ANALYSIS: Richard Howitt, who originally proposed and negotiated the EU Non-Financial Reporting Directive, welcomes Europe’s move to align corporate reporting with the TCFDs in the draft Corporate Sustainability Reporting Directive
Is this the moment where sustainability reporting goes mainstream?
After years of speculation of how the European Union would update its non-financial reporting rules, the new proposed Corporate Sustainability Reporting Directive (CSRD) was published late last month and will be debated at a high-level conference in Brussels later this week.
It positively meets the expectations of many in the sustainable business movement.
It is mainstream in that the information will have to be in the company’s management report; it will have to conform to a single set of standards; it will apply to all large companies (49,000 in total); it will have to be audited and digitised. The exemption to “comply or explain” is removed and sanctions will be imposed by the same national supervisory bodies also responsible for financial reporting.
There is a huge opportunity in building consensus for the proposals
This is a long way from the original directive, which was a first attempt to legislate in this area and necessarily involved a high degree of flexibility for companies, to introduce them to the practice and to win their support.
Today, fuelled by investor and broader stakeholder concern about a lack of consistency and comparability in sustainability reports, there is a distinct shift towards a rules rather than principles-based approach in the reporting requirements, with 81% of companies backing standardisation in the European Commission’s public consultation, prior to the draft being published.
This means there is a huge opportunity in building consensus for the proposals, in comparison to the deep polarisation that marked the negotiations in which I was directly involved (but which we overcame), at the start of the last decade.
The new draft is more prescriptive in identifying the sustainability issues that should be reported across all sectors, to align this to requirements already embedded in investor disclosure rules as part of the EU’s sustainable finance strategy – with a welcome added emphasis on governance.
As a longstanding proponent of integrated reporting, I was heartened to see the specific inclusion of a “multi-capital” approach, alongside full incorporation of recommendations from the Task Force for Climate-related Financial Disclosures.
I also welcome that companies will now report on “real world” sustainability targets, progress towards meeting them and on their principal adverse impacts.
It may be challenging for companies to measure their actual impact and to be genuinely open about shortfalls, but it is absolutely essential if the reporting is to make a genuine difference in helping us to meet sustainability challenges.
The European Commission has made some important choices on key issues in their draft
Indeed, the requirement for companies to publish information on how their strategy aligns with limiting global warming to 1.5C and to the EU’s own climate transition benchmarks, is an important step towards closing the gap between what an individual company is reporting and its performance necessary to meet globally agreed sustainability goals.
Critics who have long argued that companies fail to address the sustainability context in their reporting can also now use the clause for “contextual information”, to argue their case for reporting to properly address global thresholds and allocations at the macro-level.
The European Commission has made some important choices on key issues in their draft, which will be important to protect.
Due diligence requirements are to be reported, using a risk-based approach, applying across the whole of a company’s value chain, and are not restricted to one or more tiers.
The text specifically requires forward-looking information, together with a requirement for reporting for the short, medium and long-term. Too many companies have been reticent to address this. They will be emboldened by these new requirements.
New environmental, social, governance (ESG) standards are to match the same rigour as financial reporting, adopting well-worn accountancy principles, to be “understandable, relevant, representative, verifiable, comparable, and represented in a faithful manner”.
A major difference in the new directive is the requirement for audit, although moving from limited (no obvious error) to reasonable assurance (information is reasonably stated), would not occur for at least three years. There is a sting in the tail for the accountancy profession, however, in that new strict sustainability reporting audit competences are introduced by the directive, together with the possibility of new specialist sustainability auditors being authorised to provide direct competition with today’s financial auditing firms.
As with all European legislation, there is the potential for significant amendments, as the directive is negotiated by the European Parliament and Council in the months to follow.
I expect debate on a greater role for SDG reporting, given the urgency towards meeting the goals
Look out for attempts to refine the definition of “double materiality”’ – that information is material to the company’s finances and/or to its external impact – and potentially to requirements on how companies should undertake their materiality determination.
I expect the requirement to allow simplified reporting standards for small and medium-sized enterprises on listed markets to be supported, along with attempts to bring unlisted SMEs within the scope where they operate in high-risk sectors and to potentially limit the longer phase-in time envisaged for small businesses.
The current draft favours allowing groups to publish consolidated sustainability information, and there may be pressure towards subsidiary companies doing so in their own right, to better understand impact at as local a level as possible.
There will also be a question mark on whether there is sufficient reference to the UN Sustainable Development Goals, which are cited currently only in the non-binding recitals within the text. It may be difficult to marry goals which are set for 2030 in legislation which may well apply beyond that date, but I expect debate on a greater role for SDG reporting, given the urgency towards meeting the goals.
The draft also tilts towards environmental over human rights issues, in terms of detail. I suspect there will be efforts to rebalance that emphasis, with greater attention to the social and human rights issues in the final text.
Similarly, the EU institutions will consider the CSRD in parallel with forthcoming sustainable corporate governance legislation. The inclusion of the role of the board in the new text is extremely welcome, but I expect efforts to drive up scrutiny requirements for human rights due diligence, in the debate on both of these draft directives together. Liability remains a touchstone issue.
Carbon offsets are included in the small print of the CSRD, though their credibility is the subject of controversy. Alignment with Paris goals may be tightened up with respect to the standards, as well as in the legislative provision.
The inclusion of reporting on political engagement and lobbying may prove to be sensitive with politicians themselves – but is an interesting and important improvement in the text.
The European vision envisages a more active role for Europe in 'building on and contributing to' standardisation initiatives
Finally, I have written and spoken many times on the inter-relationship between emerging ESG standards for the European Union, alongside the parallel process aiming at global standards, now being led by the International Financial Reporting Standards Foundation.
The new directive confirms the role of the European Financial Reporting Advisory Group (EFRAG) as the lead for the European Commission in recommending new standards, starting with the first tranche by mid-2022.
The European vision, as outlined in this text, although accepting the need to ‘incorporate‘ globally accepted standards, envisages a more active role for Europe in “building on and contributing to” standardisation initiatives at the global level.
If this European activism towards ESG standardisation enables such a bold claim to be realised, sustainability reporting will indeed have moved into the mainstream.
Richard Howitt is a strategic advisor on corporate responsibility and sustainability, former chief executive officer at the International Integrated Reporting Council, and Member of the European Parliament who originally proposed and negotiated the EU Non-Financial Reporting Directive, (2014). Twitter: @richardhowitt
Sustainable finance Corporate Sustainability Reporting Directive TCFDs SDGs