Updates on the Non-Financial Reporting EU Directive

Ksapa recently contributed to the EU Consultation process around the ESG Directive. Here are a few takeaways on how to secure smarter disclosure from corporations.

Stakeholder Consultation Makes Regulation Smarter

The Non-Financial Reporting Directive (Directive 2014/95/EU, or NFRD) is an amendment to the Accounting Directive (Directive 2013/34/EU). It requires large companies to include a non-financial statement as part of their annual public reporting obligations. As outlined in its recent Communication on the European Green Deal, the European Commission expects companies and financial institutions to improve their non-financial disclosures. Investors and civil society organizations are the main users of such information and they require more and better insights into financial and non-financial company performance as well as their soio-environmental impacts.

Following the online public consultation on corporate reporting of 2018 and the 2019 online targeted consultation on climate-related reporting, the European Commission launched a new public consultation in May 2020. The goal is to gather feedback from a wider range of stakeholders in order to strengthen the foundations for sustainable investment and the requirements for an acceptable and widely applicable non-financial reporting directive. This reflects a global trend of various organizations and stakeholders calling for a new regulatory approach to non-financial reporting.

In our opinion, the resulting reporting requirements constitute a positive development for business. We therefore list some of the most important reasons why companies should publish non-financial information.

ESG Disclosure As A Mark Of Distinctiveness: Investors Demand Non-Financials Metrics And Will Increasingly Be Forced To Do So

Sustainability benchmarks and ratings abound, though MSCI, Sustainalytics, the Dow Jones Sustainability Index, Moody’s Vigeo-Eiris or the Carbon Disclosure Project have become a must. They offer companies the opportunity, not just to demonstrate their accomplishments in comparison to others but also to affect a race to the topmost sustainable performance. This non-financial disclosure is a prerequisite to sustainability commitments and presents a number of benefits to corporates, among which greater visibility among investors, easier access to capital and an improved reputation, in addition to a better integration within their territories of operation.

Exactly what should be disclosed?

We at Ksapa would agree with the Commission that a limited liability and scope of non-financial information typically hinder the credibility of corporate reporting, when they are not altogether lacking. For instance, the principles of Duty of Care would likely dictate businesses disclose thorough information on their clients, the sectors they are involved in and an extensive list of their non-financial commitments. That said, other KPIs related to energy consumption, GhG emissions, employee diversity are already regularly disclosed.

The challenge lies in reporting on material topics, including Human Rights, anti-corruption and bribery, climate change beyond energy consuption or scope 1-2 of GhG emissions, impacts of Duty of Care measures, or conflict management. This would entail quantifying of the number of employees who received appropriate training, pending or completed legal actions on anti-competitive behavior or corruption, or breaches relative to the Corporate Code of Conduct, etc… From there, businesses must ensure regulatory compliance and take measures to ensure effective implementation.

Who is expected to publish?

The Directive targets issuers listed on a regulated market, credit institution or insurance agency as well as any other institution considered as a public-interest unit by the State. The Accounting Directive defines large undertakings as those exceeding at least two of the three following criteria:

1. A balance sheet greater than EUR 20 000 000
2. A net turnover of more than EUR 40 000 000
3. An average number of employees above 250 throughout the financial year

The key role of standardization

Does the NFRD stand to benefit all stakeholders? The information it mandates not only speaks to corporate accountability but also to other stakeholders’ capacity for (well) informed decision-making. Bearing in mind the prevalence of intangibles in the real economy, the teams at Ksapa would advise businesses should be required to disclose additional non-financial information regarding their intangible assets as well as related factors, the likes of intellectual property, valuable customer data, customer retention and human capital…

Identifying priority E&S issues

The European provisional guidance states disclosure must be structured around a materiality assessment. Ksapa regularly supports corporates with this self-assessment exercise, to determine the importance and relevance of information and topics the specific context of their operations. Effectively enforcing materiality would likely go a long way toward addressing the current gap in corporate disclosure, where businesses share information they think the financial sector needs, but not all of it. The same is expected of assurance and financial players, who will  be required to identify and disclose key engagement risks, their response to these risks and any related ey observations. Naturally, a common assurance standard should hold sway.

Considering the ideal period and type of reporting

Reporting processes must comply with a number of standards including those of the Task Force on Climate-related Financial Disclosures, the UN Guiding Principles Reporting Framework  on Business and Human Rights, the CDP and Carbon Disclosure Standards Board. Several approaches have also been developed at the EU level in the environmental arena, including the Organizational Environmental Footprint and the Eco-Management and Audit Scheme (EMAS). The ideal period for doing this should certainly coincide with financial reporting. For standardized practices to prevail, reporting must first apply to all companies, whether  large, medium, or small. A specific approach relative to company size and reporting capabilities should therefore be produced and ultimately enforced.

Adapting to digitizing data

Through the Transparency Directive, the EU introduced a structured data standard in the form the European Single Electronic Format. This is expected to advantageously cut costs for annual financial report users, increase data handling and analysis speed, reliability and accuracy as well as improve the overarching information quality and decision-making. That said, Ksapa would argue such benefits may not entirely justify the cost of tagging non-financial information.

Conclusion

Non-financial reporting stands to help businesses measure their outcomes against specific sustainability metrics, often by means of (key) performance indicators. Measuring is the first step to management and allows companies to identify developments and patterns. Reactions to the EU directive have however been varied:

• Some feel there is more work to be done;
• Those most reporting-savvy point to the fact that, though the new legislation aims to raise the bar on non-financial reporting, it does not even come close to their current practices;
• The remainder has expressed doubts as to the impact of reporting on their socio-environmental performance in the first place…

It all comes down to integrating thinking. In other words, using non-financial information to feed corporate strategy. At Ksapa, we would contend that is what the future of business is all about.