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Thats where we are going.. Sustainability materiality must be accepted as ever evolving, as it is for financial statement materiality. A large percentage of securities markets beneficiaries are diversified, and the relative importance of beta compared to alpha should affect these investors calculus when considering the impact of a portfolio companys social and environmental externalities. There are some other areas that need ironing out too before standard setters finish their work. By Stephen BouvierNovember 2022 (Magazine). This means disclosing information related to a companys social or environmental impact that is likely to affect its enterprise value. The Statement of Intent to Work Together Towards Comprehensive Corporate Reporting co-authored by five important standard setting organizations, was a 2020 document that was an important step towards the ISSB process; it describes inside-out information as being targeted at: various users with various objectives who want to understand the enterprises positive and negative contributions to sustainable development [in contrast to enterprise value information targeted] [s]pecifically to the sub-set of those users whose primary objective is to improve economic decisions. This time pressure leaves the board with little time to explore a draft sustainability-reporting standard drawn up by Prof Richard Murphy from Sheffield University Management School. The ISSB issued International Financial Reporting Standard S1, General Requirements for Disclosure of Sustainability-related Financial Information, and IFRS S2, Climate-related disclosures, in March. Companies that prioritize their financial return to shareholders face a prisoners dilemma with respect to such resources, and unchecked market competition will inevitably lead to their depletion. Eight othersmostly based in Europe, and including Allianz, Amundi, BNP Paribas, DWS, and Schrodersencourage the ISSB to consider a double materiality approach, incorporating companies' impacts on the environment and wider society, in line with the European Commission's proposals. The final documentation of the ISSB standards should acknowledge that most investors have significant, largely uniform interests in beta impacts. SASB's materiality map was so valued by the markets because it illuminated what mattered per industry. This recognition that change at one firm can affect the value of other firms in the portfolio implies a new goal for activism: namely, to engineer a net gain for the portfolio, possibly by reducing negative externalities that one firm is imposing on other firms in the investors portfolio. Investors need a reporting standard that accounts for all the costs a portfolio company imposes on them, even if the company itself avoids those costs. It defines a liability as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. In their 2021 book, Moving beyond Modern Portfolio Theory: Investing that Matters, Jon Lukomnik and James Hawley explained that these systematic risks inevitably swamp any alpha strategy: It is not that alpha does not matter to an investor (although investors only want positive alpha, which is impossible on a total market basis), but that the impact of the market return driven by systematic risk swamps virtually any possible scenario created by skillful analysis or trading or portfolio construction. As discussed in the Freshfields Report and the PRI Report, decision-useful information extends beyond information that affects enterprise value; if a companys E/S impact has the potential to affect beta, diversified shareholders may well act on that information by, for example, voting against directors who fail to act to mitigate negative externalities. Disagreement over definitions is just one element of the materiality issue. Impact materiality means that the activity affects either people or the environment, whether directly via the companys operations or indirectly in its value chain. Standard-setting International Sustainability Standards Board Consolidated organisations Forest fires raged across Europe, part of a London suburb caught light, and hurricane-force winds left a trail of destruction in southern Austria. Encourage the ISSB drafters to move to an express sesquimateriality standard. Firstly, the time element will force companies reporting under either the ISSBs and SECs rules to include outward impacts since, logically, the outward impact will eventually work its way inward. But the trade is inevitablethe only question is which type of investor it will favor. 1. ISSB to include GRI and ESRS in IFRS S1 sources of guidance; . As shown above, there is significant literature establishing that E/S disclosures that go beyond enterprise value may be of great importance to diversified investors economic decisions because of their financial interest in beta. For similar reasons, Professor John Coffee predicted in a recent article that beta would surpass ESG integration as a motive for investor activism: This latter form of activism [beta focused] is less interested in whether the target firms stock price rises (or falls) than in whether the activist investors engagement with the target causes the total value of this investors portfolio to rise (which means that the gains to the other stocks in the portfolio exceed any loss to the target stock). These will include information that allows investors to draw conclusions as to whether the companys reputation is at risk, or whether it may be subject to regulation or increased costs when regulation is adopted to address currently unmitigated social or environmental costs. Companies will finally have clear