The NFRD update: getting serious about materiality
27 February 2020 - By Donato Calace, VP of Accounts & Innovation
On February 17th, I took part in a wide-ranging discussion centered on the presentation of the research carried out by the Alliance for Corporate Transparency, covering the reporting practices of 1,000 EU-based companies. Taking place in Brussels, this gathering offered an excellent opportunity to gather insights on where the NFRD review might be heading.
The NFRD: fit for purpose?
The official mandate of the NFRD is to “link ‘policies, risks, and results’ together in reporting.” The question is how effectively companies are integrating these guidelines in their reports. On this front, the recent fitness check the EU Commission ran on the NFRD showed a number of major shortfalls, which led to an initial discussion regarding how to update the NFRD.
In particular, the biggest limitation that the fitness check highlighted is that “information users consider important is not reported and information they consider irrelevant is reported.” In other words, the problem is with materiality, not simply disclosure.
Materiality is an essential part of effective reporting. Materiality analysis allows stakeholders (including the reporting companies themselves) to properly dig into data and go beyond simply reporting for reporting's sake. The Commission has already taken action in this field. Last year, non-binding guidelines to the NFRD were released, introducing the new concept of double materiality. Connecting financial materiality and non-financial materiality, this concept has proved useful in discussions about what materiality standardization might look like.
Nevertheless, there is still an urgent need for detailed and standardized requirements on how to conduct a materiality assessment.
Where companies fall short
The new report published by the Alliance for Corporate Transparency (ACT) confirms that the NFRD is in trouble.
The ACT report found that companies tended overwhelmingly to disclose their materiality analysis. They even usually disclosed policies to deal with the ESG and sustainability challenges raised by the aforementioned analysis. Where companies fall short, however, is in outlining either the specific targets that they are aiming for or the outcomes of their policies generally.
What this means for outsiders looking in is that much of the reported information isn’t decision-useful. It simply lacks the required level of detail and connection to financial consequences to achieve this. In other words, it is not material.
While, for example, over 88% of companies mention the existence of anti-corruption policies, fewer than a third actually give detail on how those policies work in practice. Such a trend is clear across every issue area identified in the report. The result is that the inconsistency of reporting patterns is very high, especially considering that reporting is already mandatory. It signals that the current policy is not effective in producing the sort of actionable data that stakeholders are looking for.
Further, fewer than 10 percent of companies explain how ESG risks are addressed in their business strategy. This is a clear sign that for many companies, these risks remain siloed apart from ‘traditional’ financial concerns.
In short, we are in front of a paradox: on one side, companies are conducting materiality assessments, on the other side, the information disclosed remains immaterial. It is evident that the problem resides in the methodology materiality assessments are carried out - it is clearly not reliable enough.
Climate as a benchmark
ESG ‘siloization’ is most apparent when it comes to climate-related risks. Despite this being an area with particularly advanced reporting methods, climate risks were severely underreported. Companies have yet to get serious about specific reporting. Taking climate change as an example, the ACT report found that “82 percent of companies have policies - but only 35 percent have specific targets and even fewer (28 percent) report on their outcome.”
Regarding disclosure on business strategies aimed at managing climate-related risks specifically, there is a clear lack of maturity in reporting. Although TCFD recommendations are already reflected in a voluntary addendum to the NFRD, these recommendations are rarely followed. To give an example, very few (on average, just 9.1% in high-risk sectors) companies undertook a systemic scenario analysis on climate as per TCFD recommendations.Disclosure of climate-related risks can serve as an indicator for stakeholders about the seriousness with which a company approaches non-financial reporting. It also demonstrates an important reality about this current iteration of the NFRD, namely, that disclosure alone is not nearly enough. Mere reporting has not yielded the serious sort of analysis required for decision-useful results. What is needed is action at the corporate governance level.
Transforming the NFRD: the path forward
The NFRD was designed not just to encourage companies to be transparent in their reporting of material risks related to climate, governance, and other traditionally non-financial issues. The real driving purpose of the NFRD is to make such transparency meaningful and actionable - promoting transformative accounting.
It has become clear that if the EU wants to accomplish this goal, then a more wide-ranging reporting structure is a necessity. Such a structure should be improved in scope and ought to include compliance penalties and incentives.
Nevertheless, there is a growing understanding that policy intervention should strike the right balance between company discretion and mandatory minimum indicators. There is room for competitive discretion while still promoting the integration of ESG and sustainability issues into wider corporate strategy.Walking this tightrope will prove central to the upcoming NFRD revision (which, incidentally, will likely occur under a different name, as ‘non-financial’ can be misinterpreted as “not financially material”). There is now the unique opportunity to contribute to the revision. On February 20th, the EU placed online a space for public consultation where stakeholders can share their thoughts - the Datamaran community will certainly take part.
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