Robert Kugel's Analyst Perspectives

The recent recommendation by the European Commission to scale back the scope, granularity and timeline for sustainability reporting represents a sea change in this form of corporate disclosure requirements. If enacted, it will substantially reduce or eliminate the reporting requirements for many enterprises, especially small to midsize establishments, as well as provide more time for compliance. While environmental reporting requirements appear to be easing, some regulatory disclosure requirements remain for large enterprises. Moreover, there is still demand for enterprises to set and meet sustainability objectives to achieve increased operating efficiency and to associate their brand with a sustainable environment. For these enterprises, there remains the need to achieve efficient compliance with reporting mandates as well as have processes and systems in place to set overall objectives and mechanisms to assign responsibility for meeting them across the enterprise, a topic I covered recently.

Attitudes toward regulation have been changing recently, and regulatory bodies have been stepping back from the scrupulously detailed environmental reporting regimes they previously created. This is especially the case for those that were enacted by the European Union’s (EU’s) Corporate Sustainability Reporting Directive (CSRD) and those proposed by the U.S. Securities and Exchange Commission (SEC) but never put into force. A push for sustainability investing—the underpinning rationale for the SEC’s actions—has faded from the headlines in part because repeated academic studies have demonstrated that this approach achieves lower returns than following basic investing principles when all costs are included. Last year, after a lengthy and contentious public comment period, the SEC created sweeping environmental reporting requirements but immediately shelved them. With the change in administration, it’s unlikely these will be put into effect.

That left the already-in-place EU's CSRD and related mandates as the main source of reporting requirements. (Other countries have their own reporting statutes, but these have a limited global impact.) As constructed, the CSRD applied even to enterprises domiciled outside the EU doing relatively little business in the EU. However, in the interest of achieving higher economic growth and greater global competitiveness, the European Commission has proposed substantially narrowing the scope of the necessary disclosures both in terms of which entities are required to report and the granularity of the information collected and reported. It is also delaying implementation, which is necessary because ISG Research asserts that through 2027, one-half of enterprises will have insufficient data and software to adequately measure their environmental, social and governance (ESG) metrics to inform their governance, strategy, risk management and targets.

The Commission's aim is to simplify EU rules and increase the bloc’s competitiveness by reducing overall administrative burdens by at least 25%, while targeting a 35% reduction for small to medium-size enterprises (SMEs). The proposed amendments cover sustainable finance reporting, sustainability due diligence, the EU Taxonomy and the Carbon Border Adjustment Mechanism. The key proposed changes include the following:

• Sustainability Reporting (CSRD and the EU Taxonomy): The amendments narrow the scope of CSRD to the largest companies (over 1,000 employees and €450 million in annual revenue) and postpone the reporting requirements until 2028. The EU Taxonomy, a classification system that defines economic activities that are environmentally sustainable, will be restructured to be less burdensome. Other large companies can elect voluntary reporting while some large entities are entirely exempt. Sector-specific standards (such as leather goods) will be eliminated and increased assurance requirements removed. The European Sustainability Reporting Standards (ESRS) that are core CSRD requirements will reduce the number of data points collected to focus on those most important while requiring less narrative text.
• Corporate Sustainability Due Diligence Directive (CSDDD) will remain mandatory for companies with over 1,000 employees and more than €450 million in annual revenue. The recommendation would simplify due diligence requirements, focusing on direct business partners, thereby reducing burdens on SMEs and harmonizing requirements across the EU. Measures imposing civil liability will be removed, while victims' rights to compensation will be preserved. The application of requirements will be postponed until 2028, with final guidelines delayed until 2026.
• Carbon Border Adjustment Mechanism (CBAM) rules for in-scope companies will be streamlined, including authorization and reporting requirements, while strengthened to prevent evasion.

Sustainability accounting is useful beyond compliance. It can provide an orthogonal view into the performance of an enterprise. It applies an operational economic lens that quantifies the opportunity to conserve resources and, as a result, can lower economic and long-run financial costs. In so doing, it can increase the sustainability of an enterprise while promoting the conservation of resources. Rather than being predicated on a foundational assumption of market failure (that is, free markets cannot work and therefore regulation is required), basic sustainability accounting serves market efficiency by laying bare what might have been overlooked in financial accounting methods.

The original purpose of requiring auditable measures of sustainability efforts was to hold enterprises accountable for environmental promises they make and to prevent greenwashing. That is not going away. What has been missing in discussions of sustainability accounting is a recognition that this form of measurement cannot replicate financial accounting’s auditability in any practical sense. This is what is driving reform in the EU. Compared to accounting methods and generally accepted accounting principles, environmental accounting lacks a double-entry foundation for verification as well as the centuries of analytical development and testing behind many financial accounting conventions and their underlying assumptions. The precision necessary to prove the soundness of the financial statements is probably not achievable because the marginal cost of additional layers of attempted precision cannot be justified in terms of achievable sustainability benefits from that additional data. Larger enterprises have the scale and systems to absorb the costs and the external impacts to justify the effort. Regulation has costs, and the European Commission’s recommendation can be seen as recognition that the poorer GDP performance of the bloc over the past two decades relative to a less regulated economy like the U.S. needs to be addressed to promote the economic sustainability of the EU.

So where does this leave sustainability initiatives and reporting? Larger enterprises covered by EU mandates will still need to meet reporting standards, albeit on a more forgiving timetable. In the current environment, it’s highly unlikely that the SEC’s sustainability reporting requirements will be enacted. But doing well by doing good remains an objective for many enterprises. The economic conservation of resources—otherwise known as increasing efficiency—is still a prime management objective. Enterprises that see value in consuming less energy and water still need to manage to objectives. They must be able to set overall targets, delegate responsibility down through the organization to achieve them and have the systems to capture the information necessary to reliably measure resource consumption.

Regards,

Robert Kugel