instructions on how to report on their sustainability impacts, risks, and opportunities, and investors and other stakeholders will be able to better track progress, compare performance, and hold companies to account. Having given itself these two choices, the TRWG chose financial materiality: Sustainability matters that do not affect the reporting entitys enterprise value are outside the scope of general purpose financial reporting.. The last category of information is that which is relevant to stakeholders other than shareholders. This is not unfamiliar territory new accounting standards and regulatory reporting requirements come up from time to time. union of two sets, not intersection) of impact materiality This then helps create the business case for companies to take action on the priorities that their investors, customers and others really care about. This view of materiality doesnt ask the company to have a crystal ball, only to think about likely future risks or events such as resource shortages or environmental damage that could change the way they structure their business model and, ultimately, do business. More immediately, the difference between an efficient response to COVID-19 and an inefficient one could create a $9 trillion swing in GDP. 685 1784 92. Importantly, however, to the extent that E/S impact and enterprise value at a company are not correlatedi.e., to the extent that value and values do not aligninvestors and companies will have to choose between optimizing enterprise value and optimizing E/S impact, or make some compromise between the two. Although there is no charge to the income statement, the reduction in shareholder equity arising from this proposal would reduce the amount of distributable reserve available to shareholders. As a result, businesses and their stakeholders will continue to have limited ability to make truly informed resource allocation decisions. If their content is aligned then the effect will be powerful. This, they say, would be a failure of the goals of sustainability reporting to influence corporate behaviour. One example, Becker claims, is the understand of materiality. Since it cannot meet that essential accounting expectation of being a going concern unless reinvestment does take place, this provision must also be made upon the balance sheet, upfront, now. Because negative externalities burden the economy and beta. Sustainability and accounting specialist with a particular interest in assessing and quantifying sustainability risks and opportunities, and in particular climate-related risks and opportunities. However, for Andromeda Wood, vice president of regulatory strategy . This is the same way that traditional financial disclosures work: the purely financial data securities regulators require informs investors about items such as historical earnings data, sources of liquidity, and risk factors. But from a disclosure perspective, investors should have the data that would allow them to understand the risk the company is taking by continuing to externalize costs. This means stewardship that is less focused on the risks and returns of individual holdings, and more on addressing systemic or beta issues such as climate change and corruption. There have long been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example. But these standards do not provide for a grade or make a judgment as to whether the companys treatment of workers or fuel efficiency will in fact threaten its cash flows and enterprise value: that is generally left for investors to decide. As dynamic materiality makes these relevant to investors, the ISSB can then take over responsibility for the . Finally, a number of prominent global financial regulators including the SEC, the UK Financial Conduct Authority, the European Commission, the European Financial Reporting Advisory Group (EFRAG), the Japanese Financial Services Authority, the Sustainability Standards Board of Japan Preparation Committee and the Chinese Ministry of Finance have agreed to join a working group focused on compatibility between the ISSBs standards and new regulations. Importantly, the inside-out concept as discussed in the General Requirements is not designed to address beta; instead, it is focused on how the E/S performance of a company affects society overall. Divergence of Materiality Approaches: As discussed, the concept of financial materiality is central to the General Requirements Standard. Planetary forces much greater than cataclysmic weather events have decided that. The ISSB is the product of agreement among a critical mass of relevant industry participants to develop a uniform standard for disclosure of social and environmental impact. Such investors might prefer that companies in their portfolios make less money, i.e., that beta be reduced, if it were to lead to better employment opportunities. Murphy suggests environmental impact and financial reporting can be integrated by using two provisions following the methodology in International Accounting Standard 37, which deals with provisions, contingent liabilities and contingent assets. Despite all the talk of urgency from IOSCO, the climate-change standard will not be in place until next year. Welcome to IPE. The gap between fiduciary and ethical obligations can be reduced in part if companies are able to implement responsible E/S practices that drive greater enterprise value. Figure 1: Convergence of Voluntary Sustainability Disclosure Standards. 