EU ESG regulatory framework – 1 Complete read

EU ESG regulatory framework

EU ESG regulatory framework – Introduction

The EU ESG regulatory framework is in every company’s interest to adequately address material ESG impacts, risks and opportunities. ESG risks just like any other corporate risks may become detrimental to the company value. The cost to repair damages can be higher than preventative measures and proactive management. Evidence shows that companies that fully integrate ESG consideration in their operations and that are transparent and accountable to their stakeholders are better positioned for a long-term success.

Furthermore, companies face increasing pressure to report on ESG matters driven by shareholder demands, regulation, reputational concerns and other factors.

ESG refers to a broad range of environmental, social and governance factors that are used to evaluate how companies are managing their sustainability impacts, risks and opportunities. These factors can be either considered from the inside-out perspective (how the company operations impact the environment and the society at large) or an outside-in perspective (how ESG issues can affect the company’s positions). Here are examples of differente ESG Issues:

EU ESG regulatory framework

 

Environmental factors include issues that stem from or affect the environment. They include but are not limited to company impact on climate change (through GHG emissions); its management of climate related risks and opportunities; the use of energy, water and other resources; pollution and waste management; and impact of its business activities on biodiversity and natural environment.

Social factors refer to how the company affects humans it interacts with – its employees, clients, suppliers, local communities and other stakeholders – and how they in turn can affect the company. They include but are not limited to issues such as treatment of workers in own operations and in the supply chain; employees’ health and safety; diversity and inclusion; respect for human rights; as well as impacts on local communities and users of company’s products and services.

Governance refers to a system of internal practices, controls and procedures that a company adopts in order to govern itself, make effective decisions, comply with the law, and meet the needs of its stakeholders. Governance encompasses a system by which a company is managed, operated and held to account. Its primary objective is to help build the environment of trust, transparency and accountability that is key to ensure stability and encourage long-term investments. In the context of a broader range of ESG issues, governance can be broken down into two main areas: corporate governance and business ethics (or responsible business conduct).

The first one covers issues such as: ownership structure; board composition, independence and compensation; approach to risk management and internal controls; shareholder rights; and communication with shareholders. Business ethics on the other hand, refers to values, standards and principles a company adopts to govern itself in a responsible way, in line with applicable laws and regulations, and commonly accepted norms. It includes issues such as anticorruption, whistle blowing, and political lobbying, among others.

ESG factors are sometimes referred to as “non-financial” or “extrafinancial”. However, there has been some scepticism around the adequacy of those terms, because they imply that the information in question has no financial relevance. Whereas ESG issues in fact may have direct implications for the company financial performance.

For example, a company with weak governance practices can face substantial regulatory fines and legal costs if it gets embroiled in a related scandal. Similarly, mismanagement of environmental and social issues can have a bearing on the company bottom line through revenue loss, lower profitability and compliance costs, among others.

EU ESG regulatory framework – Regulatory landscape

The EU Sustainable Finance Action Plan

The Sustainable Finance Action Plan3 was first introduced in March 2018 with the aim to channel more investment into environmentally sustainable economic activities. Notably, those that can accelerate transition to carbon-neutral and climateresilient economy by 2050. The plan is a part of larger sustainable finance agenda supported by a broad set of new and amended legislations demanding greater transparency from companies and financial institutions on their sustainability impacts and the way they are managing related risks. These regulations include, among others:

  • The CSRD and supplementing it ESRS
  • The EU Taxonomy setting forth a common classification system to identify environmentally sustainable economic activities; and
  • The SFDR targeting financial market participants and financial advisors, and aimed at increasing transparency on sustainability aspects in the financial sector.

EU ESG regulatory framework

 

 

Level 1 measures (regulations and directives) setting forth general framework governing certain issue, and Level 2 measures that are adopted as Delegated Acts, and supplement Level 1 regulations by providing technical guidance on how certain aspects should be implemented in practice.

Corporate Sustainability Reporting Directive (CSRD)

The introduction of the Non-Financial Reporting Directive (NFRD) and its transposition into the each counties’ legislation was a watershed moment for sustainability reporting. It helped to anchor ESG reporting and increase the amount of ESG information published by the companies. The new and expanded regulatory requirements have further strengthened companies reporting practices. While the ESG reporting has been improving in the EU, the breadth, depth and consistency of reported information continues to vary.

The NFRD was the first legal act requiring certain companies across the EU to report on sustainability matters. Accordingly, large public-interest entities (PIEs) – such as listed companies, banks, insurance providers, etc. – or PIEs being a parent company of large groups exceeding 500 employees were required to publish an annual non-financial statement containing information and KPIs related to environmental, social and employee matters, respect for human rights, and actions to prevent bribery and corruption.

