The European Commission has published a proposal for a Corporate Sustainability Reporting Directive (2021/0104) (“CSRD”), which forms just one part of a comprehensive package of sustainable finance measures (see our blog here).  The Commission has put forward these measures in response to demand for stronger and wider sustainability reporting standards, over and above what the EU Non-Financial Reporting Directive currently provides.  The CSRD seeks to mandate sustainability reporting and assurance through the amendment of existing EU laws, including the Transparency Directive, the Accounting Directive, and the Audit Directive.  More fundamentally, according to the Commission, it will move the EU one step closer to realizing its aim of having sustainability reporting be “on a par” with financial reporting, in terms of attached weight and importance.  This is reflected in the change of terminology used in the CSRD proposal, from a focus on “non-financial” information reporting, to “sustainability”.
We cover below the background and detail, but in summary, these are the key elements of the CSRD proposal that corporates should be aware of:

  • Scope: The CSRD reporting requirements will apply to all large EU companies and all listed companies, including listed small and medium-sized enterprises (“SMEs”). This is estimated to cover around 49,000 companies.
  • Reporting: The so-called “double materiality” principle remains, but in-scope companies will now have to report according to mandatory sustainability standards. Simpler and “proportionate” standards will apply to listed SMEs.
  • Audit: The CSRD will require, for the first time, a general EU-wide audit (assurance) requirement for sustainability information.
  • Digitization: The sustainability information must be published in companies’ management reports — and not separately reported — and the information will need to be digitized or “tagged” so it can be incorporated into a planned European Single Access Point.
  • Timing: If the proposal is adopted and standards can be agreed in line with current ambitious estimates, large in-scope companies must comply from financial years starting on or after 1 January 2023, publishing reports from 2024; whilst SMEs have to comply from 1 January 2026.

Context: Need for Reform

To reach the EU’s aim of becoming net zero by 2050, the Commission understands that private capital must be directed towards green, sustainable projects, and this requires that investors have access to clear and comprehensive information on their potential investees relating to, among other things, environmental sustainability and corporate governance practices.

Currently, the Non-Financial Reporting Directive requires in-scope companies to report on sustainability matters, including on environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, and diversity on company boards.

Yet, despite the Commission’s publication of non-binding reporting guidelines and specific guidelines on climate-related reporting aimed at standardizing disclosures, concerns remained over the quality and consistency of the information disclosed. These shortcomings apparently created difficulties for financial institutions and their environmental, social, and governance (“ESG”) disclosures under the Sustainable Finance Disclosure Regulation.  As a result, many such institutions lobbied to encourage the reform; and at the end of 2019, the Commission committed, as part of its “European Green Deal”, to revise the Non-Financial Reporting Directive.

Later, in response to the consultation, the Commission identified particular flaws: it said some key large companies were not reporting sustainability information at all, some were omitting valuable and desired information, and there was a general lack of consistency among reporting techniques, quality, and formats. The Commission also highlighted a lack of information relating to the sustainability-related risks to which companies are exposed, making investment into environmentally-friendly companies and projects yet more difficult.

Alignment with Other Initiatives

As part of the reform of the Non-Financial Reporting Directive, the Commission has made clear that the CSRD, if adopted, will align with other EU initiatives on sustainable finance, such that there will be no duplicated reporting requirements.  In particular, the reporting requirements and standards, which we discuss below, will likely include indicators that correspond to the indicators in the Sustainable Finance Disclosure Regulation and build on the “substantial contribution” and “do-no-significant-harm” criteria of the Taxonomy Regulation.

Proposed CSRD: Key Points

(i) Extended Scope: Large or Listed

 Under the CSRD, the scope of the sustainability reporting requirements would be expanded to include:

  • All large undertakings (i.e., undertakings that exceed at least two of the following criteria: a balance sheet total of EUR 20 million; net turnover of EUR 40 million; and an average number of employees during the financial year of 250); and
  • All listed undertakings, including SMEs, with the exception of listed micro-enterprises.

Companies that are not established in the EU but that are listed on regulated markets in the EU would be included; as would be EU subsidiaries of non-EU companies.  An exemption is proposed for those companies within groups where the parent complies with the legislation. Note also, under the proposal, an exempt subsidiary company would be required to publish the consolidated management group report and include a reference in its individual report that it is exempt from the CSRD.  Related to this, the Commission has clarified that although companies may be exempt from consolidated financial reporting requirements, the consolidated sustainability reporting regime will be separate, so they would not necessarily be exempt from the latter.

