A First Look at the EU Sustainability Standards: 10 top highlights from the new EFRAG’s report
18 March 2021 - By Donato Calace, VP of Accounts and Innovation
On March 8th, the Project Task Force on Non-Financial Reporting Standards (PTF-NFRS), created by EFRAG to explore the possibility of EU standards on sustainability reporting, finally published the Main Report and its six technical appendices. Datamaran is proud to have contributed to this fundamental piece with insights on corporate disclosure practices and regulatory initiatives.
This blog looks at the top 10 highlights of 54 detailed proposals on the potential EU Standards in no particular order.
- Goodbye, non-financial reporting
- The architecture of the EU Standards
- Striking the balance between retrospective and forward-looking information
- Double materiality
- Integrated reporting based on connectivity
- The structure of the report
- Digital from the onset
- Timeline and priority areas
- Cooperation and alignment with existing standards, frameworks and other policies
- Standards for SMEs
Goodbye, non-financial reporting
The Task Force took a clear stance on the terminology. “Defining the scope by what it does not cover (non-financial information) is commonly used but does not do justice to the underlying ambition of the contemplated reporting. The [Task Force] concluded that a reference to sustainability information would better capture (i) the interactions between the reporting entities and their stakeholders (the ways they may affect each other’s interests) and (ii) their mechanisms of value creation that are not covered by financial reporting. Sustainable business is based upon those two complementary dimensions.” So the EU Standards will adopt sustainability reporting as terminology.
The architecture of the EU Standards
Debates on principle-based vs rule-based approaches and sector agnostic vs sector-specific have always been central in defining reporting standards. The Task Force indicates that the EU Standards “must strike the right balance between a general principle-based approach consistent with the EU legal environment and the need for more detailed and prescriptive disclosure requirements to ensure the relevance and comparability of the reported information.” So, on top of the high-level reporting principles, line item disclosures can be expected.
Looking at sector specificity, the EU Standards should cover three layers: sector agnostic (applicable across sectors), sector-specific (ensuring the necessary level of detail per sector), and entity-specific (depicting the entity’s unique situation). The third layer demands that reporting entities “own” their double materiality assessment process. Hence, the sector agnostic and sector-specific standards do not replace a materiality assessment, which companies will be required to conduct.
Striking the right balance between retrospective and forward-looking information
Generally, annual reports are considered backward-looking, providing little or no information on what is coming up. In other words, a “lagging” source information. The EU Standards intend to balance retrospective and forward-looking information to ensure that “transition trajectories” are covered in the reports. The “trajectories” will serve as “conceptual guidelines on policies, targets, action plans, goal alignment, and related impacts.” The guidelines should ensure to link targets to “outcomes, set against a baseline year and time-bound, associated with relevant KPIs, where feasible, science-based, and tested against stakeholders’ expectations.”
As expected, the EU Standards will be based on the double materiality principle first introduced in 2019. The Task Force prescribes how:
a. The EU Standards should address the definition and, more importantly, the implementation of the concept of double materiality in each of the two dimensions.
b. What was initially defined as “environmental and social” materiality in the 2019 guidelines is now labeled “impact materiality” and concerns the “inside-out” impacts of the company’s own operations and its value chain. assessed in terms of severity and likelihood (where applicable) of actual and potential negative impacts, scale, scope, and likelihood of actual positive impacts, urgency derived from public policy goals and planetary boundaries.
c. Financial materiality based on “evidence that [sustainability] matters are reasonably likely to affect [an organization’s] value beyond what is already recognised in financial reporting.” More specifically, the determination of financial materiality can rely on non-monetary quantitative, monetary-quantitative, or qualitative data. In other words, the financial materiality test that applies to sustainability-related information is different from the materiality test used for financial information in financial reports. (e.g. “economic events are recognized based on their relative importance, and that for financial statements of year X materiality was determined on the basis of 5% of consolidated earnings”).
d. Both dimensions of materiality (impact and financial) are not constrained to matters that are within the control of the reporting entity. This point is extremely important to clarify accountability through the entire value chain.
e. Dynamic materiality. The dynamic interrelationship between impact materiality and financial materiality is explicitly acknowledged: “Many impacts on people and the environment may be considered ‘pre-financial’ in the sense that they may become material for financial reporting purposes over time (so-called ‘dynamic materiality’).”
