In today’s interconnected global regulatory landscape, Environmental, Social, and Governance (ESG) factors are for organizations worldwide. While the European Union (EU) has always been a trailblazer in this arena, it is evident that two of the most recent requirements will increase in importance, influence and accountability for businesses across the globe –whether they are based in the EU or not.
As the United States grapples with new climate disclosures for organizations doing business in California and the much-anticipated pending climate-related regulations from the Securities and Exchange Commission (SEC), businesses across the globe would be smart to look at what is happening in the EU and to start taking pre-emptive action today. Even with all the “anti-woke sentiment in the media today – these rulings underscore an undeniable truth: ESG is here to stay, and requirements are only going to get stricter over the years to come.
Examining the United States ESG landscape provides critical context for our discourse on the EU’s trendsetting ESG disclosure requirements, how they inform other regulatory bodies, and what it all means going forward. This dialogue intends to help organizations understand current obligations and prepare for upcoming disclosure requirements.
The EU is leading the way
The “ESG discussion” is quite nuanced, but let’s start by looking at it from two main areas the various laws endeavor to regulate: ESG data collection and disclosure and supply chain due diligence and monitoring – including human rights impact assessments and addressing modern slavery within the supply chain.
In 2023, we saw the landmark passage of several new directives. All of these will have potential global impacts, from directly affecting businesses in the EU or organizations that do a substantial amount of business in the EU, to serving as a global weathervane for what is likely to come. So, let’s start with the core ESG regulations coming out of the EU.
What is the CSRD?
The EU Corporate Sustainability Reporting Directive requires granular and comprehensive disclosure of material ESG metrics as decided through a rigorous double materiality process. The CSRD went into effect in January 2023 and is mandatory for nearly 50,000 organizations (including around 3,000 U.S. companies). Data collection is to begin in FY 2024, with the first CSRD-aligned reports published in 2025, coinciding with firm financial statements. Immediately affected organizations include those with over €20 million in assets, a net turnover of €40 million and/or 250 or more employees. Reporting will go into effect for companies with less than the above parameters, considered EU SMEs, in 2026, and non-EU companies with €150M net turnover and one branch or subsidiary in the EU in 2028. Under this Directive, organizations are required to accurately report on governance, strategy, impacts, risks and opportunities, and metrics and targets.
Additionally, companies must conduct a CSRD and ESRS (European Sustainability Reporting Standards) aligned double materiality assessment annually, and provide detailed measurements on subjects such as climate-related financial risks and greenhouse gas emissions to meet these requirements. The ESRS provides the disclosure framework to meet the needs of CSRD reporting. Companies must report on all ESRS disclosures that are material to the company or required as a general disclosure by the framework. For many, the reporting requirements will also extend throughout the value chain, further complicating information collection and solidifying that organizations will be held responsible for third-party actions.
What is the CSDDD?
Finally passed by EU Parliament in April 2024, the Corporate Sustainability Due Diligence Directive goes even further to expand on the value chain accountability of organizations and establishes reporting and disclosure mechanisms intended to increase obligations of the board and directors to ensure company compliance.
Organizations for which CSDDD applies include EU companies with more than 500 employees and a global turnover of €150 million, and non-EU companies if they generate €150 million or more in the EU market annually. The CSDDD also applies to EU and non-EU organizations with 250 or more employees and €40 million in annual turnover in the EU if half of the turnover is from a high-risk sector. High-risk sectors include the manufacturing or wholesale of textiles, leather and related products, agriculture, forestry and fisheries, extractive industries, and the food industry.
The CSDDD requires applicable organizations to conduct due diligence in assessing environmental and human rights risks for suppliers, ensure third-party compliance, establish a mechanism to report grievances, risk identification and mitigation, and public reporting.
What is the German Supply Chain Due Diligence Act?
The German Supply Chain Due Diligence Act (LkSG) entered into force on January 1, 2023, and imposes due diligence obligations on companies to identify, prevent, or otherwise address human rights and environmental issues in global supply chains. Though focused on Germany, the scope of this law is broad and applies to companies with headquarters, a principal place of business, a registered office, or branch offices in Germany. Through 2023, the LkSG applies to companies with 3,000 employees, but starting January 1, 2024, it will apply to those with more than 1,000 employees.
The LkSG requires organizations to establish risk management systems, perform regular risk analyses, create a clear human rights policy, conduct remedial actions, and develop complaint mechanisms.
While this Act is directed towards organizations based in and doing business in Germany, it creates additional implications in several ways. First, the LkSG is one of many global regulations meant to protect the environment and human rights throughout the supply chain, thus strengthening the international position on ESG in the supply chain.
Similar to when California passed its Anti-Human Trafficking Law through it supply chain, it will require increased attention, action, training and monitoring of a company’s suppliers regarding issues such as modern slavery and occupational health and safety violations.
