The Corporate Sustainability Reporting Directive: How did it get there?
Richard Howitt, former Chief Executive of the International Integrated Reporting Council, examines the latest developments of the corporate sustainability reporting directives in the EU and asks “what does this mean for business?”
Eight years ago, as proposer and negotiator for the first ever European Union rules for non-financial reporting by business, I wrote an article called ‘The Non-Financial Reporting Directive (NFRD) – how we got there’.
Yesterday, agreement of a radical update of that Directive was announced, following the fourth round of negotiations between EU Governments and Members of the European Parliament.
The new title is the Corporate Sustainability Reporting Directive and, although I am now advisor, advocate and practitioner rather than legislator, let us ask: how did it get there?
The original NFRD had been a deliberate ‘light touch’, with a scope starting at 5,000 companies extending to 11,000, more than 90% of whom had not undertaken sustainability reporting before.
What subsequently happened was that company fears about cost or administrative burden were dispelled, with one Eurobarometer survey showing that business supported the Directive as the most popular element amongst European Commission actions on what was called corporate social responsibility and became primarily known as sustainable development.
Not simply were business attitudes changing, but investors who had largely dismissed environmental, social and governance issues (ESG) as irrelevant or unreliable, began to demand change. Spurred on by the Task Force for Climate-related Financial Disclosure and Europe’s own requirements for investor obligations in sustainable finance, investors increasingly began to demand ESG disclosure from business which is standardised, consistent and comparable.
However, although companies were learning quickly about sustainability, successive research studies including those undertaken by the Alliance for Corporate Transparency, showed that too many of more than 1,000 company reports assessed were good on policy, but fell short on measuring and assessing outcomes. The European Commission’s own ‘fitness check’ on corporate reporting showed there was appetite for greater specificity in reporting obligations, in particular to meet stakeholder needs.
Meanwhile, there was growing realisation that the urgency of sustainability challenges meant significant change was needed, to a Directive which had been passed before either the Paris Climate Agreement or the UN Sustainable Development Goals were agreed. Business leaders instead of resisting regulation in this area, were suddenly making bold statements about a shift from shareholder to stakeholder capitalism.
The atmosphere between negotiating the two different Directives could not have been more different.
Crucially the new European Commission appointed in 2019, made the EU Green Deal one of its prime objectives, had agreed the Sustainable Finance Disclosure Directive aimed at investors and saw (what became) rules for corporate sustainability reporting as a key part of what was necessary both for financial markets and for delivering on its social and environmental goals.
A landmark moment came in early 2020, when European Commission Vice-President Valdis Dombrovskis announced his intention to bring forward ‘standards’ for the reporting. It was always argued that legislation is too inflexible to enshrine detailed reporting obligations, which require more frequent review and guidance to be effective. This is how financial reporting standards are set – and so Europe started on a path in which sustainability reporting standards would also follow.
The European Financial Reporting Advisory Group was tasked with bringing forward draft standards, reformed its governance to be able to do so and has worked quickly to already have thirteen different draft sets of standards on topics ranging from climate change to workers in the value chain to anti-corruption. The drafts are out for public consultation until 8 August, with the first set of standards due to be published as soon as November this year.
Debate ensued when the worldwide body responsible for financial reporting standards – the IFRS Foundation – announced its own intention to move towards creating corporate sustainability reporting standards. Whilst discussions towards alignment by the two initiatives progress, the new European Directive will ensure standards which are both mandatory and which represent significant European leadership towards the future global standards themselves.
The draft Directive itself was published in April 2021, proposing that the new European standards be compulsory, extending the scope to all large and listed companies – nearly 50,000 in all – requiring independent audit and introducing digitisation with all the reports to be available through a single access point.
The negotiations between MEPs and EU Governments saw a delay in implementation for companies newly in scope from first reports due in 2024 to one year later; enabling companies to be able to report at Group level but requiring them to detail where subsidiaries perform differently; and the exemption of all non-listed small and medium sized enterprises from any mandatory requirements. At yesterday’s press conference, however, European Commissioner Mairead McGuinness said it was the ‘duty’ of larger companies to help SMEs in their supply chains to comply.
Whilst campaigners are disappointed by some of these compromises, they are urging EU member states to use their discretion to bring in the reporting for all companies affected in 2024 and have welcomed a review clause on SME involvement by 2028.
The Parliament delegation led by Pascal Durand MEP succeeded in ensuring foreign-owned subsidiaries with an annual turnover above €150m in the European market are themselves required to comply, albeit potentially starting as late as 2029; for consistency between the new rules and a forthcoming ‘sister’ directive on environmental and human rights due diligence by business, applying the risk approach to the company’s entire supply chain; and for the introduction of an innovative right for shareholders to demand an independent assessment of the company’s sustainability performance. This last measure could represent a huge boost for shareholder activism across Europe.
Perhaps the most notable achievements in the final text are the requirements for all companies covered to produce climate transition plans which align to the Paris Goals and to reach Net Zero by 2050; the requirement for reporting according to the ‘double materiality’ principle (i.e. the impact of the company on people and planet as well as the impact of external factors on the value of the company); and the obligation for companies to set time-bound sustainability ‘targets’ and report on actual outcomes in achieving them.
By ensuring the information is provided within the company’s management report, covers business model and strategy and requires forward-looking information, the Directive is also a further step towards integrated reporting between financial and non-financial information about the business.
The endgame in the negotiations also saw new provisions introduced to ensure proper resourcing of the standard-setting process and for companies to report on how executive pay is linked to sustainability performance.
The communications from EU legislators about their agreement even go as far as to say the new Directive will mark “the end of greenwash”.
That will remain to be seen.
However, the big differences from eight years ago are that the new Directive is already being broadly welcomed.
The European Commission is insistent that reducing demands from different sources to a standardised approach, mean that the Directive will cut not add cost for business.
With the head-rush towards ESG investment in a world of sustainable finance, the new Directive will help secure access by companies to continuing investment funds.
Most of all, although the welter of detail in the new reporting requirements will presage a period of necessary rapid change at the company level to help prepare for implementation, the new rules will ultimately bring about the greater clarity, consistency and comparability which both businesses and investors have been loudly demanding.
One of my successors in the European Parliament called the previous rules ‘sub-standard’. It is certainly true to say that the more prescriptive approach now being adopted would not have been acceptable in negotiating the first Directive.
However, the new standards should now bring the rules up to standard. They can make a decisive difference in enabling companies to transition to sustainable business models.
It is not simply a question of how we got here, but of where we’re going.