Countdown for the reform that will overhaul companies’ sustainability reporting obligations in Europe

Written by Frank Bold as the first article of the series of monthly briefings on sustainability reporting and related themes provided throughout 2021. Views included in this article do not necessarily represent the opinion of other members in the Alliance.

Content outline

The European Union will take major action in 2021 to expand its leading position on sustainable finance, in order to strategically redirect private and public money to sustainable activities. Such realignment of investments will be critical to meet the Union’s 2030 targets agreed in Paris and deliver on the growth strategy set in the European Green Deal that aims to tackle the existential threat to Europe and the world that climate change represents, and achieve zero-net emissions of greenhouse gases by 2050 and decouple economic growth from resource use.

To achieve this, EU Commissioner for Financial Services Mairead McGuinness has been crystal-clear in her public appearances: we need to mobilise at least half a trillion euros per year of additional investments in the EU. She has identified the reform of the EU Non-Financial Reporting Directive (NFRD) as “one of the priorities to strengthen the foundations for sustainable investment”. Without reliable, comparable and meaningful sustainability data from companies, investors and banks will not be able to redirect needed finances towards sustainable investments, while companies themselves will be blind to major business risks and opportunities in the rapidly evolving economy.

The EU Non-Financial Reporting Directive introduced in 2018 obligations for large European companies to disclose information on their sustainability risks and impacts. However, as shown by the Alliance for Corporate Transparency research, the quality and relevance of information is still critically poor, therefore missing the point of such legislation. The newest data for instance reveal that only 16 % of companies explain alignment of their policies with science-based targets and only 6.6% use a below 2°C scenario in their risk assessment. A reform proposal is expected in March 2021 and plans to develop detailed EU reporting standards are already underway to underpin the legislation and to make it easier for companies to report.

Below, we outline ten key issues that will be addressed in the reform. Critically, the reform will extend the scope of the law. Currently, the Directive applies to approximately 5 thousand companies, which may be extended to an additional range of at least 35 thousand large companies, up to 100 thousand businesses if high-risk medium-sized companies are included, in EU-27.

What changes will this reform bring and which topics can we expect to be the main discussion points this year in the EU?

For those not familiar with the Brussels-policy train, the revision of this legislation was included in the Sustainable Finance Action Plan and received overwhelming support from all stakeholders in the public consultation organised by the European Commission last year: 82 % of business, investors and civil society organisations called for mandatory reporting obligations and the clarification of the legal framework. Similarly, EFRAG (an advisory body to the EU institutions) was tasked with developing preparatory work for the creation of EU standards, which would represent a landmark step in global standardisation.

Both the European Green Deal and the COVID-19 Recovery Package directly refer to the need for reliable and meaningful sustainability data from companies. Improving corporate transparency on sustainability matters also plays an important role in connecting the sustainable finance agenda* (i.e investors need to report on how they integrate sustainability considerations into their strategies from this March) and the upcoming legislative proposal on corporate governance (expected to clarify the obligations of directors with regards to sustainability in 2021).

* The EU Commission will follow up on the Action Plan on financing sustainable growth with a renewed sustainable finance strategy set to be published in March 2021 alongside with the NFRD reform proposal. This roadmap will determine the next steps that the EU Commission will take in order to support the transition to a sustainable economy and will likely include: further work on integrating sustainability criteria in financial markets (i.e green bonds, digitalisation, retail investors, banking prudential regulation, asset and pension funds management, accounting standards and sustainability definitions in financial products and rating agencies). The renewed strategy is also expected to take into account the work that DG Justice is leading on sustainable corporate governance.
Key elements of European Sustainable Finance reform agenda (source: EC)
Where will the money come from? (source: EC)

Why is the reform needed?

Similar to financial accounting, sustainability data is becoming essential for effective corporate management of pitfalls and opportunities in a fast-changing world. Customers, investors and banks also start to require such data to evaluate the company’s strategy and long-term viability, and factor them in their business decisions. Governments too need companies to help them deliver the commitments they have made to the Paris and Sustainable Development Goals and many in business have a genuine commitment to doing so. However, various studies show that existing reporting is not compatible with these goals and that lack of integration with financial reports means the information is not sufficiently useful for business decision-making either.