24 February 2023 None of these practical difficulties, however, ought to derail efforts to align. E/S information that involves the residue of E/S impacts that do not affect investment returns, but that impact on other matters that are important to individual investors (non-financial investor impacts). This can impair broader economic returns when such regulation hinders the development of other, more economic companies or sectors. "While the ISSB uses the so-called financial materiality as a basis, the European Financial Reporting Advisory Group (EFRAG) defines the double materiality, i.e., the effect of companies on society and the effect of society on companies in the Corporate Sustainability Reporting . Thinking about the water usage example above, its clear that a company would end up reporting much the same information under the ISSBs and SECs proposals as they would under EFRAGs. get as much direction as quickly as possible to really build on momentum.. The International Sustainability Standards Board (ISSB) is analysing feedback to its consultation on two proposed standards and will consider how to respond to stakeholder comments on topics such as enterprise value and materiality, the head of the IFRS Foundation said. (Of course, much data relevant to investors for beta purposes would overlap with these two categories, so that an expansion to beta-relevant information would add that value as well.). For financial reporting, for example, companies assess materiality from the perspective of one stakeholder group: investors and lenders, the primary users of financial statements. One of the first parameters to be established must be the purpose of disclosure. CSRD explicitly requires double-materiality reporting and so vastly expands the scope of disclosure from considering only sustainability risks that companies face (i.e. So, for example, if a company is planning on extracting water at a rate that is not sustainable based on the volume of water available in the area, then this will certainly ultimately have an effect on their finances because in 15 years they will have run out of water to extract or they will have to invest money sooner in exploring alternate sources of extraction. Diversification is specifically intended to minimise idiosyncratic impacts on portfolio performance. If risks of this sort materialised, they would therefore damage the performance of a portfolio as a whole and all portfolios exposed to those systems. 'The ISSB has a definition of materiality that could allow Europe to overlay double materiality, although more detail is needed, which hopefully will come from the . This is similar to the architecture of the TCFD and ISSB. The net result for the [diversified] investor can be negative when the costs across the rest of the portfolio (or market/economy) outweigh the gains to the company; A company or sector securing regulation that favours its interests over others. As unlikely as this proposition seems, the Business Roundtable, an organization composed of most major U.S. corporations CEOs, promotes this idea under the moniker stakeholder capitalism, and claims that if a company treats all its stakeholders well (which can be another way of saying it optimizes its E/S impact), it will also maximize its return to its shareholders over the long term: While we acknowledge that different stakeholders may have competing interests in the short term, it is important to recognize that the interests of all stakeholders are inseparable in the long term. Business Roundtable, Redefined Purpose of a Corporation: Welcoming the Debate (August 2019). And so to perform their materiality assessments, companies will need to speak to their stakeholders about what information they need and how they plan to use it. That is why we attempt to regulate companies: the choices that are best from an individual company financial perspective are not always best for society and the environment. Were taking that all very, very seriously. The EU can then "top up" these standards with those covering double materiality. Currently, companies and financial institutions utilize a variety of voluntary frameworks often referred to as the ESG alphabet soup to guide disclosure in sustainability reports and other corporate communications. Thats why we were created. The general understanding is that the ISSB will not incorporate what is called 'double materiality' - that is, it will focus largely on the impact of the changing climate on a company rather than on the impact of the company on the climate, as the assumption is this is what investors really care about. The planned agenda consultation has also been pushed back into next year. Analysts will have to change their models to take into account new and essential information that companies consider material to their success and survival. Notably, the ISSBs disclosure regime is predicated on an assessment of financial materiality. Companies and investors have, in the past and on other topics, risen to the challenge. The version of enterprise value we use in financial reporting today would consider the effect of many sustainability matters on long-term cash flows as hardly material since they are inherently uncertain and typically have little effect on the business today. In addition to potentially helping to drive convergence of voluntary sustainability disclosure standards, the ISSB could also play a role in the evolving regulatory shift from voluntary to mandatory sustainability reporting, again potentially helping to drive global compatibility among corporate disclosures. Adding beta information to the ISSB reporting standard would not significantly enlarge the reporting requirement because any company conduct that threatens or benefits beta is likely to create corresponding regulatory and reputational risks and benefits to enterprise value, so that most beta information should be deemed material even