EU Approves ESG Reporting Standards: Impacts on the US

This year proved to be the beginning of a more sustainable future for the EU: the Commission adopted the European Sustainability Reporting Standards (ESRS) for all companies subject to the Corporate Sustainability Reporting Directive (CSRD). 

Essentially, any major corporation operating within Europe is now obligated to formally disclose its environmental impact, detail its pollution-reduction and ethical strategies, and track its progress in 2025 and 2026. 

Additionally, the EU CSRD has established rigorous guidelines mandating enterprises to commence data collection, storage, and quality control relating to Environmental, Social, and Governance (ESG) reporting directives (i,e.,climate change, biodiversity, human rights, etc.) so that investors understand the sustainability impact of the companies in which they invest. 

“The standards we have adopted today are ambitious and are an important tool underpinning the EU’s sustainable finance agenda.” said Mairead McGuinness, Commissioner for Financial Services, Financial Stability and Capital Markets Union. “They strike the right balance between limiting the burden on reporting companies while at the same time enabling companies to show the efforts they are making to meet the Green Deal aAgenda, and accordingly have access to sustainable finance.”

It’s undoubtedly a major milestone in demystifying how to invest in corporations that are authentically ESG-oriented. Since the rise of ESG backlash, investors have had to establish their own due diligence processes to vet whether a corporation was being honest in its labeling. 

Now, C-level executives are wondering: what does the future look like for US-based companies and ESG-reporting legislation? 

A Need for Policy and Transparency  

As more investors shift their capital towards highly-rated ESG companies and away from those involved in pollution, bribery, or worker mistreatment, the market is adapting accordingly.

According to a Deloitte article, “in the United States, fund managers launched 149 mutual funds and ETFs with ESG characteristics or objectives in 2021, comprising about 22% of all fund launches. The one-year growth rate of ESG fund launches in the United States is more than twice that of funds without, 80% versus 34%, respectively.”

This growth, however, has brought about several challenges. While many companies have recently claimed to adhere to ESG standards, without any institutional means to assess and report their commitments, there is no way to verify their claims. 

This situation has led to a widespread backlash against ESG practices. Prior to these investigations and the growing concerns from regulatory bodies like the Securities and Exchange Commission (SEC) and International Sustainability Standards Board (ISSB), companies were less focused on providing accurate representations of their ESG commitments. 

In their pursuit of outperforming competitors and boosting stock values, corporations proposed reform plans. However, most shared unrealistic goals and falsified records to mislead investors, improve their ESG ratings, and attract investments. Such market manipulation has prompted investors to scrutinize the tactics behind greenwashing.

Today, it’s not enough for corporations to simply publish ESG reports and set arbitrary sustainability goals. With greenhouse gas emissions, greenwashing, and stakeholder activism on the rise, corporate boards are being scrutinized more than ever with evolving global regulations and tightening reporting frameworks. And for investors, due diligence only goes so far in revealing how altruistic a company’s ESG initiatives truly are.

EU’s ESG Reporting Regulations 

The European Commission’s adoption of the ESRS this past July is scheduled to come into effect on January 1, 2024. For the EU business leaders, the genesis of these standards can be traced back to the European Green Deal, which mandated an evaluation of companies’ sustainability performance. 

The standards were formulated by the European Financial Reporting Advisory Group (EFRAG) to meet the reporting obligations outlined in the EU’s Corporate Sustainability Reporting Directive and Sustainable Finance Disclosure Regulation. Although the initial draft standards were submitted to the commission in November 2022, EFRAG has since made significant revisions based on input from stakeholders and the commission. The final standards adopted by the commission are less strict and have reclassified some aspects from mandatory to voluntary.

However, it’s worth noting that while the ESRS bear the term “sustainability” in their title, they encompass a broader scope of environmental, social, and governance reporting requirements. ESG investing takes into account non-financial factors, even though surge in ESG investing was the main need for standardized reporting guidelines.

The ESRS consist of 12 standards divided into four reporting categories: general, environmental, social, and governance. The general category covers topics that have relevance across multiple categories, such as reporting format and timelines, and two of the ESRS fall under this general category.

Environmental

E1 Climate Change:

• Disclosures on climate change mitigation, climate change adaptation and energy consumption.
  
• Disclosures on climate change mitigation relate to the company’s efforts to limit global warming to 1.5°C in line with the Paris Agreement.
  
• Disclosures on Scopes 1, 2 and 3 greenhouse gas emissions and transition risks.

E2 Pollution: 

• Disclosures on pollution of the air, water, soil, living organisms and food resources, as well as the use of substances of concern and microplastics.
  
• This standard covers pollutants generated or used during production processes and those that leave facilities as emissions, products, or as part of products or services.

E3 Water and Marine Resources:

• Disclosures on consumption, withdrawal and discharge from and into water (including ground and surface water) and marine resources.
  
• This standard also requires consideration of the extraction and use of marine resources.