At the same time investors state that current reporting does not meet their needs, while many companies find the landscape confusing and ask for more clarity to be brought by the revision.

Dimitrios Dimopoulos, Director of the Sustainability Unit at Piraeus Bank and member of UNEP FI recently identified the issue of data as a major problem for banks which finance the transition to sustainability, highlighting the relevance of getting the right data from customers and clients to run their climate risk assessment and factor it in their target-setting.

According to Investor Robert Sroka, ESG Director of Abris Capital - with a portfolio of 1,3 billion USD in committed capital - the greatest challenges are quality and comparability of sustainability data, lack of understanding of its role by the management of companies, and insufficient integration of sustainability data into corporate strategy by the board.

The assessment of the Alliance for Corporate Transparency of the data disclosed by 1000 European companies shows that most companies don’t work with and disclose relevant data and information. For instance, while most companies report general policy commitments to climate change and human rights (88% and 82% respectively), a much smaller fraction report relevant and meaningful information; only 36.2% of companies report on their climate targets, and an even lower percentage report on the alignment of such target with the Paris Agreement/Science Based Target (13.9%), and consider a below 2°C scenario and relevant time horizons (~6%). Similarly, only 23% of companies report on the determination of salient human rights issues, and less than 4% report examples illustrating effective management of these issues (3.6%). Overall, reports focus on presenting general policies and commitments, but not concrete targets, outcomes of policies with respect to these targets, and specific information on risks and impacts.

In November 2020 Alliance for Corporate Transparency published a new report focusing on the newest environmental disclosures of 300 companies from Central, Eastern and Southern Europe from sectors significantly exposed to climate risks, which showed some, yet insufficient progress. For example, 16% of the analysed companies framed their climate targets with respect to the goals of the Paris Agreement, while 8.9% consider risks over relevant time horizons.

Visual resume of key findings available here

Other studies too point to similar conclusions and confirm a wide evidence-based research case for the revision, such as the one carried out by CDSB; while 68% of the companies assessed by CDSB include some reference to the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), only 18% provide details on their resilience to different climate scenarios, and an even lower 4% disclose climate risks over short, medium and long-term time horizons. Public institutions such as the German Environmental Agency have also published targeted research highlighting shortcomings in corporate reporting practices. The latter for example observes that while 83% of the companies included in its study cover climate in their reports, less than half disclose a climate target (45%); percentages fall further when looking into more detailed criteria, such as alignment of policies with long-term climate targets (17%), or reporting on risks (19%). Studies by consultants and accounting firms, while being more optimistically framed, also acknowledge these conceptual problems. For example, a global study by KPMG documented that reporting on UN Sustainable Development Goals is increasing; however, this remains highly unbalanced (86% companies report on positive SDG impacts only, without mentioning the negatives) and is typically disconnected from business goals.

Even if there is timid but promising progress, with leading companies showing the way, policy-makers must ensure the pace picks up substantially if the EU wishes to reach its climate goals.

The European Securities and Markets Authority (ESMA) also noted the persistent problems concerning the lack of quantitative disclosure, objective targets, and descriptions of human rights due diligence and climate risks. ESMA advised companies in its latest statement on common enforcement priorities to disclose risks and uncertainties as well as measures and targets linked to climate change in all relevant time horizons.

Multiple players in a high stakes game

The complexity of the issue as well as the multiple and varied interests in these developments could severely undermine the successful outcome of the reform. The legislation is an opportunity to simplify the reporting landscape and assist companies in focusing on the right data.

Companies struggle to meet the multiple and sometimes confusing external expectations they face and that they themselves want to support (climate change targets, SDGs, sustainable investment), but need help in order to translate them in practical terms. The European framework can provide clarity to pull these different expectations together and provide more certainty for those in business to apply them. Equally, however, in case it fails to set clear minimum standards, it may just reinforce the competition between private reporting initiatives and rating agencies. The multiplicity of these standards - dubbed Alphabet soup as a reference to the wide range of standards, guidances and frameworks currently out there, which combined exceed 5000 KPIs - and investors’ own ESG methodologies place excessive burdens on companies, and obscures which information truly provides useful insights to companies, investors and other stakeholders.

