Non-Financial Reporting: How to Comply? What does it mean for the climate?

New European Union rules have the potential to provide essential information for investors

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The first EU-wide requirements to report environmental, social and governance (ESG) information will come into effect in the financial year 2017. The requirements will apply to more than 6,000 large public-interest undertakings (in essence, publicly traded corporations, banks and insurers) with more than 500 employees. A number of member states have gone beyond the bare requirements of the directive. In Sweden, Iceland and Denmark, the requirements will apply to all companies with more than 250 employees, i.e. approximately 1600 companies in Sweden and 1100 companies in Denmark. These organisations will be required to disclose information on policies, risks and outcomes regarding environmental, social and employee matters; respect for human rights, anti-corruption and bribery issues; and board diversity.

The objective is to lay the foundation for a new model of corporate reporting that complements financial transparency with other information necessary for understanding of a company’s development, performance and position, as well as impact of its activity on society.

Achieving compliance

At a practical level, companies are required to disclose at a minimum the following information:
· description of the organisation’s business model
· description of policies regarding environmental, social and employee matters, respect for human rights, anti-corruption and bribery, including due diligence processes implemented;
· the outcome of these policies
· the principal risks relating to environmental, social and employee matters, human rights, anti-corruption and bribery
· non-financial key performance indicators (KPIs)

The information on principal risks must be provided with respect to the company’s direct operations as well as value chains, business relationships, and products.

There has been a lot of discussion about whether to identify the KPIs for businesses to report against, using either a general or a sectoral approach. In the end, the Commission has indicated that it will not provide detailed indicators but will rather leave it to member states or businesses to identify the KPIs that are most relevant to them. The reasoning is that non-financial reporting is at a relatively early stage compared to financial reporting, which has been refined over the course of several centuries. It may be that consensus will develop on how non-financial reporting should be done, and which point the EU or member states may impose more specific requirements. Similarly, the Commission has suggested in various conversations that it will not tell companies which reporting framework to use.That leaves a number of international reporting frameworks that companies may opt to use to comply:
· Integrated Reporting < IR > Framework – Aims to provide a complete picture of a company’s assets, including intangible assets that are broken down into six ‘capitals’ that are considered to be an important part of value creation and that could otherwise be overlooked in a traditional report on financial assets.
· Global Reporting Initiative (GRI) G4 Sustainability Reporting Guidelines – Provides detailed metrics to report on ESG matters.
· Shift UN Guiding Principles Reporting Framework – For reporting on human rights issues.
· CDSB Framework for reporting environmental information.

The investor community is concerned about how the information that companies will disclose following the NFR Directive can be standardised. Jean Guillaume Peladan, Head of Environmental Investments and Research at Sycomore Asset Management believes that standardised disclosure is necessary but that there is currently “a very poor level of ESG and climate-related reporting and a wide variety of corporate business models.” According to him, “the solution relies on the bottom-up analysis carried out for each company at an activity or business unit level, such as the purpose of each activity, its main negative environmental impacts on a lifecycle basis and its main positive externalities too.”

It should be noted that the EU’s reporting requirements are not comply or explain. As European Commission policy officer Nicolas Bernier-Abad explained: The EU legislation is “you publish your balance sheet, and your profit and loss account, you have an annual report. Make sure you also report your environmental and social information because that is part of the same package. Information needs to be there, needs to be relevant, needs to be comprehensive.” Organisations may determine that one or more of the relevant matters are not pertinent to their business, in which case they should explain the reason(s) for failing to adopt the relevant policy in their non-financial statement. This does not, however, exempt those organisation from the obligation to identify and report on principal risks in any of the applicable areas.
Additionally, reporting on due diligence processes may have implications for evaluating a company’s civil and criminal responsibility for potential wrongdoings by its employees and, where provided for, business partners. This is particularly relevant with respect to corruption.

Current status

Member States were required to introduce the directive into national law by 6 December 2016, with a view to applying the regulations to reporting periods beginning on or after 1 January 2017.

Yet only five Member States have officially communicated their plans to the European Commission.

The EC is preparing guidelines to advise companies, and to a lesser extent member states, on how to implement the Directive and achieve compliance. European Commission officials have said that the guidelines are expected to be published in the first quarter of 2017 to allow time to review the draft recommendations of the Financial Stability Board Task Force on Climate-related Financial Disclosures (TCFD), with the intention that the EC’s guidelines will align with the TCFD report.

The degree to which the new requirements are onerous on companies depend on the member state. Some, such as UK and France, have already had requirements to disclose non-financial information for several years. While many companies have disclosed at least some non-financial information, Bloomberg data shows that a majority of large companies are still not disclosing any of the four environmental indicators: energy, greenhouse gas emissions (GHGs), water and waste. The study conducted in 45 stock exchanges worldwide found that of 4469 large companies analysed, only 47% disclosed GHGs, followed by energy (41%) and water (28%).

Implications for the climate

The Non-Financial Reporting Directive builds on previous regulatory initiatives at the member state level. Notably with respect to the climate, several EU member states require corporate disclosure of greenhouse-gas emissions, including Denmark, France and the UK. The French law on energy transition and green growth (article 173-Vl) strengthens requirements for publicly traded companies to make carbon disclosures, and introduces carbon reporting for institutional investors (i.e. asset owners and investment managers).Article 173 is the leading initiative to push the financial industry to monitor and engage with investee companies on sustainability matters by requiring investors to disclose how they consider ESG criteria and carbon emissions in their investment policies – in this respect it goes beyond the NFR Directive, which does not include any requirements for investors.

Jean-Guillaume Peladan of Sycomore Asset Management noted that even if it too early to assess the impact of the Article 173-VI, “more and more players in the investment community are moving quickly in France”. For example, the French Ministry of the Environment issued the Energy and Ecological Transition for the Climate certification (EETC) to facilitate investors’ access to meaningful green investment solutions. Over the last 6 months, a number of funds totaling more than €1 billion have received EETC certification.

Business and political trends are firmly shifting towards a low-carbon economy; both risks and investment opportunities arise from this process. Investors that wish to mitigate risks need to develop a comprehensive picture of their portfolio companies’ climate-related exposures.

The way corporate activity is accounted for is crucial to shape the way investors and other stakeholders see and assess a corporation. The form of corporate reporting used creates powerful incentives for corporate boards to establish their targets and to decide the means to achieve those targets. Accounting models and the legislative framework are therefore essential for a corporation’s ability to create sustainable value. This is where legislation such as the NFR Directive has the potential to provide essential information to forward-looking investors.

Paige Morrow is head of Brussels Operations at Frank Bold, a purpose-driven law firm. The firm leads the Purpose of the Corporation Project, which invites businesses, academics, policymakers, and civil society to debate the future of publicly traded companies.