E4 Biodiversity and ecosystems:

• Disclosures covering areas such as the drivers of biodiversity loss, impact on species, and impacts and dependencies on ecosystems.

E5 Circular Economy:

• Disclosures on resource inflows, outflows, waste, resource optimization and the risks of the transition to a circular economy.
  
• A circular economy is one in which the value of products, materials and other resources in the economy are maintained for as long as possible, enhancing their efficient use in production and consumption, thereby reducing the environmental impact of their use, minimizing waste and the release of hazardous substances at all stages of the product life cycle.

Social

S1 Own workforce:

• Disclosures on the company’s own workforce – including freedom of association, working conditions, access to equal opportunities and other work-related rights.

S2 Workers in the Value Chain:

• This standard is similar to ESRS S1 in content but requires consideration of the workers in the company’s value chain(s).

S3 Affected Communities:

• Disclosures on the impact of a company’s own operations and value chain – including its products and services, impact on indigenous rights, civil rights, and social and economic rights, including water and sanitation, among others.

S4 Consumers and End-Users:

• Disclosures on the impacts of a company’s products and/or services on consumers and end-users – including access to quality information, privacy and the protection of children.
  
• Companies are not required to consider the unlawful use or misuse of products or services.

Governance

G1 Business conduct:

• Disclosures on anti-corruption and anti-bribery practices, the protection of whistleblowers, political lobbying and the management of relationships with suppliers (including payment practices).

EU’s Regulation Impact on the US

It’s important to note that while the CSRD focuses on amending the EU economy, its reach encompasses EU companies and non-EU companies, both public and private, that meet specified thresholds. The bottom line?

Even US and other non-EU companies conducting business within the EU may need to produce ESG reports in accordance with EU regulations, regardless of their listing status on European exchanges. 

Although non-EU companies have a more extended timeframe for reporting, many EU subsidiaries of non-EU firms will face earlier reporting requirements. In practical terms, non-EU companies with such subsidiaries might find it advantageous to consider early reporting at the parent company level rather than creating separate subsidiary-level reports, especially if they already produce comprehensive voluntary ESG disclosures.

For the past few years, the United States has seen a parallel but more limited shift towards expanding mandatory ESG reporting obligations. The SEC has taken a targeted approach, focusing on specific ESG issues, focusing on climate change and cybersecurity reporting, with expectations for proposed rules on human capital and board diversity disclosure in the near future. 

SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors:

• Scope 1 and 2 greenhouse gas (GHG) emissions
• Scope 3 emissions if material or if the registrant has set a GHG emissions reduction target that includes Scope 3 emissions
  
• Additional qualitative and quantitative climate risk disclosures, including the financial impacts of severe weather events and other natural conditions and transition activities on line items of the financial statements
• Governance of climate-related risks and risk-management processes

SEC’s Cybersecurity Disclosure Requirements for Public Companies:

• Report “material” cybersecurity incidents on a Form 8-K within four business days of materiality determination.
  
• Describe the nature, scope, and timing of the incident and the material impact or reasonably likely material impact on the registrant. To the extent required information is not determined or is unavailable at the time of the filing, the 8-K should include disclosure of this fact, and the 8-K should be later amended when the information is determined or becomes available.
  
• Materiality determination should be based on federal securities law materiality, including consideration of quantitative and qualitative factors.
• Prospective risks and material impacts on the business, strategy and outlook caused by climate change, generally consistent with the Task Force on Climate-Related Financial Disclosures (TCFD) disclosures (e.g. asset risks at a zip code level)

The CSRD grants the European Commission the authority to recognize sustainability reporting standards applied by non-EU countries as equivalent. However, since the SEC has not yet proposed and is not anticipated to propose sustainability reporting rules that are as comprehensive as the CSRD, it is unlikely that the SEC’s rules will be considered equivalent to all CSRD reporting standards. Though some, such as those related to climate change, may gain equivalence recognition. 

Consequently, for US issuers falling under the scope of the new EU regulations, compliance with the CSRD will likely necessitate the creation of a dedicated report. Furthermore, the CSRD’s scope extends beyond that of most voluntary reporting standards currently followed by US and global companies, such as the Task Force on Climate-Related Financial Disclosures (TCFD) framework or the Sustainability Accounting Standards Board’s 77 industry-specific standards.

An ESG Future for the US and Abroad

The rollout of CSRD reporting timelines will occur in multiple phases, so it’s essential to grasp which timelines are applicable to your situation. What applies universally is the recognition that achieving seamless ESG reporting demands a substantial investment in digital infrastructure, data collection systems, analytics capabilities, and the acquisition of skilled personnel. It’s crucial not to underestimate the complexity of this regulation, as a significant portion of the challenge involves gathering and validating data from various points across your value chain.

Ensuring your participation in ESG discussions within your organization is vital to underscore the importance of digital preparedness and its direct correlation with ESG performance. And in the age of information overload, staying on top of the latest news within your industry requires a tool that separates noise from valuable insights. 

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