EFRAG published two reports paving the way for Sustainability Reporting in the EU

On 8 March 2021, EFRAG published two reports mandated by the European Commission in the context of the revision of the Non-Financial Reporting Directive, paving the way, and urging, for the development of EU sustainability reporting standards.

The 2014 Non-Financial Reporting Directive (NFRD) was a huge inaugural step in the European Union (EU), bringing mandatory non-financial disclosures for the largest listed companies in the EU (Member States had the option to extend the scope of entities concerned). However, in the wake of the EU Green Deal, the 2030 Agenda for Sustainable Development (SDGs) and also the Paris Agreement on Climate Change, there are requests to make non-financial reporting evolve at a great pace both inside and outside the EU. The 2019 European Commission (EC) Consultation highlighted current shortcomings in terms of comparability, relevance and reliability of non-financial reporting in the EU, hence the plans to revise the current NFRD for which legislative proposals are expected to be published by the EC by the end of April.

To inform its decisions, the EC asked Mr Jean-Paul Gauzès, President of the European Financial Reporting Advisory Group (EFRAG), the technical advisor of the EC on international financial reporting standards (IFRS), to make recommendations on an ad personam basis, for possible changes to the governance and funding of EFRAG, should the organisation become the European standard-setter for non-financial (sustainability) reporting. The EC also asked the EFRAG Corporate Reporting Lab to perform preliminary work, if the EU were to start developing non-financial reporting standards. To that effect, a special Project Task Force (PTF) was established, chaired by Mr Patrick de Cambourg, President of the Autorité des Normes Comptables (the French accounting standard-setter) and author of a report on corporate non-financial reporting in June 2019. The reports to the EC of both Mr Gauzès and the PTF were made public on 8 March. Some key features are outlined thereafter.

The PTF “Proposals for a relevant and dynamic EU sustainability reporting standard-setting” is a first-in-kind comprehensive report drawing the possible roadmap and way forward for the possible European standard-setter (ESS) on sustainability reporting.

It relies on key background elements to be confirmed at the NFRD revision legislative level. In particular, it is assumed that the European standard-setting would take existence through delegated acts (i.e. non-legislative legally binding instruments which the EC is allowed to adopt when the EU Council/European Parliament have delegated that ability to the EC through an EU legislative act). It is also presumed that there would be an extension of the scope of mandatory disclosures to all large companies(1), that sustainability reporting would be included in the management report and that some level of external assurance of the sustainability information provided would be required.

One of the important features of the PTF report is the proposal for introducing a purpose for the sustainability reporting (which terminology has been preferred over non-financial reporting). It is:

“to provide relevant, faithful, comparable and reliable information:

This proposed purpose would be anchoring what is known as the “double materiality concept”, which is already featured in the current NFRD. Double materiality requires that both impact materiality and financial materiality perspectives be applied in their own right. The standard-setter would be expected to develop conceptual guidelines addressing the implementation of the concept of materiality for each of the two dimensions. Double materiality assessments would then be made by the standard-setter (for determining required sector-agnostic and sector-specific disclosures) and by the reporting entity itself (to select the information to be reported ultimately) under a process to be defined in a standard.

The PTF report is then articulated around four main sections. The first section sets out the “Foundations” for the possible standard-setting. The second section proposes “Conceptual guidelines” that would be used by the standard-setter to develop the standards, as well as by companies in preparing their reporting. It includes what could be the expected characteristics of an information of quality, namely relevance, faithful representation, comparability, understandability and reliability (auditable information). The third section proposes a “Target architecture” giving insights on how standards and sustainability reporting could be structured around three layers of information (sector-agnostic, sector-specific and entity-specific), three reporting areas (Strategy, Implementation and Performance Measurement) and three topics (Environment following the Taxonomy objectives(2) , Social with a stakeholder-centred approach, Governance+, extending beyond the pure governance aspects of an entity to cover topics such as business & ethics, management of the quality of relationships with stakeholders, organisation and innovation, and reputation and brand management). Finally, the last section sets out a “Roadmap” and elaborates on how to build on international initiatives and contribute to international convergence, including by proposing, promoting and participating to “co-construction” efforts.

