The EU plans to greatly expand the scope of its sustainable reporting rules, finds Tim Human
If the EU is to meet the challenging goals it has set itself on sustainability, companies need to play their part. The trade bloc’s policy aims – collectively referred to as the European Green Deal – include becoming the first world's net-zero continent and shifting to a ‘circular economy’ where economic growth no longer relies on the Earth's natural resources.
To help meet these objectives, the EU Commission has proposed the Corporate Sustainability Reporting Directive (CSRD). The legislation, which replaces the existing Non-Financial Reporting Directive (NFRD), has been designed to make sustainability information more detailed, comparable and credible for investors and other stakeholders.
The arrival of the CSRD reflects broader trends within corporate reporting, where companies are making more links between financial and sustainability issues, and speaking to a wider group of stakeholders, says Simon Cleveland, head of public policy and regulation at Deloitte. The EU has not called the directive NFRD II, he notes. Instead, regulators have come up with a new name that eschews the term ‘non-financial’, underlining that sustainability directly impacts the bottom line.
Simon Cleveland, Deloitte
The CSRD significantly extends the scope of Europe’s sustainability disclosure regime. Under the proposals, large private companies and listed small to medium-sized enterprises (SMEs) would now be covered. As a result, the number of companies that need to follow the EU’s sustainability reporting rules would rise from around 11,600 to 49,000, according to the commission’s estimates.
Other major changes include a new emphasis on ‘double materiality’, more detailed reporting rules, the development of EU sustainability reporting standards and a requirement for limited assurance of sustainability information. Below, we highlight five key areas IROs should be aware of.
When the EU brought in the NFRD in 2014, it included the idea that companies should report on material issues that affect the business, and also how the business impacts the environment and people – what’s known as the ‘double materiality’ perspective. The commission reiterated the importance of this dual materiality approach in subsequent reporting guidelines released in 2017 and 2019.
Despite the regular prompts, however, the EU feels companies have not fully taken on board this idea. In response, the CSRD ‘clarifies the principle of double materiality’ and removes ‘any ambiguity’ that companies should follow this approach in their reporting. Under the new rules, companies should ‘disclose information that is material from both perspectives as well as information that is material from only one perspective,’ states the directive.
‘It’s an interesting way of reframing who the report and accounts are for,’ says Cleveland. ‘Not only are you moving away from the historical financials into this broader concept of what the business is – its purpose and wider stakeholders – but you’ve also got to think about it from the point of view of those stakeholders.’
If adopted, the CSRD will bring in more detailed reporting requirements for companies. While the directive’s text only covers the required information at a high level, it does give an overview of what companies will need to publish. Among the requirements are:
A description of the business model and strategy, including risks and opportunities related to sustainability, how the business is aligned with the Paris Agreement of capping global warming at 1.5ºC and how different stakeholder views are taken into account
Sustainability targets and progress toward those goals
How sustainability issues could affect a company’s value chain and supply chain
Information on intangibles, such as human and intellectual capital.
The information will be required to cover short, medium and long-term time horizons, be both forward-looking and backward-looking and feature both qualitative and quantitative information, according to the directive.
The CSRD would also require companies to report in line with forthcoming EU sustainability standards. The creation of the standards has been delegated to the European Financial Reporting Advisory Group, a private organization supported by the EU. The commission aims to adopt the first set of standards by October 2022.
Of crucial interest to companies will be how the EU’s own standards line up – or don’t – with other approaches already in existence or being developed. Issuers have begun to widely use the standards and frameworks created by SASB, GRI and TFCD, as well as other groups.
Furthermore, the IFRS Foundation is working with a range of organizations to establish an International Sustainability Standards Board and develop harmonized global rules.
The commission says EU standards should be created via collaboration with other projects and align where appropriate, though it adds that Europe’s own specific requirements will need to be taken into account.
One of the biggest groups affected by the directive is SMEs. The CSRD proposes extending mandatory sustainability reporting to all companies listed on a regulated EU market, bar micro-cap companies. Unlisted SMEs would have the option to adopt the new reporting standards on a voluntary basis. SMEs make up 26 percent of all listed companies in the EU, according to an impact assessment conducted by the commission.
Recognizing the limited resources at smaller companies, the commission has proposed that ‘simpler’ reporting standards are developed for SMEs. In addition, it suggests the new rules for SMEs should be delayed for three years, given the difficulties they face as a result of the Covid-19 pandemic.
