With an increased demand for sustainability reporting, many have called for a consistent approach driven by consolidated reporting. Dee Moran explains recent developments and what it means for organisations.
Historically, business performance was measured through analysing financial statements. However, non-financial information is becoming increasingly important to corporate stakeholders for understanding how a business addresses environmental, social and governance (ESG) issues. Several regulations, voluntary frameworks and standards, and a substantial amount of guidance have provided a structure for the measurement and reporting of this information. In many jurisdictions, mandatory disclosure requirements have been introduced in law.
However, the lack of comparability and consistency makes it almost impossible to compare entities, and cross-framework mapping is difficult and costly. Consequently, many stakeholders have called for a consolidation of sustainability reporting standards to increase the reliability and comparability of corporate reports by companies on ESG issues across the world.
Two significant sustainability reporting developments were announced in 2021: the proposed EU Corporate Sustainability Reporting Directive (CSRD) and the International Sustainability Standards Board (ISSB). Both proposals include ambitious timeframes for their introduction. This is unusual in a standards development process, as typically changes happen over a more extended period allowing for lengthy consultation periods and a testing period to carry out impact assessments. The speed of progress, in this case, is a strong indicator of the perceived urgent requirement for new standards, but it also takes into account that these are not starting from scratch but building upon existing frameworks and voluntary requirements.
EU Corporate Sustainability Reporting Directive
In April 2021, the EU adopted the CSRD, intending to replace the current Non-Financial Reporting Directive (NFRD) implemented in Ireland and the UK in 2017, and has now been adopted into national law by all EU countries.
The CSRD will improve the reporting requirements for all the ESG elements. It is expected that the new directive will apply to approximately 50,000 companies in Europe, compared to the NFRD, which applies to about 11,000 entities. The directive will apply to large companies that meet two of the following three criteria:
- 250+ employees;
- €40 million+ turnover; and
- €20 million+ total assets.
The proposed directive includes the concept of double materiality. This requires an entity to report on the sustainability risk from two perspectives: how sustainability factors affect the company (financial materiality); and the company’s impact on society and the environment (societal and environmental materiality). It will be mandatory to disclose the assessment of this materiality. Further guidance on this concept is expected when the standards are published.
The proposed directive requires more information to be disclosed on targets, strategy details, the role of the board and senior management, and intangibles and adverse impacts connected to the company and its value chain. It specifies that qualitative and quantitative information should be disclosed and include forward-looking and retrospective information and cover short-, medium- and long-term horizons. Reporting should be in accordance with the EU Taxonomy Regulation and, if applicable, in line with the Sustainable Finance Disclosure Regulation.
The European Financial Reporting Advisory Group (EFRAG) has been tasked with developing EU sustainability reporting standards. The timelines for implementation are ambitious, with draft standards expected by June 2022. Depending on negotiations in the EU Parliament and European Council, the Commission could adopt the first set of reporting standards under the new legislation by the end of 2022. That would mean that the disclosure requirements would apply from January 2023, with the first reports in 2024, covering the financial year 2023.
According to the proposed Directive, sustainability must be included in the management report rather than the currently common practice of issuing a separate sustainability report. The report must also be digitally tagged and prepared in XHTML format per the European Single Electronic Format (ESEF).
Concerning statutory audit, the proposal introduces a general EU-wide assurance requirement for reported sustainability information for the first time. To ensure the reliability and accuracy of sustainability reporting, the European is initially proposing that companies would seek limited assurance for reported sustainability information.
Global standards and disclosures
The other significant development in 2021 was concerning global sustainability standards. In 2020, the IFRS Foundation (the Foundation) issued two separate consultations: one focused on the demand for global sustainability reporting standards and what role the Foundation might play in its development; and the other focused on amendments to its constitution that would enable the creation of an international sustainability standards board. A significant number of responses to the consultations have satisfied the Foundation that there is strong support for both initiatives. In one of the major announcements at COP26 in November last year, the Foundation confirmed the creation of the ISSB.
The Foundation also announced it had completed the acquisition of the Value Reporting Foundation and the Climate Disclosures Standards Board (CDSB). These will merge into the new board, and the acquisitions will be completed by June 2022. It is very encouraging that the organisation is not starting from scratch and, instead, is building on the experience of these organisations, as is the fact that it will also build on standards developed by the Task Force on Climate Related Financial Disclosures (TCFD). This expertise and experience will assist in the creation of standards in a timelier manner.
The Foundation also announced the publication of two disclosures prototypes prepared by the Technical Readiness Working Group (TRWG), a working party set up by the ISSB. One prototype is climate-related, while the other focuses on general sustainability-related financial information disclosure requirements. The general requirements for disclosure of sustainability-related financial information prototype are inspired by IAS1: Presentation of Financial Statements. The four pillars of the TCFD’s recommended disclosures are as follows:
- Governance – the governance processes, controls, and procedures the entity uses to monitor and manage climate-related risks and opportunities;
- Strategy – the climate-related risks and opportunities that could enhance, threaten, or change the entity’s business model and strategy (including how it informs strategy, the impact of climate-related risks and opportunities on its financial position, performance, and cash flows, as well as on the resilience of the entity’s strategy);
- Risk management – how climate-related risks are identified, assessed, managed, and mitigated by the entity; and
- Metrics and targets – the metrics and targets used to manage and monitor the entity’s performance in relation to climate-related risks and opportunities over time.
The draft standard includes a requirement to disclose significant risks and opportunities of the entity, a definition of materiality to be used, a consistent approach for the disclosure of information about significant sustainability-related risks and opportunities and guidance on the provision of comparable and connected information.
The climate-related disclosures prototype sets out the requirements for identifying, measuring, and disclosing climate-related financial information. It applies the approach for the disclosures set out in the first prototype and applies to:
- (a) climate-related risks the entity is exposed to, including but not restricted to:
- (i) physical risks from climate change (physical risks); and
- (ii) risks associated with the transition to a lower-carbon
economy (transition risks); and
- (b) climate-related opportunities available to and considered by the entity.
In common with the SASB standard, cross-industry and industry-specific metrics have also been incorporated into the prototype.
Standard-setting cooperation
The EU and international developments outlined above should expedite the realisation of unified sustainability reporting standards that are reliable, comparable and promote transparency and consistent measurement of sustainability activity.
It is critical that the EU, the ISSB and other international initiatives work together to build on and contribute to each other’s developments. As European Commissioner for Financial Services, Financial Stability and Capital Markets Union, Mairead McGuinness, outlined during COP26: “Global standards should be a common floor, not a ceiling that limits those that want to go further and faster. Global processes should be flexible enough to accommodate the need for different countries and jurisdictions to go further according to their own rules and priorities. So two-way cooperation between global and regional standard-setters is critical. We need to ensure coherence between frameworks.”
The CSRD and the ISSB apply to large companies. So, what does this mean for companies even if they are not legally required to adhere to the standards? There is no doubt that there is more pressure on companies to assess their current sustainability reporting – it could be they are part of a supply chain that will require them to report on their ESG activity, they need it to access funding, or because they think it is the right thing to do. Regardless, all entities should begin to think about who will be responsible for the ESG data in their organisation and the processes and procedures for capturing, collecting, and measuring that data. All entities will soon be required, whether by standards, lenders, investors, customers, suppliers or law, to report on their ESG activity to some extent.
Dee Moran is the Professional Accountancy Leader at Chartered Accountants Ireland.