The tiger gets teeth: Are you prepared as sustainability reporting in the EU picks up speed?

Non-financial reporting, i.e. reporting on environmental, social and governance (ESG) aspects, has been around for several years, without much impact. This is set to change now as the EU develops an ambitious revision of current legislation which significantly substantiates and expands obligations for companies in the EU. This article from Dr. Katja Grimme provides an overview of the changes to come - and what that means for companies and the economy as a whole. It could not have come at better time, given the recent IPCC report and the obvious need for companies to do more when it comes to climate.

Since 2014, when the first EU Directive on Non-Financial Reporting (NFRD) came into force, it has been subject to much discussion and criticism. Above all, it is largely seen as a toothless tiger, for several reasons. First and foremost, only a very limited number of companies (11,000 from a total of approx. 22 million in the EU) are affected by the NFRD.

Further issues are that it is unclear in terms of what is to be reported (lack of standards), that it is not systematically being monitored, let alone audited; it is non-binding - and hence, there are no consequences for incomplete reporting or non-fulfillment.

With its rising ambitions in terms of sustainability, the EU Commission realized that the sustainability information currently reported by companies is insufficient, to say the least. In particular within the context of the EU Green New Deal, the Commission sees the need for far-reaching initiatives for the transformation of the economic system towards greater sustainability. Additionally, within the EU Action Plan for Sustainable Finance, the EU Commission's aim is to:

· Re-direct capital flows toward a more sustainable economy

· Embed sustainability in risk management

· Promote transparency and long term orientation.

Among a range of measures to be implemented within the Action Plan and the Green New Deal is the strengthening of sustainability disclosure and accounting rules for companies, hence the need for a fundamental reform of the European standards framework for non-financial (aka sustainability) reporting.

The new draft for a CSR Directive sets ambitious goals

A first proposal was published in April 2021 (EUR Lex report) with an aim to finalize and implement the new Corporate Sustainability Reporting Directive (CSRD) by the end of 2022. Companies are to apply the new regulation from January 2024, for their Financial Year 2023 reporting.

A fundamental change is already in the terminology: the term "non-financial" is now replaced by "sustainability", expressing a new conception of the proposed reporting requirements. Here is an overview of the key characteristics - and changes - of the new CSR Directive:

Greater coverage: More companies are obliged to report on sustainability

All companies listed in an EU-regulated market - with the exception of micro-entities - are to be covered by the new reporting obligation. In addition, all other large companies that are not listed in an EU-regulated market are also to be covered by the scope of the CSRD, if they exceed at least two of the following three size criteria:

· More than 250 employees

· Min. €20m balance sheet total

· Min. €40m annual net revenues

This means that around 49,000 companies will now be covered, in comparison to only 11,600 today. In Germany, for example, only 500 companies are currently covered by the reporting obligation. This number will rise to approx. 10,000 companies. While a strong increase, it is still only a fraction (0.2%) of the total of around 22 million companies in Europe.

Small and medium-sized companies are still not directly affected by the reporting requirements, except for those that have securities listed on regulated markets. In addition, the reporting standards for SMEs will be simpler than those for large companies.

However, it is still likely that SMEs, too, will face growing requests for sustainability information as for example banks or larger companies will request such information as a prerequisite for doing business with them. Moreover, it is planned that listed SMEs will be obliged to the new reporting three years later, as of 2027.

Standardization and double materiality: more detailed reporting requirements and mandatory reporting standards

The Commission provides greater detail on topics to be reported on. These are to include, in particular:

· Business strategies and sustainability goals

· The role of the Board of Management and Supervisory Board and the corporate strategy with regard to sustainability

· The main adverse impacts caused by the company (including through the supply chain)

· Intangible resources not yet recognized in the balance sheet

· The way in which companies have identified and defined the disclosed information.

The new CSRD also adopts the concept of double materiality, which means reporting now comprises both sustainability factors affecting the company (financial/inward materiality) and how the company impacts on society and the environment (outward materiality). It acknowledges the need to get a full picture of a company’s impacts. With this, the current criticism is addressed that the "inside-out" perspective, i.e. negative impacts a company has on environment and society, in particular, has received too little attention so far.

The EU Commission proposes to develop EU-wide standards for sustainability reporting by means of delegated acts. Delegated acts are not subject to an adoption process into national law and are thus directly applicable throughout the EU. In this way, greater consistency is achieved.

By also considering and referring to international standards or frameworks (e.g. GRI, TCFD, CDP etc.), the EU Commission also aims to contribute to the establishment of globally uniform standards for sustainability reporting. The standards are to cover the topics of Environmental, Social and Governance (ESG), and should be:

· Understandable

· Relevant

· Representative

· Verifiable

· Comparable.

Integration with financial reporting and audit requirement

The current NFR Directive has so far given reporting companies the option of either integrating the required non-financial information into the management report or preparing a separate non-financial report. According to the draft CSRD, the required sustainability information is to be disclosed exclusively in the management report in the future, i.e. companies have to provide an integrated (financial and sustainability) report. The EU Commission holds the supervisory board responsible for the proper preparation and disclosure of this management report. It also aims to enforce an audit requirement for sustainability reporting, thus making the reported information verifiable and comparable.

Furthermore, the EU Commission wants to subject the disclosed information to a digital taxonomy ("tagging"), enabling disclosure of sustainability reporting in a suitable electronic format. The development perspective is the creation of a freely accessible database, which makes sustainability-related corporate information (and possibly other data) available to stakeholders.

Conclusion and outlook: Better get prepared for sustainability reporting requirements early on

The new CSR Directive is a significant step ahead in terms of sustainability reporting and sets ambitious goals. It is, however, still subject to negotiation - and then subject to implementation in the EU member states. It is possible that some compromises will be made before it is finalized, but  the fact that the EU Commission is very keen on wanting to adopt a leadership role on sustainability in the global context, means that it will fight hard for its proposed agenda.

In general, it can be expected that collecting and sharing sustainability information will become common business practice for companies of all sizes over the next few years. Meeting the new requirements presents a number of challenges for companies in terms of data collection, measurement, assessment, comparability, etc. Therefore, it is advisable to prepare for this early on.

One could argue that sustainability reporting and accountability is just window dressing or an invitation to greenwashing. And in the past, that was probably true to a large extent. However, the new legislation - once implemented - will increase transparency and comparability for investors, consumers and business partners. It will focus the attention and make it easier to choose whom to conduct business with. This last point is extremely important and will have positive 'trickle down' effects as smaller companies in the supply chain are forced to adopt the standards set by their customers.

The tiger's teeth strike once there is political action through incentive systems

Equally important, however, is another significant step that is enabled through the new reporting directive and that needs to be addressed: That is, to incentivize - and reward - companies that demonstrate genuine responsible behaviour. To this end, it will be necessary to develop and implement political interventions such as subsidies, tax advantages, preference in public tenders, preferential market access, etc. Once this is achieved, it will become a major accelerator towards a sustainable - and eventually even a regenerative - economy.