Last year alone, the biggest five reporting initiatives, Big Four accounting firms (WEF paper), as well as the IFRS Foundation and numerous smaller initiatives reacted to the EU plans by proposing their own platforms to drive the process of standardisation or to provide the content for the EU standards. The problem is, as put by the European Commission, that no existing voluntary standard meets the needs of the EU NFRD. And simply combining these standards would merely cement the status quo - that is an excessively complicated system, which would do little in terms of bringing clarity and simplicity.

Giulia Genuardi, Head of Sustainability Planning at ENEL describes the situation as follows: “In the current stage, we have an alphabet soup, while at the same time, we have a big ambition: a structured approach to corporate sustainability reporting framework, enhancing existing standards and the role of qualitative information. Corporate reporting should be based on two pillars on an equal footing: Financial Reporting and Sustainability Reporting and one enabler: digital interconnection between pillars.”

Rahel Damamme, Stakeholder Engagement & Sustainability Prospective Manager from Decathlon shares her perspective and hands-on experience from reporting preparation: “There’s a lack of actual consensus and worldwide acceptance on methodologies which negatively affects the implementation time and effort finally spent on defining the most relevant ones. We hope to see a playing field with common definitions on sustainability reporting and a unitary sustainability reporting framework - a common standardised language on what is expected in terms of today’s reporting answering readers’ needs on how we make progress, on how we improve our impacts and on how our company will contribute forward to a sustainable future.”

As expressed recently by Carlos Tornero, expert journalist at Responsible Investor, “we tend to think that this area (standard-setting) is technical, but it is actually quite political and there are a lot of interests at stake … This is the equivalent of the seduction dance in the animal kingdom”

However, not all those interests have to be contradictory as seen in the public statements of key global players in the reporting landscape, demonstrating that the European role is indispensable and that EU leadership is needed:

“The EU is rapidly advancing the non-financial reporting agenda. And there is momentum within business (…) At the same time, business, standard setters, policy makers and civil society need to work together to quickly drive global alignment on standards.” Robert E. Moritz, Global Chairman PricewaterhouseCoopers Int. at PwC

“I believe that Europe is in a very good position to act to accelerate the process. Being at the global table and shaping the outcome, acting as the first mover and adopter, will put Europe in a great leadership position.” Veronica Poole, partner at Deloitte, global IFRS leader and head of corporate reporting.”

“Aligning capital to sustainable business practices is at the heart of the EU’s Green Deal. The European Commission has recognized that comprehensive and reliable sustainability reporting by companies is the foundation for a sustainable economy. The process ahead of us, leading to the timely adoption of a much-improved EU disclosure system, will be intense and requires collaboration with established standard setters. GRI looks forward to cooperating with all stakeholders to reach a European solution with a global reach.” as stated in GRI’s contribution to EU public consultation.

Calendar legal reform and implementation in 2021

10 expected key points of reform proposal this March

The key changes that are expected in the European Commission’s proposal concern the issue of scope and mandatory reporting standards. The current EU NFRD applies to large listed companies, banks and insurers with more than 500 employees, a group that according to various estimations includes between 5000-10000 European companies. The European Commission has hinted that more companies need to be brought into the fold.

Increasing calls to solve the issue of data relevance and comparability prompted the EU to propose the creating of mandatory European sustainability reporting standards. This is currently being explored by the Project task force on non-financial reporting standards set up by the European Financial Reporting Advisory Group (EFRAG) upon request of the Commission, and which will publish its final recommendations by the end of this month. The most plausible scenario is that EFRAG will house a multistakeholder expert process that will develop draft standards which will be adopted into law by the European Commission. The standards should be developed on a continuous basis, with the core set of standards to be ready for application together with the adoption of the reformed EU NFRD by the end of 2021.

The 10 most important topics that will likely be addressed are the following. Two of them concern scope, four issues are connected to the first set of mandatory reporting standards and the rest concern specific themes as described below.

