Corporate sustainability in Europe: road to 2023

March 2022 | EXPERT BRIEFING | BOARDROOM INTELLIGENCE

financierworldwide.com

There is less than one year to go until the European Union’s (EU’s) proposed new directive on corporate sustainability reporting (CSRD) is supposed to enter into force on 1 January 2023. Based on the text of the proposal, companies can already prepare themselves by reflecting on the sustainability of their business. What do we already know about the proposed CSRD and how does this fit into the lager European effort to create a more durable and sustainable business environment?

The current European framework for ‘sustainability’ reporting

‘Sustainability reporting’ is the new preferred way of referring to all disclosure obligations in the environmental, social and corporate governance (ESG) field, previously known as ‘non-financial’ information. With respect to ESG, the ‘E’ requires companies to report the effects of its activities on wildlife or climate change, for example. The ‘S’ would include labour and human rights issues, such as the presence of potential forced labour somewhere in the value chain. Finally, the ‘G’ covers internal issues like the role of the board on sustainability, political affiliations of the company, its lobbying practices and so on.

Under existing law, a limited number of large public-interest companies already fall under Directive 2014/95/EU, or as it is more commonly known, the Non-Financial Reporting Directive (NFRD). This requires the disclosure of information regarding a companies’ business in terms of the environment, social challenges, human rights, anti-corruption and diversity. The NFRD complements existing financial reporting obligations in Europe and further streamlined transparency obligations throughout the EU.

However, since the entry into force of the NFRD, a new wave of activism and international agreements have led the EU to agree on a ‘European Green Deal’. The European Commission (EC) considers even more extensive disclosure of reliable and comparable ‘sustainability information’ by even more companies necessary to achieve its sustainability objectives. After all, knowledge is power and further reporting will better allow investors, customers and other business partners to make more conscious decisions and evaluate the sustainability risks and impact of their own investments and value chain.

The EU hopes to create a win-win situation by saving the planet on the one hand but also by increasing the value of its companies on the other hand, as they would be the more attractive choice for conscientious investors and consumers. The effect of the reporting obligations could also avoid damages from taking sustainability risks, in particular any reputational damage. For example, the Volkswagen emission scandal has proven that EU companies still tend to minimise these risks.

It is thought that the effect of European regulations can have an impact on worldwide trade by indirectly forcing non-EU players to adopt similar rules in order to remain attractive for European partners and investors.

The proposal for a new sustainability reporting framework

On 21 April 2021, the EC published its proposal for the CSRD, creating a short deadline for member states to transpose the directive into national law and for companies to prepare for their new compliance obligations. From the current proposed text, we can already distinguish four main aspects in which the CSRD goes further than the NFRD.

Extension of the personal and territorial scope of NFR reporting obligations. Under current legislation, only large public-interest companies with more than 500 employees on average, and on a consolidated basis also large public-interest groups, are subject to the NFR reporting obligations. The EC proposes to extend this scope to all large and all listed companies, including listed small and medium-sized enterprises (SMEs), both on an individual as well as on a consolidated group level. Non-listed SMEs will not be subject to any mandatory disclosure but are, of course, allowed to apply the same principles voluntarily, based on separate standards.

The disclosure obligations would also be applicable to third-country companies with securities listed in the EU and the EC would be able to set equivalence criteria for reports and accounts made and approved in third countries. The attractiveness of EU equivalence can cause third countries to adopt similar legislation.

Subsidiaries of large groups will be exempted from reporting obligations if their parent company registers all necessary information in a consolidated management report. The subsidiary is expected to reference the consolidated report in its own management report and must publish the consolidated report in its own jurisdiction. Large subsidiaries of non-EU parent companies would also fall under the scope of the directive.

More detailed reporting requirements. Sustainability factors mainly include ESG issues, but the extent to which information must be provided will be broadened, both in terms of internal as well as external affairs.

Firstly, businesses will have to disclose essential information on the effects of both their value chain, such as their suppliers, partners and resources, as well as the effects of their own products, services, internal workings or other activities. This goes for both their value chain within the internal market and outside, meaning that EU companies will have to request information from non-EU actors to comply, forcing their non-EU business partners to also do a sustainability due diligence on their own value chain. Information must be detailed enough to allow consumers and other businesses to evaluate the sustainability risks of the company.

Secondly, businesses should prepare and publish a strategy to increase sustainability in their business model and how this considers the different ESG factors both qualitatively and quantitatively.

Thirdly, the CSRD will put a greater emphasis on the reporting of a company’s intangible assets, such as intellectual capital, including research and development (R&D), human capital, social capital and reputation capital. It will also be expected to not just report on the company’s activities of the past fiscal year but have a more future-facing outlook on the short and long term.

Fourthly, the EU wants sustainability reporting to be better connected to existing financial reporting obligations. Both reports should not exist separately but should form one coherent overview of the company’s risks on both a financial and sustainability level.

Introduction of common standards and mandatory NFR audits. To facilitate businesses in drafting the report and help consumers and investors understand its content, a common layout and qualitative standard should be developed. To achieve this goal, the EU will propose a coherent and comprehensive framework of binding common standards. This framework should be as consistent as possible, both with global initiatives on sustainability reporting and with the existing financial reporting standards.

This will also enhance the chance to have sustainability reporting audited. Under the current framework, auditors only have to check that the non-financial reporting has been provided, without having to do any verification on its content. Member states are allowed to go further. Under the new CSRD, the required level of assurance provided by the auditor will be much higher. They will be expected to give a clear qualitative opinion on the provided information and its compliance with the law. It will be allowed to have separate firms auditing the financial and sustainability reporting. This avoids further concentration and will allow for the growth of independent specialised sustainability audit firms.

European single access point. A final novelty will be the creation of a single access point where all sustainability reports will be uploaded in digital form which will enhance the findability and usability of these reports. Where this is not yet the case, this will also lead to member states having to require companies to publish their financial statements and board reports in a digital form and on an accessible platform.

Sustainability ahead

The CSRD, even though in no way ready, will have a significant impact on large and listed European businesses. Researching a business’ sustainability risks and effects and drafting and reviewing the report might bring an initial additional burden and cost. However, according to European lawmakers at least, the current climate emergency and the demand for more transparent and ethical practices from investors and consumers provides businesses an opportunity to reflect on the sustainability of their business models and the sustainability risks they face. Further transparency in this field will allow companies to continue to develop their sustainability objectives and stay attractive to consumers and investors. Global initiatives indicate a growing emergence of similar obligations in other regions too. It could be that, soon, sustainability reporting will be a routine job which any business finds rational and prudent.

Virginie Frémat is a partner and Louis Sas is a junior associate at CMS Legal. Ms Frémat can be contacted on +32 3 206 01 57 or by email: virginie.fremat@cms-db.com. Mr Sas can be contacted on +32 3 376 16 02 or by email: louis.sas@cms-db.com.

Virginie Frémat and Louis Sas

CMS Legal