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November 29, 2022

European sustainability standards move into final scrutiny period

EU institutions as well as the industry evaluate the bloc’s first 12 draft sustainability reporting standards while the European Financial Reporting Advisory Group works on sector-specific proposals.

Last week, the European Financial Reporting Advisory Group released its first set of European Sustainability Reporting Standards, which form a key part of Europe’s legislative agenda in supporting a sustainable and just transition to net zero.

The 12 draft standards designed by Efrag underpin the EU Corporate Sustainability Reporting Directive, which recently received approval from both the European Parliament and the European Council. It will oblige nearly 50,000 companies in the bloc to report on social and environmental factors, with sustainability disclosure rules to be gradually phased in from 2024. 

The EU has said its sustainability reporting standards will be based on a “double materiality” principle, under which companies will have to disclose the effect of sustainability factors on their business, as well as the impact of business activities on the environment and society.

The EU has been a frontrunner in integrating double materiality into sustainability reporting while other reporting initiatives, such as the International Sustainability Standards Board, focus primarily on financial materiality.

The set of proposals consist of two “cross-cutting” standards addressing general requirements and disclosures in sustainability reporting, and 10 additional “topical” standards under the categories of environmental, social and governance.

The focus has been on environmental and social factors, covering five and four topics respectively, while the governance section only counts one topic, which relates to business conduct. Integrated within the environmental category are: climate change; pollution; marine resources; biodiversity; and circular economy. The social section includes: internal workforce; workers in the value chain; communities; and customers.

Over the past few months, stakeholders have had the opportunity to make recommendations to Efrag after it issued a public consultation on its sustainability reporting standards work; it said these had been included in last week’s drafts.

In a letter to the European Commission, Efrag stressed it wants to avoid unnecessary multiple reporting by ensuring companies that comply with ESRS should also be considered compliant with the ISSB standards, despite the latter not including the double materiality principle.

Efrag said the draft ESRS now follow the same structure as the ISSB but with the necessary adjustments to account for the double materiality principle. It also emphasised that the ISSB is still deliberating on its standards, but that the bodies have had “very regular exchanges … in order to anticipate and coordinate potential changes in standards”.

In the next 12 months, Efrag said it will build a second, sector-specific set of draft ESRS. The targeted industries are: agriculture; coal mining; mining; upstream and mid-to-downstream oil and gas; as well as energy production; road transport; motor vehicle production; textiles; food; and beverages. This set of sustainability standards will also focus on small and medium-sized enterprises.

Hitting the double materiality mark?

ESG Book head of regulatory research Inna Amesheva said that double materiality is “sufficiently addressed” by the proposals. She added: “The lens of materiality is mostly relevant when the ESRS-aligned data gets integrated into different investment approaches and scoring frameworks that will get developed based on the reported data.”

Others, like Bill Baue, a former member of the Technical Advisory Group for the Science Based Targets initiative, are more sceptical. In a LinkedIn post, he warned about the language used in relation to applying the double materiality principle: the ESRS general requirements documentation states that companies “may” rely on scientific research to identify and assess the enterprise’s impact materiality but Baue criticised the lack of obligation, which he says risks “leaving science-based approaches as completely optional”.

However, Teresa Gerhold, associate at law firm Mayer Brown, said requiring companies to obtain scientific research on every impact they may have could lead to the materiality assessment being nearly impossible to produce – at least within the reporting timeframes. “In my view, the language as it is now is a good middle ground to balance the need for transparency and also the practicability,” said Gerhold.

On the question of whether the lack of a science-based materiality assessment could be a reasonable cause for concern, given the rise of greenwashing in the market, Gerhold said as long as there was no indication of greenwashing, companies that put in the effort to assess impact materiality should be given the benefit of the doubt.

A major change to the previous draft ESRS put to public consultation is the shelving of the “rebuttable presumption” approach. This will alleviate the reporting burden, since this approach required companies to explain why certain sustainability disclosures are not relevant to their business operations.

However, Gerhold cautioned that the removal of the presumption should not be mistaken for a way to avoid explaining certain factors completely. “Where a company’s materiality assessment leads to the conclusion that a certain topic is not material – and as a result, the company omits all disclosure requirements in a topical ESRS – the company will still have to set out how the materiality assessment led to this conclusion.”

While various stakeholder groups examine the Efrag’s final standards, the European Commission is set to consult with relevant EU bodies and member states on the submitted ESRS before adopting them as delegated acts in June 2023. After this time, the EU Parliament and Council also have an additional period for scrutiny.

 

A service from the Financial Times