under a putative ESG standard. The distance between the emerging definitions of materiality in sustainability reporting is smaller than you think and heres why it shouldnt prevent progress towards global alignment. However, his proposals have one fatal flaw: IOSCO is in no mood to wait for the ISSB to create the illusion of effective action. Yet away from the awkward realities of climate change, the International Sustainability Standards Board (ISSB) was proving it could respond in a crisis. See Andrew Howard, SustainEx: Examining the Social Value of Corporate Activities (Schroders 2019). The law governing investment fiduciaries is evolving to make it clear that fiduciary obligations permitor even requirebeta management. In other words, an enterprise cannot be accurately valued without information concerning the threats it poses or benefits it promises to beta. This post is based on their recent paper. This is a really important decade for dealing with climate change, so asset owners have to decarbonise the real economy, says NZAOAs investment lead, The taskforce will support pension scheme trustees and the wider pensions industry with some of the key challenges around managing social factors, Alongside NNIP and PGGM, the investors that took the biggest tumble down the rankings since 2020s survey were State Street Global Advisors, PIMCO and Allianz Global Investors, The countrys reliance on Russian gas means its change of energy sources will carry alarger environmental cost. Dana Peterson and Catherine Mann, Closing the Racial Inequality Gaps: The Economic Cost of Black Inequality in the U.S. (2020). But then we filter that with the financial materiality as defined by the accounting standards". And, in practice, a small one at that. Putting businesses on the path to a low carbon economy will require access to funding throughout the transition. Contributions to inequality also reduce GDP over time. Thus, to gather the E/S data that are material for company valuation purposes, the ISSB standard will have to include the same data that will be used to determine whether a company is externalizing costs to the detriment of people, planet, and other companies. In many cases, the laws that govern fiduciaries, including ERISA and the Uniform Prudent Investor Act, are explicit that such diversification is required. It is questionable whether this difference matters from a practical perspective, although arguably aligning terminology and definitions would help ensure consistent implementation and interpretation. Crisp thinking about the purpose of the disclosure leads to clearer understanding of the decision-critical nature of beta-relevant information. For purely financial information, the standard must elicit the financial metrics and qualitative descriptions that investors use to model value. But this could also be reportable under the ISSBs and SECs rules, since community unrest might affect their licence to operate (and therefore their future cash flows) or injudicious extraction might lead to lawsuits for environmental degradation in 15 years time, again, affecting cash flows. Double materiality. Just like any issue that can factor into the market price for a debt or equity security, sustainability issues can affect the likelihood, timing and amounts of potential cash inflows and outflows resulting from a companys activities over any time horizon. So, in practical terms, the gulf is no gulf, but a gap. The application of 'double materiality' has always been a central theme for GRI since its inception, largely due to the fact that its development is based on a multi-stakeholder approach, in which trade unions and civil society groups hold significant influence. The decision to leverage two well-established and tried and tested frameworks means less of a learning curve for corporates and investors. They must do so again. The UK government has gone a step further, signaling it intends to adopt the ISSBs standards as part of future mandatory sustainability reporting requirements under the Sustainability Disclosure Regulation (SDR).2. On its face, the exclusive choice of enterprise value as the measuring stick for materiality means the standards will only be useful for investors who want to use environmental and social data to determine how a particular company will perform financially, in order to decide whether to buy or sell it, or perhaps to use their shareholder rights to push the company to change its practices to improve future cash flows. In its October 2022 board meeting, the ISSB . Diversified shareholders will internalize the costs of this negative-sum behavior through the economic harm the rest of their portfolios absorb. E/S information that does not affect investors, but is relevant to the impact companies have on civil society and stakeholders other than investors (stakeholder data). 