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Travers Smith's Sustainability Insights: The impact of the EU's sustainability reporting proposals on private companies

Travers Smith's Sustainability Insights: The impact of the EU's sustainability reporting proposals on private companies

Overview

A regular briefing for the alternative asset management industry. 

While governments around the world are working hard on new domestic sustainability reporting requirements, developing an international rulebook will be much harder. It is, however, a vital project, which promises significant benefits for investors and companies. The IFRS Foundation, whose work the UK government has endorsed, has recently established an international working group to accelerate convergence of standards, and the International Platform on Sustainable Finance, which Britain joined this year, also has a critical role to play. 

In the meantime, all governments should look closely at what others are doing, and – as one influential body wrote to the UK government last week – should avoid developing standards that create regulatory conflict. 

Corporate reporting is an integral part of the sustainability reporting framework; it will deliver the information that asset managers and asset owners need to make informed decisions about sustainability issues. The European Commission's proposal for a Corporate Sustainability Reporting Directive (CSRD), adopted last week, is therefore highly significant. It is particularly welcome that the Commission intends to bring corporate reporting in line with the requirements that already apply to asset managers and financial advisers under the Sustainable Finance Disclosure Regulation (SFDR). Consistency through the investment chain will help a lot.  The UK government, and the international community, should take note – especially since many non-EU asset managers will have to make SFDR disclosures if they want to attract European investors. 

The European Commission's proposed Directive will, if implemented, significantly increase the number of companies that are subject to EU-wide reporting requirements –  from around 11,000 to 49,000 – and dramatically broaden their scope to include detailed sustainability disclosures. As well as most EU listed companies, all "large" EU-incorporated private companies would be covered, bringing many portfolio companies of private funds in scope for the first time. Disclosures would be subject to limited external assurance and proportionate standards will also be developed for smaller companies which, in the case of smaller private companies, could be adopted voluntarily. The European Financial Reporting Advisory Group (EFRAG, who published an influential report in February) would be mandated to develop standards in accordance with some high-level principles laid out in the Directive, and consistent with the disclosure obligations in the SFDR. Company reports issued from 2024 (covering the 2023 financial year) would need to comply with the new rules, if the Commission's proposed timetable can be achieved (which is far from certain). 

The Commission has set ambitious parameters for these reporting requirements.  First, the rules would apply a "double materiality" standard – meaning that reports would not only focus on matters that are material to the financial performance of the company, but also those that have a material external impact. The obligations would extend to the operations of the value chain of the company – including, for example, its suppliers – and not only the company's own operations. Narrative reports would cover (for example) how the company takes account of stakeholder interests and how it is planning to ensure that its business model and strategy are consistent with the Paris Agreement on climate change. There would be an obligation to describe due diligence undertaken to identify principal adverse impacts on sustainability factors and to describe actions taken to prevent, mitigate or remedy those impacts. The reports would be both backward and forward looking, would include both qualitative and quantitative information, and would be digitally tagged to facilitate analysis and comparison by third parties. These companies will also have to report their level of alignment with the EU-taxonomy – significantly expanding the number of companies required to report in accordance with the EU's new binary classification tool for environmentally sustainable activities. All in all, the package would bring a very significant set of additional requirements.

...The European Commission's proposed Directive will, if implemented, significantly increase the number of companies that are subject to EU-wide reporting requirements...

Meanwhile, the UK is looking at its own corporate reporting requirements. Recently, these have focused on the internationally accepted recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), and the government has already published a roadmap that will make TCFD compliant disclosures mandatory across most of the UK economy by 2025 – indeed, from 2022 for larger UK-registered companies. However, these disclosures are focused on climate change related matters material to the company's own financial performance – and are therefore much narrower in scope than the EU's proposed CSRD. Work is also continuing on a new framework for corporate reporting, following publication of a discussion paper last year by the Financial Reporting Council (FRC) and a more recent consultation on audit and corporate governance. Although the government has not yet proposed a mandatory "public interest statement", proposals by the FRC and the Brydon Review for such an adjunct to existing reports remain under active consideration. The government has also committed to a UK-version of the EU taxonomy, but it is not clear how much that will diverge from the EU-version. 

Although the UK's sustainability reporting regime is moving in the same direction as the EU, including, for example, changes made in the last few years on stakeholder reporting, it is also very important to aim for consistency. Investors must be able to compare the information they receive from different European companies, and it would be better if private companies did not have to report in accordance with two entirely different sets of rules: one report for the private equity or other investors who have to comply with EU-mandated reporting requirements, and another under the UK's regime. 

Global convergence of standards is essential, and policymakers should therefore think carefully before establishing conflicting, or even unnecessarily duplicative, rulebooks. It is clear that the UK is serious about international co-operation, and it should study emerging EU rules and work hard to accommodate them in its own policy proposals. It might also be able to use its influence to encourage convergence between the EU's developing framework and the IFRS's ambitious project.

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TRAVERS SMITH'S ALTERNATIVE ASSET MANAGEMENT & SUSTAINABILITY INSIGHTS

A series of regular briefings for the alternative asset management industry.

TRAVERS SMITH'S ALTERNATIVE ASSET MANAGEMENT & SUSTAINABILITY INSIGHTS