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EU fails to set mandatory requirements for ESRS

© Shutterstock / lazyllamaEU flag flying against a sunny sky.
EU flag flying against a sunny sky.

The European Commission has signed the European Sustainability Reporting Standards (ESRS) into law but, despite investor pressure to standardise mandatory reporting, has chosen to move away from core sustainability disclosures as mandatory.

  • The European Commission has published the final versions of ESRS but increased the number of voluntary data points to keep costs down.
  • While managing the cost and impact of increased reporting is important, the refusal to create a coherent framework for mandatory reporting will slow the net zero transition.
  • Investors must rely on corporate reporting for their own performance reporting, so there will be a negative impact on investor behaviour as well.

There is concern within the European investment community that the versions of the ESRS signed into law fail to provide the standardised framework necessary for investors to really understand the risks facing their investment assets.

Aleksandra Palinska, executive director of the European Sustainable Investment Forum (Eurosif)  said: “The first set of the European Sustainability Reporting Standards, as published by the European Commission on 9 June, fails to address investors’ needs and risks undermining the effective implementation of the EU sustainable finance regulatory framework.

“The European Commission is now presented with a final opportunity to correct its course and find a compromise that would truly reflect all industry and stakeholders’ needs and better match the ambition of EU climate neutrality targets and the EU Green Deal”.

What are the ESRS?

EU law now requires all large companies and all listed companies (except listed micro-enterprises) to disclose information on what they see as the risks and opportunities arising from social and environmental issues, and on the impact of their activities on people and the environment. This is part of an attempt to drive transparency in corporate reporting, highlighting risk and help realign capital investment towards a nature positive, net zero future. Its implementation is part of the overall European Green Deal.

In line with the Corporate Sustainability Reporting Directive (CSRD), which outlines the obligation for companies to use standards to fulfil their legal sustainability reporting obligations, the Commission is adopting common standards which will help companies to communicate and manage their sustainability performance more efficiently and therefore to have better access to sustainable finance.

The ESRS will be mandatory for use by companies that are obliged by the Accounting Directive to report certain sustainability information. By requiring the use of common standards, the Accounting Directive, as amended by the CSRD in 2022, aims to ensure that companies across the EU report comparable and reliable sustainability information.

Common standards are expected to help companies to reduce reporting costs in the medium and long term, by avoiding the use of multiple voluntary standards as this is the case today. Currently, problems in the quality of sustainability reporting create an accountability gap. High-quality and reliable public reporting by companies will help create a culture of greater public accountability.

What did the EU change from EFRAG’s recommendations?

According to a statement from the Commission, a number of modifications to the draft standards were submitted by EFRAG. It said: “These modifications ensure that the standards are proportionate, without undermining the achievement of the policy objectives. The modifications fall into three main categories: phasing-in certain reporting requirements; giving companies more flexibility to decide exactly what information is relevant (“material”) in their circumstances; and making some of the proposed requirements voluntary.”

Changes included an increase number of phase-in opportunities for companies with under 750 employees; more specifically on biodiversity and social issues, as they are considered more challenging.

The new standards also give companies more flexibility to decide exactly what information is relevant in their particular circumstances. EFRAG recommended that  the majority of the standards would be subject to materiality assessment, but nevertheless proposed that the following be mandatory for all companies:

  • the cross-cutting standard ESRS 2 (“General Disclosures”), which specifies essential information to be disclosed irrespective of which sustainability matter is being considered;
  • the climate standard;
  • some reporting requirements about the company’s own workforce;
  • and datapoints that correspond to information required by financial market participants, benchmark administrators and financial institutions for their own reporting purposes respectively under the Sustainable Finance Disclosure Regulation (SFDR), the Benchmarks Regulation (BMR) or the “pillar 3” disclosure requirements under the Capital Requirements Regulation (CRR).

The Commission decided that all the reporting requirements should be subject to materiality, with the exception of ESRS 2. That means that if the company decides that the information is not ‘material’ it does not have to disclose it.

And that’s where the real challenge lies. If there is no mandatory requirement for companies to report on particular issues, then they may well decide that such issues are not material – and there are many differences of opinion on what constitutes materiality. There is a lost opportunity to develop coherence in reporting standards and approaches which is a blow to hopes of a transformation of capital investment.

In fact,  the Commission increased the number of voluntary reporting requirements. The draft standards submitted by EFRAG already included many voluntary datapoints and the Commission further converted a number of the mandatory datapoints proposed by EFRAG into voluntary datapoints. The datapoints concerned are those currently considered most challenging or costly for companies, such as reporting a biodiversity transition plan and certain indicators about self-employed people and agency workers in the undertaking’s own workforce.

Why investors care about the ESRS

Problems in the quality of sustainability reporting have knock-on effects. It means that investors lack a reliable overview of sustainability-related risks to which companies are exposed. Investors increasingly should be made aware about the impact of companies on people and the environment and their plans to reduce such impacts in the future.

That information can help them to meet their own disclosure requirements under the Sustainable Finance Disclosure Regulation (SFDR). More generally, if the market for green investments is to be credible, investors need to know about the sustainability impact of the companies in which they invest. Without such information, money cannot be channelled towards environmentally friendly activities.

What is the concern about the final version of the ESRS?

It is broadly accepted that timely and well implemented European Sustainability Reporting Standards have the potential to play a crucial role in the transition to a sustainable low carbon economy. Improved availability of quality, comparable and reliable corporate sustainability disclosures is essential for investors and other finance providers to make informed investment and financing decisions.

This was emphasised in a joint investor and financial industry statement, co-signed by Eurosif, PRI, IIGCC, EFAMA and UNEP FI as well as 92 companies, investors and other financial market participants need specific ESG metrics to allocate capital in line with EU Climate Law and Green Deal objectives.

Some reporting requirements should be mandatory to create a level playing field

The statement said: “In light of the EU’s climate objectives and investors’ own climate commitments, reporting on GHG emissions, transition plans and climate targets should always be considered material and hence mandatory. This would ensure that investors can access information from their holdings to support the alignment of their portfolios with net-zero and the Paris Agreement targets.”

Interested investors wanted the ESRS to ensure that environmental and social indicators relevant to SFDR, EU Climate Benchmark Regulation and Climate Benchmarks Delegated Acts, Pillar 3 disclosures and other investor reporting regulations are disclosed by in-scope companies on a mandatory basis

Eurosif said in a statement that the success of the European Sustainability Reporting Standards now largely depends on the reporting companies and their advisors, consultants, auditors and assurance providers. Performing robust materiality assessments that truly integrate the double materiality principle is essential. As these concepts are still relatively new, companies and their advisors should be upskilling key staff to ensure a sufficient degree of expertise on sustainability.

SGV take

While companies will have to flag up that they have decided a particular issue is not ‘material’ in their reporting, rather than omitting it altogether, the changes that the Commission has made undercut the transformational nature of the regulation.

What was a once-in-a-lifetime opportunity to create a clear and coherent reporting framework that covered climate, environmental and social issues – as well as financial – there will be continued confusion for investors. That itself will only discourage clarity for climate-aligned investment strategies – which are already being affected by the recent shift of focus back to fossil fuels. Short-term focus has won the battle against awareness of the trade-offs over time, and concerns about the economic impact of climate change have once again been kicked into the long grass.

There is some hope however that the importance of identifying what materiality means will open up a series of important conversations in wider society – and make companies and investors more aware of the risks they really face.

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