Why is the standardisation of sustainability reporting so important?
The aim of the EU is to significantly improve the accessibility and comparability of environmental, social and governance (ESG) data. This is increasingly important due to, for example, the acceleration of climate change.
The EU is currently pursuing a globally significant initiative to harmonise sustainability reporting practices. What makes the project so unique is the EU’s aim to extend the regulatory framework to cover non-financial information while all other international non-financial reporting standards and frameworks are voluntary at the moment. The EU also intends to invest in digital reporting solutions covering both financial and ESG data. The European Commission has announced plans to establish a centralised data register* to improve the comparability of ESG data and to make the information available to as many stakeholders as possible.
The EU’s efforts coincide with extensive international cooperation discussions between the main non-financial reporting standard-setters and framework providers. These developments are particularly interesting when examined from a historical perspective. The year 2021 marks the 20th anniversary of IFRS (International Financial Reporting Standards), which is a good reminder of the fact that fully comparable data on international entities has only been available for a couple of decades. It is also worth remembering that the introduction of financial audits in the 1930s was a reaction to a worldwide financial crisis and that a risk-based approach did not properly break through in the financial sector until the 1950s.
The situation is trickier in respect of ESG reporting now than it was with financial reporting before IFRS. I am part of an EFRAG task force**, which is mandated to undertake preparatory work for possible EU non-financial reporting standards to be presented to the European Commission in February 2021. The European Lab Project Task Force (PTF-NFRS) has identified more than 90 international standards and frameworks as well as more than 600 sustainability data providers who benefit from the challenges relating to the accessibility and comparability of ESG data. Such a broad spectrum of data collection and distribution channels combined with the challenges of accessibility is hampering the financial sector’s ability to allocate funds effectively towards the mitigation of climate change and other sustainability solutions.
What is going to change?
The EU would like to address a wide range of issues with the possible future non-financial reporting standard. The focus is on pragmatic problem-solving and harmonisation of existing EU regulation.
According to the outreach document published in January, the future standard seeks to address the following issues, among others:
- Clarifying the concept of ‘double materiality’. The concept of ‘double materiality’ will be operationalised and clarified. ‘Materiality’ refers to the issues and indicators that have been identified as most important to report on. The new EU standard will define sector-agnostic, sector-specific and entity-specific reporting requirements. For example, efforts to mitigate climate change are likely to be among issues subject to sector-agnostic reporting requirements. Entity-specific reporting requirements will ensure that companies’ non-financial reporting reflects their various business segments and geographical locations appropriately.
- Including SMEs in the EU sustainability reporting landscape in a proportionate manner with lighter requirements to smaller companies.
- Advancing integrated reporting and including both non-financial and financial information to management strategy reports. This will help create a more holistic picture on how companies create value and how various types of capital (natural, intellectual, human and social) are employed.
- One of the task force’s positive challenges is to include reporting on intangible assets as part of non-financial reporting. Despite the considerable impact that intangibles have on market values, they are not sufficiently recognised in financial reporting at the moment. Intangibles have a number of compatibilities with ESG data: for example patents (including green patents), customer and employee satisfaction, innovation ability and brands.
- Measuring innovation performance: innovation ability is becoming an increasingly important element of entities’ sustainability assessments.
The prospective standard also aims to address the specific challenges of financial institutions, which are both users and producers of non-financial ESG data. Financial institutions’ indirect ESG impacts, i.e. those stemming from the entities they finance, are many times greater than their direct impacts.
It remains to be seen how effectively the new standard will be able to factor in both monetary and non-monetary quantitative indicators as well as qualitative indicators. Monetary quantitative indicators could relate to, for example, monetizing the value of environmental emissions (the “social cost” of emissions) or losses incurred as a result of climate change phenomena such as flooding. Qualitative indicators are narrative descriptions of, for example, the degree of non-discrimination and diversity in entities’ HR policies. Quantitative monetary metrics could help market participants to compare entities’ positive and negative ESG impacts to companies’ financials. This would also support emission markets’ development. Monetary indicators could also play an important role in the “do no significant harm” assessment in accordance with the EU’s green taxonomy.
The scale of reporting that the EU would like to establish is globally unprecedented. The EU will therefore be a trailblazer in this respect. My role in the EFRAG project task force is mainly in the workstream focusing on financial institutions, in addition to which I have selectively contributed to the work of other workstreams.
*) OP Asset Management was one of the initiators of the EU-wide financial-sector initiative in the autumn of 2019, which resulted in a joint industry letter calling for EU Action to create a centralised register for ESG data in the EU in the summer of 2020.
**) The European Financial Reporting Advisory Group (EFRAG) is a private association established in 2001 with the encouragement of the European Commission to serve the public interest. EFRAG is in the process of converting itself into a public EU entity and assuming responsibility for the standardisation of corporate reporting and dissemination of best practices. Its current members are European stakeholders and national organisations having knowledge and interest in the development of IFRS and how they contribute to the efficiency of capital markets.