Executive Summary

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1) This overview of the regulatory ESG landscape in Europe delves into key regulations shaping the financial and industrial landscape: CSRD, SFDR, EU Taxonomy, and CBAM.
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2) CSRD mandates comprehensive non-financial reporting for around 50,000 European companies. It enhances transparency and comparability through the European Sustainability Reporting Standards (ESRS). Reporting starts in 2025.
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3) SFDR obligates financial service firms to disclose sustainability risks and product performance metrics. Implementation was phased in between 2021 and 2023.
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4) The EU Taxonomy classifies environmentally sustainable economic activities. It aims to guide sustainable investments. It is in force since 2020.
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5) CBAM, part of the European Green Deal, imposes a carbon tariff on carbon-intensive products imported to the EU. It is in force since 2023.

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Introduction

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In the last years, a series of regulatory frameworks have begun to reshape the landscape of ESG in Europe and beyond. What was once a niche topic is now keeping boardrooms busy. At the same time, there is frequent news about negotiations, changes, and delays. One can be forgiven to lose track of where we stand. This overview will shed light on the current ESG landscape to help separating the signal from the noise.

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The European Union is arguably at the global forefront in ESG regulation. The most influential regulation to be aware of are the following:

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1) Corporate Sustainability Reporting Directive (CSRD)

2) Sustainable Finance Disclosure Regulation (SFDR)

3) EU Taxonomy

4) Carbon Border Adjustment Mechanism (CBAM)

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They all are part of what is known as the EU Sustainable Finance Framework which has the goal of redirecting investment towards sustainable activities. This goal is supposed to be achieved by establishing a transparent unified framework for financial markets to operate in.

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The EU Sustainable Finance Framework (1) in turn is one of several policy areas contributing to the European Green Deal. The overarching goal of the European Green Deal is to achieve climate-neutrality of the EU by 2050 in line with the Paris Agreements. Besides Sustainable Finance, it encompasses plans regarding investments, subsidies, regulation and carbon tariffs (CBAM) which we will get back to later in this article. While climate change and greenhouse gas emissions are clearly at the center of the EU’s ambition, the regulation touches other areas of ESG as well.

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The CSRD and SFDR in particular build upon the work of prior legislation and initiatives. There is also an ongoing effort to ensure interoperability with similar non-EU initiatives but this topic will be covered in another article.

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CSRD

The CSRD (2) introduces comprehensive and standardized reporting requirements of non-financial data and replaces the Non-Financial Reporting Directive (NFRD). It is designed to enhance the transparency and comparability of non-financial information, ensuring that stakeholders, investors, and regulators have access to consistent and reliable sustainability data.

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In total, it is estimated that CSRD will affect around 50.000 companies across Europe. Depending on their type, affected companies must file an annual report starting between 2024 and 2028.

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The CSRD primarily applies to companies in the EU and the European Economic Area (EEA) countries of Norway, Iceland, and Liechtenstein. Switzerland is subject to certain CSDR provisions via a bilateral agreement and there are separate rules for non-EU countries.

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This CSRD came into force in January this year. The first group of affected companies will have to start reporting in 2025 on the financial year 2024, the remaining ones will follow until 2029 (see table):

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Companies subject to CSRD will be required to disclose a broad set of sustainability-related information explicitly including their upstream and downstream supply chain. The disclosures encompass not only environmental factors but also social and governance aspects i.e., all of ESG. Reporting entities are obligated to provide insights across four reporting areas (adopted from the TCFD framework):

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1) Governance

2) Strategy

3) Impact, risk and opportunity management

4) Metrics and targets

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In order to meet the reporting requirements of the CSRD, the European Sustainability Reporting Standards (ESRS) are being developed. They serve as a framework for reporting in alignment with CSRD (3).

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So far, the sector agnostic ESRS standards have been released. They consist of 12 standards: There are general requirements (ESRS 1), general disclosures (ESRS 2), and five environmental standards (ESRS E1-5), the first and most comprehensive one (ESRS E1) covering the topic of climate change. Furthermore, there are four social standards (ESRS S1-4) and one governmental standard (ESRS G1). Disclosures outlined in ESRS 2 (General disclosures) are always mandatory, all others are subject to materiality assessment.

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Double materiality was adopted as a core principle. It is used to determine whether something must be reported or not. It is based on whether either or both of two components are material based on a materiality assessment performed by the company.

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Financial Materiality describes the positive and negative effect of sustainability impacts on the financial situation of the company. It is therefore an outside-in perspective.
For example, the viability of companies operating in carbon-intensive industries such as oil & gas is under threat by the transition to a low carbon economy due to things such as regulatory pressure, the risk of stranded assets and more difficult access to capital. For a company offering renewable energy systems, the same situation may present a business opportunity.

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Impact materiality describes the positive and negative impacts of operation on people and the environment. It is therefore an inside-out perspective.For example, a chemical company emitting greenhouse gasses and polluting water would need to report this as a negative impact.

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Climate change (ESRS 1) has been changed from a mandatory to an optional topic. However, due to its wide-ranging and systemic impacts across the economy, companies will have to provide a detailed explanation of the conclusions of its materiality assessment if they find climate change to be not material. Accordingly, most companies will need to disclose carbon emission data going forward. In practice, we can expect that reporting of scope 1 + 2 emissions will be mandatory. The majority of companies will also need to disclose scope 3 emissions though not necessarily in its entirety. Requirements are overall less stringent, particularly in the beginning due to transitional provisions to reduce the burden on value chain partners.

