European Commission clarifies its amendments to the EFRAG draft standards

European Commission clarifies its amendments to the EFRAG draft standards 

During a public session of the EFRAG Sustainability Board on 14 June 2023, the European Commission (EC) provided some clarifications on its amendments contained in the draft Delegated Act adopting the European Sustainability Reporting Standards (ESRSs) which was opened for comment last Friday.  

Some key take-aways: 

• Removing the mandatory status on Climate Change and other Disclosure Requirements does NOT make these areas voluntary – rather it enforces the materiality approach on all sustainability topics and keeps the whole package intact.  

• Additional phase-in provisions allows companies to start reporting in a compliant manner while they are developing processes to gather the more challenging data. 

• The threshold of 750 employees on certain new phase-in provisions is expected to assist approx. 30,000 companies from the estimated total of 50,000 companies that will be in scope of the CSRD. 

• EFRAG is working on guidance over the materiality process, which appears to be the most challenging area of the CSRD, but emphasized that the materiality assessment must be a robust process to ensure that all needed information is disclosed and what is not needed is not disclosed. 

European Commission adoption of Tax04 

In a closely related action, the EC on Monday 13 June 2023 adopted another Delegated Act (known as Tax04) adding additional activities to the EU Taxonomy and proposing new rules for Environmental, Social and Governance (ESG) rating providers, which will increase transparency on the market for sustainable investments – expected to take effect from January 2024. While some commentators believe the simultaneous application of CSRD and Tax04 is too onerous on reporters, the Commission views this package as building on and strengthening the foundations of the EU sustainable finance framework, of which the CSRD is a key component. 

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ESG Update: European Commission proposes further streamlining of ESG reporting obligations

The European Commission proposes further streamlining of ESG reporting obligations 

The European Commission draft act adopting the first set of European Sustainability Reporting Standards (ESRSs) has further streamlined reporting obligations, while not affecting the pursuit of the objective of the Corporate Sustainability Reporting Directive (CSRD). This draft act is open for 4 weeks until 7 July 2023.  

This act supplements the Accounting Directive as amended by the CSRD, which requires large companies and listed companies to publish regular reports on the social and environmental risks they face, and on how their activities impact people and the environment. 

The modifications to the draft first set of ESRSs are: 

Materiality:
All standards and all disclosure requirements and data points within each standard will be subject to materiality assessment by the undertaking, with the exception of the disclosure requirements specified in the “General disclosures” standard. This measure is expected to lead to a significant burden reduction for undertakings and helps to ensure that the standards are proportionate. 

Phasing-in for undertakings with less than 750 employees:
– First year: may omit scope 3 GHG emissions data and “own workforce” disclosure requirements; and
– First two years: may omit disclosure requirements for “biodiversity”, “value chain workers”, “affected communities”, and “consumers and end-users”. 

Phasing-in for all undertakings:
– First year: may omit disclosure requirements for anticipated financial effects related to non-climate environmental issues (pollution, water, biodiversity, and resource use); and certain datapoints related to their own workforce (social protection, persons with disabilities, work-related ill-health, and work-life balance). 

Shift to voluntary for certain disclosures:
Certain disclosures that were mandatory in the draft standards are now voluntary, including: biodiversity transition plans; certain indicators about contract staff in the undertaking’s own workforce; and an explanation of why the undertaking may consider a particular sustainability topic not to be material. 

Further flexibilities in certain mandatory disclosures:
These flexibilities cover such areas as: the methodology to use for the materiality assessment process, the disclosure requirements on the financial effects arising from sustainability risks and on engagement with stakeholders. Further flexibilities are included on areas that might be considered to infringe on the right not to self-incriminate. 

Coherence with EU legal framework:
Some technical modifications to ensure better alignment with the Accounting Directive and other EU legal instruments. 

Interoperability with global standard-setting initiatives:
Further modifications in light of ongoing engagement with the International Sustainability Standards Board and the Global Reporting Initiative. 

Editorial and presentational modifications:
To improve the clarity, usability, and coherence of the standards, including for example a drafting convention to clearly identify all terms for which ESRS has a precise definition. 

Implementation 

The Commission anticipates that the proposed additional phase-in measures and other modifications will reduce the annual costs of compliance by a total of EUR 1,402 million compared to the draft standards proposed by the European Financial Reporting Advisory Group (EFRAG). 

The Commission is putting in place an interpretation mechanism to provide formal interpretation of the standards. The Commission has also asked the EFRAG to publish additional guidance and educational material, addressing the materiality assessment process and other issues. 

This act shall apply for financial years beginning on or after 1 January 2024 in accordance with the phase-in approach set out in Article 5 of the CSRD, and shall be binding in its entirety and directly applicable in all Member States when it enters into force. 

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The EU’s Sustainable Finance Framework and Application for non-EU Fund Companies

An overview of: EU Taxonomy, Corporate Sustainability Reporting Directive (CSRD), and Sustainable Finance Disclosure Regulation (SFDR) 

Background 

The European Union passed the Green Deal in 2019. The ultimate objective is to transform the EU into a modern, resource-efficient and competitive economy, with the following aims: 

1. no net emissions of greenhouse gases by 2050 (i.e.: climate-neutrality) 
2. economic growth decoupled from resource use 
3. no person and no place left behind 

To help achieve the first aim, the EU is aiming for greenhouse gas emissions to be cut by 55% (in comparison to 1990 levels) by 2030. 

As part of the Green Deal, the EU has outlined the Sustainable Finance Framework, which is intended to help embed sustainability factors at various levels of the economy.  

