EU Targets Convergence of ESG and Financial Reporting Requirements

By Shaf Sohail, Associate Director, Ben Walter, Manager, and Simon Taylor, Partner, Forensic Risk Alliance

Last month the European Commission (“EC”) took a major step forward on its roadmap to place ESG reporting, and more specifically the reporting of sustainability information, on an equal footing with financial reporting by publishing proposals for a new Corporate Sustainability Reporting Directive (“CSRD”).

This new directive, likely to be in force from the 2023 financial year, contains some striking features including: covering a much wider group of companies within the bloc and non-EU entities with subsidiaries in the EU; setting new standards for ESG reporting; requiring digitisation of ESG data; and, perhaps most importantly, requiring ESG to be subject to external audit. So far, in 2021, barely a day has passed without the press, pressure groups or shareholder groups identifying examples of misreporting ESG information or so-called “greenwashing”. These proposals from the EU will accelerate access to and scrutiny of ESG performance, putting it on a par with financial performance metrics.

Whilst the EU may be taking the lead on this, it is certainly not alone.  The global direction of travel, which continues to intensify in the lead up to COP26 in Glasgow, is to give equal weight to financial and sustainability information in annual reports in order to harness the power of capital markets in the transition to a sustainable economy.  See for example the Security and Exchange Commission’s (“SEC”) recent announcement of a Taskforce on Climate and ESG issues, and the IFRS’ creation of an International Sustainability Standards Board tasked with setting standards for reporting on ESG issues, based on the widely cited recommendations by the Task Force on Climate-Related Financial Disclosure (“TCFD”).

On top of these developments, news stories continue to abound showing the divergence between lofty sustainability statements and reality, and shareholders are increasingly taking aim at boards through resolutions at AGMs and regulators and litigators are ready to pounce.

These are significant changes and the global trend is clear. The implications for flat-footed organisations that fail to adapt by resetting ESG governance frameworks, are clear: loss of access to capital markets, reduced competitiveness, reputational damage and increased exposure to litigation and regulatory risk.

Why is CSRD needed?

Other than the macro drivers referenced above, there are three key reasons why the EC decided that CSRD was needed. Firstly, the existing rules for reporting ESG data (contained in the 2018 EU Non-Financial Reporting Directive (“NFRD”)) are widely recognised as not fit for purpose:  the information provided by companies being not only insufficient, inconsistent and unreliable, but also difficult to compare and access.  Secondly, problems with the quality of the information distorts the efficient flow of capital towards economic activities aligned with the EU’s ‘green deal’. Finally, investors and the financial sector need high quality sustainability information from corporates in order to meet their EU obligations under the Sustainable Finance Disclosure Regulation (“SFDR”).

What are the Key Measures in the CSRD?

On April 21, 2021 the European Commission published a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would amend the current requirements of the Non-Financial Reporting Directive (NFRD), applied for the first time in 2018.

Whilst around 11,600 public-interest companies are currently within scope of NFRD, the proposed CSRD sustainability reporting requirements will apply to all large and listed companies operating in Europe (including EU subsidiaries of non-EU undertakings), currently estimated to be 49,000 entities^[i].

The aim of the CSRD proposal is to enhance ESG disclosures, through improved comparability, accuracy and ease of use, and therefore to help direct investment towards sustainable activities in the European Union. It intends to reduce the information gap between what companies currently choose to report and the needs of the users of the information.

New requirements

To achieve the objectives of the CSRD, new sustainability reporting standards will need to be established.  The responsibility for developing these standards sits with the European Financial Reporting Advisory Group’s (“EFRAG”) Project Task Force, who published broad proposals and a roadmap in February 2021^[ii].  The roadmap for EFRAG will be to produce standards covering the following key areas where disclosure would be required by CSRD, which includes:

• Business model and strategy, including plans and implementation;
• Sustainability targets, and progress towards achieving them;
• Role of the boards;
• Policies in relation to sustainability factors;
• Due diligence processes for own operations and supply chain;
• Principal risks and dependencies;
• Indicators relevant for measuring the above;
• Intangibles, including intellectual, human, social and relationship capital; and
• Processes carried out to identify the information disclosed.

The CSRD intends to build on existing NFRD requirements, including ‘double materiality’ – i.e., the requirement to report on both how sustainability issues affect the company, as well as how the company affects society and the environment. As evident from the list above, the CSRD intends for reported sustainability information to be both forward-looking and retrospective, and include both qualitative and quantitative information.

It also aims to make sustainability information easy for users to find and in a machine-readable digital format; the information will need to be in the management report, not a separate report, and the reported sustainability information will likely need to be digitally tagged (as is already a requirement in the EU for financial information).

Finally, a key change by the CSRD will be the requirement to obtain limited assurance on the ESG information that companies disclose. Whilst a company’s statutory auditor could perform the assurance of sustainability reporting, the directive may allow separate specialized service providers to undertake it.

What should you be doing now?

In our view, companies need to adopt the mindset that reporting on ESG performance is equally as important as the financial disclosures they make. In making this change of mindset, it is important to recognise that in contrast to financial reporting, which has been refined incrementally over decades, ESG reporting is on a much steeper trajectory.  This means that organisations will need to dedicate significant short-term effort in developing a robust ESG data collection and reporting framework in which regulators and investors can be confident.

On the current timeframe, the new requirements will apply to sustainability reporting of the 2023 financial year. However, it is clear from EFRAGs current guidance that ESG standards will be prioritised and implemented in phases. It is critical that companies align with the prioritisation set by the body to ensure that their efforts on ESG disclosures are focussed on the right areas.

To prepare for the CSRD, we suggest the boards and management of your company or client take the following measures:

• Invest in dedicated resources and professional expertise to identify how key developments in ESG reporting will affect your firm and industry
• Develop internal capabilities to generate and maintain ESG data capture points and reporting that meets the needs of investors and regulators
• Perform a risk assessment to understand how ESG risks and data can be reported from different locations and levels within the value chain without losing the ability to accurately interpret the data
• Create a robust control environment for the analysis and reporting of ESG data that mirrors the controls imposed on financial reporting
• Identify ways to make reporting more comparable and accessible to assist stakeholders
• Explore opportunities for early adoption of sustainability reporting technologies and assurance

Conclusion

The EU’s proposal to scrap the non-financial reporting obligations in favour of a new directive after only a few years signals the importance of ESG reporting in the move to a sustainable economy and achieving the EU’s “Green Deal”.  The structure of the proposals make it clear that standards expected when reporting ESG information will soon converge with those already in place for financial information. In this endeavour, the EU is not on its own nor an outlier: this is a global trend.

Notwithstanding the proposed implementation date, financial year 2023, and a phased implementation, time is extremely short given the significant changes that will be required to meet the new standards and deliver a CSRD compliant ESG reporting programme in time.

The risks involved in failing to switch to a sustainable business model and accurately report ESG information are clear and include not only litigation, regulatory and shareholder action, but also business impact through reduced access to capital, impaired competitiveness and damage to reputation.  We already see these risks playing out with many companies seeing the accuracy of their ESG reporting unceremoniously picked apart by the press and other pressure groups and the increase in shareholder activism at AGMs.  However, for those that move quickly to implement ESG reporting and control framework of the kind used in financial reporting there are opportunities to attract capital and investment on favourable terms and to avoid the pitfalls of litigation regulatory enforcement, and create a positive brand image.

[i] Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/34/EU, Directive 2004/109/EC, Directive 2006/43/EC and Regulation (EU) No 537/2014, as regards corporate sustainability reporting, April 21, 2021.

[ii] Proposals for a relevant and dynamic EU sustainability reporting standard-setting, February 2021