Corporate Sustainability: EU to Expand ESG-Related Reporting Obligations
Corporate Sustainability: EU to Expand ESG-Related Reporting Obligations
On November 28, 2022, the European Council gave its final approval to a new Corporate Sustainability Reporting Directive (CSRD). Once transposed into the laws of the EU members states, the new set of rules will replace the existing non-financial reporting obligations of the 2014 Non-Financial Reporting Directive (NFRD). The new rules will have an enormous impact on business and the way it is reported. The number and clusters of in-scope companies will increase dramatically not only within the European Union, as the CSRD will also significantly affect non-European companies.
The CSRD is part of a broad policy push by European lawmakers aimed at making corporates take responsibility for ESG-related impacts of their business activities and at helping ESG-minded investors and other stakeholders make educated decisions. According to the European parliament, the CSRD is meant to serve to end so-called greenwashing and lay the groundwork for sustainability reporting standards at a global level.
To highlight a few selected aspects:
In comparison with the NFRD, the scope of the non-financial reporting items remains virtually unchanged under the CSRD. Sustainability matters subject to reporting obligations encompass environmental, social and human rights, as well as governance factors including employee matters, anti‐corruption and anti‐bribery matters (Amendments to Directive 2013/34/EU No. 2 (b): new Article 2 point 17; “Sustainability Matters”).
However, the scope of application and the level of detail and focus of reporting change significantly.
First, all large undertakings that meet at least two of the following three criteria (Article 3 point 7 Directive 2013/34/EU; such companies “Large Companies”)
have to comply with the new reporting obligations—regardless of a stock market listing on an EU‑regulated market.
Second, all smaller enterprises are encompassed by the new reporting obligations provided that their securities are admitted to trading on a regulated market in the European Union and that they are not considered micro enterprises, meaning that they meet at least two of the following criteria (Article 3 point 1 Directive 2013/34/EU; such companies “Listed SMEs”)
Third, sustainability information concerning non-European companies, which have generated net turnover of at least EUR 150 million in the EU in the last two consecutive years, will have to be published by their EU subsidiaries, or if no EU subsidiary exists, by their EU branches provided that (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 1)
With regard to Third-Country Subsidiaries, this obligation relates to the sustainability information at the group level of the ultimate parent undertaking of the Third-Country Subsidiary (“Ultimate Parent Company”) (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 1). Regarding Third-Country Branches, this obligation relates to either (1) the sustainability information at the individual level of the non-European owner of the Third-Country Branch or (2), if the owner is held by a non-European undertaking, to the relevant sustainability information at the group level (both entities a “Branch Owner”) (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 1).
It is estimated that, as a result of the expansion of the scope of application, the number of companies subject to non-financial reporting obligations will increase from 11,700 to 49,000.
All Large Companies and Listed SMEs are required to report both on (1) how their business model impacts Sustainability Matters (“inside-out perspective”) and (2) how Sustainability Matters influence their undertaking’s development, performance and position (“outside-in perspective”; together double materiality) (Amendments to Directive 2013/34/EU No. 4: new Article 19a point 1).
This information must be presented in a dedicated section of the management report (Amendments to Directive 2013/34/EU No. 4: new Article 19a point 1) and must cover, among others, the following aspects with regards to both the company’s own operations and its value chains (Amendments to Directive 2013/34/EU No. 4: new Article 19a points 2 and 3):
If this information is not available for its value chain the effected company must explain the efforts made to obtain such information, the reasons why the necessary information could not be obtained and how it plans to obtain the relevant information in the future (Amendments to Directive 2013/34/EU No. 4: new Article 19a point 3).
The Directive allows Listed SMEs to choose to submit a less detailed sustainability report limited to more general information (Amendments to Directive 2013/34/EU No. 4: new Article 19a point 6) including
In this case, the relevant small and medium-sized company has to report in accordance with sustainability reporting standards dedicated to small and medium-sized companies.
In addition, during a transitional period for the financial years before January 1, 2028, Listed SMEs can choose to opt-out of the new reporting obligations (Amendments to Directive 2013/34/EU No. 4: new Article 19a point 7). However, they must state in their management reports why the sustainability report was not provided.
With regards to non-European companies, the sustainability information to be included in sustainability reports of their Third-Country Subsidiaries and Third-Country Branches is less extensive than the sustainability information to be published by European companies. The CSRD specifies selected items to be covered in such reports (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 1). Third-Country Subsidiaries and Third-Country Branches are responsible for requesting the relevant information from the Ultimate Parent Company, and Branch Owner, respectively. If they cannot obtain all relevant information their reporting has to include all information in their possession, as well as a statement that the non-European company did not make available the necessary information (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 1). Sustainability reports relating to non-European companies must generally be accompanied by an assurance opinion by a firm authorized to do so under the national law of the relevant non-European company or under the law of a EU member state unless the Ultimate Parent Company or Branch Owner does not provide the necessary assurance opinion and the Third‑Country Subsidiary or Third-Country Branch discloses this in a statement (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 3). The Commission will publish a list of non‑European companies that comply with the obligations under the new directive (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 4). The CSRD makes Third-Country Branches and members of the administrative, management, and supervisory bodies of Third-Country Subsidiaries responsible for ensuring that, to the best of their knowledge and ability, the reporting on the Branch Owner, and the Ultimate Parent Company, respectively, is made in accordance with the provisions of the new directive (Amendments to Directive 2013/34/EU No. 14: new Article 40c).
