By Oriane Schoonbroodt, CEO of Label R and Antoine Peter, Manager at Arendt Regulatory and Consulting
THE SFDR
Europe is on the cusp of a new era of greater transparency and deeper integration of sustainability risks by the financial sector, embodied by the development of non-financial reporting and sustainability-related disclosure mechanisms for financial market participants and operational companies.
March 10, 2021 marked the entry into force of Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (the “SFDR”), which impacts European financial market participants such as fund managers and investment advisers.
The objective of the SFDR is to increase transparency and comparability by requiring financial market participants to make harmonized disclosures on sustainability-related issues over time, in order to help end investors take better-informed decisions. In reality, many financial market participants see the SFDR as yet another layer in the already overly complex world of non-financial and sustainability reporting, and struggle with how and where to obtain the data needed to comply with the new disclosure obligations it imposes.
THE GREAT PARADOX
The number of international initiatives, regulations, frameworks and other standards relating to non-financial and sustainability reporting continues to increase, even as a purported lack of ESG data and non-financial information is regularly put forward as the main obstacle to the development of the sustainable finance agenda.
The sheer volume of reporting standards and rating systems in the ESG disclosure landscape has created new challenges for organizations, which may be evaluated on the basis of multiple frameworks at once. Yet at the same time, these reporting schemes serve different worthwhile purposes. Here it is important to bring some clarity to the various systems in place, and to highlight their links with the proposed regulatory framework being set up at the European level, particularly with respect to the SFDR.
SOME MAJOR FRAMEWORKS AND KEY DIFFERENCES
First of all, it is important to clarify that most of these reporting schemes are principally aimed at portfolio companies and should be viewed as tools enabling financial market participants to aggregate data from their portfolio companies.
It is then useful to distinguish the frameworks and standards focusing principally on financially material sustainability risks, such as the Sustainability Accounting Standards Board (“SASB”), from these targeting a much broader scope of sustainability issues such as the Global Reporting Initiative (“GRI”), which covers material sustainability risks and adverse impacts (double materiality) while also taking stakeholders issues into consideration.
The SASB, for example, is an industry-specific standard that identifies, manages and communicates financially material sustainability risks and opportunities to be integrated into mandatory public filing. By contrast, the GRI Sustainability Reporting Standards focus on the economic, environmental, and social impacts of the activities of a company, and hence its contributions – positive or negative – towards sustainable development, whether or not these are financially material to the company. The GRI Standards are the most widely adopted global standards for general sustainability reporting, but companies can (and do) use both SASB and GRI standards to meet the different needs of key audiences. While they are suited to different purposes, they are both very much topic-agnostic and will cover environmental, social, as well as governance factors. The International Integrated Reporting Council (“IIRC”) facilitates corporate reporting around value creation, and is another example of a more holistic approach to ESG reporting.
For its part, the Task Force on Climate-related Financial Disclosures (“TCFD”) reporting framework provides recommendations for disclosing financially material information (quantitative and qualitative) about the risks and opportunities presented by climate change; in that sense, it targets transparency on sustainability risks much like the SASB. However, it will focus only on the sustainability risks linked to one specific ESG topic: climate change. In addition to the recommendations of the TCFD, other initiatives, such as the Climate Disclosure Standards Board (“CDSB”) or CDP (former Carbon Disclosure Project), offer companies frameworks for reporting specific environmental information that help them measure, understand and address their environmental impact. The TCFD, CDSB and CDP are principally focused on reporting in relation to climate change.
Finally, it is also important to bear in mind that some of these initiatives, such as the TCFD and CDP, are guidance frameworks which offer guiding principles but impose no specific or mandatory disclosure requirements, except with respect to greenhouse gas emissions as recommended by the TCFD. This guiding-principles approach within an overarching framework can also be seen in the Guidelines on Reporting Climate-Related Information published by the European Commission in June 2019, a set of non-binding guidelines on non-financial reporting in the context of the Non-Financial Reporting Directive.
What firms impacted by the SFDR are certainly all wondering now is whether their portfolio companies’ adherence, or their own, to any of these reporting standards and frameworks will help them comply with the transparency requirement under the SFDR – in particular on principal adverse impact (“PAI”) reporting. The answer is complex and depends on the nature and requirements of the relevant standard or framework. For example, the standards focusing on material sustainability risks and financially material issues will not generally be useful for PAI reporting, but will be very useful for integrating sustainability risks into investment decisions as requested under Article 6 SFDR (e.g. the SASB and the TCFD for climate change). Other standards will only be useful for a limited number of PAI indicators under the SFDR, for example due to their specific focus on environmental issues.
Because the GRI standards address the positive and negative impacts of a company's operations, across many sustainability topics and with an emphasis on double materiality, they are more likely to be aligned with the PAI indicators of the SFDR.
HARMONIZATION EFFORTS AND MORE TO COME ON THE REGULATORY FRONT
All this paints an admittedly daunting picture. The good news is that two deep forces are at work to push non-financial sustainability reporting towards greater harmonization, simplicity, and efficiency.
First, these different reporting frameworks and standards have brought about the development of real expertise; at this stage of maturity, years of practice and experience can now be leveraged on. The industry is well aware of the pressing need for harmonization, and in response to the “rising demand for clarity” in the sustainability reporting ecosystem, the SASB, GRI, IIRC and CDSB issued a “Statement of Intent to Work Together Towards Comprehensive Corporate Reporting” in September 2020. Such collaboration plans aim to better describe the interplay and links between the various complementary standards to guide user companies, and carry great hopes with them.
In addition to this mobilization of private initiatives, the European Commission continues to use the regulatory carrot and stick to strengthen non-financial and sustainability reporting in Europe. The European Financial Reporting Advisory Group (“EFRAG”) was mandated by the European Commission to develop recommendations about potential EU non-financial reporting standards. In February 2021 EFRAG published a report setting out recommendations to the European Commission for the development of possible EU sustainability reporting standards. Other regulatory changes are in the pipeline as well, including a reform of the Non-Financial Reporting Directive (“NFRD”) by the Corporate Sustainability Reporting Directive (“CSRD”) to enhance the reporting requirements upon portfolio companies, the Taxonomy, and the integration of sustainability risks into the AIFMD, MiFID and the UCITS directive. A substantial program, and all part of the European Commission’s Action Plan on financing sustainable growth.
The path may seem arduous, but we are confident that the EU regulator and the existing private reporting initiatives will make successful progress towards a more unified, convergent and comparable approach to non-financial and sustainability reporting.
The question is not whether, but when consistent and comparable standards that better serve the purposes of the relevant stakeholders will be broadly accepted and systematically requested.
Copyright photo @ Philippe Lanciers