The European Commission’s review of the Non-Financial Reporting Directive (NFRD), scheduled for publication shortly, comes at a time of increased scrutiny of both corporates and those who supply them with debt and equity.
NFRD has mandated a non-financial statement for companies with over 5,000 employees since 2017. It introduced the concept of ‘double materiality’ – the effect of sustainability issues on the company as well as of the company on wider society.
The EU is now set to expand the scope of non-financial reporting as a means to encourage sustainable behaviour by companies as part of the European Green Deal and the EU’s 2050 carbon-neutrality target. The aim is to shift capital and resources towards activities outlined in the Taxonomy for Sustainable Activities in support of these objectives, and presumably over time to raise the cost of capital to non-sustainable companies and activities.
The current NFRD review aims to facilitate the flow of high-quality, material non-financial information from preparers to users, wider society and others while maintaining a proportionate approach for preparers themselves, and to “encourage companies to develop a responsible approach to business”.
Yet intermediaries like asset managers often ask investee companies to report in a variety of non-standard ways to fit their own frameworks, as do ESG ratings providers. Asset managers and pension providers in turn face increasing mandatory reporting requirements towards clients, as part of the Sustainability-Related Financial Disclosures Regulation (SFDR).
A stakeholder consultation on NFRD from last summer uncovered widespread agreement on the problems inherent in current corporate non-financial reporting practice: a majority saw deficiencies in non-financial reporting, which is hardly a surprise; 67% supported stronger audit requirements, which will be needed to underpin confidence in non-financial reporting. There was also strong support for common standards.
A “cover to cover” reading exercise of the annual reports of 50 European companies conducted by the Carbon Disclosure Standards Board found deficiencies in “reporting on principal risks, materiality definition and implementing the forward-looking disclosures of the TCFD recommendations”.
Inconsistencies and deficiencies are perhaps hardly surprising given the ‘alphabet soup’ of reporting and standard setting initiatives – including the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC), the Sustainability Accounting Standards Board (SASB) and the Taskforce for Climate Related Financial Disclosures (TCFD). Two standard setters – IIRC and SASB – plan to merge to form the Value Reporting Foundation, which is a welcome process.
Unlike other actors, the EU has the advantage of being able to set mandatory standards via legislation. It could opt to endorse one or other set of non-financial reporting standards, in the way it did in 2002 when it endorsed International Financial Reporting Standards (IFRS) for EU-listed companies.
It could also develop its own sustainability reporting standards, even if this would risk adding to the ‘alphabet soup’ of methodologies. Some might see this as a way for the bloc to maintain its global edge as standard setter at a time when the Biden administration may soon turn its attention to this topic and to steer the EU away from non-European (often code for Anglo-Saxon) approaches.
Speaking at a Chatham House Conference on Sustainable Business last month, the EU’s Commissioner for financial services, Mairead McGuinness, set out a vision for European non-financial corporate sustainability reporting standards in the context of the EU’s sustainability finance agenda.
McGuinness also said both European standards and global standards are needed: “We need European standards that build on and interact with what’s happening at the international standard-setting level. And we need global processes that are flexible enough to accommodate different countries that want to go further, for example, or indeed faster, according to their own political priorities.”
To remain true to its objectives, the Commission will also at some stage need to expand the scope of non-financial and sustainability reporting from the largest companies into the small and mid-cap sector.
Here the Commission seems to be taking a cautious approach in light of the headwinds faced by the corporate sectors and SMEs in particular. McGuinness last month spoke of “enticing” smaller companies to understand the merits of enhancing their non-financial reporting and transparency – to attract investment and customers.
Supply of non-financial information may be in a state of flux now, but the broader investment value chain is supportive of greater transparency on externalities and sustainability.
The sheer weight of capital involved is driving change, and a growing number of institutional asset owners and their beneficiaries are demanding more transparency on externalities – the positive and negative impact of their investments on wider society – with a view to understanding non-financial risks to portfolios, and beneficiaries’ long-term interests, particularly in relation to climate change.
Ultimately these actors will drive best practice in corporate reporting, as well as through their own corporate governance activities. The current review of the NFRD and other legislation is likely to be a punctuation mark in the long narrative of progress towards more holistic understanding of externalities and greater transparency as institutional capital shifts towards more sustainable economic activities.
Liam Kennedy, Editor