The EU’s Corporate Sustainability Reporting Directive is due to come into effect next month. Here are three key questions that business leaders must answer.
From Creed to Corporate Catechism
In December 2019, the EU Commission approved the European Green Deal.
Seemingly intended to combat the “existential threat” to Europe and the world posed by climate change and environmental degradation, the Agreement commits the EU to the following climate-related goals:
- no net greenhouse gas emissions by 2050
- economic growth disconnected from the use of resources
- no person and no country left behind
EU Directive on Corporate Sustainability Reporting
To implement the Green Deal, EU bodies have implemented a number of measures. Prominent among them will be the Corporate Sustainability Reporting Directive (“CSRD”).
The CSRD has been approved by the Council of the EU. Scheduled for official release this month, the CSRD should come into force in early 2023.
Obvious questions that need to be answered
If the Green Deal is the creed of sustainability, CSRD is the corporate catechism.
The CSRD introduces detailed reporting requirements seeking to ensure that large companies and listed SMEs report on environmental rights, social rights, human rights and governance factors.
Companies subject to CSRD
The Directive covers all large companies registered in the EU, as well as all companies listed on regulated EU markets (except listed micro-enterprises). A reportable company must also evaluate information related to its subsidiaries.
The CSRD will also apply to EU-listed SMEs, taking into account their specific characteristics.
For non-European companies, the requirement to provide a sustainability report applies to all companies that generate a net turnover of EUR 150 million in the EU and that have at least one subsidiary or branch in the EU that exceeds the specified limits.
Establishing and presenting standards
The European Financial Reporting Advisory Group (EFRAG) will be responsible for developing the draft European standards. The European Commission will adopt the final version of the standards as a delegated act, after consultations with EU member states and a number of European bodies.
The implementation of the regulation will be done in four stages:
- reporting in 2025 for financial year 2024 for companies already subject to the EU Non-Financial Reporting Directive (“NFRD”);
- reporting in 2026 for the 2025 financial year for large companies not currently subject to the NFRD;
- reporting in 2027 for the financial year 2026 for listed SMEs (except micro enterprises), small and non-complex credit institutions and captured insurance undertakings;
- reporting in 2029 for the financial year 2028 for third country enterprises with a net turnover of over 150 million in the EU if they have at least one subsidiary or branch in the EU exceeding the specified limits.
Three key questions
This column takes no position on the desirability or usefulness of the Green Deal.
The column notes, however, how the shift from belief to catechism formalizes and mandates corporate sustainability reporting practices.
For businesses, this shift turns sustainability from a goodwill-building effort into a compliance exercise.
Here three unasked but critical questions arise:
Q1: Where should sustainability oversight sit on the Board?
Prior to mandated sustainability reporting, ESG efforts might have been overseen by the strategy committee or governance committee. This is because voluntary sustainability activities and reporting forced Boards and management to weigh the returns from different resource allocations. Corporate leaders also had to consider sustainability within the context of market entry/exit, communication and brand building.
However, with mandated activities and reporting, Boards may delegate sustainability oversight to the audit committee. Not only will this committee have greater experience with compliance issues, but sustainability data will likely be related to enterprise resource planning (“ERP”) processes and systems, which typically fall under the purview of to the audit committee as they relate to mandatory disclosures.
Question 2: Where should day-to-day responsibility for sustainability reside in management?
As mentioned above, the goodwill building component of voluntary sustainability warranted an important role for Communication and Public Relations.
Mandatory sustainability reporting, on the other hand, is likely to fall within the Legal and Compliance functions.
Expect companies in these circumstances to downplay sustainability efforts rather than celebrate them. Articulating aspirational ESG goals and activities creates risks that prudent Legal and Compliance professionals avoid.
A funny-if-it-wasn’t-so-sad example comes from the United States. Opponents of stakeholder-focused sustainability efforts have accused business groups promoting ESG standards of forming illegal cartels. As a result, meetings of the International Sustainability Standards Board’s Investor Advisory Group now begin with a call from a lawyer, hoping in his words to absolve the participants of claims that they are illegally colluding to restrain trade.
Question 3: What does “dual materiality” mean in practice?
CSRD introduces a “double materiality” approach: sustainability risk (including climate change) affecting companies + companies’ impact on society and the environment.
Such an approach requires projections with a high degree of uncertainty. It also requires companies to address issues outside their areas of competence. It is one thing to comment on how changes in inputs or market conditions may affect one’s operations and financial performance. But where will companies develop the skills and knowledge to assess their impacts on the wider world?
Also, from the financial side, a large number of rules and practices guide the determination of materiality in the context of financial reporting. In addition, monetary damages can often be measured by reference to stock price movements or performance against peer groups.
Such a lesson does not exist in relation to sustainability, especially at the level of the individual enterprise. It may be instructive to review sustainability projections for the past 30 years to appreciate human capabilities and limitations in projections of this type.
For better or worse, the European Financial Reporting Advisory Group (EFRAG) will have to contend with developing standards in this area. The jobs at EFRAG will be difficult, but undoubtedly also quite safe.
Ready or not, here it comes
While CSRD does not mandate reporting until 2025 (for 2024), the huge compliance challenge requires immediate prioritization and action.
According to Pierre Laporte, Founding Partner of Governances, a compliance risk advisory firm, “European compliance culture has matured over the past 20 years and CSRD represents another avatar of this trend.” Laporte notes, “Compliance requires leadership from the top, but CSRD remains generic, with methods for meeting its limitations, as well as sanctions for non-compliance, still undefined. Leaders who wish to uphold the letter—let alone the spirit—of CSRD will need standards that meet requirements, reflect what companies can practically achieve over different time periods, and take into account competitive pressures in global markets that do not subject to CSRD. That’s a tall order.”
Are we building Jerusalem or Babel?
Instead of clerics and theologians, the CSRD will commission lawyers to set standards, oversee compliance, and impose sanctions.
We live in critical times. Even the cynical ones. If it is permitted (encouraged, in fact) to question the connections between clergy, dogma, tithing, morality, and salvation, would it not be acceptable to ponder more deeply the connections between constancy votaries, faith, catechism, transfers of wealth? and the green and pleasant land always promised at some point in the future?
Is CSRD a plan to build Jerusalem or the Tower of Babel?