The EU's comprehensive sustainability disclosure and reporting rules will carry a heavy impact on those companies in the region or doing business there
Target dates for new regulatory reporting requirements around environmental, social & governance (ESG) issues for companies based in the European Union and with significant business interests within the E.U. are fast approaching.
The challenge is understanding the impact across a number of inter-related regulations with the E.U.’s Corporate Sustainability Reporting Directive (CSRD) at the center. Clearly, now is the time for companies to pay attention to and understand the impact of these regulations.
To shed more light on this situation, ESG regulatory experts Paul Davies, Global Co-Chair of Latham & Watkin’s ESG Practice; and Annabel Hauck, Senior Specialist Legal Editor, focusing on ESG for Thomson Reuters Practical Law spoke with us to cut through the complexity of these regulations.
The basics of CSRD and ESRS
A number of the key regulations are part of the E.U. Green Deal, an overarching policy framework that includes a goal (that has been legally enshrined) to reach net zero in the region by 2050. Among the current and proposed legislative initiatives that companies will have to be aware of are the CSRD and its underlying European Sustainability Reporting Standards (ESRS), alongside a range of other rules that will have varying impacts depending on a company’s business model, according to Davies.
The CSRD amends and expands the previous reporting regulation, the Non-Financial Reporting Directive (NFRD), which introduced certain high-level reporting requirements for a relatively small number of mostly large-listed companies. The CSRD expands the number of companies that will be required to report, and also, through the ESRS, will require reporting on a far greater range of topics in more granular detail. The date-based reporting requirements of this legislation include:
- The first companies to report under CSRD will be those already required to report under NFRD, with reporting requirements beginning for financial years commencing on or after January 1, 2024, with first reports likely to be issued in 2025.
- Next, large E.U. companies and parent companies of large E.U. groups not previously subject to NFRD, with reporting requirements beginning with financial years commencing on or after January 1, 2025, with first reports likely to be issued in 2026.
- Listed small and midsize enterprises (SMEs) will have to report for financial years commencing January 1, 2026, with first reports likely issued in 2027. Global group reporting requirements for those companies headquartered outside the E.U. that are within scope will have to report for 2028, with first reports likely to be issued in 2029.
Non-E.U. companies with securities trading on regulated E.U. markets may also be caught by earlier reporting requirements.
The CSRD requires in-scope companies to report on sustainability matters (defined as environmental, social, and human rights), and governance factors. In most instances the obligation to disclose will turn on whether the sustainability matter is material to the business. Companies must include a dedicated section in their management report that sets out the information necessary to understand both the company’s impacts on sustainability matters and how sustainability matters affect the company’s development, performance, and position.
The ESRS are the detailed underlying reporting standards that flesh out exactly what companies subject to the CSRD must report. The European Commission has now adopted the first set of ESRS (which need to be accepted by the European Parliament and Council). These consist of:
- ESRS 1, which sets out general principles on sustainability reporting;
- ESRS 2, which sets out general sustainability disclosures for all entities, and those not subject to a materiality assessment are required to be reported; and
- 10 topical standards (5 environmental, 4 social, and 1 governance standard) that are subject to a materiality assessment.
The cross-cutting standards (ESRS 1 and ESRS 2) set out general provisions applying to sustainability reporting and sustainability disclosure requirements that include: i) how an entity complies with the ESRS; ii) the way in which sustainability is embedded in an entity’s business strategy and business model(s); and iii) how an entity identifies and manages its principal sustainability impacts, risks, and opportunities.
The topical standards on the other hand set out disclosure requirements relating to specific sustainability impacts, risks, and opportunities that may be material for all undertakings, regardless of the sectors in which the company operates.
The role of materiality
One of the hallmarks of CSRD and ESRS is the concept of double materiality. Indeed, it is different from approaches being taken elsewhere, in which the focus is limited to the impact of sustainability matters on the undertaking’s balance sheet, which is known as single materiality, according to Hauck.
The International Sustainability Standards Board, which builds upon and consolidates efforts by the Task Force for Climate-related Financial Disclosures among others, has adopted financial materiality as the basis of its global baseline sustainability disclosure standards that have been developed and which may in the future be adopted in a number of jurisdictions, including the United Kingdom.
Therefore, companies subject to CSRD need to ensure that they have a robust financial and impact materiality assessment in place to ensure the disclosure of all sustainability information necessary to meet the objectives and requirements. To underline the importance of climate change as a core issue that most businesses need to address, Hauck points out that ESRS E1 requires a specific, detailed explanation from companies that seek to not disclose on the basis that they do not see climate issues as material to their business. In addition, required compliance with some standards is to be phased in over a period of one to two years, mainly for companies with fewer than 750 employees (largely due to challenges involved in sourcing data from supply chains).
Guidance for in-house lawyers
Reporting obligations under CSRD will require in-scope companies to collect significant amounts of ESG-related data from their operations. For many companies, specific reporting requirements will include the mandatory publication of data that may not, at present, be recorded internally.
As such, Davies recommends that companies that are active in the E.U. or subject to CSRD ensure that they are monitoring the development of these regulations, including being in regular contact with their legal advisors and being proactive in determining whether such regulations apply and (if so) how they apply to their businesses.
Hauck advises some basic work should be done to determine the impact of these regulations. First, plan ahead because gathering the data is a time-consuming process. Next, conduct a gap analysis to understand the scope of current reporting compared to what will be asked for under the new requirements. Make sure the board of directors understands its obligations and the business has the necessary expertise to comply; in fact, a working group provides a great vehicle for building a strategy with defined and ambitious goals that is backed up by robust policies and processes.