Europe Doubles Down on Sustainability: Proposal for a Corporate Sustainability Reporting Directive

Background

The NFRD requires large “public-interest entities”² to include a non-financial statement in their annual reports of the undertaking’s “development, performance, position and impact of its activity” relating to, at a minimum, four areas: environmental matters, social and employee-related matters (including diversity), human rights, and anti-corruption and bribery matters, together with descriptions of the undertaking’s business model, policies in relation to the four areas, the outcomes of such policies, the principal risks relating to the four areas, and non-financial key performance indicators relating to the business. The NFRD also introduced a “double materiality” perspective for reporting climate-relating information, covering both financial materiality (i.e., the effect of climate on company operations) and environmental and social materiality (i.e., the effect of company operations on the climate). Currently, around 11,700 companies meet the criteria to be large public-interest entities and, accordingly, are required to report pursuant to the NFRD.

Despite these requirements, there have been concerns about the efficacy of the NFRD in eliciting the types of disclosures desired by various parties. In particular, the NFRD leaves significant discretion to companies in terms of what is material information for the various areas covered. Investors, members of civil society, and other stakeholders have criticized the NFRD for failing to elicit sustainability disclosures that are reliable, comparable, and relevant to companies’ operations. The European Commission agreed with these critiques and, in 2020, started an initiative to revise the NFRD. This included gathering information from both the public as well as a special taskforce of the European Financial Reporting Advisory Group (“EFRAG”).

The CSRD Proposal

This revision initiative subsequently led to the proposal of the CSRD, which the European Commission adopted in April 2021. The CSRD significantly expands upon the existing NFRD reporting requirements in a number of key areas, including the following:

• It extends the scope of the NFRD significantly to capture all large private companies³ that are governed by European Union (“EU”) law or established in an EU member state, and all companies with securities listed on an EU-regulated market (excluding “micro-enterprises”), provided that the reporting obligation for small and medium-sized public companies will begin January 1, 2026. This would expand the disclosure obligations from approximately 11,000 to nearly 50,000 companies in the EU.⁴
• It expounds on the “double materiality” principle, by clarifying that companies should report information required to understand how sustainability matters affect the company, as well as how the company’s activities impact people and the environment.
• It introduces an EU-wide audit or “assurance” requirement for sustainability information reported, to ensure compliance with the reporting standards. According to the European Commission, only approximately 30 percent of large companies currently seek some form of assurance for their sustainability reporting. The CSRD would, therefore, significantly expand the number of companies seeking assurance, which may prove a costly or cumbersome addition to the reporting process. This is particular true for sustainability reporting, as the methodologies and approaches to sustainability information are still relatively varied. In recognition of these constraints, the CSRD would only impose a “limited” assurance obligation, requiring fewer assessments and a conclusion that nothing has been identified to suggest that the information is materially misstated. However, in the proposal, the European Commission does note that its objective is ultimately to have a similar level of assurance for financial and sustainability reporting.
• The CSRD brings in new and more detailed disclosure and reporting requirements, including information about the company’s strategy, its targets, the role of its board and management, the principal adverse impacts connected to the company and its value chain and intangibles (including intellectual, human and social and relationship capital). The information reported must also contain forward-looking and retrospective information, as well as qualitative and quantitative information.
• All companies falling within the scope of the CSRD must make disclosures in line with mandatory EU sustainability reporting standards, which will be developed by EFRAG.
• All information reported must be in machine-readable format (XHTML) and be digitally “tagged” so as to feed into the European Single Access Point, an EU-wide digital access platform for which a legislative proposal is forthcoming.

Following the proposal of the CSRD by the European Commission, the European Parliament and the Council of the European Union will need to negotiate and approve the final legislative text before the CSRD will enter into force. In parallel, EFRAG will begin to prepare a first draft set of sustainability reporting standards for consideration by the European Commission, which draft is expected to be ready in mid-2022, once the legislative text is agreed. Depending on how soon the legislation is adopted, it is possible that at least larger companies within its remit will need to start reporting in accordance with the CSRD by 2024.

Implications

The CSRD would represent a significant expansion in the scope of sustainability reporting in the EU, continuing the EU’s drive to bring such information on par with financial information. This may in turn have impacts in other jurisdictions, not only due to the EU’s role as a global leader in ESG regulation, but also due to bleed-over from EU-regulated entities’ incorporation of further sustainability disclosures into any filings in other jurisdictions.

While the CSRD has built in mechanisms to allow certain small and medium sized enterprises to adjust to the requirements over time, all companies subject to the CSRD will need to act swiftly to ensure that they have appropriate mechanisms in place to measure and report the necessary sustainability metrics. For companies not previously subject to the NFRD, this could entail significant investment in resources and training, and these organisations should begin making the appropriate preparations as soon as possible to avoid running afoul of the requirements.

Companies in the United States may also consider how they would handle such reporting requirements, as the Securities and Exchange Commission (“SEC”) continues to examine the possibility of ESG disclosure regulations. The SEC’s outstanding request for public input particularly contemplates the possibility of a global set of standards, instead of various countries all vying to establish their own. While it is unlikely that the SEC would simply adopt the EU’s disclosure requirements wholesale, it is possible that the SEC could build from the regulatory practices established in the EU. Because the CSRD expands on, and has been relatively transparent about the need to improve, the existing NFRD, it can be seen as a “lessons learned” directive; therefore, it could serve as weighty guidance for the SEC in showing how to foster effective ESG disclosures.

¹ https://ec.europa.eu/commission/presscorner/detail/en/ip_21_1804.

² Both “large” and “public-interest entities” are defined in the EU Accounting Directive (2013/34). “Large” means entities with more than 500 employees, and with either (i) a balance sheet in excess of EUR 20 million, or (ii) net turnover in excess of EUR 40 million, and “public-interest entities” means either: (a) entities governed by the law of an EU member state and whose transferable securities are admitted to trading on a regulated market of any EU member state, (b) EU credit institutions, (c) EU insurance companies, or (d) entities designated by a EU member state as public interest entities.

³ Meaning undertakings which on their balance sheet dates meet or exceed two out of the following three criteria: (a) balance sheet total: EUR 20 million, (b) net turnover: EUR 40 million, and (c) average employees during the financial year: 250.

⁴ See supra n.1.