Commentary

Countdown to Reform of Sustainability Reporting Obligations in Europe

Filip Gregor, Head of Responsible Companies at Frank Bold, considers recent developments in sustainability reporting, highlighting some key points on the NFRD reform proposals due to be published in March.

The European Union will take major action in 2021 to expand its leading position on sustainable finance, in order to strategically redirect private and public money to sustainable activities. Such realignment of investments will be critical to meet the Union’s 2030 targets agreed in Paris and deliver on the growth strategy set in the European Green Deal that aims to tackle the existential threat to Europe and the world that climate change represents, and achieve zero-net emissions of greenhouse gases by 2050 and decouple economic growth from resource use.

To achieve this, EU Commissioner for Financial Services Mairead McGuinness has been crystal-clear in her public appearances: we need to mobilise at least half a trillion euros per year of additional investments in the EU. She has identified the reform of the EU Non-Financial Reporting Directive (NFRD) as “one of the priorities to strengthen the foundations for sustainable investment”. Without reliable, comparable and meaningful sustainability data from companies, investors and banks will not be able to redirect needed finances towards sustainable investments, while companies themselves will be blind to major business risks and opportunities in the rapidly evolving economy.

The EU Non-Financial Reporting Directive introduced in 2018 obligations for large European companies to disclose information on their sustainability risks and impacts. However, as shown by the Alliance for Corporate Transparency research, the quality and relevance of information is still critically poor, therefore missing the point of such legislation. The newest data for instance reveal that only 16 % of companies explain alignment of their policies with science-based targets and only 6.6% use a below 2°C scenario in their risk assessment.

A reform proposal is expected in March 2021 and plans to develop detailed EU reporting standards are already underway to underpin the legislation and to make it easier for companies to report. Below, we outline ten key issues that will be addressed in the reform. Critically, the reform will extend the scope of the law. Currently, the Directive applies to approximately five thousand companies, which may be extended to an additional range of at least 35,000 large companies, up to 100,000 businesses if high-risk medium-sized companies are included, in EU-27.

Why is reform needed?

The revision of this legislation was included in the Sustainable Finance Action Plan and received overwhelming support from all stakeholders in the public consultation organised by the European Commission last year: 82% of business, investors and civil society organisations called for mandatory reporting obligations and the clarification of the legal framework. Similarly, EFRAG (an advisory body to the EU institutions) was tasked with developing preparatory work for the creation of EU standards, which would represent a landmark step in global standardisation.

Both the European Green Deal and the COVID-19 Recovery Package directly refer to the need for reliable and meaningful sustainability data from companies. Improving corporate transparency on sustainability matters also plays an important role in connecting the sustainable finance agenda (i.e investors need to report on how they integrate sustainability considerations into their strategies from this March) and the upcoming legislative proposal on corporate governance (expected to clarify the obligations of directors with regards to sustainability in 2021).

Similar to financial accounting, sustainability data is becoming essential for effective corporate management of pitfalls and opportunities in a fast-changing world. Customers, investors and banks also start to require such data to evaluate the company’s strategy and long-term viability, and factor them in their business decisions. Governments too need companies to help them deliver the commitments they have made to the Paris and Sustainable Development Goals and many in business have a genuine commitment to doing so. However, various studies show that existing reporting is not compatible with these goals and that lack of integration with financial reports means the information is not sufficiently useful for business decision-making either.

At the same time investors state that current reporting does not meet their needs, while many companies find the landscape confusing and ask for more clarity to be brought by the revision.

Expected key points of reform proposal

The key changes that are expected in the European Commission’s proposal concern the issue of scope and mandatory reporting standards. The current EU NFRD applies to large listed companies, banks and insurers with more than 500 employees, a group that according to various estimations includes between 5000-10000 European companies.  The European Commission has hinted that more companies need to be brought into the fold. 

