Opinion | (E-)merging ESG regulation and standards – can the European and US perspectives converge?

A significant criticism of ESG is often related to its lack of globally adopted standards and regulations. Prominent examples are the “alphabet soup” of ESG frameworks and the expectation for uniform regulation of ESG globally. Interestingly, while some ESG frameworks merge, new standards emerge simultaneously. Regarding regulation, the proposals of the SEC in the US and the European Union may look similar at first glance. Still, with a closer look, it becomes evident that there are substantial differences. This blog post looks at what is in store for globally accepted universal ESG standards and regulations from a European and a US perspective.

Why there is a need for interoperable and comparable ESG performance reporting

We live in a globalized world with internationally recognized accounting standards. But unfortunately, what worked for financial reporting, is not yet in sight for non-financial reporting: A globally accepted standard for non-financial reporting embedded in a likewise international sustainability reporting regime.
One would expect (or at least hope) that regulators understand the need for such a global approach to sustainability reporting. So somehow, this post can be understood as the search for the “missing link” between the CSRD and the proposed regulations by the SEC.

(E)merging Reporting Frameworks in the US and the EU

Over the years, several ESG reporting frameworks have emerged. Some are industry agnostic, while others are industry-specific. Unfortunately, this diversity of reporting standards has led to numerous problems. Most prominent: How can the results be compared to one another? How narrow or wide is the scope of ESG matters considered by the respective framework? What is the emphasis of reporting, and how balanced are qualitative information and numerical data? No wonder users of sustainability reports like investors or analysts sometimes have difficulty interpreting what they expect to be comparable and transparent firsthand.

Disclosure standards – will it get better, or will it become worse?

Besides the fact that there are well-established standards for sustainability accounting, both the EU and US regulators have decided to set new standards for non-financial sustainability performance reporting. So how comparable will the results be?

The EU perspective: CSRD, ESRS, EU Taxonomy, and SFDR

The EU Green Deal has a significant influence on sustainability regulation. The upcoming Corporate Sustainability Reporting Directive (CSRD), along with the EU Taxonomy and the SFDR, is the core of the future European Union’s sustainability regulation. 

But there is more: The European Sustainability Reporting Standard (ESRS) that comes with the CSRD. This standard will be the guideline for more than 50.000 companies in the EU that fall under the CSRD. 

The ESRS has its roots in the Global Reporting Initiative (GRI) ESG reporting framework. The EFRAG developing the ESRS has recently published a draft of the framework. What sets the ESRS apart is that ESG reporting is no longer just a numbers game. Companies will have to report detailed quantitative aspects but also disclose how they have arrived at the results of assessments, their sustainability strategy and the resources they have allocated. More than that: The ESRS will include sector-specific and sector-agnostic metrics tailored to about 40 industries. 

The US perspective: SEC’s love affair with the TCFD

While the EU reporting requirements have their roots in the GRI standard, the SEC aligned its guidelines to the Task Force on Climate-Related Financial Disclosures reporting framework. But, again, there is more. The TCFD, SEC and ISSB are working on convergence. 

Convergence and difference

ESG stands for environmental, social and governance – three different perspectives on a company’s sustainability performance. 

Emphasis on “E” or on “E”, “S”, and “G”?

The SEC is emphasizing the “E” in ESG. That reflects in the origins of the reporting framework based on the TCFD. 

On the other hand, the CSRD comes with a broader scope that includes environmental, social, and governance matters in depth in the scope of sustainability performance reporting. Therefore, reporting under the CSRD will demand a lot from companies. In addition, it will provide more transparency and insights for users of sustainability reports.

Who will have to report? “Public companies” vs “medium and large companies.”

Who are the companies affected by the upcoming US and EU regulations? A simple answer for the SEC is public companies that sell securities. The European perspective is different. The CSRD will apply to all listed and large companies (in terms of the CSRD, a company is “large” if it meets two of the following three criteria: €40 million in net turnover; €20 million on the balance sheet; 250 or more employees). However, there are exceptions for listed micro-companies. As a result, the overall bandwidth of companies that have to report is broader in the EU compared to the US. Private companies in the US may benefit from the focus on public companies. So one could argue that the European approach is much more consistent and leads to more transparency. 

Materiality – different perspectives

Concerning materiality, the EU goes one step – or one perspective – further compared to the US. The principle of “double materiality” stems from the EU Green Deal (and is a part of the GRI framework). It combines the inside-out and the outside-in perspectives of materiality. The ESRS states that “double materiality is the union […] of impact materiality and financial materiality. A sustainability matter, therefore, meets the criteria of double materiality if it is material from either the impact perspective or the financial perspective or both perspectives.”

Conversely, the SEC follows the concept of single materiality and, by doing so, emphasizes investor-focused risk governance and financial materiality. 

Conclusion

We understand that the US perspective is different from the EU approach on sustainability, which reflects in regulation, too. So there is no such question as “Who is doing it right?” or “who is doing it better?”. It is simply two different approaches to the topic. The good news is that mandatory sustainability reporting is a positive development many stakeholders demands. 

In the EU, the CSRD is embedded along with the EU Taxonomy and the SFDR in the broader concept of the EU Green Deal. In the US, the approach of the SEC is not embedded in a broader context. 

Looking at the challenge of sustainability reporting from a global perspective, some drawbacks stem from the system of two separate disclosure regimes.

First and foremost, finance is globalized, and so are (financial) accounting standards. It would have been beneficial if there had been a common ground on non-financial reporting. Investors and other stakeholders would profit from that level of interoperability. Now they will have to deal with two different non-financial reporting frameworks and will need to find a way to translate the results to make sense of it. 

Companies that are active in both jurisdictions by having subsidiaries either in the US or in the EU may simultaneously face the challenge of reporting according to two different frameworks. Doing so is a challenge and will come with extra cost and effort. 

These two aspects may cause additional friction in trade (think about global value chains) and investments (think about international investment funds, for example). 

Another friction point is not in the “Why?” or “How?” but in the “Who?”. Around 50.000 companies will have to report on the ESRS to comply with the CSRD. This number represents not only listed companies but also medium and large ones. They have in common that they will be confronted with a complex system for their sustainability performance reporting that requires the resources to do so – all that comes with a substantial price tag. 

In the US, the scope of companies that must disclose sustainability reports is much narrower.

So is there a disparity in the “Who” has to report? In the US, private companies may benefit from not having to mandatory report on sustainability. On the other hand, European companies may find a disadvantage in reporting way more granularly and with a broader scope than their US counterparts. 

At this stage, the progress of the two disclosure regimes and their final scope will have to be monitored closely to determine what measures need to be taken to close the gap between the US and EU systems in the future. 

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