European Sustainability Reporting Standards(ESRS) Adopted – End of ESG Alphabet Soup?

European Sustainability Reporting Standards(ESRS) Adopted – End of ESG Alphabet Soup? 

On Jul 31, 2023, the European Commission adopted the first set of European Sustainability Reporting Standards (ESRS) as mandated by the co-legislators in the Corporate Sustainability Reporting Directive (CSRD – Directive (EU) 2022/2464). The ESRS will be effective from Jan 1 2024, for the first set of mandated firms(those already reporting under the Non-Financial Reporting Directive). Interestingly, the International Sustainability Standards Board (ISSB) reporting standards also come into effect on Jan 1 2024. 

The adoption of the ESRS marks the culmination of years of massive work done by multiple organizations like EFRAG, IFRS, GRI and TCFD, among others, to harmonize sustainability reporting standards and make them seamlessly interoperable(more on interoperability here). The challenge was particularly severe, given the fact that the European Standards had “double materiality” at its core, while other jurisdictions had “single materiality” as their starting point. While the final version of the adopted ESRS is viewed as a diluted version of the initial ambitious draft ESRS, the good news is that there is finally a regulation, which could be improved upon later. 

The 30-40 days prior to the adoption of the ESRS saw major announcements from the other organizations involved in standard setting. This includes consolidation of standards and increased emphasis on interoperability, and avoiding duplication of efforts by reporting companies. This also could herald the beginning of the end of the ESG Alphabet Soup(read more here). 

The key dates and announcements can be seen below. 

1. Jun 26, 2023 – The International Sustainability Standards Board (ISSB) issued its inaugural standards—IFRS S1 and IFRS S2, which will be effective on Jan 1 2024 (Read more here).
2. July 10, 2023 – The Financial Services Board(FSB) asked the IFRS Foundation, which also created the ISSB, to take over the monitoring of the progress of companies’ climate-related disclosures from the Task Force on Climate-related Financial Disclosures(TCFD). This could lead to the TCFD being absorbed by IFRS. (Read here). 
3. Jul 25, 2023 – International Organization of Securities Commissions(IOSCO) endorsed the ISSB’s Sustainability-related Financial Disclosures Standards and called on its 130 member jurisdictions to adopt or apply the ISSB in their respective jurisdictions. (Read here).
4. Jul 31, 2023 – European Commission adopts ESRS. 
5. July 31, 2023 – In what appears to be a coordinated move, IFRS and GRI released their statements highlighting the alignment of ESRS with their respective standards. (Read their statements here and here). 
6. Aug 2, 2023- The International Auditing and Assurance Standards Board (IAASB) released the draft of the International Standard on Sustainability Assurance (ISSA) 5000, General Requirements for Sustainability Assurance Engagements. (Read here). 

What is new in the ESRS adopted by EC? 

The first set of the draft ESRS was submitted by EFRAG to the European Commission in November 2022, and the European Commission released the revised version on Jun 9, 2023, after stakeholder consultations. The June 2023 version of ESRS relaxed many of the reporting requirements of the ambitious first draft of ESRS proposed by EFRAG(Read more on the changes here and here). Subsequently, the EC conducted a public consultation between Jun 9 and Jul 7, 2023, and required wide-ranging feedback on the revision ESRS version(read more about the feedback here). The final ESRS draft, released on Jul 31, 2023, makes additional modifications from the previous version(released on Jun 9, 2023).

Some of the key changes include

1. All standards and disclosure requirements other than “General disclosures” standards have to be subjected to materiality assessment. Disclosure of all “material” information is mandatory, and the rest is voluntary. In case a firm concludes that a topic is not material(e.g. climate change) following the materiality assessment, it has to provide a detailed explanation of the same. In a way, firms get more flexibility in determining if a standard or reporting requirement is mandatory or voluntary based on materiality assessment. 
2. Additional phase-ins: Firms below a certain threshold(750 employees) are not required to disclose Scope 3 emissions during the first year of their reporting. 
3. Some data points like biodiversity transition plans and indicators about “ non-employees” will become voluntary. 

The bottom line is that the core of the entire reporting process is “Materiality Assessment”. Read more on creating Materiality Matrices based on Materiality assessment here and here. 

Criticisms

Not everyone is happy with the final version of the ESRS. While almost all the critics welcome the finalization of the landmark sustainability reporting standards, there is palpable disappointment in what they consider the significant dilution of ambition of these standards. One of the vocal critics is the World Wildlife Fund(WWF), which slammed the European Commission for “yielding to corporate pressure” and diluting many of the key provisions, including biodiversity protection(read here). The response from The European Sustainable Investment Forum(Eurosif) was a bit more muted and was less of a criticism but more of a disappointment. While the Eurosif statement welcomed the new standards, it lamented the missed opportunity to enforce more stringent standards that would mandate better quality data which sustainable investors rely on to make better investment decisions(read here). According to ESG Clarity, while Principles for Responsible Investment(PRI) welcomed the move as an “important stepping stone” for investors, it expressed reservations about the conduct and reliability of the materiality assessment process and the self-reporting by the corporates. 

What next?

Once the Delegated Regulation is published in the Official Journal of the European Union, the rules will come into effect from Jan 1 2024, for the first set of mandated firms. Every subsequent year, another set of companies gets added to the list of mandated firms. 

Another important change that is on the horizon is the sector-specific standards. EFRAG is currently working on these sector-specific standards, but at the moment, there is no clarity on the implementation timelines. 

The Corporate Sustainability Due Diligence Directive (CSDDD) is another major initiative of the European Union, and the interplay between the CSRD and the CSDDD-based reporting will be something to watch out for. 

Conclusion

With the release of the final version of the ESRS and the near-simultaneous adoption of the ISSB, sustainability reporting is getting much more streamlined. The absorption of various standards like SASB, VRF, CDSB by ISSB and the taking over of the monitoring responsibilities of TCFD by ISSB has led to considerable consolidation of the reporting standards. Similarly, the close collaboration between EFRAG and GRI also means that only two to three standards will remain – ESRS and GRI for jurisdictions favouring double materiality(impact and financial materiality) and ISSB for those that require single materiality(financial materiality). We can safely say that we are witnessing the end of the ESG Alphabet Soup.