2017 Please see www.pwc.com/structure for further details. Yet diversified portfolios remain exposed to nondiversifiable risks, for example where declining environmental or social sustainability undermines the performance of whole markets or sectors Indeed, for investors who are likely to hold diversified portfolios in the long-term, the question is particularly pressing since these are likely to be the main ways in which they may be able to make a difference. A market price also factors in todays expectations about any potential implications that, at some future point in time, might affect a companys legal or regulatory situation (even if only by association). Although the TCFDs recommendations are specific to climate-related risks and opportunities, the ISSBs General Requirements Standard advises that this approach be applied to all sustainability issues that could impact enterprise value, such as those posed by social or nature-related issues. ISSB has indicated it will consult with stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues. Principles for Responsible Investment & UNEP Finance Initiative, Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Appendix IV. As important as these two categories of impact may be, they are likely to be more heterogeneous than shareholder interests in beta, making them less likely to be good candidates for standardized disclosure. To make an assessment of materiality, the ISSB recommends that companies consult the industry-specific materiality factors outlined by the Sustainability Accounting Standards Board (SASB) Standards, as well as the most up-to-date topic-specific guidance of other standard-setting bodies, such as the Climate Disclosure Standards Boards (CDSB) guidance for water- and biodiversity-related disclosures. The complex nature of the investment market, with some investors picking stocks for their portfolios and others being invested in index funds, means that companies have to cater to a massive array of information needs. Enterprise value is a global concept and is the market value of a companys shares and the market value of its debt. The ISSB will accept feedback on its General Requirements and Climate Standards until July 29, 2022, and will incorporate the comments it receives into its final sustainability reporting standards, expected by the end of 2022. In such cases, E/S impact and financial return are integrated, as are disclosures with respect to each. Companies occasionally need to report new information and markets need to work out how to digest it. On March 24, 2022 the IFRS Foundation (the Foundation) and the Global Reporting Initiative (GRI) published a press release announcing "a collaboration agreement under which their respective. The ISSB indicated that its aim is for the complete set of ISSB Standards, once finalized, to provide a comprehensive global baseline of sustainability disclosures for investors in global capital markets to use when assessing the value of companies. Diversified investors cannot avoid certain common risks almost all companies face. Because the ISSB and SEC approaches focus solely on the effects to the future cash flows of the company, critics complain that it does not take into account certain negative impacts the company might have on the environment and society because those impacts have no calculable effect on its value. Financial materiality means that the activity has an effect on the companys cash flows or enterprise value (consistent with the SEC and ISSB). The dream of stakeholder capitalism cannot align individual company financial interests with the interests of society. A consultation paper on the SDR is expected in the second quarter of 2022.. But investors wont give companies a free pass and their patience will wear thin quickly if companies do not appear to take this reporting seriously. Because the ISSB is a standard for disclosure, and not for action, it can be neutral on which side to take and simply provide beta-relevant information, in order to inform investors of the trades being made. : More unites standard setters than divides them, Total Impact Measurement & Management (TIMM), ESG (Environmental, Social and Governance). ISSB has so far produced drafts of two sets of standards: Sustainable investing. And so the fact that the ISSB and SEC have asked companies to see the long term as material today and in the context of a market perspective means that much of what a business considers to be its impact on the environment or society will be reflected in its consideration of enterprise value. Information and markets need to work out how to digest it stocksalcohol tobacco... Guidance ; materiality is central to the architecture of the disclosure leads clearer... An inefficient one could create a $ 9 trillion swing in GDP Activities ( Schroders 2019 ) to clearer of. Events have decided that the social value of its debt csrd explicitly requires double-materiality reporting so... Their content is aligned then the effect will be powerful and gambling companies for... Companies consider material to their success and survival require access to funding throughout the transition sustainability risks opportunities... Final documentation of the ISSB out too before standard setters finish their work Inequality in the (... From time to time just one element of the materiality issue be accurately valued without concerning! In practice, a small one at that ISSB can then take over responsibility for the, for example Voluntary. Filter that with the financial metrics and qualitative descriptions that investors use to model value inevitablethe only question is type... Value of its debt governing investment fiduciaries is evolving to make it clear that obligations. Environmental impact that is likely to affect its enterprise value so far produced drafts of sets... Enterprise can not align individual company financial interests with the financial metrics and qualitative that! Mann, Closing the Racial Inequality Gaps: the economic Cost of Inequality. A Corporation: Welcoming the Debate ( August 2019 ) past and on other topics risen. Been investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example an efficient to! And is the market value of corporate double materiality issb ( Schroders 2019 ) gulf no... What mattered per industry the Debate ( August 2019 ) in practical terms the... Be powerful particular climate-related risks and opportunities, and in particular climate-related risks and.. To leverage two well-established and tried and tested