Investors are seeking better information to allow them to make decisions based on more than just pure financial matters. A new directive in Europe now puts non-financial reporting into the same structure as financial reporting.
Traditional sustainability reporting
Many companies have traditionally reported on sustainability matters in their corporate social responsibility reports. While these reports often highlight the great work that businesses are doing in the community, they do not require the company to report on any particular information or report in any specific format – leaving companies to select the items they want to include and write them up in a way that presents the positive aspects.
Companies can also choose to tell their stakeholders about non-financial sustainability matters on a voluntary basis. Many have elected to use standards like the Global Reporting Initiative (GRI) to ensure a consistent language for their reporting. While these methods require certain information to be disclosed to remain compliant with the standard, they are still voluntary, so information is not available for all companies, and the companies that don’t report are often those with more sustainability issues.
The current state of mandatory reporting
Mandatory reporting on a broad range of non-financial sustainability matters is currently limited to the very largest listed companies, mainly driven by the stock exchanges they are listed on or the accounting rules they are using. For large companies, this results in a need to report on sustainability issues when those issues also include some financial impact. An example might be a company investing in a factory that sits on land that is susceptible to flooding. These cases mainly relate to whether the investment will be sustained into the future. Both medium and large companies also have mandatory reporting for specific topics such as modern slavery or child labour but, again, the requirements vary by jurisdiction and there is no common reporting structure.
Issues with inconsistent reporting
Inconsistent and sporadic reporting has meant that investors have struggled to source the information they need to be able to make decisions based on sustainability criteria as easily as the information required to make financial decisions.
The ability for companies to choose what they report and how they report it has also led many to question the information that has been provided, and there are frequent allegations of ‘greenwashing’.
Similarly, the lack of reporting means that agencies that provide standardised ratings for both financial and non-financial matters struggle to provide the same robust analysis methodologies for non-financial matters.
The European solution: Corporate Sustainability Reporting Directive (CSRD)
The European Union, partially as a consequence of the European Green Deal, is determined to fix the problem for companies within its jurisdiction. With the introduction of the CSRD, which expands on and replaces the EU's Non-Financial Reporting Directive (NFRD), companies based in Europe or with a significant European presence will be mandated to provide far more information in their non-financial reporting than ever before and in a consistent manner.
European Sustainability Reporting Standard (ESRS)
The European Union commissioned the European Financial Reporting Advisory Group (EFRAG, which supports the financial reporting standards) to define the content and structure of the reporting mandated in the CSRD. The information required to be reported is documented in the ESRS, which provides a structure for determining what sustainability topics are materially relevant to each company, and what information is required to be disclosed about those topics.
The information required to be reported is complex. Each disclosure requires both quantitative information, such as strategies and policies, as well as qualitative metrics to show progress.
The ESRS methodology also combines two existing types of reporting: information that an investor might want and information that a company thinks is important to show about itself. Together, these result in the concept of ‘double materiality’.
The ESRS is formed of ten topics, comprising 82 disclosures covering a wide range of ESG risks and opportunities. The topics are related to the environment (climate change, pollution, water, biodiversity and resource use) and social aspects (own workforce, workers in value chain, affected communities, customers and end users), with less focus on governance (which is a similar set of topics as in the GRI).
ESRS implementation timeline and criteria
In addition to the sustainability topic disclosures, there are also some general disclosures that help to describe the business of the reporter plus provide support for the materiality assessment using the dual materiality concept. Unlike the GRI, the ESRS does not currently include sector-specific standards that help companies quickly determine the areas that they should focus on based on the industry sector they belong to (although it is understood that these will be introduced at some point in the future).
The aspect of double materiality requires companies to assess the topics that are material to their business under the impact and financial views. Only those topics that are material need to be disclosed, along with the reasoning for the assessment. The only exception to this self-assessment is for climate and carbon disclosures, as the CSRD has a specific requirements for large companies to disclose their plans to implement the Paris Agreement of achieving climate neutrality by 2050 and greenhouse gas emission reduction targets at least for 2030 and 2050, with both metrics and progress reports.
Large, medium and small EU companies are all required to report under the CSRD, while micro businesses (i.e. below the threshold for SMEs) are not expected to report.
