Environmental, Social, and Governance (ESG) remains one of the hottest topics in global asset management. It is also an area of rulemaking which tends to throw up a lot of other acronyms. From sustainability standards such as TCFD to SASB, from UN PRI to UN SDGs, it’s a space that lends itself to plentiful acronyms. In that vein, the European Commission has now added yet another one to the pile in the shape of the Corporate Sustainability Reporting Directive, or CSRD.
The E.U. remains the epicenter of ESG rulemaking, but there is continued policymaking actions being taken across the globe. We recently flagged the E.U.’s Sustainable Finance Disclosure Regulation (SFDR) as a significant challenge to be addressed. One of the major purported challenges to adhering to SFDR’s exacting disclosure standards is data scarcity. SFDR requires corporate issuers to disclose a large range of data and metrics about their business activities that they do not disclose today. In turn, without having access to the underlying corporate data required under SFDR, asset managers will struggle to meet their obligations to adhere to the regulation.
ESG data scarcity has been an issue for a long time in Europe and elsewhere, and previously the E.U. Commission had proposed to apply the Non-Financial Reporting Directive (NFRD) (yet another acronym). The newly proposed CSRD replaces NFRD, and the rebadging primarily reflects the fact that these sustainable disclosure metrics do in fact have financial impact. It also enhances certain areas of disclosure beyond prior NFRD proposals. Just on acronyms, they tend to be very confusing, and the latest joiner to the E.U. policy alphabet soup should not be confused with the very similar CSDR (Central Securities Depositary Regulation), a topic that also remains in very sharp focus across the industry but has very little do with ESG integration.
For two reasons, CSRD is a good news story for asset managers. Firstly, it is not directly applicable to most and as such doesn’t result in significant additional burden in the same way as SFDR, for example. Secondly, the central tenet of CSRD is to make more ESG related information available to investors to assess issuer sustainability, so in a rare occurrence it is an E.U. policy change which will reduce rather than increase assets managers data acquisition needs.
The purpose of CSRD is to create a consistent corporate reporting regime which provides investors with better information on companies regarding their ESG in order to base their investment decisions - not just on climate change but also on other sustainability issues including employee welfare and diversity & inclusion. Currently, this type of corporate information is generally not disclosed for E.U. issuers, or if it is, it is disclosed on a voluntary basis. This results in no uniformity making it hard for investors to source reliable or comparable data for various firms they might wish to invest in. At its heart, the CSRD looks to compel corporates to disclose the data needed under SFDR & E.U. Taxonomy standards on a mandatory basis. It is a proactive policy attempt to bridge the current data gap between its ESG investment rules and the current level of corporate disclosures available in the market.
In terms of scope, CSRD applies to all large E.U. companies (listed or not) and all E.U. listed companies (extra territorial impact), except listed micro-enterprises. "Large companies" are defined as those exceeding two out of three following criteria:
1. A balance sheet total of EUR 20 million
2. Net turnover of EUR 40 million
3. An average number of employees during the financial year of more than 250
Initial estimates of the market indicate that nearly 50,000 E.U. companies fall into the scope of CSRD based on the screening criteria. In-scope companies must report on the impact and risks of their business relating to the five following prescribed areas:
2. Social and employee matters
3. Respect for human rights
4. Anti-corruption and anti-bribery
5. Governance matters.
The E.U. Commission has tasked the European Financial Reporting Advisory Group (EFRAG) with responsibility for developing draft standards of what financial reporting outputs should look like including an assessment of each company’s entire supply chain. These reporting standards aim to be aligned with the disclosure requirements under the SFDR and Taxonomy Regulation. EFRAG will also incorporate the E.U. Taxonomy ESG concepts of “substantial contribution” and “do-no-significant-harm” into their work. There is also a commitment within CSRD to aligning with existing globally accepted reporting standards (SASB, TCFD) which are being developed at this time as well. However, it is suggested that the E.U. standards should go further where necessary to meet the E.U.'s own ambitions. The E.U. has uniformly pushed to have the highest ESG rulemaking standards, yet setting this continually high bar is creating a great burden for E.U. firms and raising questions of competitiveness and also global fragmentation as the E.U. charts its own course and others calibrate their rules more moderately.