Increasing calls to solve the issue of data relevance and comparability prompted the EU to propose the creating of mandatory European sustainability reporting standards. This is currently being explored by the Project task force on non-financial reporting standards set up by the European Financial Reporting Advisory Group (EFRAG) upon request of the Commission, and which will publish its final recommendations by the end of this month. The most plausible scenario is that EFRAG will house a multistakeholder expert process that will develop draft standards which will be adopted into law by the European Commission. The standards should be developed on a continuous basis, with the core set of standards to be ready for application together with the adoption of the reformed EU NFRD by the end of 2021.

The 10 most important topics that will likely be addressed are the following.

Expansion of the scope:

  1. Very likely, the NFRD scope will be extended to include all large companies (both those with assets listed on stock exchanges and private); following the example of Denmark, Greece, Spain and Sweden, which have already adopted such an extended scope. This change would increase the number of companies obliged to report to more than 41 000 companies in EU-27 that employ 250 persons and more (for illustration, 0.2% of all EU enterprises)
  2. In addition, there is an ongoing debate on small or medium enterprises that have high impact or high risks, such as energy producers or importers of high-risk commodities, to be included in the scope of the new obligations with reporting requirements being proportionate to their size and impact and thus avoiding a “one size fits all” approach. The European Parliament included a request to the EU Commission to consider this, and investor groups such as EFAMA and IIGCC together with accounting bodies and NGOs published in summer that “Whether companies have a significant impact on the environment and society does not depend on their size or legal status, neither are investments limited to assets listed on stock exchanges” (see joint statement here). With an estimated proportion of 20 – 30 % of companies in high risk sectors, this means an additional 41 000 – 62 000 medium-sized companies in EU-27 falling under the scope. (0.2%-0.3% of all EU enterprises)
  3. Mandatory reporting standards:

  4. Qualitative criteria for disclosure of forward-looking information on identification of risks and setting the targets.
  5. Definition of information needed to understand companies’ climate transition plans, including timeline, intermediary objectives and time horizons, and alignment with the public objectives and science-based targets.
  6. Disclosure requirements concerning human rights and environmental due diligence regarding management of risks and impacts in supply chains. The EU NFRD already requires this type of disclosures, but only 1 out 5 companies do according to independent findings by the Alliance for Corporate Transparency, Corporate Human Rights Benchmark of the World Benchmarking Alliance, and the German government. The due diligence requirements might be supported by additional requirements for high-risk sectors concerning transparency of the supply chain and conditions therein.
  7. Mandatory Key Performance Indicators (KPIs) in the area of climate change (such as greenhouse gas emissions Scope 1, 2 and 3), use of natural resources and biodiversity impacts and pollution, and workforce statistics (composition, wages, collective rights). The list of KPIs is expected to be sector-sensitive.
  8. Other specific topics likely to be included in the reform:

  9. Integration of sustainability reporting within annual reports.
  10. Governance and integration of sustainability in the corporate strategy.
  11. Clarification of the double materiality principle (which refers to both the financial impacts stemming from sustainability topics and corporate impacts on people and the planet).
  12. The specification of mandatory assurance.

The standards in these areas will be required to support the European Commission’s legislative initiative on sustainable corporate governance, which is developed in parallel to the NFRD reform, and which will provide a legal framework for corporate human rights and environmental due diligence (that is, obligation to identify, prevent and mitigate risks of severe environmental and human rights impacts in a company’s value chain), and integration of sustainability in corporate governance practices.

Don’t miss the train

The clarification of corporate sustainability reporting obligations can address major challenges facing companies and investors alike. It can overcome the current confusing reporting landscape, set focus on data that really matters, and ensure easier access to finance for those companies who are leading the way. In the words of Commissioner McGuiness, the reform of the EU NFRD is meant to be a targeted intervention to ensure that “we channel investments into companies that can deliver on our green and sustainable objectives”.

 The full original article was published as a part of Frank Bold’s series of 2021 monthly briefings focusing on sustainability reporting. It can also be accessed on the Alliance for Corporate Transparency website.

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