Upright’s stance: The "gross vs. net" problem in the new ESRS draft is a flawed simplification

EFRAG's latest exposure drafts for the ESRS mark a major step forward in simplification, and the commitment to easing the reporting burden is a welcome development. However, a critical detail within the new materiality rules – the proposed 'gross vs. net' assessment for potential negative impacts – warrants closer examination as it could lead to counter-intuitive and confusing outcomes for reporters and investors alike.

The "gross vs. net" rule at a glance – and why it is a problem

The new ESRS drafts propose a complex rule for assessing potential negative impacts. In short:

• If a potential negative impact is managed by a past, completed action (like building a wall), the company assesses its materiality after considering the mitigation (a net basis).
• If a potential negative impact requires ongoing mitigation or prevention measures (like active monitoring), the company must assess its materiality before considering the mitigation (a gross basis).

This distinction, while subtle, creates a reporting paradox that could mislead investors and other end-users of sustainability statements. Let's look at an illustrative example of two companies.

Example: A reporting paradox in practice

Passive PetroChem and Active AgriCorp both operate chemical plants near sensitive wetlands. The unmitigated impact of a chemical leak at both sites is identical and highly material.

Passive PetroChem relies on a 30-year-old containment basin. It was a one-off project, but it was built to a lower engineering standard than is used today. The basin is not monitored on an ongoing basis but it might be subject to fatigue due to its age.

• Assessment: Because the containment basin is considered a "passive", already completed mitigation action, the company argues for a NET assessment. The potential impact is deemed NOT MATERIAL because the basin still functions.
• Reporting outcome: Passive PetroChem does not have to mention this potential impact at all in its sustainability report.

Active AgriCorp recently invested in a brand-new, state-of-the-art active safety system. It has triple redundancy and a statistically proven 99.99% reliability rate, far exceeding the likely performance of Passive PetroChem’s aging basin.

• Assessment: Because the system requires ongoing management, the company must assess its impact on a GROSS basis, ignoring its superior safety system. Consequently, the potential impact is deemed MATERIAL.
• Reporting outcome: Active AgriCorp must report on this potential impact in its sustainability report.

The investor's dilemma

An investor comparing these two companies faces a serious problem. The sustainability reports are not telling the whole story - in fact, they are distorting reality.

• Flawed comparability: The reports make the two companies look fundamentally different. Active AgriCorp appears to have a material environmental impact which Passive PetroChem doesn’t have. In reality, the probability-weighted impact of a chemical leak might be significantly higher for Passive PetroChem.
• Misleading risk perception: The investor is led to believe that Active AgriCorp is the riskier investment. They may penalize the company for its transparency, while rewarding Passive PetroChem for a reporting outcome that obscures the underlying gross risk.
• Perverse incentives: This rule inadvertently punishes companies for investing in modern, active risk management systems and rewards older, passive approaches. It creates a disincentive for the very innovation and proactive safety culture that sustainability reporting should encourage.
• Lack of transparency: When a topic that the investor would expect to be material is not mentioned in the report, they are left to guess the reason. Is the omission due to a flawed materiality assessment, or is it because the company’s mitigation measures have been so effective that the impact is no longer material?

Why this matters to investors and reporters

Ultimately, this approach forces investors to second-guess current data, or dig through years of old reports just to piece together the context of past mitigation actions. Instead of providing clarity, it creates confusion, undermines comparability, and could lead to capital being allocated based on reporting loopholes rather than genuine sustainability performance – a disservice to both investors and reporters.

A straightforward "gross basis for all" approach would be far clearer and more useful for all stakeholders.