knowledge | 19 May 2021 |
Within the evolving international, EU and domestic sustainability policy framework, one area which is of critical importance for corporates, but whose practical impact has probably not yet been fully absorbed, is that of sustainability reporting.
Increased disclosure on sustainability matters is seen as important for a number of reasons including the growing awareness of investors of sustainability risks, the growing market for investment products that seek to achieve sustainability objectives, and the need from a public policy perspective to assess the environmental and social impacts of companies and sectors which will then inform strategies for the future.
Reporting obligations under the Taxonomy Regulation1 and the recently proposed Corporate Sustainability Reporting Directive (“CSRD”), as well as other EU legislative initiatives, will fundamentally change the nature of mandatory periodic reporting for many companies and are intended to – over the next few years – elevate the status of sustainability reporting to that of financial reporting.
We have prepared this short note to examine, from the perspective of non-financial companies, the rapidly changing sustainability reporting landscape at EU level.
What can be measured can be managed
Although some companies have been reporting sustainability information for many years on a voluntary basis, mandatory corporate non-financial disclosures have only been introduced in recent years at EU level by the Non-Financial Reporting Directive (“NFRD”)2. NFRD, which amended the Accounting Directive3, applies to certain large public interest companies with more than 500 employees and requires them disclose information on environmental, social and employee matters, human rights, anti-corruption and bribery matters. In-scope undertakings were required to report for the first time in 2018 (for the 2017 financial year).
However, the shortcomings of NFRD have quickly become apparent and there is broad consensus that the needs of end-users are not being met. Many companies still do not report sustainability information whilst the information disclosed by others is not sufficiently complete, reliable or comparable given the lack of third party assurance or the use of common standards.
In this context, a number of EU legislative measures have been advanced to introduce new obligations on companies to disclose sustainability information, namely the Taxonomy Regulation and the newly proposed Corporate Sustainability Reporting Directive.
Looking firstly at the Taxonomy Regulation, it sets out criteria for determining whether an economic activity can be described as environmentally sustainable by reference to six environmental objectives, alignment with detailed technical screening criteria, and adherence to certain minimum social safeguards.
The Taxonomy Regulation will require non-financial companies as well as banks, asset managers and insurance undertakings subject to reporting obligations under NFRD to disclose how and to what extent their activities are associated with environmentally sustainable economic activities.
For non-financial companies, that will involve reporting against certain key performance indicators (“KPIs”), namely the proportion of their turnover, capital expenditure (“CapEx”) or operating expenditure (“OpEx”) that is taxonomy-aligned. For financial companies such as banks and asset managers, where those KPIs would not be as relevant or useful, different KPIs are being developed (see further below).
Disclosure obligations under the Taxonomy Regulation will apply from 1 January 2022 (with respect to the climate change mitigation and climate change adaptation environmental objectives) with respect to the 2021 financial year which means that in-scope companies need to start planning as soon as possible for the disclosures they will be required to make next year.
As discussed further below, NFRD is itself being reviewed and the EU Commission has published its proposal for CSRD (which is intended to revise NFRD). If the scope of CSRD is expanded in the manner currently proposed to capture all non-SMEs as well as certain listed SMEs, then this will in turn result in more companies coming within scope of the reporting obligations under the Taxonomy Regulation.
Corporate Sustainability Reporting Directive
In April 2021, the EU Commission published its proposal for a new Corporate Sustainability Reporting Directive to revise the existing reporting rules that were introduced by NFRD. The new CSRD is intended to ensure a consistent flow of sustainability information from companies which will be available to banks, insurance companies, asset managers, end investors, non-governmental organisations and others that wish to scrutinise their social and environmental impact.
If implemented in the form currently proposed, CSRD will introduce a number of significant changes to the existing NFRD reporting regime:
- the scope of the reporting obligations will be widened to apply to all non-SMEs and certain SMEs with securities listed on EU regulated markets (estimated as capturing approximately 49,000 companies in the EU, up from approximately 11,000 reporting under NFRD);
- the information reported by these companies will be subject to third party assurance by auditors (initially on a limited assurance basis) and digitally tagged so that it could feed into the European Single Access Point envisaged under the Capital Markets Union Action Plan;
- the obligation to report on a ‘double-materiality’ basis will be clarified with companies being obliged to make disclosures about (i) the impact of the company on sustainability matters as well as (ii) how sustainability matters affect the undertaking’s development, performance and position;
- an in-scope company will be required to include much greater detail in its disclosures than currently required by NFRD including its sustainability strategy, its sustainability targets and the progress made towards achieving those targets, together with a description of the due diligence process implemented to identify actual or potential adverse sustainability impacts connected with its value chain;
- the information required to be disclosed under CSRD will have to be prepared in accordance with new mandatory EU sustainability reporting standards to be provided for under delegated acts adopted under CSRD and which will include simplified and proportionate standards for SMEs.
As regards the development of common reporting standards, the European Financial Reporting Advisory Group (EFRAG) will be responsible for developing these standards. EFRAG recently published technical recommendations and a roadmap for the development of EU sustainability reporting standards intended to advise the European Commission on what EU sustainability reporting standards could look like.
