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12 May INSIGHTS | Get Ready for EU’s Corporate Sustainability Reporting Directive (CSRD)
On April 21, 2021, the European Commission adopted the Corporate Sustainability Reporting Directive (CSRD) proposal, which would amend the existing requirements of the Non-Financial Reporting Directive (NFRD). The CSRD envisages the adoption of the European Sustainability Reporting Standards (ESRS). It identifies the European Financial Reporting Advisory Group (EFRAG) as a technical advisor to develop ESRS in parallel with the legislative process of the CSRD.
On April 29, 2022, the EFRAG released the Exposure Drafts (EDs) of the ESRS for public consultation with a 100-day period due by August 8, 2022. These EDs correspond to the CSRD, covering all environmental, social and governance (ESG) matters.
Current Requirements: NFRD
The NFRD was established in 2014. Large public-interest entities with over 500 employees are required to report five non-financial issues under the NFRD provisions for the first time in 2018, for information covering FY2017. This covers approximately 11,600 companies across the EU, including listed companies, banks, and insurance companies.
Next Step of CSRD Proposals
The proposal is to finalize a legislative text based on the CSRD. If the European Parliament and the Member States can reach an agreement by mid-2022, the Member States shall incorporate the ESRS into their state legislation by December 2022. Shortly after, the ESRS will be effective from January 1, 2023. Companies in scope for the CSRD need to release their first sustainability report in 2024, covering the information in FY2023.
Key Changes in the CSRD
The NFRD can be viewed as a leading example of how the EU sustainable disclosure landscape has changed and continues to change. It also shows the EU’s effort to promote the development of ESG responsibility. However, it still has some inefficiencies. In order to upgrade the NFRD, the CSRD adjusts the requirements in the following areas:
Only 11,600 entities are eligible for the NFRD reporting. This is because the NFRD excludes private companies as well as small and medium-sized enterprises (SMEs) from reporting obligations. Moreover, subsidiaries are not obliged to report if their parent companies can meet NFRD requirements on a consolidation basis. As a result, investors and stakeholders wishing to reference the NFRD reports often face the challenge of insufficient information due to the limited scope.
The CSRD expands the scope to approximately 49,000 EU companies and relevant foreign subsidiaries, accounting for 75% of the turnover of all limited liability companies. Compared to the NFRD, it applies to listed SMEs except for micro-enterprises. It also includes all large companies that are EU-governed or established in an EU member state, as well as those already falling under the NFRD. According to the CSRD, large companies within the scope should meet two of the following criteria:
1. over 250 employees;
2. over EUR40m net revenue;
3. over EUR20m total assets.
- Flexibility and Granularity of Requirements
With the exception of the climate reporting guidelines, the NFRD is a principle-based framework without any detailed guidance, which provides companies with considerable discretion in deciding the content and materiality principles. Besides, the reporting companies are not bound by any non-financial reporting standards, and either national or global frameworks can apply to the report. Hence, these characteristics of the NFRD impair the comparability of the reports and sometimes lead to the disclosure of information deemed irrelevant by NFRD report users. Vague guidelines in the principle-based framework will influence the data quality and make it difficult to gather accurate data in the reporting process.
Under the CSRD proposals, companies need to publish separate sustainability statements as part of their management reports containing sector-agnostic, sector-specific, and company-specific disclosures. This can help preparers connect financial and non-financial information in their reports.
The recent 13 EDs of the ESRS attribute to the sector-agnostic standards, covering one standard on general principles for sustainability reporting, one standard on overarching disclosure requirements, and 11 KPIs-driven disclosure requirements on ESG topics. The EFRAG is working on the remaining standards, where the entity-specific one is designed for SMEs. KPI-driven standards can assist the preparers to disclose more comprehensive and precise information to meet users’ demands, which will further enhance the credibility of the report.
- Audit and Assurance
In the NFRD, the statutory auditor is required to verify the existence of the non-financial statement but is not obliged to check the accuracy of the data and the procedure of processing data. The lack of deep auditing work will impose the risk of poor data quality from reporting companies. However, the CSRD published a mandatory audit requirement for the sustainability reports to increase their reliability. Companies within the CSRD scope should seek limited assurance over their sustainability disclosure, which will move towards a reasonable assurance requirement at a later stage.
Potential Impacts of the CSRD
- Double Materiality
The term “double materiality” is introduced in the NFRD, which will be succeeded by the CSRD proposals. According to the EDs of ESRS 1 and ESRS 2, the CSRD enhances the concept and specifies the disclosure requirements of double materiality. Encompassed in the term are two aspects of materiality: financial materiality, and impact materiality.
Impact materiality refers to a sustainable matter that has an actual or potential material impact on people or the environment in the short, medium, or long term. The impact can be anything occurring in any tier of business relationships in the value chain. The materiality of actual impact is determined by severity such as scale and the irremediability of damage. On the other hand, the materiality of the potential impact will depend on its likelihood.
When assessing financial materiality, companies should focus on sustainable matters that may trigger financial effects on undertakings in the short, medium, or long term. For example, a company that operates factories with effluent discharge should consider pollution prevention to be a financially material sustainable matter, as the mismanagement of discharge may lead to a financial penalty from regulators and negatively impact its revenue-generating capacity due to reputation damage.
- Interaction with Global Standards
Before developing the ESRS, the Global Reporting Initiative (GRI), the standard-setter for a widely adopted ESG disclosure framework, signed a cooperation agreement with the EFRAG to align its voluntary reporting framework with the ESRS. Additionally, the CSRD proposal stated that it would follow the Task Force on Climate-related Financial Disclosure (TCFD) concerning the requirements for climate-related sustainability information. Moreover, the NFRD requires preparers to report climate-related information in accordance with the GHG Protocol. As an extension of and amendment to the NFRD, the CSRD also refers to the GHG Protocol as its guidance for climate-related disclosure. Finally, the EFRAG agrees to join a working group across standard-setting initiatives established by the International Sustainability Standards Board (ISSB) to work on developing a global baseline of sustainability financial disclosure. It also conducts a comparative analysis against the ISSB proposal, finding out that due to the differences between standards, companies and investors may have to deal with various sustainability reporting standards in the short term.
How companies should prepare for the CSRD
1. Identify the company’s ESG risks and opportunities. Undertake risk assessments to find gaps in the existing governance, policies, and procedures in place against ESG matters as laid out in relevant ESG standards. This should be done at both the parent level and subsidiary level as non-EU companies along the value chain are also included in CSRD reporting.
2. Conduct a materiality assessment following the pivotal principle of double. Describe the impacts and document the process, methodologies, and resources applied in practice.
3. Ensure data coverage and quality, as well as the reliability of the data collection, as the CSRD calls for a higher quality of reports and mandatory auditing work.
4. Keep an eye on the development of sustainability reporting requirements as the CSRD is still at the proposal stage and the ESRS is under consultation.
Compliance with the new CSRD requirements remains challenging for many companies because this process demands a large knowledge pool and diversified skillsets. Seneca ESG provides a SaaS platform targeting problem settlements during the reporting and other aspects of sustainable management for companies. Our experienced team will provide professional services to help companies with CSRD compliance, decarbonization, and sustainable investment. Contact us at email@example.com to get customized solutions for you.