The necessary transition from the current economy to a sustainable model requires significant development of non-financial information. Consequently, regulations have begun to be issued that seek to standardize and facilitate market participants’ access to all necessary information, a process that has received significant impetus in Europe with the new Corporate Sustainability Reporting Directive proposal. Financial institutions, given the highly significant role they are called upon to play in the so-called “transition” and the need for customer information they will require, are closely following this initiative and have received it very favorably. The financial sector particularly values the expansion of the scope while also making very relevant proposals regarding aspects such as the implementation timeline and sequence, the need for international coordination, or an improved definition of the scope to include aspects concerning the impact on sustainability beyond the size of the entities.
1.- INTRODUCTION
Few topics have generated such a high level of international consensus as the need for a change in economic activities so that they contribute to transforming the world into a more sustainable one from environmental, social, and corporate responsibility perspectives.
This gives rise to the concept of “sustainable economy,” which has permeated public and private institutions, from the United Nations to the smallest municipalities and households: either CO2 emissions are reduced, or the damage will be irreversible.
The magnitude of the problem becomes evident when assessing the essential investment required to face this transformation, and the resulting figures reflect the need for financing from the markets, as public investment could by no means cover it. The investment is not only of a high volume, but it will be fundamental that it is directed towards sustainable technologies and activities, long-term investments, and the promotion of the so-called circular, resilient, and low-carbon economy.
In Europe, the main proposals for fulfilling the 2030 Agenda are embodied in the Sustainable Finance Action Plan published in 2018, followed by the European Green Deal in 2019, and complemented by the instrument known as Next Generation EU in 2020.
In this process of transforming traditional activities into sustainable ones, information plays a fundamental role. Not only do investors need to know the degree of sustainability of their investment, but economic actors themselves need information that clarifies where they are and where they need to go. This need for more information is exacerbated by the exponential growth in the supply of financial products that seek to address the new orientation of economic activity. The strong impetus given by the so-called “green bonds” (i.e., any type of bond whose received funds are applied to the financing or refinancing, in whole or in part, of new or existing “green” projects) has been accompanied by an explosion of offerings aimed at directing private sector savings towards ecologically sustainable companies. Therefore, it is foreseeable that initiatives such as “ecolabels” will evolve rapidly as they seek to avoid “greenwashing,” which ultimately aims to gain an unfair competitive advantage by marketing a financial product as environmentally friendly when it is not.
It is important to note that all these concepts linked to “eco” or “green” must evolve towards “ESG,” because while the ecological orientation was the first to emerge, the social and responsible corporate governance orientations have experienced a great boost during the COVID pandemic.
The lack of information on the greater or lesser degree of sustainability of activities thus becomes a major obstacle to identifying and defining investment opportunities. Therefore, both the report prepared by the European Platform on Sustainable Finance and the European Union’s Action Plan grant it a fundamental role from the outset. The need for information that went beyond traditional financial metrics was already evident even before the entire regulatory machinery for sustainability was set in motion. Furthermore, the increasingly stringent regulatory requirements regarding sustainability can only be met with more and better non-financial information about companies.
In 2014, the so-called Non-Financial Information Directive[i] was published, transposed in Spain into Law 11/2018[ii]. These rules will represent the first steps towards the mandatory publication of non-financial information, which in Spain will be supervised by the CNMV, insofar as these obligations initially affect entities listed on the stock market.
Thus began the publication of Non-Financial Information Statements, in which, along with information on the business model and its policies and due diligence processes, results, risks and their management, as well as relevant key performance indicators (KPIs) for the business, entities had to publish information on four sustainability issues: environment, social and employee matters, human rights, and bribery and corruption. No mandatory standard or framework was introduced or required, nor were detailed disclosure requirements imposed, but it did include the need for these statements to be verified by a third party with the aim of confirming that they do not contain material errors.
2.- RESPONSE TO NEW SUSTAINABILITY REPORTING OBLIGATIONS: THE ROLE OF THE FINANCIAL SECTOR
The entities’ response to these new obligations was truly positive and confirmed their commitment to the new paradigm of economic activity, highlighting the fact that most of them published more information than was mandatory.
However, despite this positive response from companies and the great qualitative leap that the beginning of non-financial information publication represented, it was the European Commission itself that clearly outlined the limitations of the information published under this regulation.
Firstly, it is important to note the scope of the obligation, which only includes large entities, referred to as “public interest” entities (in practice, this includes listed entities, large banks and insurance companies, and those with more than 500 employees).
Secondly, regarding the content of the information, the diversity of possible indicators, their measurement, and the absence of a mandatory standard, neither for measurement nor for standardized presentation, hinder the comparability of data and highlight the need for significant improvements in the area of information if it is to be an effective driving force for the necessary transition to a sustainable economy.
