In response to growing investor demand for information concerning companies’ sustainability-related financial risks, the sustainability disclosure landscape has rapidly changed over the last decade. In what marks one of the latest developments to the sustainability disclosure landscape, on 29 April 2022, the European Financial Reporting Advisory Group (“EFRAG“) – a private organisation that provides technical assistance to the European Commission – issued its initial draft European Sustainability Reporting Standards (“ESRS“) for public comment. The ESRS, which EFRAG were tasked with preparing by the European Commission as part of the proposed Corporate Sustainability Reporting Directive (“CSRD“), set out proposed requirements for companies to report on sustainability-related impacts, opportunities and risks under the CSRD.
The CSRD aims to strengthen in-scope companies’ sustainability reporting requirements under the existing Non-Financial Reporting Directive (“NFRD“) by improving the quality, consistency, and comparability of information disclosed by companies. It aims to do so by:
- Enhancing the scope of the NFRD framework so that all companies listed on EU regulated markets (excluding micro-enterprises) and large companies located in the EU are in-scope. A company is deemed as large if it satisfies any two of the following conditions: (1) over €40 million in net revenue; (2) over €20 million in total assets; or (3) over 250 employees. European subsidiaries of foreign parent companies will be in-scope if they meet this definition of ‘large’;
- Enhancing the scope of the NFRD framework to listed SMEs and non-EU companies that: (1) generate a net turnover of €150 million in the EU; and (2) have at least one subsidiary or branch in the EU. The latter was confirmed in the European Council’s 21 June 2022 press release, which announced that a provisional political agreement had been reached between the Council and the European Parliament on the CSRD;
- Introducing more detailed non-financial reporting requirements; and
- Mandating the audited assurance of reported information by an independent third party.
The ESRS will provide the basis for implementation of the mandatory sustainability disclosures required under the CSRD. A second set of standards is expected to be adopted by 31 October 2023, along with specific standards for listed SMEs. For more information on the CSRD, read our earlier blog post here.
The ESRS have been released as a series of exposure drafts. Under the exposure drafts, in-scope companies will be required to publish separate sustainability statements as part of their management reports, containing sector-agnostic, sector-specific and company-specific information. The requisite sustainability statements are split into four categories:
- Environment – covers (1) Climate Change, (2) Pollution, (3) Water and marine resources, (4) Biodiversity and Ecosystems, and (5) Resource use and the circular economy;
- Social – covers (1) Own Workforce, (2) Workers in the value chain, (3) Affected communities, and (4) Consumers and end users;
- Governance – covers (1) Governance, risk management and internal control, and (2) Business conduct; and
- Cross-cutting standards – covers (1) Strategy and business model, governance and organisation, and impacts, risks and opportunities, implementation measures covering policies, targets, actions and action plans, and allocation of resources, and (2) Performance measurement.
The ESRS also include conceptual guidelines to help companies in preparing their sustainability statements. The concept of “double materiality” is particularly significant, since it means that in-scope companies will have to disclose how sustainability matters affect their performance and position, as well as their own impact on sustainability matters.
The conceptual guidelines also require in-scope entities to consider their value chain when reporting. For example, the ‘Climate change’ exposure draft requires disclosure of “gross indirect Scope 3 GHG emissions in metric tons of CO2 equivalent”, which encompasses emissions outside of companies’ direct control, including emissions generated by upstream purchasing, selling products, goods transportation, travel and making financial investments. Similarly, the ‘Workers in the value chain’ exposure draft requires companies to report on their approach to identifying and managing the actual and potential impacts on value chain workers, which covers topics including working conditions, access to equal opportunities, and forced labour. There is a significant amount of overlap between these requirements and the scope of companies’ human rights and environmental due diligence obligations under the proposed EU draft Corporate Sustainability Due Diligence Directive (“CSDD“) (for more information on the CSDD, read our earlier blog posts here and here).
Alignment with other disclosure regimes
By adopting the “double materiality” principle, the ESRS consider a wider range of stakeholders than the International Sustainability Standards Board’s (“ISSB“) Sustainability Disclosure Standards (for further information on the ISSB, read our earlier blog posts here and here) or the US Securities and Exchange Commission’s (“SEC“) proposed new climate-related disclosure requirements (for further information on the SEC’s proposal, read our earlier blog posts here and here).
However, the ISSB aims to align these different disclosure regimes. For instance, the ISSB has recently announced the establishment of a working group to enhance compatibility between the ISSB’s Exposure Drafts on climate and general sustainability-related financial disclosures and ongoing jurisdictional initiatives on sustainability disclosures, which, among others, includes EFRAG and the SEC. This alignment will simplify the steps that companies will need to take to prepare their disclosures.
The ESRS are available for public consultation until 8 August 2022. Following the consultation, EFRAG will submit the final first set of proposals to the European Commission, which is expected to occur in November 2022.
In order to ensure that companies are prepared to make ESRS-compliant disclosures, their management teams should now begin thinking about the effects that the ESRS (in their current form) may have on the company’s processes and systems of internal controls, as well as their ability to gather the relevant information.