Expansion of the scope:

1. Very likely, the NFRD scope will be extended to include all large companies (both those with assets listed on stock exchanges and private); following the example of Denmark, Greece, Spain and Sweden, which have already adopted such an extended scope. This change would increase the number of companies obliged to report to more than 41 000 companies in EU-27 that employ 250 persons and more (for illustration, 0.2% of all EU enterprises)

2. In addition, there is an ongoing debate on small or medium enterprises that have high impact or high risks, such as energy producers or importers of high-risk commodities, to be included in the scope of the new obligations with reporting requirements being proportionate to their size and impact and thus avoiding a “one size fits all” approach. The European Parliament included a request to the EU Commission to consider this, and investor groups such as EFAMA and IIGCC together with accounting bodies and NGOs published in summer that _“Whether companies have a significant impact on the environment and society does not depend on their size or legal status, neither are investments limited to assets listed on stock exchanges”_ (see joint statement here). With an estimated proportion of 20 - 30 % of companies in high risk sectors, this means an additional 41 000 - 62 000 medium-sized companies in EU-27 falling under the scope. (0.2%-0.3% of all EU enterprises)

Mandatory reporting standards

3. Qualitative criteria for disclosure of forward-looking information on identification of risks and setting the targets.

4. Definition of information needed to understand companies’ climate transition plans, including timeline, intermediary objectives and time horizons, and alignment with the public objectives and science-based targets.

5. Disclosure requirements concerning human rights and environmental due diligence regarding management of risks and impacts in supply chains. The EU NFRD already requires this type of disclosures, but only 1 out 5 companies do according to independent findings by the Alliance for Corporate Transparency, Corporate Human Rights Benchmark of the World Benchmarking Alliance, and the German government. The due diligence requirements might be supported by additional requirements for high-risk sectors concerning transparency of the supply chain and conditions therein.

6. Mandatory Key Performance Indicators (KPIs) in the area of climate change (such as greenhouse gas emissions Scope 1, 2 and 3), use of natural resources and biodiversity impacts and pollution, and workforce statistics (composition, wages, collective rights). The list of KPIs is expected to be sector-sensitive.

Other specific topics likely to be included in the reform:

7. Integration of sustainability reporting within annual reports.

8. Governance and integration of sustainability in the corporate strategy.

9. Clarification of the double materiality principle (which refers to both the financial impacts stemming from sustainability topics and corporate impacts on people and the planet).

10. The specification of mandatory assurance.

The standards in these areas will be required to support the European Commission’s legislative initiative on sustainable corporate governance, which is developed in parallel to the NFRD reform, and which will provide a legal framework for corporate human rights and environmental due diligence (that is, obligation to identify, prevent and mitigate risks of severe environmental and human rights impacts in a company’s value chain), and integration of sustainability in corporate governance practices.

Further details and key priorities for the reform of leading NGOs gathered in the Alliance for Corporate Transparency can be found in the joint position.

Don’t miss the train

The clarification of corporate sustainability reporting obligations can address major challenges facing companies and investors alike. It can overcome the current confusing reporting landscape, set focus on data that really matters, and ensure easier access to finance for those companies who are leading the way. In the words of Commissioner McGuiness, the reform of the EU NFRD is meant to be a targeted intervention to ensure that “we channel investments into companies that can deliver on our green and sustainable objectives”.

Indeed, private and public investment is increasingly being connected to higher transparency and sustainability standards, which places companies that better report on the management of their financial and sustainability related risks and impacts at an advantage. BlackRock, the largest asset manager in the world recently published the results of a survey on 425 investors in 27 countries with nearly $25trn in assets under management, showing that investors “plan to double their allocations to sustainable products over the next five years, and 20% said that the pandemic would actually accelerate their sustainable investing allocations”.

The first Non-financial Reporting Directive showed it was possible for companies to undertake non-financial reporting without undue cost or burden. However, there is recognition that it is still too focused on compliance by producing a report, rather than on generating information which is useful to internal as well as external stakeholders in managing the sustainability risks and impacts of a company. The revised NFRD and ESG standards will focus on helping companies and their investors better manage risk and take advantage of new business opportunities, as the economy rapidly transitions to meet the challenges of low carbon growth, recovery from the Covid-crisis and of the Fourth Industrial Revolution.

This is the first article of Frank Bold’s series of monthly briefings focusing on sustainability reporting in various contexts that we will be publishing here throughout 2021. Look out for our February topic on the connection between non-financial reporting and sustainable corporate governance. You can also attend a webinar organized by Frank Bold and CDSB on the same theme 9th February (9.30h - 11h CET). Register here.

Views included in this article do not necessarily represent the opinion of other members in the Alliance.

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