The European Sustainability Landscape: Introducing the European Sustainability Reporting Standards (ESRS)

As the global push for sustainable development and responsible business practices gains momentum, the European Union has taken a significant step forward with the introduction of the European Sustainability Reporting Standards (ESRS). Developed by the European Financial Reporting Advisory Group (EFRAG), the ESRS aim to provide a comprehensive and standardized framework for sustainability reporting, enabling companies to disclose their environmental, social, and governance (ESG) performance in a consistent and comparable manner.

The Significance of ESRS

The ESRS is set to have a profound impact on the corporate reporting landscape in Europe, with far-reaching implications for companies, investors, and stakeholders alike. Unlike voluntary reporting frameworks, the ESRS is mandated by the Corporate Sustainability Reporting Directive (CSRD), which requires approximately 50,000 EU-headquartered companies and an estimated 11,000 international companies with significant operations in the EU to comply with the standards. This mandatory nature of the ESRS ensures a level playing field and promotes transparency and accountability across industries.

Moreover, the CSRD requires companies to obtain an audit opinion on their ESRS reporting, adding an extra layer of credibility and assurance to the disclosed information. This requirement sets the ESRS apart from other reporting frameworks, such as the International Sustainability Standards Board (ISSB) standards, for which regulators are not currently mandating an audit.

The Structure of ESRS

The ESRS consist of 12 documents, with 11 standards containing disclosure requirements. The first document, ESRS 1, outlines general requirements for compliance with the ESRS but does not include specific disclosures. ESRS 2 provides high-level guidance, similar to ISSB S1, but with less detail due to the extensive resources available to the ESRS development team.

The remaining standards are categorized as environmental, social, or governance standards. The environmental standards cover various topics, such as climate change (E1), pollution (E2), water (E3), biodiversity (E4), and circular economy (E5). These standards demonstrate the advanced nature and complexity of the ESRS compared to the ISSB, which currently only has two standards.

The development of the ESRS serves as a potential roadmap for how the ISSB standards may evolve in the future, as the ISSB is likely to draw inspiration from the ESRS while applying a financial lens to the disclosures.

The Challenges of Implementing ESRS and the Concept of Double Materiality

Companies subject to the European Sustainability Reporting Standards (ESRS) face significant challenges in complying with the extensive disclosure requirements. Each standard within the ESRS framework requires a substantial amount of data, which companies may not currently be collecting, measuring, or fully understanding. Establishing the necessary systems and processes to gather and report on this data, both quantitative and qualitative, will be a considerable undertaking for many organizations.

While the ESRS share some conceptual similarities with the ISSB standards, such as the focus on governance, strategy, and risk management, as well as the consideration of risks and opportunities arising from sustainability matters, a key difference lies in the concept of double materiality.

Double materiality encompasses two dimensions: impact materiality and financial materiality. Impact materiality considers the potential positive and negative impacts of a sustainability matter on people and the environment over the short and long term, regardless of its financial impact on the reporting entity. This contrasts with the ISSB’s focus on financial materiality alone.

The ESRS further distinguishes between actual and potential negative impacts. For actual negative impacts, companies must make a judgment on the severity of the impact, which can be challenging without clear guidance. For example, if a company destroys a forest, there is a clear impact materiality but possibly not a financial materiality if there are no immediate financial consequences for the company.

However, it can be argued that even if there are no direct financial repercussions, such actions can still have financial implications if stakeholders become aware of the negative impact, potentially leading to reputational damage and loss of business.

The ESRS also introduces the concept of potential negative impacts, which adds another layer of complexity to the materiality assessment process. Companies must consider the likelihood and magnitude of potential negative impacts, even if they have not yet occurred.

Implementing the ESRS will require significant effort and resources from companies to navigate the extensive disclosure requirements, gather the necessary data, and make judgments on materiality. The concept of double materiality, particularly the assessment of impact materiality, presents additional challenges and may require companies to re-evaluate their approach to sustainability reporting.

The Materiality Assessment Process and Its Challenges under ESRS

One of the first and most critical steps for companies reporting under the European Sustainability Reporting Standards (ESRS) is conducting a comprehensive materiality assessment. This process is a significant undertaking due to the broad scope of the ESRS, which covers a wide range of environmental, social, and governance topics. However, once the initial materiality assessment is completed, it becomes easier to maintain and update in subsequent reporting periods.

The challenges associated with ESRS reporting are similar to those faced under the ISSB standards, but the ESRS requirements are generally more detailed and extensive. Companies will need to gather and report on a larger volume of data, provide more qualitative disclosures, and conduct a more thorough analysis of their supply chain. The increased level of detail and scrutiny under the ESRS can be attributed to the concept of double materiality, which considers both financial materiality and impact materiality.

One of the most significant challenges for companies reporting under the ESRS is the requirement for an independent third-party audit. Auditors will review the reported information and may challenge the company’s efforts in areas such as supply chain analysis or data collection on specific topics like pollution. The risk of receiving a qualified audit report, where the auditor expresses dissatisfaction with the company’s reporting, can undermine confidence in the business and its ability to accurately report on its sustainability performance.

It is important to note that companies subject to the ESRS must comply with these standards even if they have voluntarily reported under the ISSB standards. While there is some overlap between the two frameworks, the ESRS builds upon the foundation laid by the ISSB and requires additional disclosures and analysis.

The ESRS introduces a specific disclosure requirement related to the materiality assessment process itself, which is not present in the ISSB standards. Under ESRS 2 General Disclosures, companies must disclose the process they have undertaken to determine their double materiality topics. This requirement places greater scrutiny on the robustness and appropriateness of the materiality assessment process, drawing from the precedent set by the Global Reporting Initiative (GRI) and its long-standing approach to double materiality reporting.

However, the ESRS also present opportunities for companies to enhance their sustainability performance, strengthen their relationships with stakeholders, and position themselves as leaders in responsible business practices. By embracing the double materiality approach and transparently disclosing their impacts, companies can demonstrate their commitment to sustainable development and attract investors and customers who value ESG performance.

The Path Forward

As companies embark on their ESRS reporting journey, it is essential to approach the process with a strategic mindset. Conducting a thorough materiality assessment, engaging with stakeholders, and aligning sustainability initiatives with business objectives will be critical success factors. Companies should also seek guidance from industry associations, sustainability experts, and peer organizations to share best practices and navigate the complexities of the ESRS.

The introduction of the ESRS marks a significant milestone in the evolution of sustainability reporting. By providing a comprehensive and standardized framework, the ESRS aim to drive meaningful change and accountability in the corporate world. As the standards continue to evolve and companies adapt to the new reporting landscape, the ESRS have the potential to catalyze a transformative shift towards a more sustainable and responsible future.

As the ESRS continue to shape the corporate reporting landscape in Europe, their influence is likely to extend beyond the EU borders. The standards set a high bar for sustainability reporting and may serve as a model for other jurisdictions seeking to enhance the quality and comparability of ESG disclosures. The ESRS also complement and align with other international initiatives, such as the ISSB standards, contributing to the global harmonization of sustainability reporting practices.

As companies navigate this new reporting landscape, it is essential to approach the ESRS not merely as a compliance exercise but as an opportunity to embed sustainability into the core of their business strategy. By doing so, companies can unlock the full potential of sustainable practices, create long-term value for all stakeholders, and contribute to a more resilient and prosperous future for generations to come.