The CSRD extends the scope of the NFRD and introduces more detailed and ambitious reporting requirements for affected companies. Some of the major changes include:

INCREASED SCOPE

CSRD extends the scope of the reporting obligations to all large companies (listed and not listed) and the SMEs listed on the EU regulated markets (except micro enterprises) as well as (indirectly) certain non-EU companies

DOUBLE MATERIALITY PERSPECTIVE

Companies will have to report on the financial impact of ESG issues on their businesses as well as on the impacts they operations have on people and the planet.

EUROPEAN SUSTAINABILITY REPORTING STANDARDS

Companies will be required to use mandatory European Sustainability Reporting Standards (ESRS) to prepare their sustainability disclosures.

TRANSPARENCY ON VALUE CHAIN IMPACTS

Companies reporting will need to cover their direct operations but also material impacts, risks and opportunities in upstream and downstream value chain.

LINKS TO BUSINESS MODEL AND STRATEGY

Companies will have to explain how material ESG issues impact (positively and negatively) their strategy and business model and whether any adjustments will be made to mitigate negative sustainability impacts.

THIRD-PARTY ASSURANCE

Companies will be subject to limited assurance by accredited auditors and will likely be subject to more rigorous reasonable assurance in the future.

The NFRD undoubtedly helped to improve the availability of ESG information among the companies in the EU. However, many stakeholders (including investors) have been raising concerns that the disclosures provided by the companies are insufficient and difficult to compare due to the lack of common unified sustainability reporting standard. Moreover, it was necessary to align the NFRD requirements with the regulations introduced at the later stage as part of the EU sustainable finance agenda, i.e. the EU Taxonomy and the SFDR.

Who is in scope of the CSRD?

The CSRD will apply to the following entities:

  • all companies listed on the EU regulated market, including SMEs (except micro-enterprises)
  • all large companies exceeding two of the three following criteria (as per the Accounting Directive 2013/34/EU):
    • more than 250 employees
    • net turnover exceeding EUR 40 million
    • balance sheet exceeding EUR 20 million
  • (indirectly) non-EU companies operating in the EU meeting the following criteria:
    • net turnover generated in the EU exceeding EUR 150 million and a subsidiary in the EU that is in scope of the CSRD
    • net turnover generated in the EU exceeding EUR 150 million and EU branch with an annual net turnover exceeding €40 million.

Subsidiaries will be exempted from publishing sustainability statements if they have been included in the parent company consolidated management report that was prepared in accordance with the CSRD requirements, or in the consolidated sustainability reporting of the third-country parent company prepared in accordance with the ESRS or other standard recognised as equivalent. The exemption is not available to large listed companies. Exempted subsidiaries must include in their management report the following information:

  • name and registered office of the parent company that is reporting sustainability information at the group level;
  • link to the consolidated management report;
  • reference of this exemption in their own management report.

When will the CSRD start to apply?

EU ESG regulatory framework

 

European Sustainability Reporting Standards (ESRS)

In line with the CSRD provisions, all companies subject to the CSRD are required to use mandatory regulatory sustainability reporting standards as a basis for preparing their sustainability disclosures. Those standards are referred to as European Sustainability Reporting Standards (ESRS)7 and are adopted as Delegated Acts supplementing the CSRD.

The first set of standards was adopted in July 2023 and contains 12 sector agnostic standards. The standards architecture also anticipates the adoption of sector-specific standards as well as proportionate standards for SMEs and non-EU companies.

The standards are being developed by the European Financial Reporting Advisory Group (EFRAG) – a private organization that provides technical assistance to the European Commission.

Link to other regulations and sustainability reporting initiatives
The ESRS consider European law and initiatives under the EU sustainable finance agenda, EU Taxonomy, SFDR, proposal of the CSDDD, as well as sustainability reporting initiatives such as ISSB, TCFD and GRI to ensure standards interoperability.

EU Taxonomy

The EU Taxonomy (Regulation (EU) 2020/852)8 establishes a common classification system to help identify environmentally sustainable economic activities. It applies to:

  • Companies in scope of the NFRD/CSRD, and
  • Financial market participants offering financial products in the EU in scope of the SFDR. Notably, those offering products with sustainability objectives or promoting characteristics (SFDR Article 8 and 9 funds).

What are the EU Taxonomy classification criteria?

To be classified as environmentally sustainable, an economic activity must make substantial contribution to at least one of the six environmental objectives outlined in the figure below whilst not significantly harming any of the others. It must also comply with the Minimum Safeguards such as OECD Guidelines, UN Principles and ILO core conventions.

