The sustainability topic has emerged as front and centre for any business model nowadays, with an increasingly demanding regulatory framework, calling both for transparency and action from leaders and managers.
The European legislation on sustainability has moved at an incredible fast pace in recent years, as the topic became a key policy priority in Europe. Following the adoption of the EU Corporate Sustainability Reporting Directive (CSRD) by the end of 2022 and the subsequent creation of the European Financial Reporting Advisory Group (EFRAG), the path for detailed non-financial reporting has reached a point of no return. This will represent a quintessential pilar for the public and the private sectors in upcoming decades, with the EU Taxonomy taking centre stage. It is therefore of the utmost importance to keep track of all those impending regulatory changes.
Technically, the CSRD will replace the existing Non-Financial Reporting Directive (NFRD), widening its scope regarding requirements, details, and targeted size companies. While under the current NFRD framework only listed companies with over 500 employees (a universe of about 11,000 European companies) are required to report non-financial information, the CSDR broadens the scope to organizations that meet two of the following three criteria: i) balance sheet above EUR 20 million; ii) net revenue above EUR 40 million; iii) over 250 employees on average throughout the reporting year (representing an estimated universe of 50,000 European companies when fully deployed). The plan envisages that eventually even SMEs will be subject to CSDR reporting.
The tight defined timeline therefore urges companies to prepare for CSRD sooner rather than later. More precisely, by 2025 listed companies with over 500 employees will have to publish a report according to CSRD in respect to its 2024 activities. It is widely expected that by 2027 listed SMEs will be required to report according to a simplified CSRD version, in respect to their 2026 activities. Broad CSRD reporting items will include: i) alignment of business model and strategy to achieve climate neutrality by 2050; ii) science-based targets and progress; iii) most significant negative impacts; and iv) identification of main climate-related risks and mitigation actions.
The challenge is a hidden opportunity
Reporting is undoubtedly a significant upcoming challenge for economic agents, albeit the impact will differ depending on each activity sector. In particular, the EU Taxonomy brings important changes as each entity must report on the alignment of each economic activity (in terms of Capital Expenditure, Operation Expenditure and Turnover) to its contribution to one of the six EU environmental objectives1.
Notably, non-financial institutions will be required to correctly quantify and report on a vast array of sustainability items, including their Taxonomy eligibility and alignment. For those companies, this also represents an opportunity to revisit their business model and acknowledge sustainability-related risks they may be facing in the future and adjust accordingly. With sustainability becoming a key competitiveness factor in financial markets, businesses perceived as more sustainable will be capable to attract more capital and possibly secure funding at lower costs.
Credit institutions will face slightly different challenges. With ESMA, ECB, EBA and other supervisory authorities soon finalizing their recommendations, credit institutions must adjust to the new sustainability framework in different areas, including reporting asset-side Taxonomy alignment (which may include compute alignment for loans to SMEs and mortgages) and reporting sustainability-related risks (with a focus on climate-change risks). Additionally, financial products must be classified according to their Taxonomy alignment, thus enhancing comparability and transparency for investors. Credit institutions may eventually also benefit from this challenge, as cheaper funding may be available and even some positive discrimination for “green” assets may be envisaged in a near future.
Data and more data
Reporting will require organizations to efficiently collect data, both internally and externally. While this will consume additional resources and imply stepping-up quality data-collection, it will equally enable businesses to make more grounded decisions. In fact, the reporting exercise can become a very powerful management tool and an opportunity for businesses to become less vulnerable to sustainability-related risks. Even though the ESG theme is still essentially regarded as a reputational issue by some, it already has a real impact on any business’ profitability presently.
The concept of double materiality
Sustainability can be seen through two lenses: “outside-in” and “inside-out”. The outside world (i.e., climate change) may negatively impact any company, thus representing a risk for its profitability. Conversely, the company may have an external (positive or negative) impact on the outside world. The two dimensions are equally important and equally monitored, especially when different ESG rating agencies apply different methodologies to score an individual entity under each perspective. The harmonization of ESG rating agencies’ methodologies will surely be an important discussion topic during 2023.
Yet this concept of double materiality may soon gain additional importance in the context of the Greenhouse Gas (GHG) Protocol. Under the so-called Scope 1, companies report on direct emissions, such as emissions from fuel combustion in their own factories. Under Scope 2, the computation includes also emissions related to the purchased energy. As regulation evolves, Scope 3 will eventually require companies to also report greenhouse gas emissions produced through indirect emissions along the value chain, including in purchased goods, business travel, and up- and downstream distribution. This will also imply that companies will increasingly have to consider implementing both CO2 offsetting technologies and nature-based CO2 sequestration projects.
A great opportunity for the Portuguese economy
The new regulatory framework will greatly favour investments, capital-raising, and funding in green and social projects. The Portuguese economy has a tremendous untapped potential to embrace the sustainability-led transformation, with its outstanding natural conditions to collect clean energy and its vibrant innovation cluster. The economic agents can (and should) therefore reap the benefits of a rapid adjustment to the green and circular economy. SMEs can play a particularly important role in this regard, given their flexibility to adapt and reinvent their business models rapidly. Ultimately, sustainability is the key to unlock further growth potential.