Companies subject to the EU’s Corporate Sustainability Reporting Directive (“CSRD”) will be required to report on material sustainability impacts according to the disclosure requirements set forth in the European Sustainability Reporting Standards (“ESRS”). On July 31, 2023, the European Commission (“Commission”) adopted a delegated act that sets out the final version of the ESRS (“Adopted ESRS”). The Adopted ESRS build on, but make significant changes to, the first draft ESRS that the European Financial Reporting Advisory Group (“EFRAG”), a private association that provides technical advice to the Commission, published late last year. It largely follows the version that the Commission put out for public consultation several weeks ago. There will now be a two-month (extendable to four-month) scrutiny period during which the European Parliament and the Council of the EU can submit any objections to the Adopted ESRS. If no objections are made, the Adopted ESRS will be published in the EU Official Journal, become binding for companies under EU law, and take effect from January 1, 2024. The Commission also released an FAQ document on the ESRS on July 31, 2023.
In this alert, we describe key elements of the Adopted ESRS, as compared to the earlier drafts from EFRAG and the Commission. We also highlight the overlap and differences between the Adopted ESRS and the first set of sustainability-focused International Financial Reporting Standards (“IFRS”) issued by the International Sustainability Standards Board (the “ISSB Standards”) in June 2023 (details of which can be found in our recent blog post).
The Adopted ESRS
What has remained the same?
The Adopted ESRS include the same twelve standards as both previous drafts: two cross-cutting standards, covering General Requirements and General Disclosures; and ten topical standards, which are depicted below.
The Adopted ESRS also retain key concepts that originated in the EFRAG draft, including the “double materiality” principle, which is enshrined in the CSRD. The double materiality principle will require reporting companies to evaluate materiality not only from the standpoint of how sustainability matters may impact the company, but also from the standpoint of how the company’s activities impact people and the planet. The Adopted ESRS also retain a reference to forthcoming sector-specific standards (adoption of which is expected to start from June 2024 onwards).
What has changed?
The Adopted ESRS retain the three key changes that the Commission made to the EFRAG draft before it launched its public consultation: (i) all disclosures under the ten topical reporting standards are now subject to a materiality assessment; (ii) certain types of companies and certain disclosure requirements are subject to phase-in periods before reporting becomes mandatory; and (iii) reporting companies have additional flexibility as several disclosure requirements are no longer mandatory but only voluntary.
Before briefly explaining these changes below, it is useful context that Mairead McGuinness, the EU Commissioner responsible for the CSRD and wider Sustainable Finance Package, stressed at a presentation to EFRAG last month the importance of developing a version of the ESRS that is fully compliant with the mandate and ambition of the CSRD, and that avoids imposing disproportionate burdens on companies. Commissioner McGuinness went on to say that the Commission’s draft took into account the difficulties companies may face in reporting, and that part of the aim of the amendments was to foster engagement from corporates rather than resistance.
(i) All topical disclosure requirements are now subject to a materiality assessment
Under the Adopted ESRS, only the cross-cutting General Disclosures in ESRS 2 (and related topic-specific process disclosures about the materiality assessment) will be mandatory. The EFRAG draft had proposed that certain disclosures be mandatory regardless of the outcome of a company’s materiality assessment, such as greenhouse gas emissions disclosures and certain disclosures related to a company’s own workforce. In a change designed to ease reporting burdens, all disclosure requirements except those mentioned above will now only be mandatory where they are assessed as material.
Although this change may reduce the reporting burden for companies, the new approach further elevates the significance of the materiality assessment. Companies will need to establish rigorous processes to collect relevant information and determine what must be disclosed. Highlighting the close relationship between the CSRD and the proposed EU Corporate Sustainability Due Diligence Directive (“CSDDD”) (on which, see our previous alert), the ESRS expressly acknowledge that materiality assessments will be informed by the company’s sustainability due diligence efforts. Indeed, the description of impact materiality in the Adopted ESRS draws directly from key concepts in prominent due diligence frameworks such as the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises. This will necessitate an integrated approach to substantive environmental and human rights due diligence and reporting on material sustainability impacts.
(ii) Additional phase-in periods have been included
The Adopted ESRS include additional phase-in periods for smaller companies and selected reporting obligations that the Commission proposed in its draft. These include:
- For all reporting entities:
- For the first reporting year, companies can omit from their sustainability statements certain disclosures on anticipated financial effects under the environmental ESRS as well as certain social disclosures (including some disclosures relating to characteristics of non-employee workers in their own workforce, people with disabilities, social protection coverage, health and safety, and work-life balance).
- For the second and third reporting years, companies can provide qualitative rather than quantitative disclosures on certain matters under the environmental ESRS.
- For companies with fewer than 750 employees:
- For the first year in which they are required to report under the CSRD’s tiered phase-in periods, companies can choose to omit data points on scope 3 emissions and total greenhouse gas emissions as well as disclosure requirements under ESRS S1 (Own Workforce).
- For the first two years in which they are required to report, companies can omit disclosures under ESRS E4 (Biodiversity and Ecosystems), ESRS S2 (Workers in the Value Chain), ESRS S3 (Affected Communities), and ESRS S4 (Consumers and End Users).
- A company must still conduct a materiality assessment covering all ESRS. If it decides to make use of the exception above and omit information under ESRS E4, S1, S2, S3, or S4, it must nonetheless disclose in its report which, if any, topics covered by one of these standards have been deemed material as a result of the materiality assessment. For each material matter, the reporting company must also include in its report a brief description of any time-bound targets, relevant metrics, and policies, as well as any actions taken to identify, prevent, mitigate, remediate or bring to an end actual or potential adverse impacts.
