Mandatory ESG reporting and what it means for your business
What are the changes?
Since the term was first coined in 2004, SMEs would be excused if they had never heard of ESG. It was largely considered a concern for international financial market participants.
The rest of the market developed voluntary CSR-type reporting that often resembled a PR exercise, concealing the true ESG impacts of company’s activities. It was difficult to compare ESG performance between companies and there were over 70 firms globally providing different forms of ESG ratings.
This is all about to change. The whole business landscape will soon have to grapple with three significant developments:
- Launch of the first ever comparable international accounting standards
- Mandatory ESG reporting under EU legislation that applies to both EU and non-EU enterprises
- New legal obligations for supply chain sustainability due diligence
What are the challenges for businesses?
On 26 June 2023, the International Sustainability Standards Board (ISSB) launched two international disclosure standards that become effective for accounting periods beginning on or after 1 January 2024: IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information, and IFRS S2 Climate-related Disclosures. IFRS S2 requires the reporting of Scope 3 emissions.
It is up to each country to endorse IFRS standards. The UK is currently consulting on the creation of UK Sustainability Disclosure Standards (SDS), which will address this matter. A decision is expected by July 2024. The Department for Energy Security and Net Zero has launched in December 2023 a call for evidence to help inform the government’s decision on whether to endorse the ISSB's standards in the UK.
Mandatory ESG reporting under the Corporate Sustainability Reporting Directive (CSRD)
Since 2015, the Non-Financial Reporting Directive (NFRD) required reporting of certain non-financial and diversity information by large public-interest entities in the EU with more than 500 employees. The CSRD introduces mandatory ESG reporting for a much broader group of companies and includes non-EU companies that do business in the EU.
The CSRD is being implemented in phases. The first phase started in January 2024 and is applicable to listed companies in the EU with over 500 employees already subject to NFRD, with reports due in 2025. The second phase will start on 1 January 2025 and will be applicable to EU companies with at least two of the three following criteria: (a) more than 250 employees, (b) a net turnover of more than 40 million euros and/or (c) a balance sheet of more than 20 million euros, with ESG reports due in 2026.
Third country undertakings (including UK companies) with net turnover above 150 million euros in the EU, and who have an office or subsidiary in the EU, must report in 2019 based on 2018 ESG data. CSRD organisations need to report according to new European Sustainability Reporting Standards (ESRS) which includes scope 3 value chain emissions.
Corporate Sustainability Due Diligence Directive (CSDDD)
On 19 March 2024, the EU Parliament’s Legal Affairs Committee approved the delayed Corporate Sustainability Due Diligence Directive (CSDDD).
It’s a controversial piece of EU legislation, initially proposed by the EU Commission in February 2022, that requires very large companies to identify and prevent actual and potential adverse human rights and environmental impacts.
The new due diligence duty extends to the companies’ own operations, their subsidiaries, upstream supply chain and some downstream activities such as distribution and recycling.
After Germany and Italy threatened to pull their support, the EU Council increased the CSDDD thresholds for EU companies and parent companies from 500 employees to 1,000 employees and raised the global turnover from 150m Euros to 450m Euros.
Non-EU companies and parent companies with a net turnover generated in the EU/EEA of at least 450m Euro will also be subject to the new due diligence duty, regardless of the number of employees.
Lower thresholds for “high risk sectors” (textiles, clothing, agriculture, mineral extraction and construction) were removed.
This has excluded over two thirds of the original large companies that were anticipated to be affected.
Despite the political u-turn, the impact of CSDDD will still be significant as very large EU and non-EU companies will need to audit their own supply chains to address any negative impacts on human rights and the environment.
The CSDDD will be introduced in phases, with in-scope companies having up to five years to comply.
The revised directive is expected to be adopted in the plenary session of the EU Parliament at the end of April 2024.
What actions should your business take?
Sustainability as a measure of corporate value
As well as considering financial performance, IFRS will ensure that companies are judged on their ethical behaviour and how they treat employees, influence their stakeholders and protect the environment. Businesses should proactively integrate sustainability practices into their operations, such as regular assessments of their environmental and social impacts. This should be transparently recorded, so they’re able to report their progress towards achieving sustainability goals.
Access to finance
Compliance with ESG standards will increasingly be requested and monitored by lenders, investors, competitors, civil society organisations and employees. ESG performance is expected to have a substantial impact on the access to finance in the future.
Management systems
To get prepared for CSRD and CSDDD, companies will need to ensure that there are proper governance procedures and processes in place to measure and manage ESG issues. A management system approach will ensure continual improvement.
Supply chains
CSRD requires management of Scope 3 value chain GHG emissions and CSDDD introduces a new due diligence duty to minimise adverse environmental and human rights impact throughout a company’s international supply chain. Larger companies subject to ESG and carbon reporting will request evidence of climate action and ESG performance from its value chain. Failure to produce ESG policies and strategies could result in SMEs losing key customers and missing out on new business opportunities. It’s no longer a “nice to have”, ESG will become a requirement for doing business. Make sure you have evidence clearly documented, with a clear mechanism to track and disclose performance metrics.
Due diligence in transactions
There will be increased demand in M&A transactions for ESG desktop searches and audits as part of technical due diligence. This involves conducting thorough assessments of ESG factors associated with target companies to identify risks and opportunities. There is also a need for ESG and climate clauses in legal documentation, to ensure sustainability considerations are addressed and integrated into the deal structure. This will help businesses align M&A activity with broader sustainability objectives.
Taxonomy audits to combat greenwashing
Companies will need to ensure that their ESG reports do not misrepresent the true picture and that any claims relating to sustainability are backed by written evidence and data. The EU Taxonomy framework provides a classification system to identify sustainability activities. Investors in EU companies (including UK companies subject to CSRD or CSDDD) are requesting taxonomy assessments and climate risk assessments as evidence of sustainability claims.
ESG real estate strategy
A large part of a company’s impact on the environment, and the enjoyment of its workforce, relates to the quality of its real estate assets. There will be an increased demand for grade A accredited space and Net Zero buildings and every stage of the property’s lifecycle from design, acquisition, occupation and disposal will need to consider sustainability issues. There will be a greater use of green leases and the focus needs to shift from data sharing to collaboration between landlords and tenants in terms of planning and costing of works.
Companies will be judged on their pledges
CSR policies were often seen as a polish for corporate reputation. Now that metrics and disclosure standard have been agreed in ESRS and IFRS, and ESG performance can be compared between companies, reports will be subject to greater scrutiny and commitments must be put into action.
Expert opinion
For the first time in history, the new IFRS international accounting standards (effective from 2024) formally recognise that the value a company creates for itself and its shareholders is inextricably linked to the natural resources that its uses, its human capital and the civil society in which it operates.
Stefano Giancarlo D’Ambrosio Nunez and
Keith Davidson
Solicitor and Partner