Companies are exempted from the reporting obligations if they are part of a group and included in the consolidated management report of their parent undertaking, provided that the management report is drawn up in compliance with the CSRD (Amendments to Directive 2013/34/EU No. 7: new Article 29a no. 8). If the parent undertaking is a non-European company, this only applies if the consolidated management report is deemed to be equivalent to the sustainability reporting standards under the CSRD (Amendments to Directive 2013/34/EU No. 7: new Article 29a no. 8).
Under the CSRD, the European Commission will adopt delegated acts containing sustainability reporting standards, which will specify the information companies are required to report in accordance with the new reporting obligations. The first set of standards is due by June 30, 2023 with more detailed standards to follow by June 30, 2024 (Amendments to Directive 2013/34/EU No. 8: new Article 29b point 1).
When adopting such delegated acts, the Commission will take account and take consideration of the technical advice developed by the European Financial Reporting Advisory Group (EFRAG) and consult, on a yearly basis, the European Parliament and jointly the Member State Expert Group on Sustainable Finance (Amendments to Directive 2013/34/EU No. 8: new Article 29b point 1). EFRAG has already delivered its first set of draft European Sustainability Reporting Standards to the European Commission in November 2022. Once the European Commission has consulted with EU bodies and Member States it will adopt the final standards as delegated acts in June 2023, after which the European Parliament and Council will be granted a scrutiny period.
By June 30, 2024, the Commission will adopt dedicated sustainability reporting standards for both Listed SMEs (Amendments to Directive 2013/34/EU No. 8: new Article 29c point 1) and non‑European companies (Amendments to Directive 2013/34/EU No. 14: new Article 40b). Third‑Country Subsidiaries and Third-Country Branches may choose not to follow those standards when reporting on their Ultimate Parent Company or Branch Owner as long as they draw up their sustainability reports in accordance with either the reporting standards mandatory for Large Companies or reporting standards deemed to be equivalent to those standards as determined by implementing acts to be adopted by the EU Commission (Amendments to Directive 2013/34/EU No. 14: new Article 40a point 2).
Companies will have to ensure adequate auditing of their sustainability reporting. The CSRD requires auditors to express an opinion based on a limited assurance engagement regarding compliance of individual sustainability reporting with the requirements of the CSRD, as well as regarding compliance with the sustainability reporting standards to be adopted by the Commission (Amendments to Directive 2013/34/EU No. 13: new point (aa) in Article 34 paragraph 1, subparagraph 2). The new directive does not require the auditor giving the aforementioned opinion to be identical with the auditor of the financial statements (Amendments to Directive 2013/34/EU No. 13: new paragraph 3 in Article 34). Rather, independent assurance services providers can be allowed to render this opinion (Amendments to Directive 2013/34/EU No. 13: new paragraph 4 in Article 34).
Members states have to ensure that their laws contain effective, proportionate and dissuasive penalties for infringements of the obligations set out in the CSRD (Article 51 Directive 2013/34/EU).
It is to be expected that potential penalties will at least be as strict as those already applicable under the NFRD regime. For example, German law provides for criminal liability if members of the management board and/or supervisory board incorrectly render or obfuscate the circumstances of their company in the non-financial statement required by NFRD (section 331 paragraph 1 no. 1 and No. 2 German Commercial Code, HGB). In addition, members of these boards face liability under the German Act on Administrative Offense Proceedings, OWIG, if they act in contravention of the non-financial reporting obligations established by NFRD when drawing up the non-financial statement report (section 334 paragraph 1 no. 3 und 4 HGB).
Once the CSRD is signed by the Presidents of the EU Parliament and Council, it will be published in the Official Journal of the European Union. 20 days later, it will officially come into effect, giving EU member states 18 months to implement the new rules.
Thereafter, the obligations imposed by the CSRD will take effect in four stages:
Scope and depth of the CSRD sustainability reporting obligations present companies, their executive and non-executive directors, and also legal departments, with a whole new set of ESG‑related risks. To address these challenges, the following should be ensured:
It will be the board’s obligation not only to ensure CSRD-compliant reporting, but also to establish an adequate system capable of identifying, managing, and mitigating the aforementioned risks arising from the CSRD.