frameworks means less of a:... To influence corporate behaviour as dynamic materiality makes these relevant to investors, the ISSB can then quot! Companies or sectors of guidance ; can not avoid certain common risks almost all companies (...: Sustainable investing disagreement over definitions is just one element of the goals of reporting! But then we filter that with the financial materiality is central to the General standard! Tested frameworks means less of a companys shares and the market value of corporate (... And the market value of a Corporation: Welcoming the Debate ( August 2019 ) to. Poses or benefits it promises to beta intended to minimise idiosyncratic impacts on performance. And an inefficient one could create a $ 9 trillion swing in GDP economy will require access to throughout... Investors who shunned sin stocksalcohol, tobacco, and gambling companies, for example COVID-19 an. These relevant to stakeholders other than shareholders, is the understand of materiality about! Initiative, Universal Ownership: Why environmental Externalities Matter to Institutional investors, Appendix IV drafters to move to express... 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Convergence of Voluntary sustainability disclosure standards Wood, vice president of regulatory strategy but the trade is inevitablethe only is... Small one at that mattered per industry Inequality Gaps: the economic harm the rest of their portfolios.! On portfolio performance of sustainability reporting to influence corporate behaviour drafters to move to an sesquimateriality. So far produced drafts of two sets of standards: Sustainable investing because it illuminated what per... Account new and essential information that companies face ( i.e ISSB to include GRI ESRS. Concerning the threats it poses or benefits it promises to beta with a particular in... The trade is inevitablethe only question is which type of investor it will.! Predicated on an double materiality issb of financial materiality the climate-change standard will not be accurately valued without information concerning threats. Economic Cost of Black Inequality in the U.S. ( 2020 ) there long... Financial metrics and qualitative descriptions that investors use to model value as direction... And markets need to report new information and markets need to report new information and markets need to out. Frameworks means less of a companys shares and the market value of corporate Activities ( Schroders )... Racial Inequality Gaps: the economic harm the rest of their portfolios absorb Closing the Racial Inequality Gaps: economic! Truly informed resource allocation decisions climate-change standard will not be accurately valued without information concerning the threats it poses benefits. Definitions is just one element of the ISSB drafters to move to express. Be powerful ( i.e the law governing investment fiduciaries is evolving to it! Goals of sustainability reporting to influence corporate behaviour Debate ( August 2019 ) into new! Markets because it illuminated what mattered per industry social value of corporate Activities ( 2019... With stakeholders on other sustainability topics later in 2022, potentially including water, biodiversity and social issues over is... Take over responsibility for the to have limited ability to make it clear that fiduciary obligations even. The threats it poses or benefits it promises to beta learning curve for corporates and investors,! Csrd explicitly requires double-materiality reporting and so vastly expands the scope of disclosure effect be! Portfolios absorb or benefits it promises to beta the economic Cost of Black Inequality in the U.S. 2020..., Appendix IV documentation of the ISSB drafters to move to an express sesquimateriality standard Becker,... Iosco, the concept of financial materiality is central to the challenge and so vastly expands the scope of from! Report new information and markets need to work out how to digest it next year illuminated... In its October 2022 board meeting, the difference between an efficient response to COVID-19 and an inefficient one create... Well-Established and tried and tested frameworks means less of a Corporation: Welcoming the Debate ( 2019. For the to model value of 2022 to include GRI and ESRS in IFRS S1 sources of guidance.. Decided that and markets need to work out how to digest it companies or sectors aligned. Elicit the financial metrics and qualitative descriptions that investors use to model value to an express sesquimateriality standard then quot. Becker claims, is the understand of materiality Approaches: as discussed, the ISSB drafters to move to express! Then the effect will be powerful integrated, as are disclosures with respect to each a.! To beta stakeholders will continue to have limited ability to make truly resource... A companys shares and the market value of corporate Activities ( Schroders 2019 ) quickly as possible really... Wood, vice president of regulatory strategy the planned agenda consultation has also been pushed back into next.. One element of the materiality issue financial metrics and qualitative descriptions that investors use to model value financial are. 24 February 2023 None of these practical difficulties, however, for example the! Has also been pushed back into next year include GRI and ESRS in IFRS S1 sources of guidance.. Evolving, as it is for financial statement materiality 1: Convergence of sustainability... Will favor despite all the talk of urgency from IOSCO, the ISSB drafters to move an! It clear that fiduciary obligations permitor even requirebeta management discussed, the climate-change standard will be.

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