What is the CSRD, and why does it matter?

The European Union has been at the forefront of regulation on transparency regarding issues such as carbon emissions, deforestation and biodiversity, labour standards and other sustainability issues. Having started the process of requiring environmental and social impact disclosures from companies, the EU is beginning to impose penalties on businesses that misrepresent the sustainability of their activities. The Corporate Sustainability Reporting Directive is the latest piece of legislation designed to increase transparency for asset managers, investors, business partners and other stakeholders.

The first reporting requirements under the directive are imminent, and the biggest companies should already be taking action. They were required to start collecting data from their financial year starting from January 1, 2024, so as to be ready to submit their first mandatory report in 2025. The next layer of European companies will need to start collecting data at the start of January for their first report 12 months later, while smaller European companies will be required to start reporting in 2027 for the year 2026.

For investors, it will mean a range of new data to interpret, and it should give greater insight into how sustainability factors may affect a company’s longer-term prospects.

Insights into long-term operational sustainability

The CSRD is not completely new, but it represents a major step forward from the EU’s Non-Financial Reporting Directive, the previous EU sustainability reporting framework for large listed companies. Over time, the new directive will significantly expand the number of companies that are required to provide sustainability disclosures, along with their scope. By the end of the decade more than 50,000 European companies will need to report, along with 10,000 groups based abroad that have activities within the EU.

The CSRD requires reporting requirements on companies’ impact on the environment, human rights and other social standards, as well as on their sustainability-related risk. The disclosures are designed to ensure that companies report not just on financial performance, but on their long-term operational sustainability, including that of companies in their supply chains.

The disclosures are designed to ensure that companies report not just on financial performance, but on their long-term operational sustainability, including that of companies in their supply chains.

The aim is to help investors and stakeholders understand whether a company’s growth is in harmony with or at the expense of the natural environment, human rights or society at large – and to enable asset managers to report on the sustainability characteristics of their own investment products under the EU’s Sustainable Finance Disclosure Regulation. While the legislation does not require companies to change their behaviour, there is a presumption that public disclosure will give them an incentive to embrace a more sustainable business model.

European Sustainability Reporting Standards

CSRD requirements are comprehensive and complex. The regulator has created a framework for disclosure, the European Sustainability Reporting Standards (ESRS), which provides a standardised view of a company’s ESG risks, impact and opportunities through metrics as diverse as climate emissions and gender pay difference.

The cross-cutting standards* have two main parts: ESRS 1 outlines the concepts and principles that must be followed by companies when reporting under the CSRD, including general drafting conventions, due diligence procedures, and the definition of what is known as double materiality; ESRS 2 sets out the reporting requirements in key focus areas: impact, risk and opportunity management, governance, strategy, and metrics and targets. This information must be audited by an independent third party.

Double materiality is an important concept in the CSRD, and all companies will be required to conduct a double materiality assessment as part of their reporting obligations. This involves both their outward environmental and social impact, and the relationship between sustainability issues and their effect on financial performance.

The financial perspective examines how sustainability factors could affect a company’s financial performance, such as the impact of rising fossil fuel prices on an airline’s cost base, or how long-term water scarcity might affect a chemicals manufacturer.

Requirements for non-European companies

The impact perspective considers a company’s operational footprint, and its impact on the wider environment and society in the immediate, medium and long term. That entails examining areas such as a company’s supply chain, and the impact it is having on the natural environment. This provision aims to ensure that companies are not ‘outsourcing’ their carbon emissions to third parties in their supply chain, or indirectly encouraging poor labour practices.

The double materiality assessment will determine whether the company must disclose additional data judged to be of material importance according to the EU’s standards, involving multiple parts of the business, including the legal, audit, finance and operations functions, as well as third-party suppliers. Companies are also encouraged to consider input from other stakeholders including customers, employees, shareholders and civil society organisations. All this will require a co-ordinated approach at the top of any organisation.

Non-EU companies with significant operations in Europe will also be in scope under the new rules, but they have a slightly longer timeline for compliance – their first report is due in 2029, covering activities in 2028. The requirements only apply to larger companies – those with net annual turnover > €150 million within the EU, or whose shares or bonds are listed on an EU regulated market.

Also in scope are groups outside the union with EU subsidiaries defined as a large company by meeting at least two of three criteria: an average number of employees during the financial year superior to 250 EU-based employees; a balance sheet exceeding €25 million; and European revenue of more than €50 million.

Disclosure from suppliers

The European Commission says the CSRD requirements “will ensure that investors and other stakeholders have access to the information they need to assess the impact of companies on people and the environment, and for investors to assess financial risks and opportunities arising from climate change and other sustainability issues. Reporting costs will be reduced for companies over the medium to long term by harmonising the information to be provided.”

As disclosure becomes more widespread, it should help provide investors with a broader understanding of a company’s sustainability impact and risk. This may ultimately be reflected in share prices, if investors shun companies with substantial future risks, and embrace those that manage these threats in good time.

Although at present the legislation applies only to large companies, they are likely to require greater disclosure from their suppliers. It could become business-critical; companies may increasingly want to do business only with other sustainable providers. As companies effectively are required to assimilate the carbon emissions and sustainability footprint of other businesses, they may well adapt their business practices accordingly. Investors should bear this in mind when making decisions.

The CSRD’s aim is to foster a more sustainable and resilient economic system by encouraging businesses to adopt more responsible social and environmental practices within their own operations, and to partner with other responsible businesses. This is likely to be a long, slow process, and the burden on companies in the short term could be high. However, it should help investors make more informed decisions.

Although at present the legislation applies only to large companies, they are likely to require greater disclosure from their suppliers. It could become business-critical; companies may increasingly want to do business only with other sustainable providers.

* In addition to these cross-cutting standards, there are topical standards (E-S-G) and there will be specific standards for each sector in the future.