources of financial return. A business might be the one that disrupts the market, attracts green finance, employs the brightest young talent and then realises the profitable growth that a transitioning economy inevitably offers.

But consider the information that the financial statements provide with respect to these sustainability-related risks and opportunities. There are gaps.

We can start with the observation that current risks and opportunities relate to (uncertain) future events. In contrast, the financial statements are anchored in the reporting of past transactions and events-the financial performance for the year and a statement of financial position showing recognised assets and liabilities at the end of that year. The financial statements do not ignore all future events. They should reflect expectations about the economic lives of assets, and they will factor in expected cash flows in asset impairment tests and in fair value assessments, which could be affected by sustainability-related matters. However, these expectations relate only to the circumstances that exist on the date of the financial statements. They do not otherwise anticipate the future. If business conditions change, it follows that past profit might not be an effective guide to future profit. For example, if the past performance of a business had relied upon burning fossil fuels, yet the market for this activity could no longer be relied upon, then there is limited predictive value in past performance. An auto maker that had dominated the market for diesel cars might have a strong profit record but prospects that are exposed to a new entrant that specialises in next-generation vehicles.

Sustainability reporting places greater emphasis on anticipating future events, for example disclosing not just actual greenhouse gas emissions during the reporting period but also plans to reduce those emissions. Such disclosure should enable users to understand how an entity is preparing for an unknowable future. Sustainability reporting therefore includes information relating to: governance (oversight); strategy (how an entity has identified risks and opportunities and how it plans to respond to them, over the short, medium and long term and how it expects its future financial performance will be affected); risk management (the processes by which the entity seeks to understand its resilience); and metrics and targets (the performance criteria by which it sets expectations and evaluates performance).

A further important difference is that the financial statements are defined and measured with respect to the net assets controlled by the reporting entity, yet the transactions or events that create sustainability-related risks and opportunities also arise beyond this boundary. An auto maker's transition risks might arise mostly downstream from its own operations, where CO2 emissions are generated by the cars it produces and where it risks loss of demand as customers shift towards electric vehicles. Transition risks can also come from upstream activities, such as the carbon footprint of steel production. Although the auto maker does not make the steel that it uses, it is likely to have choices about which supplier to use, not least whether the steel it produces has a relatively high or a low carbon footprint. Those choices affect the auto maker's sustainability credentials and, therefore, its exposure to transition risk in a consumer and regulatory context that is increasingly sensitive to greenhouse gas emissions.

Sustainability-related financial disclosures are also likely to be more heterogeneous than financial statement disclosures. The financial statements are essentially universal in format and in defined content, with information on such things as profit or debt being universal. In contrast, sustainability-related disclosures are likely to vary for different industries. For example, the consumption of fresh water is important in industries such as agriculture, textiles and mining, but less so in entertainment, transportation or professional services. The ways in which each industry uses water will also differ. Moreover, each sustainability issue brings its own challenges of measurement. While financial statements universally apply monetary measurement, the measurement required for greenhouse gas emissions is necessarily different from the methods of measuring freshwater consumption. In addition, there is then the need to 'translate' such measures so they can be understood from the monetary perspective with which investors understand economic value creation. Data on (for example) greenhouse gas emissions are not themselves the direct concern of investors. They are instead measures of a physical phenomenon that, in turn, indicate the challenge and risk associated with transition to a low-carbon business model. What investors would ideally like to know is the capital expenditure required for transition, the expected effects on revenue and operating cost, the likely resilience of financial performance, and so on. The disclosure of these financial effects is a secondary step in sustainability-related financial disclosure rather than, in the case financial accounting, the direct object of measurement.

Finally, a difference in practice-though not in principle-is that, in contrast with financial accounting, the field of sustainability reporting has far fewer experienced professionals and far more immature data systems and reporting and auditing standards. Sustainability reporting is an emerging practice; it remains a long way from being fully formed.

Sustainability issues are wide-ranging. While climate change is the most obvious and widely recognised example, sustainability relates to a plethora of environmental and social resources on which business activity depends, and upon which business activity has an impact. These range from an entity's dependency upon natural resources such as fresh water and other naturally occurring raw materials, to the transition risks and opportunities arising from waste, deforestation and other environmental impacts, to dependency upon social resources such as a healthy and highly trained workforce, and to the transition risks and opportunities arising from social impacts such as the effects of breaches in data privacy, of products or services on physical or mental health, or of plant closures on local communities.

Within this broad sustainability domain, the specific focus of this book is on the disclosure of sustainability-related information for the benefit of investors. We are therefore concerned primarily with International Financial Reporting Standards (IFRS)-or, more specifically, with IFRS Sustainability Disclosure Standards.

We acknowledge that an entity's sustainability performance and plans are of interest not just to its investors but also to others affected by its operations, such as local communities, customers, suppliers or employees. Arguably most important are the interests of future generations because, at heart, sustainability is concerned with ensuring that the quality of life enjoyed in the future will be at least as high as that in the present. This is most famously expressed in the 1987 report of the United Nations' Brundtland Commission, which defined sustainability as the constraint of 'meeting the needs of the present without compromising the ability of future generations to meet their own needs'.

To an extent, the interests of different stakeholders in an entity are shared. They all have an interest in mitigating climate change and in adapting to its effects. If, thereby, there is increasing demand for carbon-neutral cars, aided perhaps by government regulation, then the financially viable activities of auto makers will switch...