Compliance professionals need to pay special attention to when the intersections of the EU's CSRD and sustainability taxonomy pose unique compliance challenges for their companies in ESG reporting
The first reporting deadline of the European Union (EU) Corporate Sustainability Reporting Directive (CSRD) for the largest EU companies is fast approaching. Companies headquartered outside of the EU have more time to prepare but have a significant compliance burden to get ready in time. As businesses prepare to navigate this complex regulatory landscape (thanks to CSRD) while mitigating challenges in sustainability communications and greenwashing trends, they face the task of aligning their reporting practices with the extensive European Sustainability Reporting Standards (ESRS) and adapting to the evolving requirements of the EU sustainability taxonomy.
Intersection of EU’s sustainability taxonomy and CSRD presents challenges
There are a few key challenges for companies preparing to report on CSRD and the taxonomy, according to Brian Tomlinson, Managing Director of Environmental, Social & Governance (ESG) at EY. For example, he points out that companies scoped into CSRD will also be scoped into reporting on the taxonomy which can present novel elements that may intersect with the CSRD. The EU taxonomy defines for organizations which of their activities can be categorized as sustainable by reference to a set of largely science-based criteria developed by the EU’s Platform on Sustainable Finance. The EU’s expectation is that this notion of green by law which the taxonomy introduces will help organizations reorient capital flows to focus more on sustainable investments and business activities.
A critical challenge of the taxonomy is the complexity of accurately classifying and reporting on business activities by referencing the eligible activities set out in the taxonomy. The taxonomy sets out more than 150 activities that can contribute to the EU’s sustainability goals across six environmental objectives, including climate change mitigation, adaptation, and pollution prevention, among others. Mapping nuanced business practices to taxonomy criteria is one of the first challenges companies will face.
Further, the taxonomy requires detailed reporting of financial metrics associated with sustainability criteria. The core taxonomy figures that need to be disclosed are the share of a company’s revenue, capital expenditures, and operational expenses that are sustainable. Finding the available data to answer these questions is a common challenge as many companies may not have collected data to be able to assess the sustainability of their activities in the way directed by the taxonomy. As a result, across both sustainability and controllership functions, it can be complex and resource-intensive for organizations to collect, assess, and report these key performance metrics (KPIs), especially to a level of confidence necessary to meet assurance requirements.
“Now is the time to accelerate [companies’] readiness efforts for CSRD and taxonomy… [and] assess the size of the problem.”
To better navigate the multi-layered complexity, it is important that organizations divide up the tasks into phases and remain focused and avoid becoming overwhelmed and feeling like the sustainability data is managing you.
Indeed, companies have often set out ambitious sustainability goals, and invested accordingly, in addition to making claims about the sustainability of their activities and products. After assessing in which taxonomy the activities in which they are engaged are included, along with the proportion of those activities that are green, companies also need to consider how the taxonomy criteria compare to their own proprietary claims about the sustainability of their products and practices.
To that end, taxonomy is partly intended as an anti-greenwash device and a framework for credentialing the seriousness and ambition of climate transition plans.
Double materiality assessment for in-scope activities also add complexity — Tomlinson explains that there are interaction effects between an organization’s double-materiality assessment and the taxonomy framework, and companies need to ensure consistency across these efforts. This is a theme which the European Financial Reporting Advisory Group also has addressed in implementation guidance. For example, a company may be engaged in an activity that qualifies as eligible under the taxonomy; however, the taxonomy disclosures may identify that that activity is not aligned (for example, not being done in a green way), which can mean that the activity in question may be creating negative environmental impacts.
In this context, companies will need to consider if their double-materiality assessment captures those negative impacts and, if there is a mismatch between taxonomy and double-materiality assessment outputs, it can be explained.
This overlap between the double-materiality assessment and taxonomy framework aims to ensure that companies provide consistent and comprehensive information on their sustainability practices. By being scoped in for both CSRD and taxonomy reporting, companies are required to disclose a broad range of ESG metrics under the ESRS standards and also identify the proportion of their business activities and investments that align with the EU’s established sustainability criteria.
Guidance for companies in the second reporting deadline wave
Businesses should expedite their adaptation and build capacity for regulatory compliance now and for future deadlines by performing key actions, which include:
Accelerate readiness to comply with CSRD — “Now is the time to accelerate [companies’] readiness efforts for CSRD and taxonomy” and “assess the size of the problem,” Tomlinson advises, adding that this involves conducting gap assessments, forming a roadmap for implementation, and prioritizing closing the most material gaps as a priority (such as those presented by taxonomy disclosures). Companies should also expand headcount, budget, and resources dedicated to ESG reporting and compliance, such as hiring ESG controllers to deal with the significant expansion in disclosures and related risks.
Harness ESRS for global compliance — The ESRS are the most extensive set of mandatory ESG standards, covering a maximalist set of disclosures across the ESG issue spectrum. As a result, preparing for ESRS compliance globally can help companies meet disclosure of the ESG reporting requirements in many other jurisdictions as well. Tomlinson notes ESRS has “the potential to become one standard to rule them all” in terms of global ESG reporting.
Be ready for new regulations — To prepare for the eventual Corporate Sustainability Due Diligence Directive (CS3D), companies should recognize that these regulations impose duties beyond just disclosure. Indeed, CS3D “actually is about dictating behavior rather than just disclosure” by requiring companies to perform certain types of sustainability due diligence and implement the results in order to avoid adverse human rights and environmental impacts coming from their own activities and those in their value chain, explains Tomlinson. The directive also contains a requirement for a Paris-aligned transition plan. Companies scoped into CSRD may also be scoped into CS3D, so they should first determine if that is the case, and if so, they should start planning for these extensive requirements now.
The journey towards comprehensive ESG reporting and compliance is a complex and evolving one, requiring companies to remain proactive. By embracing the challenges posed by the ESRS, the EU sustainability taxonomy, and ongoing legislative developments, organizations can drive positive environmental and social impact while strengthening their own market position.
You can find more on the challenges involved in corporate disclosure & reporting here.
