Wider scope and increased granularity will bring Europe one step closer to effective sustainability reporting.
Comprehensive reporting by corporates on environmental and social impacts is vital to institutional investors looking to monitor ESG-related investment risks and opportunities.
That’s why the number of recorded regulations around non-financial reporting grew by 72% between 2013 and 2018, according to a global insights report by software firm Datamaran.
In Europe, asset owners’ need for better information about the ESG characteristics of investment solutions marketed by asset managers is recognised in the Sustainable Finance Disclosure Directive (SFDR) and the EU Taxonomy. The former came into force this year and the latter will be implemented from 2022.
Directive 2014/95/EU, better known as the Non-Financial Reporting Directive (NFRD), is an existing framework that has the potential to make life a lot easier for asset managers and owners. It was first introduced by the European Commission (EC) to all EU member states in 2014, officially coming into effect from 2018.
It currently requires large Public-Interest Entities (PIEs) with more than 500 employees and a net turnover of more than €40 million to include a non-financial statement in their financial reports. This includes large companies with securities listed in EU-regulated markets, large banks, large insurance companies and even large asset management firms.
In the statement, companies are asked to outline impact, development and overall performance relating to the following non-financial issues: environment, human rights, diversity on boards, anti-corruption and bribery, and social and employee aspects. But compliance is only required on a ‘comply or explain’ basis, meaning companies must explain why they have not disclosed against a category if they fail to do so.
Responding to calls for more clarity on climate-related information, the EC published additional guidance in June 2019. This turned up the heat on climate-related reporting, going further than NFRD guidelines for other non-financial issues.
However, disclosing information beyond NFRD’s original guidelines is not yet a legal requirement, which starves asset owners and managers of the ESG-related information needed for effective investment decision-making, and compliance with incoming sustainability regulations.
Investors hope that making NFRD mandatory will force a drastic improvement on the low numbers that comply on a voluntary basis.
In a 2019 survey of 1,000 qualifying European companies, only 23% reported on the determination of salient human rights issues, with less than 4% providing examples of effective management of these issues, according to an assessment by the Alliance for Corporate Transparency.
The updated NFRD is expected to be issued by April 21 2021, followed by a launch conference on May 6.
Reporting under review
The EC pledged that the updated NFRD will help to simplify the complex reporting landscape, streamlining their focus on specific ESG-related data.
The first consultation ran in Q1 2020, allowing stakeholders to provide their views on three key areas: Should the NFRD maintain its non-binding guidelines to assist companies when reporting under it? Should the EC consider endorsing an existing voluntary non-financial reporting standard, or develop one specific to NFRD? Should the EC revise and strengthen the existing provisions of the NFRD?
A second consultation ending in June 2020 more specifically asked whether NFRD criteria needed to be broadened to include other non-financial issues that would provide asset managers with the information they need to comply with new disclosure obligations under SFDR and the Taxonomy.
Feedback unsurprisingly reflected that a lot has changed since 2014, with the NFRD no longer meeting the demands of ESG-conscious institutional investors.
The number of corporates that fall under NFRD is currently too small, numbering around 5,000, says Dominik Hatiar, Regulatory Policy Advisor for the European Fund and Asset Management Association (EFAMA).
“NFRD doesn’t cover large companies that aren’t established in the EU but are listed in EU-regulated markets, for example,” he points out, let alone large non-listed or listed companies with less than 500 employees. Just because it’s a smaller company, that doesn’t mean it doesn’t have a big impact on society or the environment, after all.
A logical improvement would be to match the size criteria laid out in the EU’s Accounting Directive, which “applies to corporates with a 250-employee threshold rather than 500”, says Elise Attal, Head of EU and UK Policy at the Principles for Responsible Investment (PRI).
If NFRD’s scope is extended to this new threshold, the number of corporates under scope would rise up to around 41,000. This massive escalation would likely have a huge impact on the EU’s progress in its sustainable action plan, while giving investors, and even governments, more visibility of ESG-related performance.
Upgrading disclosure quality
As well as wanting more firms to report under the revised NFRD, many are keen for improvements to be made to the quality and quantity of information provided by companies. Overall, it is currently “deficient in terms of comparability, reliability and relevance”, says Maria van der Heide, Head of EU Policy at non-profit organisation ShareAction.
For example, 2020 research by the Alliance for Corporate Transparency highlighted that 19.8% of assessed companies weren’t publishing any of their environmental and social KPIs, despite it being an NFRD requirement.
Van der Heide says companies’ non-compliance with NFRD is largely because the directive “fails to define which specific information and KPIs companies must disclose, nor the specific matters they should address”.
These firms are under considerable pressure to provide non-financial information on social and environmental issues from sustainability rating agencies, data providers and investors, too. Having clear and easily appliable KPIs in place will enable corporates to improve their disclosures for all interested parties.
However, the updated NFRD is expected to introduce mandatory KPIs specifically for climate change reporting, meaning that companies must disclose relevant information that details how they are mitigating climate risks and recognising opportunities. This will allow investors to better hold corporates accountable as they try to decarbonise their own portfolios.
It’s anticipated that the updated NFRD will flesh out the information corporates need to provide for all the directive’s original objectives as well, including plans to diversify their board, intermediary objectives for employee benefits and level of alignment with public objectives.
