Keeping up with ESG regulatory developments

Keeping up with ESG regulatory developments

Keeping up with ESG regulatory developments lately has been a challenge. The EU is at the forefront of regulatory and policy activities designed to mitigate climate change and protect the environment, as well as social and human rights. Recently, the EU effort has been most visible in the Corporate Sustainability Reporting Directive (CSRD) and its proposed new Sustainability Reporting Standards (ESRS).

The U.S. has also taken important regulatory steps forward through the climate-related disclosure requirements proposed last year by the Securities and Exchange Commission (SEC), including financial data and greenhouse gas emissions insights for public companies. The proposed rules would require information about a registrant’s climate-related risks that are reasonably likely to have a material impact on its business, results of operations, or financial condition.

In the EU the scope is also extended to social matters, human rights issues and governance practices, based on continuous due diligence process requirements including stakeholder analyses as defined by ESRS.

The concept of double materiality

The concept of double materiality features in both sets of requirements.

Materiality can be defined as the threshold above which missing or incorrect information in statements is considered to have an impact on the decision making of users.

A company shall disclose all the material information enabling the understanding of the company’s impacts on sustainability matters and how they affect the company’s development, performance and position.

A company’s principal sustainability impacts, risks and opportunities are understood to be the same as its material impacts, risks and opportunities as defined in the proposed ESRS. Actual impacts are referred to as impacts (positive or negative). Potential impacts are referred to as risks when negative and opportunities when positive.

The concept of double materiality acknowledges that a company should report simultaneously on sustainability matters that are:

  1. material to the market, the environment and people, and;
  2. financially material in influencing business value.

Focus on strategy rather than reporting

As companies come to terms with these new and challenging reporting requirements, they need to ensure that their approach to sustainability is built on strategic commitment and efficient strategy execution processes, rather than merely on reporting.

A strategy that encompasses the climate-related risks and opportunities presented by climate change, as well as the impact business operations have on climate change and the environment, and that is protective of social and human rights, is a strategy likely to create long term value and outperform competitors.

A cost-benefit assessment carried out by Centre for European Policy Studies (CEPS) with a sample of future preparers of the proposed ESRS, concluded that the proper implementation of ESRS is likely to ultimately contribute to increased sustainability, but also to more effective corporate strategies and improvements in internal processes and procedures.

Some of the benefits expected by the companies in the sample are:

Globally

  • a reduction in the systemic risks to the economy
  • increased capital flows to undertakings addressing sustainability issues
  • strengthening of the social contract between companies and citizens
  • increased awareness on sustainability matters overall

Internally

  • raised profile of sustainability within the company with the members of the executive board of directors expected to become further involved
  • ?better integration of sustainability risks and opportunities in strategy
  • improvements in internal processes and procedures
  • better coordination, cooperation and trust between departments and in the value chain through deepened dialogue
  • changes, revisions and adoption of internal policies related to the environment, climate, social, employee, fundamental rights, and anti-corruption and bribery matters

Harvard Business Review France published an interesting article on this subject on December 8 (2022) - "The essential link between ESG objectives and financial performance" - encouraging companies to focus on strategy rather than on reporting:

“Most companies still treat sustainability as secondary issue (linked to reputation, regulation or reporting), rather than making it a core component of their strategy.”

”If companies do not integrate ESG factors into their internal strategy and operational decisions, and explain to investors how improving ESG performance affects their financial results, their statements on progress on sustainable development goals will, at best, be public relations – and, at worst, deliberate deceit.”

Being accused of misleading stakeholders is not good for business. Greenwashing can be described as the process of giving a false impression or misleading information about how a company's products and/or operations are green. The EU is determined to put an end to these practices.

In March 2022, the EU adopted a proposal banning greenwashing. Transparency is regarded by the EU as the key to sustainability and real transformation. In particular when forward-looking information is requested.

Tackle greenwashing is important, and encouraging companies to increase strategy execution effectiveness will generate trickle-down benefits.

ESG creates value

ESG regulatory developments will be beneficial to society and to our planet, as well as to companies and their stakeholders, but they also come at a cost for companies. EU companies are likely to experience direct administrative costs (one-off and recurring) under the ESRS, in addition to insurance costs and indirect costs. The estimated costs per company vary depending on its characteristics (size, complexity, etc.).

The cost-benefit assessment carried out by CEPS, concluded that estimated administrative one-off costs for a company will range from EUR 36?000 to 287?000 for the first year of compliance with all the disclosure requirements.

In addition, estimated yearly administrative costs for a company will range from EUR 40?000 to 320?000 on average. In larger companies own costs equivalent to between 2 and 2.5 inhouse FTEs (full-time employees) are expected to represent about half of the yearly costs.

However, research has also shown that companies that invest in environmental concerns, social responsibility and responsible governance do not perceive it as an obstacle to value creation – quite the opposite, in fact.

A strong ESG proposal is correlated with higher equity returns, reduced credit default swap spreads (CDS) and higher credit ratings, which in turn lead to lower cost of loans and financial investments.