Although there are moves at international level to develop global sustainability reporting standards (including the proposals of the International Financial Reporting Standards (IFRS) Foundation to create a new Sustainability Standards Board), the EU Commission is clear that, although it will engage with and support these global initiatives, those emerging global standards are seen as a floor rather than a ceiling in terms of the expected standards to be applied to sustainability disclosures given the EU’s own sustainability ambitions which currently exceed those of other jurisdictions.
In terms of timing, if the European Parliament and the European Council can agree the text of CSRD during the first half of 2022, it is anticipated that companies will report under CSRD applying the new sustainability reporting standards for the first time to reports published in 2024 (covering financial year 2023) other than listed SMEs whose reporting obligations will not commence until 2026. EFRAG has commenced work on a first set of draft sustainability reporting standards and aims to have the first set of draft standards ready by mid-2022 with a view to the European Commission adopting the first set of reporting standards under CSRD by the end of 2022.
As mentioned above, the information to be produced by in-scope companies under the Taxonomy Regulation and CSRD will, in addition to providing important information to policy makers, customers and civil society more generally, be critical in enabling banks, asset managers and other financial institutions to meaningfully allocate capital towards sustainable investments and also to meet their own regulatory obligations, including disclosure obligations under the Taxonomy Regulation, CSRD and other EU legislation such as the Sustainable Finance Disclosure Regulation4 and the Capital Requirements Regulation5 (e.g. Pillar 3 disclosures).
The obligations of banks, asset managers and other financial undertakings, as well as non-financial undertakings reporting on their value chain, will also have a knock-on impact on the disclosures required to be made by companies which do not come within scope of the Taxonomy Regulation or CSRD, such as SMEs. For example, under the Taxonomy Regulation, one of the relevant KPIs that banks will have to disclose will be their ‘Green Asset Ratio’ (“GAR”), showing the extent to which a bank’s financing activities in their banking books are Taxonomy-aligned. Collecting the information necessary to calculate GAR will mean banks requiring borrowers to make available sustainability information, both with respect to the use of proceeds (where specified) and the activities of the relevant borrowers more generally. This process will be simplified where the relevant borrower is subject to CSRD and the Taxonomy Regulation and publicly reporting this information. However, in the case of SMEs it will mean putting in place processes and systems for gathering this information and educating SMEs who may initially lack the resources, expertise or regulatory obligation to produce the relevant data. Similar considerations apply to SFDR which requires financial market participants to disclose sustainability information to end-investors and asset owners and which requires the collection of adequate and relevant information from, amongst other sources, investee companies.
Recognising this challenge, as part of the CSRD proposal, the EU Commission envisages non-listed SMEs using the simplified and proportionate reporting standards to be prepared by EFRAG on a voluntary basis when preparing disclosures for banks, asset managers or others seeking sustainability information.
The world has changed over the past number of years in terms of global acceptance of the need to tackle the climate crisis and to achieve other defined environmental, social and governance goals as described in the Paris Agreement and the UN Sustainable Development Goals. The availability of comprehensive, reliable and comparable data is a prerequisite to achieving these goals and ensuring that investment is channelled into sustainable activities.
This decade has been described by EU policy makers as a ‘make-or-break decade’ in terms of tackling the climate emergency. The breakneck speed at which hugely significant changes are being introduced to how companies in all sectors of the European economy, financial and non-financial, are expected to conduct and report on their businesses reflects this urgency.
Although direct mandatory reporting obligations may be, at least initially, limited to larger companies, the sustainability disclosure requirements of banks, asset managers and other financial institutions will mean that all companies, big and small, seeking to access external sources of funding, will be required to collect and disclose information relevant to these matters into the future. In addition, it is also worth noting that national measures may be introduced to supplement those applied at European level which could apply to all companies with the Irish government recently indicating that it was awaiting the outcome of the review of NFRD before formulating proposals in this regard.
However, notwithstanding the logistical difficulties in collecting the relevant information and the costs and resources that will have to be committed to sustainability reporting, there will be powerful incentives for companies to do so, even in the absence of a regulatory obligation, including access to a more diverse investor base and potentially lower cost of capital, better informed decision making, strategic planning and understanding of risks and opportunities in a rapidly-changing environment as well as well as enhancing corporate reputation and maintenance of social licence to carry on business.
This mixture of obligation and incentive seem likely to result in the mainstreaming of sustainability reporting over the coming years.
McCann FitzGerald is an acknowledged leader on sustainable finance and sustainability matters more broadly in Ireland. It has advised on many “firsts” in the sustainable finance market, including the first public green bond issued by an Irish corporate and the first sovereign green bond issued by Ireland (being one of the first in Europe). It also provides strategic advice to companies, banks and others across a range of industries and sectors on what sustainable transition means for them and on the rapidly evolving regulatory environment in which they operate.
For further information, please contact Éamon Ó Cuív or your usual contact in McCann FitzGerald.
- Regulation (EU) 2020/852.
- Directive 2014/95/EU.
- Directive 2013/34/EU.
- Regulation (EU) 2019/2088.
- Regulation (EU) 575/2013.
This document has been prepared by McCann FitzGerald LLP for general guidance only and should not be regarded as a substitute for professional advice. Such advice should always be taken before acting on any of the matters discussed.