An evolving regulatory landscape in the European Union means businesses will have to adapt.
Big changes are coming on the sustainability-reporting front for organizations doing business in the European Union.
For years, the EU has led the way in its commitment to reducing greenhouse gases as it strives for climate neutrality by 2050. For companies with a presence in the region, this has meant complying with regulations that require them to reveal to investors and stakeholders the impact their business has on people and the environment. Large corporations, especially, are familiar with the sustainability disclosures mandated by the Non-Financial Reporting Directive. Passed into law in 2014, the NFRD has become the EU’s primary catalyst for environmental, social, and governance (ESG) reporting.
Now, however, a new rule is taking effect: the Corporate Sustainability Reporting Directive (CSRD). Created to update and fortify the regulations put forth by the NFRD, the CSRD requires companies to follow standards developed by an independent association called the European Financial Reporting Advisory Group (EFRAG). These European Sustainability Reporting Standards, better known as ESRS, establish a novel framework for disclosure revolving around a concept called “double materiality.” Here, we’ll take a closer look at the ESRS and CSRD and explain what organizations can do to successfully navigate this evolving regulatory landscape.
The CSRD: Pushing for a Greener Future
Taken together, the CSRD, ESRS, and a classification system called the EU Taxonomy aim to improve transparency and consistency in reporting on ESG issues in the European Union. The CSRD, for its part, emerged from the European Green Deal, a set of policies designed to help Europe achieve net-zero emissions within three decades. The directive went into effect in January 2023 and will be implemented gradually over the next six years.
The European Commission (EC), which implemented the CSRD, has said that it did so 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.” It’s estimated the directive will eventually affect approximately 50,000 companies, but only large organizations with over 500 employees and small to midsize enterprises that have issued securities on the EU market will be subject to the rule. Deadlines for initial compliance will range from early 2025 for those companies currently required to follow the NFRD, to early 2029 for international companies with subsidiaries in the EU and more than $150 million in annual revenue.
The ESRS: Metrics for Sustainability Reporting
Central to CSRD reporting are the new European Sustainability Reporting Standards from EFRAG. ESRS include 12 standards overall, but companies will be required to report only on standards that actually apply to them. While the CSRD is the law mandating sustainability reporting, the ESRS serve to specify the environmental, social, and governance metrics that must be included in those reports.
The ESG topics covered by the ESRS fall within sector-agnostic, sector-specific, and entity-specific “layers,” and cover everything from climate change and pollution to “workers in the value chain” and business conduct. ESRS S4 Consumers and end-users, for example, specifies disclosure requirements “which will enable users of the sustainability statements to understand material impacts on consumers and/or end-users caused or contributed by” a company’s operations and services; while ESRS E3 Water and marine resources requires companies to show how their undertakings positively or negatively affect (or potentially affect) the ocean and other water environments.
Double Materiality: Two Approaches to Sustainability
Double materiality in the context of the CSRD has to do with accounting not only for how a business and its operations impact matters of sustainability, but also the financial impact those sustainability issues have on the business itself. The law requires reporting to include both perspectives (“inside-out” and “outside-in”) when applicable. An inside-out assessment, for example, might be appropriate in the case of a chemical plant with emissions affecting air quality, while an outside-in assessment would apply to that company if it happened to be located on the coast and was affected by rising sea levels resulting from climate change.
EU Taxonomy: A “Common Language” for Disclosures
The final piece of the puzzle in the CSRD is the EU Taxonomy, a classification system designed to encourage sustainable investments while helping organizations align their operations with the European Union’s climate-neutrality objectives. Described by the European Commission as “a common language” for matters of sustainability, the system provides a framework for identifying economic activities that impact the environment in a positive way. These include, for example, initiatives in areas like climate change mitigation, the protection of marine resources, and pollution prevention and control. By requiring companies to disclose information that adheres to the definitions established by the taxonomy, the CSRD “should create security for investors, protect private investors from greenwashing, help companies to become more climate-friendly, mitigate market fragmentation and help shift investments where they are most needed,” the EC notes.
Benefits and Challenges Ahead
As organizations ramp up their CSRD reporting, they stand to benefit in many different ways. They could, for example, see improved access to capital as they attract investors looking for companies that can show they’re complying with the EU’s climate-focused regulations. They could also reap gains from better decision making as they leverage what they learn through their reporting to identify and address potential risks and opportunities.
The big challenge with the directive, on the other hand, will likely involve the need for quality data. For companies with limited resources, it will be difficult to collect accurate and consistent ESG information at a level that meets CSRD requirements. Success will depend on having the right processes, resources and tools for data collection, consolidation, and submission.
The one thing for certain in the years ahead: Those organizations that find ways to navigate this new system and demonstrate their commitment to sustainability will be a step ahead of those that do not. The CSRD and ESRS are about to make waves in the EU. When they do, it’s almost guaranteed it will be good for the environment and for complying organizations as well.