The cost burden for companies obliged to publish information in such a highly uncertain context was also not negligible, as the lack of precision in requirements and the high number of regulations made it extremely difficult to know exactly what information they should publish. This difficulty was compounded by that of obtaining necessary information from suppliers, clients, etc., all of which generated costs beyond what is reasonable in a regulatory environment pursuing a common goal. Even ESMA (European Securities and Markets Authority) itself pointed out the excessive pressure placed on companies.
In this context, the European Parliament raised the need for further development of non-financial reporting requirements, and the European Council, in its conclusions on the Capital Markets Union, asked the European Commission to study the development of a stricter regulatory framework for the publication of non-financial information. The European Commission explicitly took up this task in the European Green Deal, committing to review the Non-Financial Reporting Directive in 2020 as a necessary element to boost sustainable investment.
The process of improving information in Spain, in coordination with various European initiatives, is reflected in Law 7/2021[iii], known as the Climate Change Law, which dedicates two articles to the integration of climate risk in entities whose securities are admitted to trading on regulated markets, credit institutions, insurance and reinsurance undertakings, and companies by reason of size.
In the European context, two fundamental milestones should be noted: on the one hand, the first step forward in improving the information needed for the market to efficiently allocate resources to sustainable projects is taken by the Regulation on sustainability-related disclosures in the financial services sector[iv]; on the other hand, the new approach to non-financial information will be reflected in the new Directive proposal[v], published in April 2021, one of its most striking elements in an initial analysis being the change of name.
Although the regulation continues to be based on an instrument – a Directive – which requires national transposition and, therefore, opens doors to national discretions, it no longer refers to “Non-Financial Information” but presents a proposal for a “Corporate Sustainability Reporting Directive.”
Beyond a mere name change, this update represents a complete paradigm shift in the function this information is called upon to fulfill. It is no longer about providing information that reflects the activity of traditional areas known as corporate responsibility, but about embedding sustainability into the DNA of all entities as the backbone of their philosophy and, therefore, of their economic activities.
Information, as part of this change, is not only necessary but must act as a driver of this reorientation in the economy. Therefore, in addition to fulfilling the objective of improving data availability, reliability, relevance, and comparability, it was essential to expand the scope of reporting obligations to a greater number of entities, including those with higher transition risks, while always keeping in mind the requirement not to excessively penalize obliged entities, especially SMEs. In a country like Spain, with a universe of micro-SMEs as the backbone of its business and economic system, it is very important that all these small businesses are not left out of the new engine that is sustainability, without the necessary information impositions being excessively burdensome.
With the aim, therefore, of improving sustainability information at the lowest possible cost, the main novelties of the proposal can be summarized as follows:
Regarding the Taxonomy Regulation, it is necessary to briefly mention that it establishes a classification system for environmentally sustainable economic activities. The relationship between this Regulation and the Reporting Directive stems from the fact that the Taxonomy Regulation requires companies within the scope of the Directive to publish certain indicators on the extent to which their activities are environmentally sustainable according to the taxonomy, which provides complementary information to what companies must disclose under the Directive itself.
The effective application of the Directive will require the necessary Delegated Acts, among which the European Commission’s proposal includes:
As a result of the significant role the financial sector is called upon to play in the transition process towards a sustainable economy, acting as a vehicle for transmitting and mobilizing private sector resources towards sustainable activities, the entire process of reforming the Directive has been closely monitored. The European Commission’s new proposal has been very favorably received as it ensures consistent and standardized information from non-financial companies, a key element to ensure that banks and other financial market participants are able to assess the sustainability profile of their portfolios and allocate capital effectively to serve the objectives of the European Green Deal.
Given the financial sector’s need for information, the expansion of the scope of application is particularly welcome, as is the recognition of the need to coordinate the content and scope of reporting obligations arising from the application of the Disclosure Regulation, the Taxonomy Regulation, and solvency regulations (Pillar 3); the intention to ensure digital tagging; and the recognition of the need to ensure consistency in the timeline of obligations with the creation of the European Single Access Point for sustainability information (an initiative that proposes the existence of an EU-wide ESG database, an infrastructure that would have incalculable added value in the process of improving information availability).
It should be noted that, while banks and their non-financial clients have made enormous progress in their ability to methodologically assess the interaction of their business models with sustainability risks and impacts, the expanded scope of requirements in the new proposal, as well as the inclusion of new sustainability factors, requires a careful cost-benefit evaluation of being able to prepare and use the required non-financial information by the initial application date of 2023 for large companies, and subsequently, in 2026, for SMEs.
