ESG regulatory framework for companies with (certain) activities in the EU

Sustainability factors, commonly coined as Environmental, Social and Governance (ESG), have become a global imperative, placing companies under increasing scrutiny.

Over the past several years, the European Commission (Commission) has assessed practices and implications of sustainable finance, which refers to the process of taking due account of ESG considerations when making investment decisions in the financial sector, leading to increased longer-term investments into sustainable economic activities and projects.

This follows the EU’s commitment:

• To achieve the United Nation’s 2030 Agenda and Sustainable Development Goals (SDGs); and
• To comply with various international agreements, such as the Paris Agreement on Climate Change (Paris Climate Agreement).

All UN member states adopted the 2030 Agenda and the SDGs in 2015. The SDGs call on all nations to combine economic prosperity, social inclusion, and environmental sustainability with peaceful societies and are orientated towards 2030. The SDGs are linked with the Paris Climate Agreement, which is incorporated in SDG 13 (Climate action), and oriented towards climate neutrality by 2050, requiring major progress by 2030.

As part of a two-part review of the EU’s ESG framework, this article will look at what companies with activities in the EU should consider, while a second article will look at other key legislative changes in this space.

The EU’s progress with implementing the SDGs/ESG ambitions

In 2019, Europe became the first continent to commit to achieving climate neutrality by 2050, via the European Green Deal. The Commission has since adopted a set of proposals to make the EU’s climate, energy, transport and taxation policies fit for reducing net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels. Some of these proposals have already become law, some will shortly do so.

The EU Climate Law, for example, obliges the EU institutions and EU member states to cut greenhouse gas emissions by at least 55% by 2030, the first legally binding obligation to do so worldwide.

Some other important related initiatives include:

1. The Taxonomy Regulation
   

The EU’s Taxonomy Regulation (TR) entered into force on 12 July 2020 and facilitates a pan-European ecolabel for financial products.

The TR acts as a common reference-point dictionary for sustainable finance reporting, with large public interest entities (basically all EU-listed companies with more than 500 employees and either a balance sheet of more than EUR20 million; or a net turnover of more than EUR40 million) being required to include (consolidated) non-financial statements information on how and to what extent their activities are associated with environmentally sustainable economic activities. It also obliges financial market participants making available financial products to comply with this dictionary.

Its main purpose is to set out eligibility criteria for business activities to be deemed ‘sustainable’. Once a company meets the eligibility criteria, it is seen as “taxonomy aligned” with the EU taxonomy requirements. The more taxonomy alignment a company has, the more ‘green share’ it has.

To comply, an activity must:

• Contribute substantially to at least one of six environmental objectives defined in the TR;
• Do no significant harm to any of the other environmental objectives;
• Comply with Minimum Social Safeguards; and
• Comply with Technical Screening Criteria (TSC).

Various implementing legislation (so-called Delegated Acts) has been and is in the making.

While the TSC for the first two objectives (climate change mitigation and climate change adaptation) are contained in the Taxonomy Climate Delegated Act (CDA) of 4 June 2021, on 5 April 2023, the Commission launched a four-week feedback period on a new set of EU taxonomy criteria for economic activities making a substantial contribution to one or more of the non-climate environmental objectives:

• Sustainable use and protection of water and marine resources;
• Transition to a circular economy;
• Pollution prevention; and
• Control and protection and restoration of biodiversity and ecosystems.

Amongst other things, the Commission is also consulting on proposed amendments to the CDA.

2. Corporate Sustainability Reporting Directive (CSRD)

To help improve money flow towards sustainable activities across the EU, the Commission adopted the Sustainable Finance Package on 21 April 2021. One of the proposed measures within the package is the CSRD which entered into force on 5 January 2023 and needs to be implemented by EU member states by 6 July 2024.

The CSRD extends the scope and reporting requirements of the already existing Non-Financial Reporting Directive (NFRD).

The CSRD not only applies, inter alia, to all EU listed SMEs (other than micro enterprises), but also in principle to non-EU companies with substantial activity in the EU (i.e. with a net turnover of over €150 million in the EU), if they have either a large or listed EU subsidiary or a significant EU branch (generating €40 million in revenues).

With its new requirements, the EU is tackling the problem of quality reporting by establishing a common reporting framework: according to the Commission, the ability for investors and other stakeholders (such as consumers and NGOs who are increasingly holding companies to account for their impact on the world) to trust and benchmark reported information requires a common basis for reporting.

One of the CSRD aims is to ensure that businesses report reliable and comparable sustainability information to re-orient investments towards more sustainable products and companies.

It requires companies within its scope to report using a double materiality perspective in compliance with European Sustainability Reporting Standards (ESRS). The CSRD also requires that reported information is subject to an (initially) limited level of assurance (i.e. audit, in due course to respond to reasonable assurance), and for companies to digitally tag information so that it is machine-readable and feeds into the EU single access point.

The European Financial Reporting Advisory Group (EFRAG) was appointed technical adviser to the Commission for the development of the draft ESRS under the CSRD.

On 23 November 2022, EFRAG announced that it had submitted the first set of draft ESRS to the Commission. These standards are still to be adopted, with the initial deadline of 30 June 2023 having been postponed.

The consequences of getting reporting under the CSRD wrong will depend on how the EU member state in which the breach occurred has transposed the NFRD, which is amended by the CSRD. In some countries (such as Germany), possible sanctions include potentially high fines; in general terms, sanctions must be “significant”.

If you have questions about the EU’s ESG regulatory framework, please contact Alexandra von Westerhagen.