The commission argues that extending reporting standards to listed SMEs will help them respond to requests for sustainability information from various stakeholders, while also drawing a line around what they are reasonably expected to provide.
The changes will further help SMEs gain access to funding and play a role in the shift to a sustainable economy, say EU lawmakers.
But the extension has proved contentious. EuropeanIssuers, an association that advocates for publicly listed companies, has called on the commission to offer a voluntary opt-in approach for all SMEs, not just unlisted ones. This would ‘avoid the excessive burden and excessive cost that the majority of SMEs cannot bear, especially in light of the Covid-19 crisis,’ says Giorgia Migaldi, policy officer at the association.
EuropeanIssuers further argues that both listed and non-listed SMEs should be treated equally, given that listing status doesn’t affect a company’s impact on the environment. ‘We don't see the correlation there,’ notes Florence Bindelle, secretary general of the association.
Another key change is the requirement for limited assurance of sustainability information for all companies within the scope of the directive.
Presently, only around 30 percent of large EU companies apply some kind of assurance to their sustainability data, according to an analysis by the EU.
The CSRD has proposed only ‘limited’ assurance to begin with, rather than the tougher demands of ‘reasonable’ assurance, due to the costs involved for companies and the current capabilities of the audit market. ‘Reasonable assurance of sustainability reporting is difficult at this stage in the absence of sustainability assurance standards,’ notes the commission in a Q&A on the directive.
Limited assurance usually involves fewer tests and smaller sample sizes than reasonable assurance, and results in a negative statement, such as ‘nothing came to our attention’ that information is misstated. By contrast, reasonable assurance leads to a positive statement backing the assertions in the reporting.
The CSRD proposals encourage member states to open up the market for sustainability assurance to third parties, meaning those beyond traditional audit firms, although the decision on this will ultimately sit with each country. Crucially, the auditing proposals allow the commission to mandate reasonable assurance of sustainability data in the future, explains David Roberts, ESG analyst at Leaders Arena, a consultancy.
‘In the event that sustainability assurance standards are developed and adopted by the EU, an automatic legal requirement for reasonable assurance of sustainability data would come into effect,’ he says. ‘This creates a soft direction of travel toward reasonable assurance of sustainability data. But this is unlikely to happen for several years.’
Companies are currently spending time thinking about how to package their sustainability information (a topic discussed in this issue’s cover story: see How IR can shape ESG reporting). Should they opt for an integrated report with financial and ESG metrics in one place? A separate sustainability report? Or a completely different model?
The CSRD takes a prescriptive approach on this issue. It would delete a line from the NFRD that says companies can choose whether to include their sustainability information in the management report – which is part of the annual report for EU firms – or a separate document. Under the proposed rules, the required sustainability information must appear within the management report.
The commission argues that a separate report makes it harder to find sustainable information and link it to financial issues. It may also ‘give the impression’ that sustainable information is less important than the content of the management report. The change will affect a large number of companies, given that the majority currently choose to use a separate document, according to EuropeanIssuers.
For critics who argue the CSRD lacks flexibility, this change is a good example. In its feedback on the proposals, EuropeanIssuers says the shift to a single approach is ‘premature’, given the broader discussion taking place within the market about how companies should organize and present their sustainability information.
The association notes that the UK and EU appear to be diverging on this issue. Last October the UK’s Financial Reporting Council published research on the future of corporate reporting, in which it proposed a move away from a single annual report to a ‘network of interconnected reports’ where each document has a specific communications objective.
Florence Bindelle, EuropeanIssuers
Impact on non-EU companies: The proposals state that non-EU companies listed on a regulated EU market will be covered by the CSRD requirements, as will EU-based subsidiaries of non-EU companies, although they are exempt if the parent company publishes information that is equivalent to EU standards.
Links to other EU legislation: Alongside the CSRD, companies need to keep an eye on other EU legislative developments. The new directive is designed to complement other initiatives, such as the Sustainable Finance Disclosure Regulation, which sets out disclosure rules for asset managers, and the Taxonomy Regulation, a classification system that defines which activities are sustainable. For example, the Taxonomy Regulation requires companies that fall under the NFRD – and the expanded group covered by the CSRD – to disclose certain ‘indicators’ about how sustainable their activities are.
Digital tagging of sustainability information: The CRSD proposes that sustainable information is disclosed in a ‘digital, machine-readable format’. This builds on existing EU rules that require the digital tagging of financial information. It also supports the bloc’s aim of creating a ‘single access point’ for corporate information, a free public resource where stakeholders can access and compare data.
