In the rapidly evolving world of corporate governance, environmental, social and governance (ESG) criteria have emerged as a cornerstone of responsible business practice. With stakeholders increasingly demanding transparency and accountability, the need for robust ESG reporting continues to grow.
Enter the Corporate Sustainability Reporting Directive (CSRD), the ambitious regulatory framework aimed at standardising sustainability reporting across the EU. As firms scramble to align with these new requirements that become mandatory for the first tranche of covered firms in 2025, the directive promises to reshape the landscape of corporate sustainability, holding companies to a higher standard of environmental and social responsibility.
Meanwhile, across the Atlantic, the ESG story unfolds quite differently. In the US, ESG legislation has become a contentious battleground, where political ideologies clash, and legal disputes are the order of the day.The Securities and Exchange Commission (SEC) has attempted to implement its own set of guidelines. However, these efforts continue to be entangled in a web of litigation and partisan debate. As firms navigate this turbulent environment, the contrast with Europe’s more pragmatic approach becomes apparent.
In this article, we will delve into the CSRD implications from the contexts of governance, workflow, data management, and enabling technology and explore the challenges that arise in each area.
The Corporate Sustainability Reporting Directive (CSRD)
The CSRD mandates that companies report in accordance with the European Sustainability Reporting Standards (ESRS). These standards encompass a broad range of sustainability topics, structured into two general standards and ten topical standards covering ESG aspects. The general standards (ESRS 1 and ESRS 2) provide guidelines on the overall framework for sustainability reporting and general disclosures that all companies must make. The topical standards delve into specific areas such as climate change, pollution, water and marine resources, biodiversity, and social matters like labour practices and human rights.
Companies must conduct a double materiality assessment to identify which sustainability issues are material from both an impact perspective (how the company affects the environment and society) and a financial perspective (how sustainability issues affect the company’s financial performance). This comprehensive approach ensures that all significant sustainability impacts, risks, and opportunities are reported.
The European Financial Reporting Advisory Group (EFRAG) provides comprehensive guidance on implementing the double materiality approach required under the CSRD. Double materiality encompasses both financial materiality (how sustainability issues affect the company’s financial performance) and impact materiality (how the company’s operations impact the environment and society). EFRAG has been tasked with developing the digital XBRL taxonomy for the ESRS, which will facilitate the tagging of sustainability reports in a machine-readable format.
EFRAG’s implementation guidance (IG) outlines several critical steps and considerations for firms to measure materiality effectively:
Understanding Context and Stakeholders
Firms are advised to start by thoroughly understanding their operational context, including business processes, business relationships, and affected stakeholders. This step involves mapping the company’s value chain to identify relevant sustainability matters and potential impacts, risks, and opportunities (IROs).
Criteria for Materiality Assessment
EFRAG recommends using objective criteria to assess the materiality of identified impacts. For impact materiality, companies should evaluate the severity of impacts based on their scale, scope, and irremediable character, along with the likelihood of potential impacts. For financial materiality, the focus is on the magnitude and likelihood of financial effects, including performance, financial position, cash flows, and access to capital.
Stakeholder Engagement
Engaging stakeholders is crucial for substantiating the materiality assessment. This involves consulting affected stakeholders (e.g., employees, communities) and users of sustainability reports (e.g., investors) to gather diverse perspectives and ensure the assessment reflects the concerns and priorities of all relevant parties.
Key Challenges for In-Scope Firms
ESG terminology introduces many new terms and definitions, some of which are not readily represented digitally, creating new data requirements and sourcing challenges.
Existing GRC teams will need to absorb new roles and responsibilities, or new roles will need to be created and positions filled with the right skill sets. The terms of reference, authorities and accountabilities for these roles must be clearly defined.
Integrating materiality assessments into corporate governance frameworks requires that boards and senior management be actively involved in overseeing the materiality assessment process, ensuring that sustainability considerations are embedded in strategic decision-making. Regular updates and reviews of the materiality assessment process are essential to maintain its relevance and effectiveness
The materiality assessment process must be integrated into existing business processes, particularly risk management, strategy development, and reporting. This integration ensures that sustainability risks and opportunities are considered alongside traditional financial metrics.
Companies will need to collect, process, and analyse large volumes of sustainability data from many sources. including internal operations and external stakeholders. One of the biggest challenges will be identifying, collecting and preparing these new data sources. Scope 3 emissions data is particularly complex in this regard.
Scope 3 emissions encompass the indirect greenhouse gas (GHG) emissions that occur throughout a company’s value chain, both upstream and downstream. These include emissions from suppliers, business travel, employee commuting, waste disposal, and the use of sold products.
Unlike Scope 1 (direct emissions from owned or controlled sources) and Scope 2 (indirect emissions from purchased energy), Scope 3 emissions are often the most challenging to measure and manage due to their diffuse nature and dependence on third-party data. Despite these challenges, addressing Scope 3 emissions is crucial as they frequently represent the largest portion of a company’s total carbon footprint.
Scope 3 emissions include those produced by suppliers (upstream) and by customers using the company’s products or services (downstream). Scope 3 is critical because it often represents the largest portion of a company’s total emissions, significantly affecting the company’s carbon footprint.
Effective management and reduction of Scope 3 emissions are essential for companies aiming to achieve net-zero targets and contribute to global climate goals. Ideally, carbon footprints would be available at individual workload levels in near real-time. But that’s a long way off, and several things need to happen before it becomes feasible. Principal among these is the lack of scope 3 data granularity currently available from cloud service providers.
Data centre power consumption is a major contributor to the carbon footprint of capital markets firms. The rapid uptake of Generative AI(GenAI) and other frontier AI technologies is projected to disproportionately increase data centre power consumption. This will force firms to rethink their data centre and hybrid multi-cloud strategies.
Technology will be a critical enabler for a successful CSRD implementation as it is for all GRC functions. GenAI and LLM’s ability to process vast quantities of unstructured sustainability data and automatically match compliance obligations with impacts, risks and opportunities (IROs) for double materiality assessments will significantly boost efficiency and productivity for sustainability compliance.
The alignment between CSRD and the IFRS Sustainability Disclosure Standards, including the integration of Scope 3 emissions, reflects a global move towards more transparent and standardised sustainability reporting. The International Sustainability Standards Board (ISSB) has also included Scope 3 emissions in its climate-related disclosure requirements, emphasising the importance of these emissions in understanding a company’s overall environmental impact and climate resilience.
As companies navigate the CSRD and the data integration challenges of Scope 3 emissions, they are presented with an opportunity to lead in sustainability and transparency. By embracing the challenges of robust data management, advanced technology integration, and comprehensive governance frameworks, businesses can not only achieve compliance but also drive significant environmental and social impact.
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