Marlyn Chantre, ESG Policy Analyst at Apex Group, outlines the impact of Europe’s Corporate Sustainability Reporting Directive on private markets investors and portfolio companies.
Despite the continued focus on ESG globally, and the sustainability principles that underpin it, in recent months we have also seen growing pains arising. Particularly in the US, ESG has become a divisive topic of debate in an ever more partisan political landscape. Meanwhile, greenwashing remains a concern and risks undermining trust in ESG claims.
The EU’s Corporate Sustainability Reporting Directive (CSRD) is a concerted attempt by the EU to seize the ESG agenda and require private companies to publish annual reports on the social and environmental risks they face, and how their business activities impact people and planet. Ultimately, this is designed to help investors, consumers and other stakeholders evaluate the sustainability performance of companies, as part of commitments set out by the European Green Deal.
The CSRD is a strong signal from the EU of its confidence in the prominent role that ESG will continue to play and its value in delivering positive change and more responsible business. It also recognises the role of data in achieving this – as it stands, ESG data standards vary widely across geographies and regulatory regimes.
The new rules will ensure that investors and other stakeholders have access to the information they need to assess investment risks arising from climate change and other sustainability issues and support a culture of transparency around the impact of companies on people and the environment. Detractors have argued that the EU is making it more onerous for big international businesses to comply and operate in the EU member states, however, reporting efficiency is expected to be increased, and costs reduced, for companies over the medium to long term as reporting standards are harmonised globally.
So, what requirements does the CSRD introduce? Who falls in scope? How will it impact private markets investors and their portfolio companies? And how can businesses and investors begin to prepare?
Firstly, the CSRD will apply to a wider scope of entities than was previously the case under the Non-Financial Reporting Directive (NFRD) regime. The NFRD reporting rules applied to large and public-interest companies with more than 500 employees; less than 12,000 large companies and entities across the EU fell within its scope. CSRD applies to a broader set of public and private companies, as well as listed SMEs, which will now be required to report – with an estimated 50,000 subject to the regulation.
In addition, the reporting and information requirements are far more detailed than has previously been the case. The directive introduces standardised reporting covering a wide range of metrics including historic data and future risk identification and mitigation. Data points include emissions data, biodiversity impacts, impacts on water as well as social indicators including compensation and diversity.
Alongside this, the CSRD introduces the concept of double materiality. This concept stems from the European Sustainability Reporting Standards (ESRSs). The ESCRs are the specific rules developed by the European Financial Reporting Advisory Group (EFRAG) that underpin the new directive. The double materiality assessment is a key component of the ESRS framework as the outcome determines the material topics that should be included in CSRD reporting. It will require businesses to report on both the environmental and social factors materially impacting their business, and on their businesses’ own material social and environmental impacts.
Exactly how the ESRSs will impact business remain to be seen. While the first set of standards are well understood, including double materiality, a second set of sector-specific standards within the ESRS framework is yet to be finalised. The European Commission is set to adopt the first set standards by 30 June 2023. These standards will be rolled out initially to large listed companies in 2024 with reporting expected in the next fiscal year, followed by other large companies in 2025 (reporting in 2026) and listed SMEs in 2026 (reporting in 2027).
The new regulatory framework will also go further than has previously been the case when it comes to examining business value chains. This concept will be new to many, especially in the private markets. Building sustainable supply chains means looking at the process that turns raw materials into products and ensuring that the process is sustainable and non-exploitative. Firms will need to go a step further and look in a more holistic way at not just ensuring a supply chain is sustainable, but also looking at how it can be proactively improved and where value can be added.
As a result, the CSRD will create far more information points that investors and others may have to report, but conversely will also increase the data available for them to assess before directing their capital towards a particular business. Another key aspect of the CSRD will be that the data which is produced will not only be standardised, but will also be machine readable. This will make it easier to assess, digest and analyse. Third parties – whether data auditors or investors – will be able to apply machine learning tools to quickly evaluate the data that comes out of CSRD reporting, and make better decisions off the back of it.
When does the CSRD go live?
The CSRD actually came into force on 5 January 2023 – but don’t panic! Companies which fall in scope have sufficient time to apply the new rules for the first time in the 2024 financial year, for reports published in 2025. But don’t feel tempted to leave this until the last minute as many companies did prior to the SFDR’s introduction in 2021 – businesses, investors and their portfolio companies should take steps now to ensure they are ready to meet this reporting challenge.
How can businesses prepare?
For businesses, the key thing to do now is prepare the foundations for CSRD compliance. As these new reporting standards will be phased in over a period of years, businesses have plenty of time to identify potential information and processes gaps and to build the necessary infrastructure to capture the data they need to report effectively.
The CSRD represents a significant but not insurmountable challenge for businesses – particularly for private equity firms and their portfolio companies, who may be unaccustomed to collecting and reporting such a broad set of qualitative and quantitative information and data around their ESG risks. First, private markets investors must determine if their business – and those in their portfolio – meet the CSRD’s threshold to fall within scope. This includes EU entities with 250+ employees, net turnover €40m, or €20m in assets and non-EU entities which generate a net turnover of €150m in the EU and have at least one subsidiary or branch in the EU.
Growing investor and regulatory scrutiny – including the introduction of the CSRD – has precipitated a dramatic shift over the last year, from a reliance on unverified, in-house ESG information reporting to the need for independently evaluated and authenticated data collection and analysis. Companies and their investors have realised that taking short cuts when it comes to ESG data reporting will not deliver meaningful outcomes and brings with it regulatory and reputational risks associated with accusations of greenwashing.
In preparing for the CSRD, more investment managers than ever are taking steps to outsource their ESG needs, to those who are experts in the complexities of data collection, with many understanding that ‘marking their own homework’ in this regard, will only invite further scrutiny further down the line.
The CSRD is a signal of intent from the EU, to continue to be a leader not just in terms of developing an approach to ESG reporting that will ensure ESG’s success, but also by playing a proactive role in harmonising ESG reporting standards. While the EU alone can’t deliver that, the CSRD is a step in the right direction. These ambitions are commendable and crucial to giving investors the confidence they need to direct capital flows into ESG compliant investments, and to ensuring a sustainable future.
As more and more businesses seek to comply, both in the EU and across the value chain (after all, globally businesses with branches in, or plans to supply the EU will find it easier to do so if they are compliant with the principles of the directive), and as more technology driven services emerge to make reporting easier, businesses will find that compliance is far more achievable that initially anticipated within the CSRD’s timeline.