3.- IN CONCLUSION
Companies need sufficient time and clarity to adapt their reporting processes to the new and complex obligations, a need especially relevant for entities that have not previously been subject to sustainability reporting and, in many cases, still lack adequate organizational structures.
It will be very important that the new rules are based on existing international practices or at least coordinated, given the novelty of this area, without complicating the information landscape by creating disconnected requirements between the main frameworks.
Co-legislators and EFRAG should continuously evaluate the evolution of IFRS, and conversely, future international standard-setters should leverage the work of the European Commission and EFRAG to avoid an excessive burden of obligations and an uneven playing field in Europe. While the existence of a cohesive set of international standards appears difficult at this time, at least an equivalence regime should be established to prevent European companies from having to report under two or more different regimes.
If coordination is necessary at an international level, the need for harmonized application of the Directive in the 27 Member States of the European Union goes without saying. The financial industry constantly points out that if progress is to be made towards a true European single market – and in this specific area, to improve comparability and consistency – it would have been ideal for the regulation to take the form of a Regulation rather than a Directive. However, given that the Directive has been chosen, its final wording will have to reasonably ensure that its content prevents overregulation during the transposition process, as well as the need to achieve a common set of rules at the European level in balance with the specificities of the Member States. Thus, it is fundamental to ensure that national differences do not hinder capital flows towards sustainable projects.
A topic of special interest in all regulations, but which gains greater relevance in new areas such as sustainability reporting, is that of the implementation timeline. In this regard, several reflections are necessary in light of the European proposal:
In this sense, banks should be able to fulfill their obligations based on the latest publicly available information, i.e., the information published by their clients in the previous year.
The expansion of the scope of application has been very favorably received, as the availability of information on a large number of market participants is a fundamental ingredient. However, regarding financial entities, the indicated magnitudes might not be adequate, potentially subjecting small credit institutions to complicated reporting requirements. Consequently, the financial industry proposes including and providing specific treatment for the category of “small and non-complex” entities, recognized in the prudential sphere, as well as excluding unlisted entities in the same way as for SMEs.
For non-financial companies, given the importance of their information for a complete information system, it would be essential to conduct an impact assessment to examine whether companies in high-risk sectors (e.g., mining, chemicals, etc.), regardless of their size and whether they are listed or not, should be subject to reporting obligations.
Among the national discretions pointed out in the Directive, it is very positively valued that Member States have the possibility to require sustainability reports to be part of the Management Report or to be kept separate, thus allowing for some flexibility.
This flexibility is justified by the fact that, if broad dissemination of this non-financial information is desired, it must be accessible to a wide range of stakeholders, from sophisticated investors, shareholders, counterparties, clients… The mandatory inclusion of this information in the management report can be an impediment to this dissemination, apart from the possible discrepancy between the collection of financial and non-financial data, which will depend on clients. Preparing separate reports will facilitate the communication of the most up-to-date data.
On the other hand, presenting sustainability data independently from the rest of the management report content should not create significant obstacles to the completeness of the information provided, as these separate reports must meet the same level of rigor whether the data is included in the management report or not.
In conclusion, the importance of non-financial information in the transition of the current economy towards a circular, sustainable, and low-carbon economy is recognized by all actors destined to play a relevant role in said transition.
The challenge we face in this area is not limited to the market having sufficient information, but rather maintaining a balance between sufficient information and an excess of it, or that, as a consequence of its acquisition and analysis cost, its effectiveness runs the risk of being limited or having a disproportionate cost.
Likewise, it must be ensured that all necessary elements are included within the scope of the regulation and that its implementation is carried out with a reasonable timeline both for those who have to provide the information, and especially, for those who require information from other participants to fulfill their obligations, as is the case for financial entities.
The coordination of initiatives at a global level – not just national or European – is a very necessary element, for which the definition of standards at a European level is a more than desirable first step.
Information in the field of sustainability is fundamental. Only with a complete, harmonized, and accessible information system can investments be guided towards the design of a truly sustainable economy.
Patricia Rodriguez, Senior Advisor Financial Markets at the Spanish Banking Association
[i] DIRECTIVE 2014/95/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups
[ii] Law 11/2018, of December 28, amending the Commercial Code, the revised text of the Capital Companies Law approved by Royal Legislative Decree 1/2010, of July 2, and Law 22/2015, of July 20, on Audit of Accounts, regarding non-financial information and diversity
[iii] Law 7/2021, of May 20, on climate change and energy transition
[iv] REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability-related disclosures in the financial services sector
[v] Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directive 2013/34/EU, Directive 2004/109/EC, Directive 2006/43/EC and Regulation (EU) No 537/2014, as regards corporate sustainability reporting
[vi] REGULATION (EU) 2020/852 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088
