Understanding and anticipating the European Sustainability Reporting Standards

February 6, 2023

In June 2022, the Council and European Parliament reached a political agreement on the Corporate Sustainability Reporting Directive (CSRD), which revises and strengthens the provisions introduced by the Non-Financial Reporting Directive (NFRD).

Under the CSRD, the European Financial Reporting Advisory Group (EFRAG) was appointed technical adviser to the European Commission in developing draft European Sustainability Reporting Standards (ESRS), to be published as final standards in June 2023. The first companies will have to apply the ESRS in financial year 2024 for reports published in 2025. Listed SMEs are obliged to report as from 2026, with a further possibility of voluntary opt-out until 2028.

The ESRS are a welcome development that will provide companies with a common set of standards to measure, manage and report their sustainability performance, helping to increase comparability and promote the production of reliable, comparable and relevant information on sustainability risks and opportunities. That being said, companies will also face a number of challenges in implementing the ESRS, including the need to develop specific internal processes and systems to produce the information required, as well as training and communication measures for internal and external stakeholders. Fortunately, in the period leading to adoption of the ESRS, companies can still move forward with a number of measures to anticipate future challenges, including those below.

The CSRD involves the concept of double materiality, which means that companies will have to report not only on how sustainability issues might create financial risks for the company (financial materiality), but also on the company’s own impacts on people and the environment (impact materiality). Listed companies are familiar with the concept of financial materiality (also promoted by the International Sustainability Standards Board), but may have less experience carrying out internal analyses of impact materiality (i.e., identifying the specific risks and opportunities associated with their business model, operations and supply chain, as well as any other relevant aspects of their sustainability performance).

Moreover, the CSRD represents a significant step up from the NFRD in terms of the scope of information that companies will need to collect and analyze, including data from consolidated entities and from the value chain, including third-party suppliers and other business partners. Under the directive, companies will need to develop processes and systems to capture a much wider range of data points than under the NFRD, such as human capital indicators, information on input materials used within their operations and value chain, as well as measures related to progress towards achieving sustainability goals.

The amount of forward-looking information will also be more significant in future reports. This requires not only examining the nature of new forward-looking information that will be required, but also how internal assumptions with respect to that information are made and verified. In addition, CSRD will also require narrative reporting of information on a host of topics not currently covered in detail by the NFRD, ranging from human rights to biodiversity, which require increased technical expertise both internally in data collection as well as in the process of engaging with third-party verification providers.

These challenges are compounded by the very recent definition of the information requirements, which will necessarily imply a strong learning curve for preparers of reports, as well as revising internal controls and systems to prepare the information. The early years of CSRD reporting will also likely be characterized by a limited availability of benchmarks, sector average data or comparative data, which companies may need to make sense of their performance levels.

In preparing for CSRD implementation, companies can already begin anticipating some of these challenges. First, through engaging in applications of impact materiality and its interplay with financial materiality, and by examining various scenarios across the value chain. Second, through mapping the information that is available, and filling gaps through appropriate data collection measures. Third, by anticipating how third-parties can support their efforts in collecting and verifying new types of data points, in addition to training employees on impact analysis and measurement. And fourth, by adapting internal controls to provide for the verification of sustainability-related information, including impact materiality.

By taking steps now, companies will be better positioned to build a robust foundation for the implementation of ESRS reporting with higher levels of credibility, transparency and internal collaboration. At the same time, this work will also help kickstart an improved understanding of sustainability performance in the organization and help identify areas where more effort is needed to improve.

CPM