EU ESG regulatory framework

 

The assessment whether an activity contributes to or harms the environmental objectives is made based on the harmonized performance thresholds, also called the Technical Screening Criteria (TSC). They are outlined in the EU Taxonomy Delegated Acts9, which provide technical guidance on practical implementation of the Taxonomy Regulation. Notably:

  • The Climate Delegated Act (Delegated Regulation (EU) 2021/2139)10 and a the Complementary Climate Delegated Act (Delegated Regulation (EU) 2022/121411, providing technical screening criteria for activities that can make a substantial contribution to climate change mitigation and climate change adaptation, and
  • The Environmental Delegated Act, providing technical screening criteria for activities that can make a substantial contribution to the remaining four environmental objectives.

What has to be reported under the EU Taxonomy?

Although the EU Taxonomy is not intended to be a reporting framework, it introduces certain reporting obligations on companies and financial actors it applies to. Those obligations differ depending on the type of entity and the underlying regulation that is applicable to it. Below figure provides details on the timelines and disclosure requirements for different types of organisations.

EU ESG regulatory framework

The Disclosures Delegated Act (Delegated Regulation (EU) 2021/2178)12 supplementing Art. 8 of the Taxonomy Regulation specifies the reporting timelines as well as the content, methodology and presentation of information to be disclosed by financial and non-financial companies in scope of the NFRD/CSRD, concerning the proportion of environmentally sustainable economic activities in their business, investments or lending activities.

Accordingly, non-financial companies subject to NFRD/CSRD are required to report the following KPIs:

  • proportion (%) of turnover derived from products or services associated with environmentally sustainable economic activities;
  • proportion (%) of capital expenditures (CAPEX) related to assets or processes associated with environmentally sustainable economic activities;
  • proportion (%) of operating expenditures (OPEX) related to assets or processes associated with environmentally sustainable economic activities.

Financial companies in scope of the NFRD/CSRD have to report corresponding KPIs. Specifically, credit institutions have to disclose Green Asset Ratio (GAR) which shows the proportion of Taxonomy-aligned on-balance-sheet exposure in relation to the total assets.

On the other hand, financial market participants who are subject to the SFDR are required to provide product-level disclosures (in case of SFDR Article 8 and Article 9 funds) in line with the Art. 5 and 6 of the Taxonomy Regulation. The details on how this information should be presented in pre-contractual disclosures and periodic reports, including a mandatory template is specified by the Regulatory Technical Standards (RTS) supplementing SFDR.

What is the difference between the Taxonomy eligibility and alignment?

The EU Taxonomy provides a list of business activities that have a potential to contribute to outlined therein environmental objectives. For those activities, technical screening criteria were developed to evaluate whether an economic activity can be considered environmentally sustainable. Those activities fall in scope of the EU Taxonomy (in other words they are Taxonomyeligible).

If an economic activity is not included in the EU Taxonomy, it does not mean that it has negative environmental impact. It simply means that it was not classified either because it has negligible positive impact or is considered neutral.

The eligibility assessment is the first step of a full Taxonomy-alignment analysis. The remaining four conditions have to be met to support the alignment conclusion. These are:

  • Making a substantial contribution to at least one environmental objective
  • Do no significant harm (DNSH) in relation to the other environmental objectives
  • Compliance with Minimum Safeguards to ensure that companies engaging in the sustainable activities meet certain social and business ethics standards
  • Compliance with the technical screening criteria set out in the Taxonomy Delegated Acts

Sustainable Finance Disclosure Regulations (SFDR)

The SFDR (Regulation (EU) 2019/2088)13 was introduced in 2019 and came into effect in March 2021. It imposes mandatory ESG disclosure obligations on two types of financial entities:

  • financial markets participants that manufacture and sell financial products and perform portfolio management services (i.e., asset managers, pension fund providers, banks and insurers), and
  • financial advisors.

What is the objective of the SFDR?

The SFDR aims to increase transparency on the European capital markets by requiring financial actors to report more accurately about their ESG risks and integration of sustainability aspects in the investment processes.

To provide end-investors with a better overview of the sustainability profile of investment products, SFDR also requires fund managers to classify their funds into the following categories:

  • Article 6 Funds – funds that have no specific ESG focus
  • Article 8 Funds – funds that promote environmental or social characteristics
  • Article 9 Funds – funds that have sustainable investment as their objective

What must be disclosed under the SFDR?