f. Double materiality assessments. The Task Force clearly states that double materiality assessments are “key to proper sustainability reporting,” and “they should be performed by the standard-setter (for sector-agnostic and sector-specific disclosures), and by the reporting entity itself under a process defined by an appropriate standard (entity-specific disclosures and ‘comply or justify’ principle)”. Hence, we can expect a standardized process to conduct double materiality assessments. For example, concerning impact materiality, the Task Force addresses the inadequacy of current stakeholder engagement approaches (based on “meetings” or “questionnaires”), noting that “the interests of the stakeholders that are users of sustainability reporting are not necessarily proxies for the potential and actual impacts of the company on people and the environment. In practice, if reporting entities determine impact materiality based on what all users of sustainability reporting find decision-useful, then it is quite likely that everything comes out as ‘material.’ However, when impact materiality is determined based on what a subset of these users of sustainability reporting finds decision-useful then materiality depends on who the company asks. “The latter approach has dominated most companies’ practices with regard to impact materiality, inviting certain experts, NGOs and others to express their interests in what the company should report through ‘materiality’ meetings or on-line questionnaires. This has not led to sufficiently relevant information being disclosed from a double materiality perspective.”
g. Materiality assessments are about strategy. The disclosures concerning the materiality assessment process should be adequately covered in the strategy area of the “sustainability statements” (see Structure of the report).
Integrated reporting based on connectivity
Linking sustainability and financial reporting will be based on anchor points. Anchor points could be direct (as a monetary impact derived from accounting data) or indirect (ensuring coherence between financial and sustainability disclosures), and should be present in both financial reports and sustainability reports.
The structure of the report
The Task Force clearly indicates that the standardized sustainability information is part of the management report. In particular, it should be covered “in a separate and clearly identifiable section of the management report which would be presented as ‘sustainability statements.” The sustainability statements should cover three areas: strategy, implementation, and performance measurement. The strategy should include materiality, governance, management responsibilities, and the business model across all ESG topics while the implementation and the performance management should address topic-specific goals, targets, and performance indicators.
Digital from the outset
Technology is key to effectively implementing the EU Standards. “To facilitate digitisation, the standard-setter should translate the architecture’s classification and segmentation of sustainability disclosures into a digital taxonomy from the outset. This digital taxonomy should be issued in parallel with the standards. This will permit sustainability information to be tagged based upon a granular analysis of data points.” The Task Force refers to a digital XBRL taxonomy for EU standards, similar to the technology (iXBRL) that has been adopted to develop the technical standards for the European Single Electronic Format (ESEF).
Timeline and priority areas
The first set of EU Standards should apply from reporting year 2023 (reports published in 2024). These would allow companies to report in compliance with the revised Non-Financial Reporting Directive (NFRD). The first set (to be drafted within Q2 2022) should include two priority conceptual guidelines: double materiality and quality of information. More broadly, the Task Force aims to establish standard-setting as an ongoing process, in line with a dynamic vision of materiality. “Progressive ‘enhancement of content’ [...] will be essential.”
Cooperation and convergence with existing standards, frameworks, and other policies
Harmonization and convergence to an international standard are at the top of the agenda for the EU Standards. The Task Force outlines the alignment of the existing and upcoming EU disclosure requirements as follows:
The Task Force states that the EU Standards are open to building on existing or upcoming international standards and frameworks, as long as their objectives match. Furthermore, in the spirit of “co-construction,” the EU Standards will be available for partners and initiatives to build international standards.
Standards for SMEs
Finally, there is a clear ambition of creating dedicated EU Standards for small and medium enterprises. The Task Force states that those standards “should not simply be a dumbed-down or simplified version of the sustainability reporting requirements for large reporting entities. These would likely not be fit for purpose and prove difficult and costly to produce. Instead, so far as is reasonably practicable, SME-specific sustainability reporting standards should be designed for SMEs on a stand-alone basis (‘think small first’).” Although it is recognized that the NFRD revision will likely not include mandatory disclosure requirements for SMEs, it is an important signal that they are also potentially included in the scope of the future EU Standards.
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