Second time lucky? How to make the EU Non-Financial Reporting Directive work this time around

Mardi McBrien, CDSB's Managing Director, outlines how the EU Non-Financial Reporting Directive (NFRD) should be rewritten to make it work for investors.

As promised in the EU Green Deal, the European Commission is launching its review of the Non-Financial Reporting Directive (NFRD), which is a welcome advancement within the corporate reporting community. While the introduction of the NFRD was a significant milestone for Europe, it has not achieved its objectives in its current form. 

To make “the Green Deal a reality”, as Executive Vice-President Dombrovskis so succinctly put it, we must seize this opportunity to deliver the real change and progression needed to facilitate the allocation of capital towards sustainable activities.

Core to this will be helping investors evaluate the non-financial performance of large companies. However, the current NFRD is flawed, and steps need to be taken to bolster the linkage between financial and non-financial information and effectively convey material issues to the reader.

In particular, ensuring that information is reported in company management reports and not published up to 6 months after the financial report, could drive significant improvements with the consistency and comparability of disclosure. 

The European Commission’s Inception Impact Assessment on the Revision of the Non-Financial Reporting Directive found that “it is hard for investors and other users to find non-financial information even when it is reported” and that reported non-financial information is not sufficiently reliable. This highlights that the exemption to allow the non-financial statement to be reported outside the management report is removed from any update to the Directive to ensure that this information is easy to find, prepared with robust governance procedures and connected to other information in the annual report.

The scope should also be increased by changing business size to more than 250 employees as opposed to existing number of more than 500. Recognising the need to avoid the overall regulatory burden on SMEs, ESG matters may pose material risks and opportunities to businesses irrespective of their size. As Accountancy Europe states: “Expanding the NFRD's scope should capture all those companies that significantly impact the environment due to their sector's environmental and social profile. Stakeholders are interested in non-financial information to better understand a company's performance, its future developments and impact on society. Reporting on non-financial matters make businesses better assess, measure and manage their risks and performance on specific ESG-metrics. That could lead to lower funding costs, fewer and less significant business disruptions, strong consumer loyalty and better relations with stakeholders.”

The word "climate" should also be explicitly stated. It is not explicitly referred to in the current Directive under environmental matters, however the Guidelines refer to the UN SDGs, the Paris Agreement and the Task Force on Climate-related Financial Disclosure (TCFD). Therefore, despite the absence of the term climate from the language of the Directive, the NFRD’s intention appears to cover climate under the auspices of “environmental matters”. This ambiguity, however, has created uncertainties for preparers and inconsistences in reporting practice when comparing disclosures and in some cases has resulted in a lower rate of climate disclosure. For example, CDSB’s review of corporate reports found that 58% of companies provided information on management’s role on environmental matters, but only 20% for climate-related matters.  

To further facilitate a unified approach to disclosure and ensure consistency and connectivity of information, ESG information in the management report should cover all four elements of the TCFD. According to the TCFD recommendations, Risk Management and Governance of ESG matters should be disclosed irrespective of materiality and an update to the Directive would benefit from a similar approach.

Of equal weighting is setting the investor as the primary audience. Investors require information presented in a way that is suitable for their decision making. Having multiple audiences with varying information needs can result in less clarity of the reported information and lengthy disclosures that contain information that is immaterial for investors.

The European Commission has also acknowledged this issue. It even goes as far as to say that investors cannot take sufficient account of sustainability-related risks and opportunities, or of the social and environmental impacts of their investments. As a result, this could present systemic risks to the economy with companies not adequality pricing sustainability risks and inadequate capital flows to companies focused on resolving sustainability-related problems. While other forms of reporting outside the management report might be better suited for different stakeholders, this is a separate issue and more work needs to be done to address this.

There is no doubt that to meet the ambitions of the EU Green Deal, the existing NFRD needs to be significantly strengthened.

Can we make this second time lucky?

The next update to the NFRD must provide the catalyst to push companies to increase their disclosure on environmental and climate risks and opportunities and ensure that investors are fully informed about the sustainability of their investments. A light touch to the existing Directive simply won’t do and certainly won’t channel the extra €260 billion needed in annual investments to deliver on the EU’s 2030 climate and energy targets. 

The suggestions above are just a snapshot of our position and I welcome the opportunity to discuss our full draft position and tracked changes to the NFRD with you. 

Read our full draft positions and tracked changes to the NFRD. 

Get in touch with Michael Zimonyi, the Director of Policy and External Affairs here at CDSB to discuss in more detail.