Global markets value environmental, social, human rights, biodiversity, & work ethics factors on par with finance

Once upon a time, the only goal of an accountant was to avoid books in the red at year-end. Since then, a splash of green is now the new normal.

A new European directive, however, may cause accounting departments to wring their hands because the economic value of an environmental good or service is no longer merely the sum of what someone would be willing to pay for it.

A global impact is likely to follow as the European Parliament (Parliament) and the Council of the European Union (Council) recently reached a provisional political agreement on the Corporate Sustainability Reporting Directive (CSRD).

The proposal for the CSRD, first presented by the European Commission (Commission) on 21 April 2021, foresees the adoption of EU-wide sustainability reporting standards and aims to revise and strengthen the rules set out already in 2014 in the Non-Financial Reporting Directive (NFRD).2 The new proposal came after the Parliament’s call for an extension of the scope of the NFRD beyond public-interest entities.

Furthermore, the evidence gathered by the Commission showed deficiencies in the current non-financial reporting framework, making it difficult for investors and other stakeholders to compare publicly available information, resulting in accountability gap of reporting companies.

Economists recognize that people value and have preferences for environmental improvements, and are willing to pay for bettering their environment.

As an example, people in major cities might be willing to pay for cleaner air and less smog, while someone whose local lake was closed by water pollution might be willing to pay to have it re-opened.

With the new proposal, the European Union aims to achieve more complete and meaningful sustainability reporting that includes not only information on climate-related topics but also on other matters such as biodiversity, social rights, and human rights, taking the non-financial reporting to a new level.

“In practice, this means that companies must contact all their subcontractors, including small, independent companies, and ask them about, for example, their greenhouse gas emissions,” said Thomas Riise Johansen.

A professor of accounting at Copenhagen Business School, Johansen previously worked in the accounting profession and he likes the expanded requirements for sustainability accounting, but he is somewhat cautious about the directive.

“Most industries have numerous tiers in the value chain but also multiple companies at every tier. For example, the entire value chain in a large technology firm has 170 direct contractors and 7,000 subcontractors in the value chain on average,” said Johansen.

“Not only that, the value chain also includes customers and consumers. It becomes a colossal task to get each and every tier to provide quality numbers on their sustainability efforts,” said Johansen. “Especially for smaller firms that are part of the value chain and that probably do not possess sufficiently detailed knowledge about accounting or the green transition to deliver reliable data.”

He also predicts that the new rules may present a challenge for collaboration in the value chain.

If, for instance, a company has contractors that only use diesel forklifts or tools with high energy consumption, then it may request that they replace equipment before the collaboration can continue.

Or food manufacturers may consider asking farmers to use a different feed to reduce their climate impact.

In both cases, the requests emerge due to the negative effect the contractors’ environmental impact has on the company’s green accounting.

The new reporting requirements will apply to all (listed and non-listed) large companies, i.e., companies with over 250 employees and €40 million turnover, as defined in the Accounting Directive.

In the current market, American dollars—indicated by the symbol $— are roughly equal euros—indicated by the symbol €.

The new rules will also apply to listed Small and Medium Enterprises (SMEs). Following Parliament’s proposal, an opt-out clause was introduced in the proposed text making it possible for in-scope SMEs not to apply CSRD requirements until 2028.

Non-European companies will also be in the scope of the CSRD.

In particular, non-European companies with at least one subsidiary that generate an annual net turnover of €150 million will be subject to the new EU reporting requirements. Non-European companies will also benefit from a transitional period before the rules would fully enter into force.

When it comes to company groups, while parent companies will have the responsibility to report the relevant information and to assess the information of their subsidiaries and branches, the company group will be obliged to present only one consolidated report.

The CSRD provides that the sustainability information to be reported by in-scope companies will need to be independently audited and certified by an accredited independent auditor or certifier, just like financial information.

This obligation effectively results in matching the level of importance amongst both types of reporting, ensuring companies will comply with reporting standards adopted at EU level and provide reliable, transparent, and comparable data. The non-financial reporting will be included in the so-called managing report, which will contain all the information subject to audit.

In the initial proposal, the Commission proposed for the sustainability assurance to be performed by the statutory auditor or audit firm, arguing that it would help with the consistency between financial and non-financial auditing.

However, under the provisional agreement, non-financial reporting audit will be open also to other auditors and assurance providers, provided they will obtain a certification for non-financial auditing.

The process of accreditation for non-financial auditors and assurance providers will be carried out at national level.

Furthermore, Member States will also set the requirements to ensure the quality of the assurance engagement carried out by independent assurance services providers; the requirement should also ensure consistent outcomes in the assurance of sustainability reporting.

The European Financial Reporting Group (EFRAG) will be the authority in charge of setting up the European sustainability reporting standards. The standards will be built as much as possible on already existing international standardization initiatives and relevant EU policies. EFRAG is set to publish some initial general standards in early summer 2023 and the standards for companies in specific sectors are expected to be published in June 2024.

The CSRD sets a precedent in sustainability reporting, broadening the scope by not only including environmental topics but also social and human rights, biodiversity, and work ethics.

Furthermore, for the first time, financial and non-financial reporting factors are considered equally important.

The reporting will have to be performed in accordance with the new EU sustainability reporting standards set up by EFRAG. The information provided by companies will then be audited by independent and certified auditors.

In terms of timeline, the application of the new requirements will take place in three different phases. The reporting will enter into force as of 1 January 2024 for companies already in scope of the NFRD. For companies not previously subject to the NFRD, the new reporting requirements will enter into force as of 1 January 2025. Finally, for listed SMEs the requirements will enter into force as of 1 January 2026.

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