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NFRD

CSRD

The Evolution of NFRD into CSRD

The road to sustainability is paved with good intentions... We need to make sure those good intentions actually make a positive impact

Denis Noonan

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The Evolution of NFRD to CSRD

Remember back in the good old days, when the world was rebounding from the global financial crisis and we realised the importance of including more than just financial information in annual corporate reporting? Things that would inform investors how responsible a company’s approach to business was? Even back then it was apparent that the non-financial information that was seen to be most important was the information related to environmental and social factors. So the Non-Financial Reporting Directive (NFRD), which started out as a natural extension to annual financial reporting requirements, provided companies with guidelines on how to disclose their approach to managing environmental and social challenges and include them in their annual reports, along with their financial reporting.

However there is a difference between disclosing an approach and making sure the actions that management talk about are actually executed and completed. Are companies actually managing ESG factors or is it all talk and no action? We have learned a great deal about defining and measuring activities that impact social and environmental factors since the original drafting of the NFRD in 2014. As a result, Europe has put several other frameworks into place to augment the NFRD, with further standardized definitions and methodologies for measuring and disclosing ESG information. So where does that leave us today? How do we make sense of all the different frameworks and regulations? This article provides background on the Non-Financial Reporting Directive, how the market has evolved to expose its weaknesses, and highlights what we can expect to see regarding further development of the NFRD, in the context of the other EU regulatory initiatives related to non-financial and sustainability reporting.

The What, How & Who of the NFRD

Double Materiality:

Since the NFRD was put into effect in 2018, the overall objective has had two core components. The first is to provide information to enable investors and stakeholders to make better assessments of a company’s non-financial activities in relation to their overall risks and value creation. The second is to influence companies to establish more effective practices in the area of social and environmental management, and therefore incorporate a more ‘responsible’ business mindset. This two-sided perspective - one focusing on how external ESG factors impact the company, and the other focusing on how the company impacts external ESG factors - has become known as the ‘double materiality perspective’.

What should be disclosed and how?

To comply with the NFRD, companies must disclose details on their policies related to 5 core factors in their annual reports:

With respect to how the information must be disclosed, the NFRD is rather flexible. Companies are free to choose from a wide range of International, European or nation frameworks that they are most comfortable with. These frameworks include the OECD guidelines for multinational enterprises, ISO 26000 for Social Responsibility or the EC’s guidelines to help companies disclose environmental and social information, GRI, SASB to name a few.

The NFRD is only for large, listed corporates

So which companies are required to comply with the Non-Financial Reporting Directive? Actually, it only applies to a subset of the overall economy. Large companies with more than 500 employees and publicly listed companies - which accounts for around 11000 companies - need to comply. The question is, what about the remaining private SMEs? As of 2018, there were more than 1.7 million companies in Europe with between 10 and 250 employees, leaving a significant portion of the economy to report non-financial information on a voluntary basis. 

On the Fast-track for Sustainability

Since the Paris Agreement in 2016, the EU has wasted no time when it comes to making progress on sustainability… and therein lies the challenge! Even while the NFRD was being drafted we saw the creation of other initiatives and regulations which were directly relevant to the NFRD. The EU Green Deal and the action plan on Sustainable Finance for example, led to the EU Taxonomy Regulation  and the Sustainable Finance Disclosure Regulation (SFDR). These regulations have direct relevance to the NFRD, and are even referenced within each regulation as direct supplements to the NFRD.

For example, the Taxonomy requires companies already required to comply with the NFRD to also meet Taxonomy disclosure requirements. Where the Non-Financial Reporting Directive requires companies to disclose allocation of turnover, operating expense and capital expense across environmentally sustainable activities, the Taxonomy provides the specific details for classifying those activities, and the methodology for measuring and disclosing the impact the company achieves in those activities. This gets us one step closer to ensuring that the non-financial disclosure is not just talk, but a basis for real action and results. 

However, all these different regulations (and the relationships between them) leave us with lots of questions and uncertainty. How do we know which regulations to comply with and how they relate to each other? Do they measure the right information effectively? Do they provide sufficient coverage of all market participants to the intended stakeholders? Is there consistent interpretation of the NFRD across Europe? These types of questions are what led the EC to review the NFRD in 2019, and issue a consultation to gain stakeholder feedback on possible revisions in 2020.

The consultation released the Implementation Appraisal of the NFRD on January 21, 2021. The appraisal consolidated the concerns of market participants and identified several shortcomings of the NFRD which need to be addressed:

  • There is a lack of comparability, reliability and relevance of non-financial information provided by companies;
  • There are overlaps between different pieces of legislation on sustainability reporting which cause uncertainty around the reporting requirements for companies, as well as extra financial cost;
  • There is high demand for common reporting standards, digitalisation of non-financial information, and stricter audit requirements;
  • Stakeholders want companies to disclose their materiality assessment process;
  • A requirement for all information to be disclosed in the management report would create consistency in transparency;
  • The scope of the NFRD should be expanded to include a wider subset of companies. This should include all listed and private companies regardless of size, but with proportionality of reporting requirements for SMEs to ensure feasibility of disclosure.

With a similar objective, the EU ESAs (EBA, EIOPA, ESMA) also worked in coordination to publish their responses to the EC Call for Advice on KPIs and Methodologies for disclosure between the NFRD and the Taxonomy. While each ESA published a separate response to address the individual factors related specifically to each ESA, the reports are consistent across all common areas. In parallel, the EC issued a ‘request for Technical Advice’, mandating the EFRAG to produce ‘Proposals for a Relevant and Dynamic EU Sustainability Reporting Standard-Setting’ which defines a comprehensive set of EU sustainability reporting standards.

CSRD - Evolving to the next level

On the 20th of April 2021, the European Commission announced the proposal of the Corporate Sustainability Reporting Directive (CSRD) that will ultimately replace the Non-Financial Reporting Directive. The proposed CSRD is intended to resolve the issues highlighted by the Implementation Appraisal of the NFRD, the Call for Advice on coordination between the NFRD and the EU Taxonomy, and the request for Technical Advice on Sustainability Reporting Standards. This announcement was especially important as it was made at the same time that the EU Taxonomy First Delegated Act was released, demonstrating the EC's clear intention to proactively integrate all EU sustainability regulations - including the CSRD, the Taxonomy and SFDR. 

While it is now in the proposal phase, the CSRD expects to achieve the following objectives by 2023:

  • Extend the scope of the reporting requirements to additional companies, including all large companies (those with 250 employees or more) and listed companies, as a result increasing the overall number of companies subject to the Non-Financial Reporting Directive from 11,000 to 50,000
  • Establish binding sustainability reporting standards that set scope and content, and require the inclusion of Taxonomy aligned data;
  • Require third-party verification of reported sustainability data;
  • Integrate sustainability reporting with all required management reporting;
  • Publish all management reports in electronic format, with digitally tagged sustainability data;
  • Establish collective, active management responsibility for sustainability reporting..


The EC also intends for the CSRD to contribute towards the establishment of a baseline for a global sustainability reporting standards, which will be overseen by the Sustainability Standards Board being formed by the IFRS Foundation. This means that the story here is not over - there will be much more information to come in the following months as the proposal is first transformed into text, then reviewed and eventually turned into a legislative text. What’s more, while we may not know the details in full yet, we do know some of the starting points regarding how these objectives will be achieved. These starting points will be addressed in a future article on the continuing evolution of the NFRD into the CSRD.

 


 

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