Aligning on disclosure
Voluntary frameworks are unifying to support the increase in global ESG governmental regulations. The International Sustainability Standards Board (ISSB), established in November 2021 at COP26 in Glasgow, brought together multiple frameworks to develop a high-quality, comprehensive global baseline for ESG reporting. Focused on meeting the needs of investors and the financial markets, the ISSB will absorb the reporting requirements of the Taskforce on Climate-related Financial Disclosures (TCFD), seen as the standard for climate-related financial risk disclosures, as of 2024.
The ISSB standards build on the existing frameworks and standards for disclosure to address the information gap and issues with the reliability and comparability of ESG data. Since ESG data looks different depending on the organization and corresponding value chain in question, establishing a common taxonomy has long been an issue for compiling this information for disclosure. Merging the requirements of ISSB, TCFD and furthermore SASB (The Sustainability Accounting and Standards Board) will encourage easier and more efficient disclosure to better inform investors, lenders, insurance underwriters, customers, suppliers and vendors. Aligned frameworks will help provide ESG data to stakeholders who can accurately assess financial risks related to climate change and other ESG metrics.
In short, these two voluntary frameworks overlap with the requirements coming out of the EU in significant ways, including disclosure of climate risks and opportunities, risk management and business continuity plans, climate targets, Scope 1 and 2 disclosures, and more. Because of the many material financial impacts ESG metrics have on capital markets, this reporting merger will provide disclosures that will be as essential as financial statements as practices advance.
What do EU ESG requirements mean for the U.S.?
Though the California and SEC decision on climate-related disclosures will have the greatest impact on U.S.-based companies, the EU requirements are important for the many larger U.S. companies doing business in the EU already meeting those requirements for the CSRD and CSDDD. These U.S. companies would do well to begin preparation for both SEC and EU reporting to avoid the financial and human capital constraints put upon a company when it becomes a laggard in meeting regulatory obligations.
Then, there is the question of enforcement. While the EU has enforcement mechanisms for many ESG regulations, how the U.S. will enforce ESG targets and disclosure is still uncertain and unpredictable. Part of the noise regarding ESG regulation in the U.S. concerns the looming elections and what will happen should a conservative administration take over in 2025. While this political shift is a distinct possibility, one thing is clear: ESG is not going away, and this information is quickly becoming as vital as financial disclosure, and global trends will continue to move in this direction, regardless of the political climate in the U.S.
California. SB 253, the Climate Corporate Data Accountability Act, will require all corporations doing business in California (both public and private) with more than $1B in annual revenue to fully disclose Scope 1, 2 and 3 in accordance with the Greenhouse Gas Protocol and get assurance on those greenhouse gas disclosures. SB 261, the Climate-Related Financial Risk Act, will affect public and private companies with over $500M in annual revenue, requiring biennial preparation of a climate-related financial risk report disclosing the entity’s climate-related financial risk and measures adopted to reduce and adapt to climate-related financial risk. While smaller companies will be excluded from these bills, the regulations would have major implications for U.S. companies.
How can organizations prepare?
The following advice probably won’t come as a surprise: start the work now and start getting audit ready. While your organization may not need to file ESG disclosures at this moment, it will eventually. We could publish an entire book about how to get started, but in simple terms, organizations can get moving by:
- Determining ESG topics material for your company – conduct a double materiality assessment
- Establishing a cross-functional committee to collect ESG data
- Gaining buy-in and educating the C-suite and board of directors (including securing adequate funding)
- Measuring your ESG impacts and greenhouse gas (GHG) emissions
- Adhering to any existing regulatory and customer/vendor requirements on ESG for your business
- Consolidating the information in a digestible format for audit-ready disclosure
- Aligning data and ESG efforts to ISSB and applicable regulatory disclosure frameworks
Of course, that all sounds easy in theory; in practice, those just now getting started have their work cut out for them. However, for companies where ESG practices and disclosure are not yet required, starting early will avoid the scramble once these requirements do come into effect.
Prediction
The global ESG landscape will continue to consolidate, enforcement will ramp up and be made more public, and stakeholders and regulators will continue to look closely at how businesses do business.
If history is any indicator, the EU will continue to lead the way with ESG regulation and enforcement – with the U.S. and rest of the world following suit. Publicly traded companies have a clear need to align on these requirements and disclosure frameworks, and private firms should also prepare now as this information is financially material and will impact future equity events.
Regarding the SEC decision – it will certainly be both imperfect and controversial, but it will soon impact companies operating in and likely those doing business with the U.S. in some capacity. There will likely be significant overlap with the disclosure requirements coming out of the EU and California, so aligning with the CSRD, CSDDD will be important, as well as using the ISSB and TCFD frameworks for disclosure.
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