Why we're flying the flag for a stricter EU Non-Financial Reporting Directive

Filip Gregor 27th May 2020

An EU law on how companies report their non-financial impact is up for review later this year. Filip Gregor, from the law firm Frank Bold, sets out four things that need to change to ensure companies capture and disclose their true impact on society and the environment – and why that matters if we're to build a sustainable economy.

Since 2018, the EU Non-Financial Reporting Directive has required large companies and financial corporations operating in Europe to disclose information on environmental, social, human rights and anti-corruption matters. This Directive will now be reformed by the end of the year (with a public consultation on this closing on 11 June), as part of the European Commission’s strategy to strengthen the foundations for sustainable investment and the EU Green Deal Initiative.

We believe that guidance or voluntary measures alone – no matter how good – will not have a substantial and positive effect on the quality of companies’ reporting. This is based on every major qualitative assessment of corporate sustainability reporting, including the research on 1,000 EU companies non-financial statements carried out by the Alliance for Corporate Transparency (a project coordinated by us at Frank Bold). These studies consistently point to the fact that only a minority of companies provide meaningful information on their impacts, risks and strategies – and indicate that clearer legal requirements are needed.

Studies consistently point to the fact that only a minority of companies provide meaningful information on their impacts, risks and strategies

Research on the sustainability information disclosed by 1,000 European companies shows that there is a critical lack of comparability and relevance of companies’ disclosures on sustainability-related issues. For instance, very few companies, even from the most critical sectors (such as the energy and resource extraction, transportation or financial sectors), report on the alignment of their climate change mitigation targets with Paris goals (13.9% on average for all companies, and 23.5% for those in the energy sector). Only 14.6% report on adverse human rights impacts.

Which companies are bound by the Non-Financial Reporting Directive?

The directive applies to large ‘public-interest’ companies with more than 500 employees and a balance sheet in excess of €20m or a net turnover in excess of €40m. This covers approximately 6,000 large companies and groups across the EU, including listed companies, banks, insurance companies, and other companies designated by national authorities as public-interest entities. The scope of companies covered may be subject to changes with the reform of the Directive.

In view of the questions that the European Commission has opened for public consultation, we have four key recommendations, which are supported by the research carried out by the Alliance for Corporate Transparency, to ensure that the reform of the legal framework is effective:

The revised Non-Financial Reporting Directive should include a clearer overview and specification of matters that companies should disclose, coupled with a focus on targets. It should also require transparency on governance-related matters, namely how sustainability strategies are embedded in accountability at top level, through, for example, disclosure on matters discussed by boards.
The EU should develop detailed requirements for disclosure of critical sector-specific information. This concerns for example climate-related information for the energy and financial sectors, or transparency of supply chains in the garment sector.
The Directive already requires that companies should disclose information necessary for understanding their impacts on society and environment, as well as the financial risks posed by sustainability matters to the company, but this double requirement is poorly understood in practice. The review of the law should clarify what specific information on both risks and impacts, and the form in which companies should analyse and disclose such information.
Materiality is the guiding principle for corporate disclosure and related requirements. The Non-Financial Reporting Directive is based on a double-materiality principle, that is the requirement to report information on impacts linked to the company, as well as information relevant from the perspective of management of risks facing the company. The reformed legislation must specify the required elements for companies to explain which specific issues are considered to be material as well as why and how it has determined them. The law should specify that companies need to disclose inputs into this process, implications for the content of sustainability disclosures, and how the results of this determination translate into a company’s governance and actions.

Chain effect: reporting as a prerequisite for sustainable finance

The NFRD aims to provide investors, consumers, and other stakeholders with a clearer picture of companies’ non-financial performance in relation to environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery.

Reviewing the legal framework is an essential part of the Commission’s effort to scale up sustainable finance by improving corporate transparency and providing more comparable and relevant information on sustainable business activities. As Valdis Dombrovskis, Executive Vice-President for an Economy that Works for People, stated regarding the review of the NFRD, “Our transformation to a carbon-neutral economy means that people need more information from the companies they are investing in. As things stand today, there is currently a sustainability reporting gap that is hampering progress towards a sustainable financial system. The needs of investors for corporate sustainability information are growing faster than any improvements in company reporting.”

'The needs of investors for corporate sustainability information are growing faster than any improvements in company reporting' - Valdis Dombrovskis, European Commission

The current reporting requirements under the NFRD are not specific enough, which explains the poor quality of companies’ disclosures on environmental, social and governance (ESG) matters.

This situation leaves investors (who need comparable and reliable data on sustainability to factor climate and ESG risks into their decisions), and stakeholders (such as enforcement agencies or NGOs monitoring companies’ compliance with the law), without relevant information.

ESG matters are also crucial for companies’ strategic planning and a key component for business resilience and long-term value creation. EU supervisory authorities (who enforce EU legislation) have repeatedly called for the specification of reporting requirements as a prerequisite to do their job properly and have supported the development of EU and international standards. The EU European Securities and Market Authority frequently mentions the shortcomings of the NFRD in its latest report, such as the lack of quantitative disclosure, objective targets and accompanying assessment of whether the company was meeting those targets.

Lastly, investors and asset managers will be required, by 2021, to disclose how they are integrating ESG factors in their risk management. Again, they can only do so with adequate information from the companies they invest in. Businesses covered under the NFRD will also need to disclose information on the proportion of their activities that is classified as ‘sustainable’ according to the EU taxonomy regulation in 2022. While there must be alignment with the indicators developed for the taxonomy (which currently look at the positive opportunities and activities), the purpose of the NFRD is to capture and disclose both actual and potential impacts to society and the environment, as well as financial risks posed by sustainability matters to the company.

The Commission has launched a public consultation (closing 11 June) to gather views about potential changes to the legislation. The feedback from the public consultation will feed into the Commission’s review of the Directive. We urge EU regulators to move forward with this important policy reform, as it is the foundation for proper implementation of both existing and future EU Sustainable Finance measures.

Filip Gregor is head of responsible companies at Frank Bold.

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