Sustainability reporting is growing rapidly in the European Union (EU) and requirements are becoming more stringent. The von der Leyen Commission has not only pushed forward the EU Green New Deal but has made it its distinctive trademark. On the private sector side, companies are preparing to enhance their sustainability reporting capacity to develop new key performance indicators that enable them to go beyond their traditional responsibilities and contribute to the EU’s environmental and social targets. While companies are increasingly reporting on sustainability aspects, there is still a clear lack of standardization. In this context, investors need to be able to compare the sustainability impact of potential financial decisions.
In response, the EU has shown increasing ambition to regulate sustainability reporting. Three pieces of legislation represent its main drivers: the revision of the Non-Financial Reporting Directive (renamed the Corporate Sustainability Reporting Directive [CSRD]), the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation. Each scheme tackles sustainability reporting from a different perspective.
The New Corporate Sustainability Reporting Directive (CSRD)
The newly proposed CSRD draws on the Non-Financial Reporting Directive (NFRD). Adopted in 2014, the NFRD was designed as an initial attempt to provide reporting transparency on the impact of large, public interest companies’ operations on non-financial aspects.
The CSRD goes one step further in the integration of wider EU strategies. It answers the question: What must companies disclose on sustainability? According to the EU Commission’s proposal, the Directive would apply to private (unlisted) companies with at least two of the following: a balance sheet of €20 million, a net turnover of €40 million or more than 250 employees. Publicly listed companies with over 10 employees or a turnover of over €700,000 are also within the scope of the Directive.
The CSRD requires comprehensive consideration of sustainability in companies’ disclosure requirements. First, companies must report on how sustainability is integrated into their management system, with related targets and policies. Second, and most importantly, the CSRD draws on the logic of “double materiality”: Companies must indicate how they mitigate the negative effects of their operations on sustainability and the main risks linked to sustainability issues in their business models. If identified as a material issue, supply chain-related aspects must also be included in CSRD reporting.
The CSRD goes beyond simply what is to be reported and delves into how it must be done. It will require companies to report according to new mandatory EU reporting standards. These standards will be developed by the European Financial Regulation Advisory Group (EFRAG) and draw from existing reporting initiatives and the SFDR and Taxonomy indicators. Listed small and medium-sized enterprises will see a simplified set of standards. The reporting standards will be adopted at a later stage in a Delegated Act and reviewed every three years.
Two additional CSRD points constitute an unprecedented change from the NFRD. External assurance of sustainability reporting by third-party auditors will now be required. This will remain in the form of “limited assurance” rather than “reasonable”, as the Commission has not yet adopted sustainability assurance standards. Second, companies will have to publish information in a digital, machine-readable format aligned with the European Single Electronic Format regulation. As a result, the Commission will put forward a legislative proposal to set up the European Single Access Point, which will consist of an EU-wide digital access platform for companies’ public financial and sustainability information.
CSRD is currently still a Commission proposal. The European Parliament and Member States will draw on the legislative text to negotiate a final version that is expected to be transposed into national law by December 2022. CSRD should therefore be applicable from fiscal year 2023 onwards. In parallel, EFRAG will develop an initial set of sustainability reporting standards by mid-2022. They will be adopted depending on CSRD adoption itself. At the earliest, these standards would become applicable for 2024 reports covering fiscal year 2023.
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The Sustainable Finance Disclosure Regulation (SFDR)
The SFDR is the cornerstone of the EU’s sustainable finance strategy. It answers the question: How sustainable are financial products and what are investment firms doing for sustainability? Disclosure requirements are introduced to benchmark performance and steer sustainable investment. The focus of the regulation is not only on firms but also all financial products offered on the EU market: The SFDR covers any organization operating in EU financial markets, regardless of whether it is headquartered in a Member State. This includes asset managers, insurance funds, pension providers and venture capital activities.
The SFDR requires financial market participants to publish two types of disclosures:
1) Disclosure at the entity level: Companies are required to disclose how they integrate sustainability efforts into their investment process. This includes describing how policies consider environmental, social and governance (ESG) principal adverse impacts (PAIs), as well as including information on the integration of sustainability risks in investment decision-making processes or financial advice, the alignment of remuneration policies with sustainability risk and pre-contractual disclosures including information on PAIs. Companies with less than 500 employees will have less stringent reporting requirements.
The EU Taxonomy
The Taxonomy is the EU’s classification system answering the question: Is an economic activity environmentally sustainable? The Taxonomy helps monitor EU climate targets, provide an industry benchmark on ESG performance and encourage the development of green finance. It covers seven sectors, accounting for 93 percent of greenhouse gas emissions in Europe. Two types of stakeholders are involved: financial companies offering products in EU financial markets and non-financial companies based in the EU that are required to provide non-financial statements under the NFRD.
To qualify as environmentally sustainable as per the Taxonomy, activities must:
1) Contribute substantially to at least one of the six following environmental objectives: climate change mitigation and adaptation, ecosystems, water management, circular economy and pollution prevention. Technical Screening Criteria (TSCs) define the qualitative and quantitative thresholds that must be met for each business activity to contribute substantially to the environmental objectives.
2) Do No Significant Harm to the other five objectives. This is also assessed based on TSCs specific Technical Screening Criteria.
3) Respect Minimum Social Safeguards based on ILO conventions, the International Human Rights Charter and other international standards for social rights and sustainable labor practices.
Although the Taxonomy Regulation has already been formally adopted by the EU, TSCs have only been partially defined: TSCs have only been specified for climate change mitigation and adaptation. TSCs for the remaining four environmental objectives will continue to be specified in two additional EU Commission’s Delegated Acts, expected in June and December 2021.
Concretely, two kinds of disclosure requirements have been defined. Financial actors shall report whether their financial products are aligned with the Taxonomy to be able to call them “sustainable”. Non-financial companies, on the other hand, shall publish a non-financial statement with information on each environmental objective. The two main metrics to be disclosed are the percentage of turnover and the amount of capital and operating expenditure aligned with the Taxonomy.
How Can Your Company Prepare?
ESG disclosure legislation is evolving rapidly in Europe. Companies will be required to put unprecedented effort into reporting on the sustainability aspects of their business. While each legislation has its distinct challenges, some common lessons can be drawn. First, companies should ensure they have a clear sustainability reporting strategy. Second, companies should enhance their reporting capabilities and implement data collection systems that will enable them to collect and consolidate information aligned with the new EU reporting standards. Finally, companies should make sure this reporting is published in a digital, machine-readable format in line with the EU's wider digitalization strategy.
The EU ESG reporting journey has just begun. By integrating international reporting frameworks and aligning financial and non-financial performance, the EU is striving to make sure that companies not only abide by the law but also lead the green transition from the front.
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