Under the SFDR, financial actors must make a number of entity level and product-level disclosures in relation to sustainability risks and consideration of adverse sustainability impacts in their investment processes, among other things. They must also disclose sustainability-related information with respect to the financial products they offer. Products that promote environmental or social characteristics or have a sustainable investment objective (so called Article 8 and Article 9 funds) are subject to stricter disclosure rules. Required information must be disclosed through different channels: on the company website, in precontractual documents and in periodic reporting.

Content, methodologies and presentation of the sustainability related disclosures required under SFDR is further specified in the Regulatory Technical Standards (RTS),14 which have been adopted in April 2022 and started to apply from 1 January 2023.

What will be the impact of the SFDR on the listed companies?

While SFDR is applicable to financial actors, it will impact companies indirectly through increased demand for ESG data from investors as they will be seeking to fulfil their reporting obligations.

Listed companies should specifically take notice of the Principal Adverse Impact (PAI) indicators, that fund managers subject to the SFRD are required to report across their investments in a given period. PAI indicators are divided into mandatory and voluntary ones and have been established for corporate, sovereign, and real estate holdings. Mandatory PAI indicators for corporate investments are outlined in this table:

SFDR Mandatory PA Is applicable to corporate investments
1 GHG emissions Scope 1 GHG emissions15
Scope 2 GHG emissions
Scope 3 GHG emissions
Total GHG emissions
2 Carbon footprint Carbon footprint
3 GHG intensity of investee companies GHG intensity of investee companies
4 Exposure to companies active in the fossil fuel sector Share of investments in companies active in the fossil fuel sector.
5 Share of non-renewable energy consumption and production Share of non-renewable energy consumption and non-renewable energy production of investee companies from non-renewable energy sources compared to renewable energy sources, expressed as a percentage.
6 Energy consumption intensity per high impact climate sector Energy consumption in GWh per million EUR of revenue of investee companies, per high impact climate sector.
7 Activities negatively affecting biodiversity-sensitive areas Share of investments in investee companies with sites/operations located in or near to biodiversity-sensitive areas where activities of those investee companies negatively affect those areas.
8 Emissions to water Tonnes of emissions to water generated by investee companies per million EUR invested, expressed as a weighted average.
9 Hazardous waste and radioactive waste ratio Tonnes of hazardous waste and radioactive waste generated by investee companies per million EUR invested, expressed as a weighted average.
10 Violations of UN Global Compact principles and OECD Guidelines for Multinational Enterprises Share of investments in investee companies that have been involved in violations of the UNGC principles or OECD Guidelines for Multinational Enterprises.
11 Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises Share of investments in investee companies without policies to monitor compliance with the UNGC principles or OECD Guidelines for Multinational Enterprises or grievance /complaints handling mechanisms to address violations of the UNGC principles or OECD Guidelines for Multinational Enterprises.
12 Unadjusted gender pay gap Average unadjusted gender pay gap of investee companies.
13 Board gender diversity
14 Exposure to controversial weapons (anti-personnel mines, cluster munitions, chemical weapons and biological weapons) Share of investments in investee companies involved in the manufacture orselling of controversial weapons.

Corporate Sustainability Due Diligence Directive (CSDDD)

Beyond on-going developments related to the CSRD, the ESRS, the EU Taxonomy and the SFDR, the EU Commission proposed also other regulations further specifying companies’ obligations around management of sustainability issues.

Specifically, in February 2022, European Commission proposed the Corporate Sustainability Directive (CSDDD)16, which will increase companies’ accountability for the negative environmental and human rights impact across their value chain. The new directive is closely linked to the CSRD and the minimum safeguards included in the EU Taxonomy.

The directive will require companies to identify and mitigate (based on the severity and likelihood) any potential adverse impacts in their own operations, their subsidiaries and other entities in their value chains with which they have direct and indirect business relationships. These include issues such as child and forced labour, abusive labour practices, unsafe working conditions, impacts on biodiversity, pollution, etc.

When enforced, the directive will require companies to perform the following due diligence activities:

  • include due diligence in relevant policies; EU ESG regulatory framework
  • identify and mitigate any potential adverse environmental or human rights impacts; EU ESG regulatory framework
  • bring to an end or minimise actual impacts; EU ESG regulatory framework
  • establish and maintain a complaints procedure; EU ESG regulatory framework
  • onitor the effectiveness of the due diligence policy and actions; EU ESG regulatory framework
  • publicly disclose on due diligence. EU ESG regulatory framework

In terms of human rights due diligence, the CSDDD proposal is aligned with existing international standards. such as the UN’s Guiding Principles on Business and Human Rights, the OECD Guidelines for Multinational Enterprises, and the OECD Due Diligence Guidance for Responsible Business Conduct.

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