Given the level of urgency and EU ambition to move swiftly, the PTF recommends that the sustainability reporting standards be developed in phases, with an enhancement of content approach, to eventually achieve the target architecture for a complete sustainability reporting over time. The first set of standards would be applicable for fiscal year 2023 reports, to be published in 2024.

In France, Deloitte particularly welcomes the importance given to global convergence in the PTF report by dedicating the second building block of the “Foundations” and a large part of the “Roadmap” to international cooperation features. Choices made in the architecture for the “Reporting areas” and the “Topics” are also good signs of consistency with international frameworks and practices. Also, the explicit suggestion of a dialogue with the IFRS Foundation once the IFRS Foundation has set a possible course of action is encouraging. Of note, the publication date by EFRAG coincided with the IFRS Foundation’s announcement on their strategic direction for sustainability reporting prioritising climate-related reporting, while also working towards other ESG (environmental, social and governance) matters. Among other things, they propose a building block approach, also working with standard-setters from key jurisdictions, so as to provide a globally consistent and comparable sustainability reporting baseline.

The PTF report provides elements on why the EU may wish to embark on developing sustainability reporting standards at its jurisdictional level. One of them stems from the PTF extensive assessment work showing the momentum for sustainability reporting in the EU and the need to cater for EU specificities, as well as to ensure consistency in the EU regulatory landscape (in particular with the Sustainable Finance agenda and implications: Taxonomy Regulation, Sustainable Finance Disclosures Regulation - SFDR, amongst others). Another one is that the PTF has concluded that no on-the-shelf standard from international initiatives (e.g. the Group of Five(3) or TCFD) is available to date to cover the width and depth of the proposed EU ambition. Main recent international developments, including the IFRS Foundation announcements for its strategic direction to undertake technical preparation for a potential sustainability reporting standards board, indicate working towards an investor focus on enterprise value (financial materiality lens), rather than the larger audience and focus generally considered in the EU. In practice, it remains to be seen whether the different ambitions would lead to different outcomes. It is hoped that the desire of all the parties to work together for global convergence will prevail.

The report prepared by Mr Jean-Paul Gauzès “Potential need for changes to the governance and funding of EFRAG”, under his ad personam mandate, includes proposals for a revised governance structure for EFRAG, should it be entrusted with European sustainability standard-setting. The governance would keep the Financial Reporting pillar unchanged and add a Non-Financial Reporting (NFR) pillar with a proper governance, under an overall umbrella of a new EFRAG Administrative Board and an enlarged General Assembly. The NFR pillar governance would include a NFR Board, defining, reviewing and approving the standard-setting work and cooperating with the existing (global) non-financial reporting standard-setters and initiatives. This new pillar would also include a dedicated NFR Technical Expert Group (TEG) responsible for developing standards for the NFR Board, as well as a Consultative Forum of National Authorities and National Standards-Setters of the Member States and other players, for consultation and advice on the development of the sustainability standards. The organization would be expected to remain an independent public-private partnership, with separate funding for each pillar. However, the public (EU) funding would play a leading part for the NFR pillar, given its public interest mission in standard-setting.

The next step is the publication of the legislative proposals by the EC, after their discussion by the EU Commissioners expected on 21 April. This will give the kick-off for the debates with the EU Council and Parliament. The timeline for the development sustainability standards set out in the PTF report is very ambitious. In order to make available the first standards by mid-2022 the preparatory work would need to continue in some forms. The target is not impossible to achieve but implies that the momentum observed and support from the EU stakeholders translate into mobilising financial and/or expert resources very soon for the work to begin expeditiously.

1 As defined in Article 3(4) of Directive 2013/34/EU (the “Accounting Directive”): Large undertakings are undertakings which on their balance sheet dates exceed at least two of the three following criteria: balance sheet total: 20M€; net turnover: 40M€; average number of employees during the financial year: 250.

2 The Taxonomy Regulation defines 6 environmental objectives: Climate change mitigation, Climate change adaptation, The sustainable use and protection of water and marine resources, The transition to a circular economy, Pollution prevention and control and The protection and restoration of biodiversity and ecosystems.

3 This “group of five” includes the CDP, the Climate Disclosure Standards Board, the Global Reporting Initiative, the International Integrated Reporting Council, and the Sustainability Accounting Standards Board. In 2020, they published a statement of intent to work together towards comprehensive corporate reporting which was illustrated with a prototype for a climate-related financial disclosure standard.