The three most important elements that comprise the Sustainable Finance Framework are: 

1. the EU Taxonomy Regulation 
2. the Corporate Sustainability Reporting Directive (CSRD) 
3. the Sustainable Finance Disclosure Regulation (SFDR) 

The three elements are separate, but closely interlinked. While the EU Taxonomy provides the classification framework for sustainable activities, the CSRD regulates sustainability reporting and the SFDR defines the disclosure requirements for selling financial products.  

The EU Taxonomy Regulation 

The EU Taxonomy Regulation (“the Taxonomy”) sets criteria to determine whether an economic activity can be considered sustainable.  

The Taxonomy provides companies and investors with appropriate definitions of economic activities that can be considered environmentally sustainable. The aim is to create security for investors, protect private investors from greenwashing, help companies to become more climate-friendly, mitigate market fragmentation and help shift investments where they are most needed.[1] 

The Taxonomy establishes six environmental objectives: 

1. Climate change mitigation 
2. Climate change adaptation 
3. The sustainable use and protection of water and marine resources 
4. The transition to a circular economy 
5. Pollution prevention and control 
6. The protection and restoration of biodiversity and ecosystems 

It sets out four overarching conditions that an economic activity must meet in order to qualify as environmentally sustainable. According to the Taxonomy, a sustainable economic activity has to be (i) assigned to a defined taxonomy activity, (ii) contribute substantially to one of six environmental objectives above, (iii) not significantly harm any of the remaining environmental objectives, and (iv) comply with a series of minimum social safeguards.[2] 

The Taxonomy has applied to certain, large EU companies from 1 January 2021.  

The Taxonomy will apply to non-EU companies with a net turnover over €150,000,000 (c. $165 million) in the EU, if they have at least one subsidiary or branch in the EU and exceed certain other thresholds. For such companies, the Taxonomy will apply from January 1, 2028, with reports due in 2029. 

The Corporate Sustainability Reporting Directive 

The Corporate Sustainability Reporting Directive (“CSRD”) establishes a uniform framework for the reporting of non-financial data for companies operating in the European Union. 

The CSRD aims to provide greater transparency and more comparable and standardised information on how companies perform from a sustainability perspective. This information is essential for funds and fund managers seeking to integrate ESG considerations into their investment decisions and to comply with their obligations under the EU Sustainable Finance Framework.[3] 

The CSRD will replace the existing Non-Financial Reporting Directive (NFRD), significantly extending the scope of companies required to report and expanding the range of reporting requirements. Companies will have to cover key ESG areas such as the environment, human rights, social responsibility, and diversity in their reports. 

A key concept introduced by the CSRD is double materiality. Double materiality means that companies must consider and report on not only the impact of environmental changes on their business, but also on the impact of their operations on the environment (including social and governance issues). 

The CSRD is applicable to non-EU parent companies which either: 

1. have securities listed on an EU regulated market and have more than 500 employees, or 
2. have a qualifying EU branch or subsidiary (see below) and generate net turnover of more than €150 million in the EU over two consecutive years. 

A qualifying EU branch is one having net turnover of more than €40 million.  

A qualifying EU subsidiary is a large company being one that exceeds any two of:  

       i. 250 employees;

      ii. €40 million net turnover; or  

     iii. €20 million total assets;  

or a small or medium-sized entity (SME) with securities listed on an EU regulated market. 

The CSRD will begin to impact the 2024 reporting period for in-scope, EU companies.  

For non-EU parent companies, CSRD consolidated sustainability reporting requirements on their EU operations will be required from their 2028 financial year. However, if the non-EU Parent company has securities listed on an EU regulated market and has more than 500 employees, its individual and consolidated reporting obligations will start from its 2024 financial year. 

Sustainable Finance Disclosure Regulation 

The Sustainable Finance Disclosure Regulation (“SFDR”) is a set of rules which require financial market participants (i.e.: fund managers) to provide information about how they deal with negative environmental and social impacts and risks of their investments.[4] 

The disclosure requirements of the SFDR are intended to illustrate to investors and the public the extent to which companies or products meet sustainability benchmarks. Fund managers must disclose how sustainability risks are considered in their investment process, what metrics they use to assess ESG factors, and how they consider investment decisions that might result in negative effects on sustainability factors. 

The SFDR requires disclosures at the company level as well as at the product level. 

In addition, financial companies must disclose their Principal Adverse Impacts (PAIs) on Sustainability. PAIs consist of mandatory, core indicators and additional opt-in indicators from the areas of greenhouse gas emissions, energy efficiency, biodiversity, water, waste, social and employee affairs, human rights and corruption. The information on PAIs must be published on in-scope companies’ websites. 

At the product level, the SFDR distinguishes three categories of financial products, with different levels of disclosure requirements depending on classification: 

• General financial products (“Article 6 funds”) 

• ESG financial products with environmental or social characteristics (“Article 8” or “light green funds”) 
• ESG financial products with the aim of sustainable investment (“Article 9” or “dark green funds”) 

Mandatory disclosure of sustainability data under SFDR has been in place since 10 March 2021. 

Non-EU fund managers will be in scope to the extent that they register any of their funds for marketing under national private placement rules in any EU member state. They are also potentially in scope to the extent that they manage or advise EU-domiciled funds, even if those funds are not privately placed in the EU. 

The three regulatory requirements above are interlinked with some overlap in terms of content. The Taxonomy defines what is considered sustainable under any financial product level information disclosed by investee companies under the CSRD. The reporting provided by the CSRD will be used by fund managers to satisfy the Principal Adverse Impacts (PAI) disclosures under SFDR.

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