Audit & Assurance
One of the primary challenges to higher levels of corporate disclosure is the ability to independently verify the validity of information to back up the disclosures. Maintaining robust independent audit and assurance of financial statement disclosures on sustainability is crucial to build trust and credibility in such disclosures. CSRD introduces for the first time a general E.U.-wide audit (assurance) requirement for sustainability information, to help ensure that reported information is accurate and reliable. However, while traditional financial audit processes such as validating inventory, bank statements, and invoices/receipts against payables and receivables are tried and trusted, CSRD demands “sustainability audits” which deviate into territory very different than the traditional audit and assurance model. Moving beyond profit and loss and balance sheet assessments into climate science and diversity and inclusion estimations requires a very different range of skills and experience. But it appears to be the direction of travel for assurance firms offering challenge and opportunity in equal measure. In fact, the novelty of this new demand is recognized by the E.U. Commission in their proposals. CSRD recognizes that the immaturity of sustainability audits means that assurance firms even in the “Big Four” need time to get up to speed on these new requirements. As such, CSRD suggest that initial sustainability audits begin with “limited” assurance requirements, rather than a more demanding “reasonable assurance” standard. There is also pragmatic recognition that there might be certain capacity and capability issues within traditional audit firms, so the rules allow for so-called “independent assurance services providers” which opens up the possibility to work with specialist sustainability partners (D&I, climate scientists, emissions specialists, water experts etc..) who might work in conjunction with the traditional audit firms on the CSRD component. What’s for certain is the E.U. audit industry is changing for good as non-financial measures become increasingly important aspect of corporate reporting.
Another goal enshrined in CSRD is that the data produced from the mandated corporate disclosures must be made available in digital format. The prescribed format for financial statement preparation is XHTML (oops, another one). This format makes statements machine readable. The E.U. wants to digitize all financial statements in order to have them feed directly into its planned European Single Access Point (ESAP) (this is getting ridiculous now). As of today, the ESAP database doesn’t actually exist but one of the EU and industry’s shared ambitions is to have a central digital repository of financial and non-financial information on corporate made readily available to both investors, and wider society. ESAP is a step toward this shared goal, but it is highly ambitious. If it came to fruition however, it would bring huge benefits in terms of general availability of raw harmonized ESG data and greatly increase the transparency, comparability if ESG data and greatly reduce data scarcity and costs across the industry.
Timing and Next Steps
As with all major E.U. regulations, its speed of progress will be measured. The E.U. Commission will send the CSRD proposal to the European Parliament and the E.U. Council to agree final texts. This will take up to 18 months based on prior experience but could be longer given the scale and complexity of the proposals. CSRD is one aspect of a wider Sustainable Finance Package released on April 21. CSRD is also interdependent on a number of other regulations and projects which at this time remain incomplete (E.U. Taxonomy) or have not even yet begun (ESAP).
CSRD lays out two phase approach to the new financial reporting requirements, with the first set of reporting standards be adopted by October 31, 2022 to include all SFDR disclosures. Then an upgraded set of standards by October 31, 2023, adding in sector-specific information. On this timeline, an educated guess would suggest the first set of financial statements prepared to incorporate CSRD standards would be published sometime in Q1 2024. These statements would cover the financial year end 2023. That might sound like a long way away but given the materiality of changes and the number of deliverables required to move this from “idea” phase to practical implementation, it is an aggressive deadline with a lot of uncertainty for the in scope disclosing firms.
The roadmap to the reduction of ESG data scarcity in Europe is now set, but once more the path is long and hard. Also, it’s littered with several confusing acronyms.