Applied since only January this year, the EU’s Corporate Sustainability Reporting Directive (CSRD) has already emerged as a global, transformative force in the ESG regulatory context.
Replacing the Non-Financial Reporting Directive, CSRD came into force in January 2023 and has applied since the start of this year. Alongside CSRD, the European Financial Reporting Advisory Group (EFRAG) developed the European Sustainability Reporting Standards (ESRS) as a roadmap for CSRD compliance by generating information that helps investors understand the sustainability impact of the companies in which they invest. This must be used by the 50,000 or so organizations to which CSRD applies.
This figure includes larger European companies, both private and public, and listed small and medium-sized entities. In addition, subsidiaries of non-EU companies and all so-called third-country (non-EU) companies with revenues in Europe exceeding €150 mn ($163 mn) will have to meet CSRD requirements.
The main – and major – changes of this new piece of legislation include a significant focus on double-materiality. This is what has been worrying many companies over the past three years since the European Commission (EC) first adopted the proposal that would become the rules we have today.
The nature of the data to be collected and the scale of the process to follow in order to collect that data is daunting. A survey by Baker Tilly published at the end of last year finds that 88 percent of companies do not feel ready to meet the CSRD’s expectations and 57 percent say they have little to no knowledge of the regulations. The study also finds that 21 percent of respondents describe CSRD as a ‘burden with little additional value.’
A burden of compliance
It may be a burden but the regulation is up and running, and compliance is the only way forward. Brian Tomlinson, managing director of ESG at Ernst & Young, highlights four main challenges companies may face. The first he says, is the concept itself.
‘This includes the notion of impact materiality, which is that inside-out concept: how is the company impacting the world around it?’ he tells Governance Intelligence sister publication IR Magazine. ‘And then it has that outside-in notion of financial materiality: how are sustainability issues affecting the company?’
Such notions, or their nuances, may be new to finance and sustainability teams, Tomlinson argues. ‘Putting into practice the concepts of both presents challenges with understanding and implementation – and everyone is on a learning curve,’ he says.
Beyond the difficulties presented by the notion of double-materiality, Tomlinson lists value-chain mapping, interpretive guidance, lack of indicative thresholds and the process of navigating the standards as other main hurdles – though he notes this is not an exhaustive list.
‘That guidance itself indicates the range of different approaches and judgement calls that need to be made as part of implementing a double-materiality assessment,’ he explains. ‘You then have the question of thresholds. In relation to impact materiality, companies need to assess the scope, scale, remediability and likelihood of the actual or potential impact.
‘In financial materiality, you are thinking about the size and likelihood of impact. But the ESRS standards themselves don’t provide specific indicative thresholds so many companies are thinking through how to determine the most appropriate thresholds for their business.’
Giulia Scanferla, senior ESG reporting manager at London-listed British American Tobacco (BAT), agrees with the challenges presented by the definitions of materiality, which are the core of CSRD. BAT started its double-materiality assessment exercise in 2022 and the first hurdle was to make stakeholders understand the difference between the importance and the impact of certain topics.
'So far, traditional or single materiality has been regarded as a tick-box exercise and was focusing on the importance of topics rather than the impact the topics have on us, or vice versa,’ she says. ‘That is quite a big step change in how the assessment needs to be conducted and the fact that it needs to be a fact-based exercise rather than perception-based – it’s not about how you and I think a given topic is important, it’s about what the actual inward and outward impact of this topic is.’
Scanferla also notes that it’s not easy for businesses to adapt to new reporting requirements and explains that, traditionally, BAT has focused on assessing and managing inward risks rather than outward risks. Having to identify and assess that outward risk was a substantial learning process, she recalls.
But the work paid off. In 2023, as the company carried out its second double-materiality assessment, the process was easier because it was able to use the efforts made in the previous year to align more closely with the ESRS requirements.
‘What we learned is that education and communication are essential to drive progress against this exercise,’ Scanferla says. ‘CSRD makes [the double-materiality assessment] very real and more fact-based than perception-based. All stakeholders involved must understand what it means and how it’s going to be used. Otherwise, it can be very tricky to use double-materiality strategically and correctly from a reporting perspective.’
The importance of gap analysis
Given the complexity and extent of the ESRS requirements, even companies with broad-ranging experience in ESG reporting may find they are still miles away from achieving full compliance. This is why conducting a gap assessment can be a good first step.
Technology company Royal Philips, for example, discovered after carrying out its first double-materiality assessment in 2022 that it was compliant with only 30 percent of the data points it needed to report under CSRD and ESRS. This was despite the firm boasting more than 15 years’ sustainability reporting experience.
