The new – and bigger – ESG threat to American companies

[Editor's note: This story originally was published by Real Clear Wire.]

By Adam Olsen
Real Clear Wire

Talking with executives at American companies across the country, they are focusing on the upcoming SEC climate disclosure requirements, and rightfully so. The new environmental, social and governance (ESG) standards have dominated headlines and countless hours of preparation have been devoted to getting organizations properly positioned. However, an equally significant set of regulations across the pond could also have a profound impact and similarly compel urgent action. It’s the European Union’s Corporate Sustainability Reporting Directive (CSRD), and despite the vast number of American businesses in scope for the CSRD with relatively little time to prepare.

Given the estimated 50,000 companies the CSRD will ensnare – compared to the roughly 11,000 in scope for the EU’s current Non-Financial Reporting Directive (NFRD) – the CSRD is an entirely different, far bigger animal that will catch many American companies off-guard unless they start preparing soon.

Background on the CSRD

The European Financial Reporting Advisory Group (EFRAG) created the EU framework for reporting sustainability information. This framework, called the European Sustainability Reporting Standards (ESRS) and enforced through the CSRD, represents a far more expansive set of reporting requirements than its predessesor, encompassing areas like pollution, biodiversity, work forces, and corporate conduct.

With its many cross-cutting and topic-specific standards, complying with the CSRD won’t be a simple or quick task for in scope organizations. In fact, the first set of standards alone includes 84 disclosure requirements as well as 1,144 quantitative and qualitative datapoints.

Therefore, the CSRD represents an entirely new set of complex and demanding reporting requirements for many US-based companies with overseas operations. In terms of scoping, both public and private companies domiciled inside and outside of the EU member states, including U.S. businesses, may find themselves falling in scope of the CSRD and ESRS.

Navigating the New EU Standards

The ESRS categorize requirements by topics and layers which, once again, include two cross-cutting and ten topic-specific standards covering key environmental, social, and governance topics. In total, the standards comprisee:

• Climate change
• Pollution
• Water & marine resources
• Biodiversity & ecosystems
• Resource use & circular economy
• Company workers
• Workers in the value chain
• Affected communities
• Consumers & end-users
• Business conduct

ESRS Disclosure Layers

The ESRS also includes three “disclosure” layers – sector-agnostic, sector-specific, and entity-specific – although the current draft only covers sector-agnostic and entity-specific disclosures, leaving the sector-specific layer for future updates. Like other components of the CSRD, however, these layers can be just as much a benefit for companies as they are additional responsibilities.

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For example, entity-specific disclosures require businesses to provide additional information related to impacts, risks, and opportunities associated with environmental, social, and governance matters. Granted, these disclosures are only necessary if the standards fail to capture such information with sufficient granularity and are material to a company’s specific facts and circumstances. Still, required or not, such disclosures provide information that stakeholders, investors, employees, and the general public both expect and demand.

Companies that provide clear, accurate disclosures on ESG-related data and strategies will hold an advantage over those cobbling together ESRS reporting at the last minute. Obviously, this shines a bright spotlight on an organization’s ability to quickly and reliably identify, collect, analyze, and report ESRS data.

ESRS Reporting Areas

The expansive CSRD also includes requirements beyond the standards and layers. In fact, the three disclosure layers themselves encompass four reporting areas companies should cover for all cross-cutting and topical standards:

• Governance – the processes, controls, and procedures a company uses to monitor and manage impact, sustainability risks, and opportunities
• Strategy – how an organization’s strategy and business model interact with its material impact, risks, and opportunities
• Impact, risk, and opportunity management – the processes an organization uses to identify, assess, and manage impact, risk, and opportunity through policies and actions
• Metrics and targets – how an organization measures its performance and tracks its progress toward its targets

Materiality in the CSRD

One of the more notable components of the CSRD is its use of double materiality. All sustainability reporting within the ESRS and mandated by the CSRD revolves around a double materiality principle that focuses on two dimensions companies must consider – impact materiality and financial materiality.

The financial materiality covers impacts to financial performance, position, and cash flows. Companies must evaluate financial materiality over short, medium, and long-term time horizons, focusing their assessments on the size and likelihood of the financial impact.

Impact materiality includes actual or potential impacts – both positive and negative – on people or the environment. Like financial materiality, companies must evaluate it over short, medium, and long-term time horizons, including the impacts across their full upstream and downstream value chains in the assessment.

Preparing for the CSRD

The first in scope companies must start their CSRD reporting in 2025 for the 2024 fiscal year. Obviously, that doesn’t leave much time for finance organizations to get up and running. Therefore, putting together some semblance of a path forward should be toward the top of a CFO’s to-do list, beginning with a few critical questions:

• Legal entity scoping and materiality assessment – are you in scope of the CSRD requirements? If so, do you have the data, systems, and processes in place to meet both sides of the double materiality assessment?
• Readiness assessment and gap analysis – how well do your current performance metrics, practices, and disclosure levels align with the ESRS?

Answers in hand, companies can proceed with planning and building a roadmap for CSRD compliance, one that should focus on at least four areas:

• Ensuring processes and controls can effectively handle CSRD disclosure requirements
• Shoring up data-gathering abilities by identifying essential information and the people, processes, and technologies that will provide it
• Identifying and implementing the reporting systems necessary to deliver the timely, accurate information the ESRS require
• Preparing for the mandatory external assurance requirements ramping up later in the decade

Thankfully, the same systems and processes a company uses for SEC climate disclosures can also shoulder much of the CSRD requirements. However, as discussed, there are still significant differences between the two, making it imperative for in scope American businesses to begin their preparation for the CSRD while there’s still time.

Adam Olsen is a Managing Director, Financial Accounting Advisory Practice Leader, business advisory firm Embark.

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