The Non-Financial Reporting Directive currently catches around 11,000 companies. Under the CSRD, due to the broader definition of “large undertaking”, as compared with “large public interest entity” under the Non-Financial Reporting Directive, the Commission estimates this number could rise to approximately 49,000.

The listed SMEs, however, would not be subject to the same reporting standards as large undertakings.  In parallel with the new rules for large undertakings, “proportionate standards” (i.e., simpler, less onerous standards) will be developed for SMEs by October 2023.  While SMEs that are not listed on EU regulated markets do not fall under the proposed rules, the Commission suggests they would be able to use such standards on a purely voluntary basis, possibly as a method to enable more cost-efficient responses to requests for information from upstream entities, including banks and insurers.

(ii) Reporting Requirements: Inwards-Outwards, Forwards-Backwards…

 One of the criticisms levied against the Non-Financial Reporting Directive was that it did too little to encourage consistent coverage in reports.  The CSRD is intended to provide a much more granular level of detail regarding what information undertakings should report, covering the entire value chain.

The Commission now proposes that mandatory disclosures form part of a company’s management report and include descriptions of:

  • business model and strategy, including plans and implementation;
  • sustainability targets and progress made towards achieving those targets;
  • role of the management and supervisory bodies regarding sustainability;
  • policies in relation to sustainability factors;
  • due diligence processes for operations and the supply chain;
  • principal risks and dependencies;
  • indicators relevant for measuring all the above;
  • intangibles, including intellectual, human, social, and relationship capital; and
  • processes carried out to identify the information disclosed.

As well as quantitative information, the CSRD proposal requires that qualitative information is included in the disclosures too, providing forward-looking and retrospective information that covers short, medium, and long-term horizons.  The proposal also clarifies that the principle of “double materiality” remains, but clarifies that this means undertakings should report information necessary to understand how sustainability matters affect them and information necessary to understand the impact they have on people and the environment – i.e., to look inwards and outwards.  Large multinationals should be aware that this, and the focus on “sustainability” information (as opposed to “non-financial” information), is distinct from the single or financial materiality lens of the Task Force on Climate-related Financial Disclosures standards.

The CSRD proposal also introduces mandatory sustainability reporting standards.  These standards are intended to complement the disclosure list above and further specify the information undertakings are required to disclose — which could be sector-specific.  These standards will take the form of delegated acts prepared on the basis of advice from the European Financial Reporting Advisory Group (“EFRAG”) — a private association supported by the EU — and its consultations with key stakeholders.  The first set of standards is planned by October 2022, followed by a second set a year later.

The sustainability reporting standards are expected to relate to the following subject matter headings:

  • Environmental factors, including: climate change mitigation; climate change adaptation; water and marine resources; resource use and circular economy; pollution; and biodiversity and ecosystems.
  • Social factors, including: equal opportunities for all; working conditions; and respect for human rights.
  • Governance factors, including the role of the undertaking’s management and supervisory bodies; business ethics and corporate culture; political engagements; management and quality of relationships with business partners; and internal control and risk management systems.

The standards will incorporate the essential elements of globally accepted standards, including the narrower, climate-related Task Force on Climate-related Financial Disclosure standards, to ensure the EU remains broadly aligned — even if it decides to go further.

(iii) Audit Requirement: Limited, Then Reasonable?

So that the reported sustainability information is accurate and reliable, the CSRD proposes a mandatory EU-wide audit — or an assurance requirement — of the sustainability information provided.  Initially, the assurance obligation would be “limited”, but as sustainability assurance standards are developed, we may ultimately see assurance obligations similar to those used for financial reporting.  The CSRD proposal would allow Member States to choose firms, other than ordinary auditors of financial information, to assure sustainability information.

(iv) Digital Reporting: Tagged and Centralized

The CSRD proposal requires companies to prepare management reports and financial statements in the European Single Electronic Format (“ESEF” / “XHTML”), which will incorporate a tagging system for sustainability information using a taxonomy that is yet to be developed.  The digital reporting and tagging system would allow for the reported data to be incorporated into a planned European Single Access Point (outlined in the Capital Markets Union Action Plan) and permit novel AI and machine learning techniques to be applied.

(v) Implementation Timeline: Too Ambitious?

 The CSRD proposal will now be scrutinized and amended by the European Parliament and Council.  EFRAG will work on the reporting standards in parallel.  If the final legislative text is formally adopted and sustainability reporting standards can be agreed in line with current — and ambitious — estimates (by the first part of 2022), EU Member States will be required to implement the CSRD by 1 December 2022.  Large in-scope companies will have to comply from financial years starting on or after 1 January 2023, publishing reports from 2024, while listed SMEs have to comply from 1 January 2026.