A strong ESG proposal safeguards long-term success and increases the company’s financial value*:

1.?????Facilitates top-line growth: helps tap new markets and expand into existing ones, drives consumer preference

2.?????Cost reductions: helps combat rising operating expenses (such as raw-material costs and the true cost of water or carbon), reduces unnecessary waste disposal costs

3.?????Reduced regulatory and legal interventions

4.?????Employee productivity uplift: helps attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall (employee satisfaction is positively correlated with shareholder returns)

5.?????Investment and asset optimization: enhances investment returns by allocating capital to more promising and more sustainable opportunities, helps avoid stranded investments that may not pay off because of longer-term environmental issues

*Five ways that ESG creates value – McKinsey Quarterly, November 2019

The EU Corporate Sustainability Reporting Directive (CSRD) is replacing the NFRD as of financial year 2024

NFRD - Non-Financial Reporting Directive

Since 2018 large public interest entities (listed undertakings - or enterprises, banks and insurance companies) with more than 500 employees are required to publish sustainability information under the Non-Financial Reporting Directive (NFRD)

This information includes a non-financial statement with material information on their business model, policies, outcomes, risks and risk management, in addition to key performance indicators related to at least environmental, social and employee matters, respect for human rights, anti-corruption, and bribery matters.

The NFRD does not impose the use of any reporting framework or standard, but if preparers rely on particular frameworks, they should state this in their non-financial statement. The EU Member States are allowed to determine whether the statement should be integrated into the management report or published as a separate report.

CSRD - Corporate Sustainability Reporting Directive

In April 2021 the European Commission presented a new Corporate Sustainability Reporting Directive (CSRD) proposal as part of the European Green Deal and the Sustainable Finance Agenda. In June 2022 the European Parliament and Council reached a political agreement on a CSRD, to which the Council gave its final approval in November 2022. The first companies will have to apply the new CSRD rules for the first time in financial year 2024, for reports published in 2025.

The CSRD introduces more detailed reporting requirements on non-financial sustainability matters, replacing the NFRD, which is no longer tailored to the EU's transition to a sustainable economy, and expanding its scope and content with the aim to improve the quality of the reported information, standardize sustainability information for EU reporters and tackle greenwashing.

The CSRD ensures that all large companies and listed small & medium-sized companies (SMEs) are required to report on sustainability matters such as environmental rights, social rights, human rights and governance factors.

A broader set of EU companies will now be required to report on sustainability – approximately 50,000 companies in total.

ESRS - EU Sustainability Reporting Standards

The NFRD did not envisage EU-wide non-financial reporting standards, which could lead to inconsistent information being reported. The CSRD will now require companies to publish sustainability information in line with the European Sustainability Reporting Standards (ESRS), tailored to EU policies, while building on, and contributing to, international standardization initiatives.

The European Financial Reporting Advisory Group (EFRAG) is responsible for preparing the sustainability standards in its role as technical advisor to the European Commission.

The last version of the first set of ESRS were approved by the EFRAG board on 15 November 2022 and have been subject to editorial review before its final submission to the European Commission on 22 November 2022.

The European Commission is expected to adopt this first set of standards by June 2023.

The provisions apply to fiscal years starting on or after 1 January 2024 for companies already subject to the NFRD.

Financial markets need access to environmental, social and governance information that is reliable, relevant and comparable if private capital is to be channeled into financing the green and social transition. Disclosure of sustainability information could attract additional investment and funding to facilitate the transition to a sustainable economy, as described in the EU Green Deal.

The proposal also aims to simplify the reporting process for companies. Many companies are currently under pressure to use an array of different sustainability reporting standards and frameworks. The proposed EU sustainability reporting standards should be a 'one-stop-shop', providing companies with a single solution that meets the information needs of investors and other stakeholders.

The new rules and reporting standards are expected to:

  • ensure that investors and other stakeholders have access to the information they need to assess investment risks arising from climate change and other sustainability issues;
  • create a culture of transparency about the impact of companies on people and the environment;
  • reduce reporting costs for companies over the medium to long term by harmonizing the information to be provided.

The new EU sustainability reporting rules will apply to listed and large enterprises ?

An enterprise, or 'undertaking' in the ESRS, is considered to be any entity engaged in an economic activity, irrespective of its legal form and the way in which it is financed. Any activity consisting in offering goods or services on a given market is an economic activity.

In short, the new sustainability reporting rules will apply to enterprises

  • listed on regulated markets, providing they are not micro-undertakings, meaning which employ more than 10 persons and whose annual turnover exceeds EUR 750 000, and/or an annual balance sheet total exceeds EUR 350?000. SMEs can opt-out until 2028.
  • which employ more than 250 persons and/or whose annual turnover exceeds EUR 40 million, and/or an annual balance sheet total exceeds EUR 20 million.

These companies are also responsible for assessing the information applicable to their subsidiaries.

For non-European companies, the requirement to provide a sustainability report applies to all companies generating a net turnover of EUR 150 million in the EU and which have at least one subsidiary or branch in the EU exceeding certain thresholds. These companies must provide a report on their environmental, social and governance (ESG) impacts, as defined in the CSRD.

?Application date

The application of the regulation will take place in four stages:

  1. reporting in 2025 on the financial year 2024 for companies already subject to the NFRD;
  2. reporting in 2026 on the financial year 2025 for large companies that are not currently subject to the NFRD;
  3. reporting in 2027 on the financial year 2026 for listed SMEs (except micro undertakings), small and non-complex credit institutions and captive insurance undertakings;
  4. reporting in 2029 on the financial year 2028 for third-country undertakings with net turnover above EUR 150 million in the EU if they have at least one subsidiary or branch in the EU exceeding certain thresholds.

Receive a guide

In the coming weeks we will be publishing a series of articles with information and advice on how to comply with CRSD and the proposed EU Sustainability Reporting Standards (ESRS). We invite you to follow us on LinkedIn to share these insights.

You can also send us an e-mail on [email protected] if you would like to receive the full guide.

You are welcome to contact us if you would like a demo of the SaaS solution Cleerit that helps you structure and simplify sustainability strategy execution, and comply with CRSD and the coming EU Sustainability Reporting Standards (ESRS).

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