The European Union’s Corporate Sustainability Reporting Directive (CSRD) has gained significant attention since its enactment in January, especially as interest around environmental, social, and governance (ESG) issues continues to grow.
While the CSRD is primarily set to affect E.U.-based companies (plus the European Economic Area countries of Norway, Iceland, and Liechtenstein), non-E.U. companies with significant operation within the E.U. will also be subject to the regulation. Both double materiality and Scope 3 will need to be incorporated into reporting to meet the new directive, which also contains more stringent rules on corporate social and environmental disclosure.
What is new?
The CSRD builds upon previous regulations such as the E.U.’s Non-financial Reporting Directive (NFRD) and increases the depth and breadth of organizations that are impacted. Some of what is in the CSRD includes:
- New regulations mandate reporting from companies of all sizes — According to the official CSRD guidelines, approximately 50,000 large, medium, and small-sized companies in the E.U. will need to apply the CSRD rules starting between 2024 and 2029. Indeed, large companies or large groups with consolidate subsidiaries must meet two of these three criteria — €40 million in net turnover, €20 million in assets, or 250 or more employees. International companies with subsidiaries located in the E.U. will need to abide by the CSRD if they conduct significant operations there.
- Impact on society and climate is part of CSRD — A double materiality approach, which requires businesses to disclose climate change related risks as well as the impacts that such risks have on society and climate, will be required by the CSRD, which signals a new approach to unaccustomed U.S. and international companies.
- The supply chain information mandate is here — The CSRD requires Scope 3 reporting, which includes the collection of sustainability information across a company’s value chain or supply chain. Many U.S. companies have only been reporting their Scope 1 and 2 emissions, if any. Target dates for reporting requirements vary, and reporting exemptions exist as well.
- Third-party verification for assurance is required — Verification by an independent assurance service provider (g., a third-party audit) will assess the processes that a company has in place for gathering data. This, along with the need to digitalize data, will ultimately require companies to invest in technology to ensure reliable data-gathering processes and a reliable data trail. This is consistent for both the E.U. and non-E.U. parent scoping. At first, limited assurance is sufficient, but the European Commission intends to move to reasonable assurance in the future.
Digitization requirements & costs
Reporting in compliance with the CSRD will incorporate the increasing demand for digitization. Companies will be required to prepare their reporting in XHTML format in accordance with the European Single Electronic Format Regulation. Companies are also required to tag sustainability information within the report according to a digital categorization system, which should be developed with the European Sustainability Reporting Standards (ESRS).
Digitalization in sustainability reporting makes information transfer more efficient and easier to locate. It also promotes transparency and accountability and carries potential significant cost savings for companies. Digitization also allows greater accessibility of data for investors and key stakeholders.
The immediate downside to digitization is the cost factor. While the CSRD requirements will likely lead to higher costs in the short term, the E.C. notes that companies will likely face an increase in costs anyway due to the growing demand for sustainability information. At the same time, the short-term costs are likely to be negated with the goal to incorporate and harmonize reporting requirements in the medium- to long-term timeframe.
Another challenge that remains is the multiple overlapping frameworks and standards already in place, although efforts to align them are evolving. The ESRS need to be consistent with the ambition of the European Green Deal as well as with the E.U.’s current legal frameworks, the Sustainable Finance Disclosure Regulation (SFDR) and the E.U. Taxonomy.
Through the European Financial Reporting Advisory Group, the CSRD has incorporated key elements of the ESRS, which draws upon several existing frameworks including the Global Reporting Initiative (GRI) and the International Sustainability Standards Board-driven (ISSB) Taskforce for Climate related Financial Disclosures (TCFD) framework. In fact, the E.C. supports TCFD to develop the global baseline, and collaboration between GRI and ISSB continues to evolve.
Recommended actions to take now
With the E.U. and CSRD leading the way with the most stringent reporting regulations thus far, international companies need to prepare themselves for the future of reporting in their jurisdictions. For industry professionals facing the challenge of the sustainability regulatory environment, the following actions are recommended:
- Get familiar with CSRD regulations — Expanding the rigor of ESG reporting with the CSRD is a key first step. Studying the CSRD and implementing similar reporting standards, such as Scope 3 and double materiality, can give companies a head-start in their reporting journey. In fact, stakeholders and investors are likely to look favorably on the increased transparency and preparedness of the company for upcoming regulation, such as the Security Exchange Commission’s rules on Scope 3.
- Benchmark with peers — Understanding how peer companies are engaging with Scope 3 emissions and how they approach sustainability reporting are a necessary action to stay up to date on where your organization stands against competitors. U.S. companies unaffected can use the CSRD regulation to analyze how their E.U. competitors are reporting to give them valuable insight for when the requirements from the SEC are updated.
Over the next five years, new regulations around ESG will continue to increase, while deadlines come due for implementation of existing regulations. At the same time, companies in the short term will experience headaches around increased costs and complexity around global frameworks and standards.
What is clear, however, is that ESG reporting requirements are more stringent than ever, and companies need to prepare themselves to meet these new requirements.