What you need to know about EU’s proposed sustainability reporting rules

The European Commission last week unveiled its long-awaited proposal to amend EU laws to make sustainability reporting and the audit of the reports mandatory for companies in the 27-member bloc, quadrupling the number of entities required to make sustainability disclosures to 49,000.

These proposals are part of the EU's road map to become climate neutral by 2050 and comes at a time when there is a growing global effort to standardise sustainability reporting. In March, the IFRS Foundation formed a working group to accelerate convergence in global sustainability reporting standards. A potential international sustainability reporting standards board under its governance could be announced at COP26, the United Nations Climate Change Conference happening in November.

EU rules have required large businesses to produce nonfinancial statements since 2018. This latest proposal, called the Corporate Sustainability Reporting Directive (CSRD), extends the scope of sustainability disclosures to more entities and provides greater detail on the information that should be included in sustainability reports.  

The goal is to get sustainability reporting to be "on an equal footing with financial reporting", Mairead McGuinness, the EU's financial services chief, said in a speech at the release of the proposal.

"At the moment companies can use any standards, or all standards or a mix and, frankly, that market is too fragmented and too unspecific," she said, adding that the proposal will give much-needed clarity on what should be included in sustainability reports.

Entities included in the proposed rules

In the EU's current sustainability reporting rules under the Non-Financial Reporting Directive, only large companies with more than 500 employees and those considered as "public interest entities", such as listed companies, banks, and insurance companies — amounting to about 11,000 companies — are required to produce nonfinancial reports.

This new proposal will remove the 500-employee threshold and will apply to all large companies, listed or not, extending the responsibility of large companies to care about their impact on people and the environment. Companies not established in the EU but with securities listed on the EU regulated markets would also be required to disclose information on sustainability matters.

Listed small and medium-size enterprises (SMEs) will also be required to produce sustainability reports but according to simpler standards. Further, the requirements for listed SMEs would apply three years after they apply to large companies.

What is required in the sustainability report

The CSRD requires businesses to report how they affect sustainability matters and how sustainability issues affect their strategy, performance, and financial position, including descriptions of a company's:

• Business model and strategy, including the resilience of its business model and strategy related to sustainability issues, its plans to meet the Paris Agreement target, how its business model and strategy affects stakeholders, and its sustainability strategy.

• Sustainability targets and its progress towards achieving those targets.
• Administrative, management, and supervisory bodies' role in sustainability issues.
• Policies on sustainability.
• Due diligence process, actual and potential adverse impacts connected with its value chain (ie, operations, products and services, business relationships, and supply chain), and actions taken to manage the impacts.
• Main risks related to sustainability issues and risk management.

In language similar to the International Integrated Reporting Council's (IIRC's) integrated reporting framework, the CSRD's disclosures should include intangibles, including intellectual, human, and social and relationship capital.

The reports will include both qualitative and quantitative information that look to past activities and are also forward-looking. The disclosures should also take account of short-, medium-, and long-term horizons.

An EU sustainability reporting standard and how will it fit with other standards

The sustainability reporting standard will require disclosed information to be understandable, verifiable, and comparable, among others. The work to develop an EU sustainability standard will be led by the European Financial Reporting Advisory Group (EFRAG). There are three key areas in the reporting standard:

• Environment. Examples of information that should be included are climate change mitigation and adaptation, resource use and circular economy, and pollution.
• Social. Companies will be required to reveal information about equal opportunities for all genders, pay equality, and training and skills development. Companies will also be expected to uphold international human rights standards.
• Governance. These include composition of the company's management and supervisory bodies, business ethics and corporate culture, and political and lobbying activities.

With the momentum growing for a truly global, comparable, and reliable sustainability reporting standard, led by the IFRS Foundation and supported by other framework providers and standard setters, how will a European sustainability reporting standard fit with the rest?

In the announcement the European Commission explained that the focus on the EU's own sustainability reporting standard is to support the European Green Deal and the bloc's climate-related targets.

As more clarity emerges from the IFRS Foundation, the EU plans to incorporate elements of a globally accepted standard. The proposed EU sustainability reporting standards would build on and contribute to standardisation initiatives at a global level.

Audit of sustainability information

In a first, the proposal introduced requirements for audit (assurance) of EU sustainability reports to ensure that disclosed information is accurate and reliable. This is to address concerns from investors and other stakeholders on the reliability of sustainability reports issued by companies today.

While the objective is to have a similar level of assurance for financial and sustainability reporting, the proposal suggests a progressive approach starting with a requirement for companies to obtain a limited level of assurance on their reported sustainability information.

Companies will be required to provide a limited assurance on their reports, which can ensure the reliability of current reports while not demanding too strong a requirement for "reasonable" assurance, which would be more costly and requires more technical abilities in the audit services market.

What's next

The timetable of when these new rules will come into force will depend on the negotiations at the European Parliament and Council. If the legal proposals are agreed upon in the first half of 2022, the first set of reporting standards will be adopted by the end of 2022. Companies would begin applying the new standards for the first time in their 2023 financial year report.

— Alexis See Tho (Alexis.SeeTho@aicpa-cima.com) is an FM magazine associate editor.