“By strengthening requirements for disclosure, the NFRD has the potential to increase corporate accountability and provide investors and other stakeholders with comparable and decision-useful information,” says Peter Paul van de Wijs, Chief External Affairs Officer for the Global Reporting Initiative (GRI).
Aspects of the existing NFRD should be “explicitly retained” and enhanced, such as its focus on ‘double materiality’, the non-profit Sustainability Accounting Standards Board (SASB) emphasised in its feedback to the second consultation.
Double materiality means that companies should not only disclose how sustainability issues may impact them, but also how companies affect wider society and the environment.
It’s a useful concept in the context of sustainable business practices, the non-profit highlighted, explaining that issues that are material solely from a social or environmental impact perspective can also become “financially material over time”.
“[Double materiality] effectively captures the important interactions between businesses, the markets they serve and the world in which it operates, and it enables meaningful accountability to a broad range of stakeholders,” SASB said.
Van de Wijs agrees, adding that double materiality is a “significant” part of addressing the impact companies have on people, the economy and the wider world.
Aligning with other EU legislation
Scope for confusion remains when taking other EU legislative reporting requirements into account, and attempting to understand how these co-exist with NFRD, according to an Implementation Appraisal report published by the European Parliamentary Research Services (EPRS) in January 2021.
“The effectiveness of SFDR and Taxonomy disclosures is dependent on high quality and open-access company reporting,” Hatiar says.
Asset managers will struggle to meet the demands of SFDR or the Taxonomy if NFRD-aligned disclosures aren’t comprehensive and comparable. It would be “like building a house without solid foundations”, he points out.
SFDR Level 1 came into force on March 10, asking asset managers to do a preliminary sorting of their ESG funds and other investment products into three progressively greener categories. Level 2 (expected to commence from Q1 2022) will ask asset managers to provide more detail justifying why funds have been sorted into each category.
There’s a clear crossover between SFDR and NFRD: both require participants to disclose the environmental and social impacts introduced by social and employee matters, respect for human rights, and anti-corruption and bribery matters, explains Attal.
“The NFRD has the concept of adverse impacts already embedded in the current version,” she says, which links specifically to the principle adverse impacts (PAIs) asset managers will have to address within their SFDR-compliant PAI statements from 2022.
Theoretically, NFRD-aligned statements should be an efficient way for asset managers to access relevant information on each large company within their funds.
They should be able to clearly identify how ‘green’ the individual company is and how it impacts the overall shade of green the fund can be marketed as according to SFDR requirements.
The Article 8 mandate
NFRD also applies to Article 8 of the Taxonomy Regulation, a mandate requiring organisations falling under NFRD to include information in their non-financial statements on the extent to which their activities are “associated with” environmentally sustainable activities.
Many have called for further clarification as to how corporates should interpret their level of “association” with environmentally sustainable activities.
In response, the European Securities and Markets Authority (ESMA) published its recommendations outlining how and to what extent the activities of businesses that fall within the scope of NFRD qualify as environmentally sustainable under the Taxonomy Regulation.
When Article 8 comes into force with the rest of the Taxonomy next year, corporates that fall under NFRD will be required to attach a Taxonomy-focused caveat to their non-financial statement. Feedback in the consultation process highlighted that corporates won’t be able to provide the detail necessary in this area until NFRD reporting requirements are clarified.
If the NFRD’s scope is expanded, and a wider variety of corporates are then expected the comply, they will also need to be aware of the information they need to align with Article 8, says Hugo Gallagher, Account Manager at investor relations firm Hume Brophy.
“This will be all the more challenging for companies that are embedded along an extensive supply chain or that rely on supplies from outside the EU. Getting a clear picture of their environmental and social impacts will require the allocation of substantial resources with operational and compliance costs rising accordingly,” Gallagher warns.
Plugging data gaps
Non-financial sustainability reporting won’t work effectively unless the ever-prevalent issues surrounding ESG data quality are addressed, experts say.
At present, companies still have considerable latitude in how they arrive at the information they provide under NFRD, and the revisions to the directive won’t change that. This is part of the wider problem investors and their service providers are having to contend with when attempting to collate and measure ESG-related corporate performance.
“Currently, the lack of quality data on how companies perform against sustainability metrics stands out as a fundamental challenge to leveraging private capital addressing the EGD funding gap,” Hatiar explains.
To be most effective, ESG data needs to be “forward-looking and science-based in order for shareholders to best assess how corporate management is addressing sustainability issues,” van der Heide agrees.
Policymakers are putting in the work to plug those gaps.
Hatiar points to the efforts of the European Financial Reporting Advisory Group (EFRAG), which is leading preparatory work on the world’s first public standards for sustainability reporting. Part of its focus will be on improving the standardisation and quality of ESG data, which Hatiar notes could be a “game-changer unleashing the impact of the EU’s sustainable finance regime”.
There’s also the European Single Access Point (ESAP) to consider, which aims to enhance data accessibility and credibility and address the fact that, right now, EU law “rarely prescribes specific dissemination channels”, despite the fact the collection and dissemination of data is highly “fragmented”.
ESAP is the first step in the EC’s wider action plan on the capital markets union (CMU).
“[ESAP] will help investors identify ESG risks and opportunities, understand sustainability performance in the context of social and environmental goals, and implement SFDR obligations,” Attal says.
“That said, its value for investors will also depend on whether the information reported meets their individual needs,” she adds.