ESRS reporting requirements for large companies
Large listed companies with more than 500 employees will be required to start reporting under the ESRS for the 2024 financial year (i.e. reports issued in 2025). All other large companies will need to report under the ESRS from the 2025 financial year (i.e. reports issued in 2026).
After an amendment to the CSRD in October 2023 to adjust for inflation, large companies are defined as those that exceed two of three of:
- revenue of €50 million
- balance sheet of €25 million
- 250 employees.
ESRS implementation for SMEs
Small and medium-sized enterprises (SMEs) – that is, those companies that do not meet the criteria for large companies but have a balance sheet of more than €450,000, turnover of more than €900,000 and ten or more employees – and other small and non-complex institutions must implement the CSRD and align to the ESRS from the 2026 financial year.
However, they will have the option to opt out of the reporting rules until 1 January 2028. Under the CSRD, SMEs must provide a more limited set of information than large companies, but must still report: their business model and strategy; sustainability policies; a summary of the actions taken to identify, monitor, prevent, mitigate or remediate any actual or potential adverse impacts; a summary of sustainability risks and how the undertaking manages those risks; and the key metrics and indicators needed to identify progress.
ESRS and non-EU companies
The CSRD and ESRS also cover non-EU companies that have at least one subsidiary or branch in the EU and revenue of €150 million generated in the EU for each of the last two years. These companies will need to deliver their reports by 2029 (using 2028 data), although the reporting standard for non-EU companies has not yet been finalised.
Legislative progress and potential changes
It is estimated that approximately 50,000 businesses within the EU will be directly impacted by the new legislation – a considerable increase from the 11,000 or so affected by the NFRD.
As of November 2023, the legislation to support the ESRS has been adopted by the European Commission. The European Parliament and the European Council scrutiny period, which would have allowed either body to amend the legislation, ended on 21 October 2023 and was not extended. The ESRS will therefore be published in the EU's Official Journal, and the ESRS and CSRD will apply from 1 January 2024.
One topic that might change the current reporting requirements is an initiative from the EU to rationalise the reporting obligations of European companies across all areas to ensure competitiveness.
The aim of this initiative is to reduce burdens on business by 25% (with even greater reduction for SMEs), without undermining the related policy objectives.
EFRAG's role in implementation
EFRAG is still obliged to support companies to implement reporting. It has recently published a detailed guide to materiality and how to perform the double materiality assessment, has provided a comprehensive list of data points that need to be reported on (if material), and has a question-and-answer platform available on its website.
Future initiatives from EFRAG
Further alignment with other global standards
The International Financial Reporting Standards body, which implements the Sustainability Accounting Standards Board (SASB) standards and the GRI, is working to ensure a very high degree of interoperability between EU and global standards and prevent unnecessary double reporting by companies.
Further guidance for SMEs
EFRAG is planning to produce specific reporting standards for SMEs in early 2024. These standards are likely to follow the more limited disclosure requirements for SMEs in the CSRD.
Having baseline information about materiality and expected disclosures based on the sector that a business works in is a key element of the SASB standards and has been found to be extremely helpful. The ESRS doesn’t currently provide sector guidance but has committed to it for key sectors in the next two years.
Many financial reports are now delivered in both human- and machine-readable formats. The commonly used XLRB tagging format is planned to be extended to cover ESRS sustainability reporting, allowing companies to report their financial and non-financial matters in a common manner. The taxonomy of the format is expected to be delivered in 2024.
The ESRS revolutionise the ESG reporting landscape
So it is clear that sustainability reporting has arrived in Europe. The directive and standards have cleared their legislative hurdles and are on track to become European law. The impact will be significant, not only as a driver for other jurisdictions to follow suit but by forcing businesses to think about non-financial strategies and goals in the same way they consider financial matters.
The work required to implement the ESRS (or any of the other standards) will be substantial, especially in the first few years; however, with a combination of new business processes and technology, it should be no more than what is required to produce statutory financial reporting today.
The benefit to investors will be a combination of easier access to and better analysis of information, allowing them to include any (or all) of the ESG/sustainability criteria in their investment decisions.
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