From the gap assessment, however, the company was able to put a plan in place to address the issue. ‘After we completed the gap assessment, we created work streams per the ESRS standard to close the gap,’ says Simon Braaksma, senior director of sustainability reporting at Philips.
‘We need to comply with six topical standards, so six work streams. We created a CSRD steering committee, comprising a diverse group of senior managers reporting to top management on a regular basis. At Philips we have a lot of reporting experience, and yet this has been a major effort.’ He adds that ‘starting early was key’.
For Tomlinson, the gap assessment is ‘foundational’. ‘It is crucial to carry out the gap assessment in conjunction with the double-materiality assessment,’ he says. ‘The latter identifies elements within the standards that you must report on, in addition to those that are mandatory under all circumstances.’
And there are nuances throughout. ‘Beyond generating information for reporting against these metrics, the gap assessment will highlight the need to establish robust processes and controls, ensuring the accuracy of the data and making it assurance-ready,’ says Tomlinson.
CSRD outside the EU
CSRD and ESRS apply to certain non-EU listed companies or non-EU parent companies. These are:
All non-EU listed companies that meet two or more of the following criteria:
- Have more than 250 employees in the EU in a financial year
- Have a net turnover of more than €50 mn from EU activities
- Have a balance sheet that exceeds more than €25 mn for EU activities
These companies have a compliance timeline of 2026 for FY 2025.
All parent companies from a third country (the US, for example) that meet the following criteria:
- Register a turnover of more than €150 mn in the EU for two consecutive financial years
- Have a subsidiary in the EU that meets the same criteria outlined in the first point
- Have an EU branch with a turnover of more than €40 mn
For these companies, the timeline for compliance is 2029 for FY 2028.
Tomlinson defines the challenges faced by third countries as some of the most complex under CSRD. ‘For example, US groups that have more than a de minimis footprint in the EU are likely to be scoped into CSRD,’ he says. ‘Many of those US-based companies are thinking about reporting on the ESRS standards at a global level. The reporting boundary you use for CSRD and the reporting boundary for your double-materiality assessment need to align.’
In February this year, the EC agreed to grant a two-year delay for specific sectors and third-country companies. On the surface, this shows a semblance of flexibility from the EU. In reality, it doesn’t change much for those companies. In fact, the first batch of ESRS standards (ESRS 1), which are the most extensive, will apply to companies scoped in from FY 2024 and FY 2025, notes Tomlinson.
‘What has been delayed is the development of the sector-specific standards and the development of the third-country reporting standards,’ he explains. ‘But for those third countries, the delay doesn’t push back the date of the reporting obligation which is still 2029 for 2028. And many people we’ve spoken to have indicated that this delay is somewhat unhelpful because, as companies are weighing their reporting options and making decisions, it would have been useful to have those third-country standards to hand as part of those reporting option considerations.’
De facto global standard
Undoubtedly CSRD ushers in a new era of sustainability reporting, driven by double-materiality assessments. Scanferla says ‘CSRD changes everything and makes sustainability real as sustainability and business leaders will have a bigger opportunity to catalyze this change and make individuals responsible for progress across the organization.’
For Braaksma, the regulations ‘will level the playing field and, for the first time, investors will have a host of data points allowing them to compare apples with apples.’ While it will not directly influence Philips’ strategy, he notes it will give the company a competitive advantage.
Tomlinson says that while CSRD and ESRS pose huge challenges for businesses globally, these may also become the new global baseline for ESG disclosure.
‘When EFRAG developed the standards, it was asked to incorporate and consider a range of existing voluntary standards such as those of the GRI, the Sustainability Accounting Standards Board and TCFD among many others,’ he says. ‘It means the ESRS standards are extremely extensive but also interoperable. And if many global companies are reporting on the ESRS standards at a global level, it may become a de facto global ESG reporting standard.’
Getting started
- Start early: ‘We have a lot of experience reporting on ESG topics and it is [still] a lot of work to comply with CSRD and ESRS,’ says Braaksma. ‘Begin with the double-materiality assessment and do a gap assessment as the [next] step. This will allow you to understand the gaps and work in an efficient manner.’
- Be strategic: Don’t look at it as just a compliance exercise, says Tomlinson, but rather ‘a strategic opportunity to understand the impacts your business has – both positive and negative.’
- Engage early: ‘It’s important to ensure you’re using reasonable data, engaging stakeholders in the right way and carrying out a process that is documented so that your assurance provider can review and be confident in it,’ adds Tomlinson.
- Educate stakeholders: Make sure all stakeholders understand the meaning of CSRD, ESRS and how the double-materiality assessment is going to be used in your company’s reporting. ‘Education and communication are essential to drive progress against this exercise,’ says Scanferla.