(iii) Increased flexibility has been built into the standards
The Adopted ESRS makes voluntary a number of disclosure requirements and data points that EFRAG originally proposed be mandatory. These include, for example, some disclosure requirements on biodiversity, collective bargaining, social protection, training, and various requirements related to non-employee workers in a reporting company’s own workforce. In addition, if a reporting company concludes in its materiality assessment that a topic is not material, it will usually have the discretion to choose whether or not to explain how that conclusion was reached in its sustainability statement. However, for disclosures under ESRS E1 (Climate Change), a detailed explanation of the conclusions of the materiality assessment must be provided. In addition, if a company concludes that certain data points that are relevant for other EU reporting laws—such as for the Sustainable Finance Disclosure Regulation and the Benchmarking Regulation—are not material for its disclosures under the CSRD/ESRS, it must make an explicit statement to that effect for each data point.
Targeted modifications have also been made to other disclosure requirements in the interest of proportionality. For example:
- companies may omit classified information (e.g., secret and top-secret information) and sensitive information (e.g., genetic and biometric data) (ESRS 1);
- information must only be disaggregated at the level of a significant site or asset if the material impact, risk, or opportunity is “highly dependent” on the specific site or asset (“highly dependent” replaced the phrase “is linked to” in EFRAG’s draft ESRS) (ESRS 1);
- companies can now qualify as uncertain any forward-looking information they disclose (ESRS 2); and
- companies will only be required to disclose actions taken to address identified cases of bribery and corruption (whereas under the EFRAG draft ESRS, companies would have been required to disclose both the actions taken and “insufficiencies” in those actions) (ESRS G1).
Comparison to the ISSB Standards
On June 26, 2023, the ISSB issued its inaugural sustainability and climate-related disclosure standards: IFRS S1 on “General Requirements for Disclosure of Sustainability-related Financial Information” and IFRS S2 on “Climate-related Disclosures” (see here for more detail). IFRS S1 requires disclosures on financially material information about sustainability-related risks and opportunities to meet investor information needs. IFRS S2 requires disclosure of financially material information about climate-related risks and opportunities, including physical and transition risks. The ISSB Standards are currently non-binding, with mandatory application depending on adoption by each jurisdiction.
The ISSB Standards differ from the Adopted ESRS in some key respects. Most notably, they employ a narrower materiality concept that focuses solely on financial materiality (and not also on the ESRS’s concept of impact materiality) and they cover a narrower range of subject matter areas. The ESRS disclosures are designed to provide additional information on impacts relevant for users other than investors, including business partners, trade unions, social partners, and academics. Nonetheless, the Commission has made efforts to increase alignment and interoperability with the ISSB standards as well as the widely-used Global Reporting Initiative standards. For example, all climate-related definitions in IFRS S2 and ESRS E1, with the exception of the definition of “carbon credits,” are now aligned between the two, and the concept of financial materiality in ESRS 1 was amended to align with the ISSB Standards. As a practical matter, it is possible that companies that voluntarily report under the ISSB Standards may subsume their ISSB disclosures within mandatory CSRD/ESRS reporting as and when they come into scope.
Next Steps
The delegated act will be formally transmitted to the European Parliament and Council of the European Union for scrutiny later this month. The institutions will then have a two-month scrutiny period (which can be extended for a further two months) to register any objections to the delegated act. If no objections are raised, the delegated act will enter into force. Several delegated acts under the Sustainable Finance Package have proven contentious, including most publicly the Climate Delegated Act that rendered gas and nuclear activities eligible under the Taxonomy Regulation. Given the significant attention to the ESRS, Members of the European Parliament and Member State governments are likely to use the scrutiny period to carefully assess the ESRS and to set out any objections they may have. Affected companies may wish to do the same, and to raise any remaining concerns with the institutions.
EFRAG will periodically publish additional non-binding technical guidance on the application of ESRS, with guidance on conducting a materiality assessment and understanding a company’s value chain to be prioritized. EFRAG is planning to provide an update on the first draft guidance in late August. Draft guidance will be published for open consultation before being finalized. EFRAG is also planning to host a portal for technical questions on the ESRS.
Of relevance to the financial sector, EFRAG launched a call for candidates for three sustainability reporting financial institution advisory panels (for the banking, capital markets, and insurance sub-sectors) in June, with a deadline for stakeholders to express interest in a panel position by September 15, 2023. The aim of these panels will be to advise EFRAG on the development and maintenance of sector-specific ESRS for financial institutions (these ESRS are unlikely to come until 2025), and also to develop value chain guidance for financial institutions based on the ESRS. In particular, EFRAG appears to acknowledge the need for guidance on how to define the boundaries of a financial institution’s value chain, given the nature of their business relationships with clients.
Steps Companies Can Take Now to Prepare
With the CSRD beginning to apply to an initial group of large EU companies from 2024 and gradually applying to more companies over the next four years, companies with operations in Europe should evaluate whether and when they may be subject to the CSRD, consider preparations for materiality assessments and begin to marshal the data and resources that will be needed to prepare reports. In light of the extensive reporting requirements under the CSRD and the potential need to align CSRD and other sustainability reporting and due diligence measures, multinational companies may find a global, cross-functional approach to be most effective.
If you have any questions concerning the material discussed in this client alert, please contact members of our leading ESG practice.
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