Comment: How to make the EU Non-Financial Reporting Directive work

Mardi McBrien argues that the Directive needs to widen in scope, integrate reporting and namecheck climate change.

At the end of last week, the European Commission published its ‘roadmap’ on the revised Non-Financial Reporting Directive, asking for feedback from stakeholders over the coming weeks. Another consultation on the NFRD – this time on the actual revisions proposed – is expected soon, with the formal review being launched later this year. Here, Mardi McBrien, Managing Director of the Climate Disclosure Standards Board (CDSB), outlines how she believes the EU Non-Financial Reporting Directive (NFRD) should be rewritten to make it work for investors.

As outlined in the EU Green Deal, the European Commission is set to launch its review of the Non-Financial Reporting Directive (NFRD). While the introduction of the NFRD was a significant milestone for corporate accountability and transparency in Europe, it has not achieved its objectives in its current form.

To make “the Green Deal a reality”, as Executive Vice-President Dombrovskis so succinctly put it, we must seize this opportunity to drive more ambitious corporate reporting policy that delivers the real change needed to facilitate the allocation of capital towards more sustainable activities.

Core to this will be helping investors evaluate the non-financial performance of large companies. However, the current NFRD is flawed in this respect, and steps need to be taken to bolster the linkage between financial and non-financial information and effectively convey material issues to the reader. In particular, ensuring that information is reported in company management reports and not published up to 6 months after the financial report, could drive significant improvements with the consistency and comparability of disclosure.

The European Commission’s Inception Impact Assessment on the Revision of the Non-Financial Reporting Directive has found that “it is hard for investors and other users to find non-financial information even when it is reported” and that reported non-financial information is not sufficiently reliable. This highlights that the exemption to allow the non-financial statement to be reported outside the management report should be removed from any update to the Directive to ensure that this information is easy to find, prepared with robust governance procedures and connected to other information in the annual report.

The scope should also be increased by changing business size to more than 250 employees as opposed to existing number of more than 500. Recognising the need to avoid the overall regulatory burden on SMEs, ESG matters may pose material risks and opportunities to businesses irrespective of their size. As Accountancy Europe states: “Expanding the NFRD's scope should capture all those companies that significantly impact the environment due to their sector's environmental and social profile. Stakeholders are interested in non-financial information to better understand a company's performance, its future developments and impact on society. Reporting on non-financial matters make businesses better assess, measure and manage their risks and performance on specific ESG-metrics. That could lead to lower funding costs, fewer and less significant business disruptions, strong consumer loyalty and better relations with stakeholders.”

The word "climate" should also be explicitly stated in any update to the Directive. Currently it is not explicitly referred to under environmental matters, however the Commission’s guidelines on non-financial reporting refer to the SDGs, the Paris Agreement and the Task Force on Climate-related Financial Disclosure (TCFD). Therefore, despite the absence of the term climate from the language of the Directive, the NFRD’s intention appears to cover climate under the auspices of “environmental matters”. This ambiguity, however, has created uncertainties for preparers and inconsistencies in reporting practice when comparing disclosures and in some cases has resulted in a lower rate of climate disclosure. For example, our review of corporate reports found that 58% of companies provided information on management’s role on environmental matters, but only 20% for climate-related matters.  

But the buck does not stop at climate change. To further facilitate a unified approach to disclosure and ensure consistency and connectivity of information, all forms of ESG information in the management report should cover all four elements of the TCFD. According to the TCFD recommendations, Risk Management and Governance of ESG matters should be disclosed irrespective of materiality and an update to the Directive would benefit from a similar approach.

There is also a unique opportunity to bring natural capital reporting to a stronger footing within the NFRD and increase natural capital-related financial disclosures, just like the TCFD did for climate. With 2020 being hailed as the “super year of biodiversity”, we are on the cusp of mainstreaming biodiversity within financial decision-making. At CDSB, we are currently seeking views on how the CDSB Framework can support the market with this.

Finally of equal weighting is setting the investor as the primary audience. Investors require information to be presented in a way that is suitable for their decision making. Having multiple audiences with varying information needs can result in less clarity of the reported information and lengthy disclosures that contain information that is immaterial for investors.

The European Commission has also acknowledged this issue. It even goes as far as to say that investors cannot take sufficient account of sustainability-related risks and opportunities, or of the social and environmental impacts of their investments. As a result, this could present systemic risks to the economy with companies not adequately pricing sustainability risks and inadequate capital flows to companies focused on resolving sustainability-related challenges. While other forms of reporting outside the management report might be better suited for different stakeholders, this is a separate issue and more work needs to be done to address this.

There is no doubt that to meet the ambitions of the EU Green Deal, the existing Non-Financial Reporting Directive needs to be significantly strengthened.

The next update to the Directive must provide the catalyst to push companies to increase their disclosure on environmental and climate risks and opportunities and ensure that investors are fully informed about the sustainability of their investments. A light touch to the existing directive simply won’t do and certainly won’t channel the extra €260 billion needed in annual investments to deliver on the EU’s 2030 climate and energy targets.

Mardi McBrien joined the Climate Disclosure Standards Board (CDSB) as Managing Director in 2011. She is a member of the Global Reporting Initiative’s Stakeholder Council.