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With regards to data quality, ESRS acknowledges that it is not always possible to collect primary data, especially when it comes to value chain information. In such cases, using sector averages and proxy data is permitted. However, companies will still need to meet a number of requirements, including accurately describing assumptions and limitations and maintaining consistency with assumptions used in financial data. With regards to Scope 3 emissions, the percentage calculated using primary data from suppliers must be disclosed.

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On October 17 in its 2024 Commission work programme, the European Commission proposed (4) to postpone the deadline for the adoption of sector-specific ESRS as well as for requirements for large non-EU companies that operate in the EU. The CSRD requires the European Commission to adopt both by June 2024. The plan would see this to be changed to June 2026. Instead, the focus should be on supporting the implementation of the (sector-agnostic) first set of standards (5).

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It is important to note that these delays will have only a limited effect on the overall timeline. The roll-out of the sector-agnostic standards will proceed as planned. Non-EU companies will still be required to report starting in the financial year 2028. The plan would only postpone the deadline for the adoption of these standards giving them less time to prepare.

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SFDR

The SFDR (6) requires financial service companies to provide information about how they consider sustainability risks and how their products perform. This has the goal to provide investors with the transparency needed to assess assets and ultimately support the financing of sustainable growth while preventing greenwashing.

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The SFRD applies to financial market participants such as investment firms providing portfolio management and financial advisors such as insurance intermediaries. The SFDR came into force in March 2021 and disclosure requirements were phased in between then and June 2023.

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Disclosures are required at the entity level as well as the (financial) product level. On both levels, companies report on two types of metrics in alignment with the principle of double materiality: sustainability risks which may impact the value of the investment and Principle Adverse Impacts (PAI) which measure negative impacts of investments on the environment and people. Financial advisers are exempt from reporting PAIs on a product level.

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At the entity level, companies must disclose their policies on the integration of sustainability risks (article 3). Furthermore, they must be transparent about whether they consider PAIs of investment decisions (article 4). Companies with less than 500 employees can choose between reporting PAIs or explaining their choice to not do so (“comply or explain”).

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At the product level, pre‐contractual disclosures have to state how sustainability risks were considered and to include information on likely impacts of sustainability risks on the returns of the financial products. Financial institutions must categorize their investment products into the following three categories which have increasingly stringent disclosure requirements:

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1) products without sustainable characteristics (article 6)

2) products with a sustainable focus, also called “light green” (article 8)

3) products with specific sustainability objectives, also called “dark green” (article 9)

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For article 6 products, which is the default, requires only disclosure of the integration of sustainability risks. For article 8 and 9 products, there are requirements to demonstrate how they contribute to and do not undermine ESG objectives in accordance with the EU Taxonomy.

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There are mandatory and voluntary PAI across the topics environmental, social, and governance (ESG). Climate change is again a key component. Among the mandatory PAI are emissions-related metrics such as Scope 1, 2, and 3 GHG emissions and the share of non-renewable energy consumption and production. This information is collected as part of the due diligence process. SFDR lets companies leverage different types of data sources e.g., company disclosures as well as using estimates but requires them to publish details on their approach.

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EU Taxonomy

The European Union’s taxonomy for sustainable activities (7) is a classification system that defines which economic activities are environmentally sustainable. Its goal is to help to avoid greenwashing and enable investors to make informed sustainable investment decisions.

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The target groups of the EU taxonomy are on the one hand companies who disclose the alignment of their activities with the taxonomy and on the other hand financial market participants who disclose the alignment of their investments with the taxonomy. The taxonomy came into force in July 2020. Reporting started in 2022 when the first set of companies disclosed the proportion of Taxonomy-eligible and Taxonomy non-eligible economic activities in their total turnover, capital and operational expenditure.

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In order for an activity to meet the definition of sustainable, it must contribute substantially to one of six environmental objectives (8) while not significantly harming any of the remaining ones. This is determined using the so-called technical screening criteria.

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These six environmental objectives are:

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1) climate change mitigation,

2) climate change adaptation,

3) sustainable use and protection of water and marine resources,

4) transition to a circular economy,

5) pollution prevention and control, and

6) protection and restoration of biodiversity and ecosystems.

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Carbon emissions are covered by the objective climate change mitigation. At a high level, economic activities that qualify as contributing substantially to the climate change mitigation are based around avoiding emissions, reducing emissions and increasing greenhouse gas removals and long-term carbon storage. The technical screening criteria lay out detailed requirements for a wide range of activities ranging from afforestation to manufacturing of iron and steel, and research and development of direct air capture of CO2. Reporting this data can require sophisticated carbon calculation and modeling capabilities which many companies do not possess yet.

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Which activities should be considered environmentally sustainable can be a contentious issue. This became especially clear during the debate about natural gas and nuclear energy (9). They were ultimately included in the taxonomy provided a number of conditions were fulfilled.

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In addition, an activity must comply with minimum safeguards (10). Those are composed of criteria which need to be fulfilled across four dimensions: human rights (incl. labor and consumer rights), bribery/corruption, taxation, and fair competition. For example, a company would fail to fulfill the human rights safeguards if it has not established an adequate human rights due diligence process as outlined in the UN Guiding Principles and OECD Guidelines for Multinational Enterprises.

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It is important to note that there are no mandatory requirements regarding environmental performance. Companies may still pursue activities that are not deemed sustainable and investors may still invest in them. Instead, the idea is that transparency and a common classification will encourage a transition towards sustainability over time.

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The Taxonomy will primarily be applied in conjunction with other regulations. The NFRD, CSRD and SFRD encompass a wide range of disclosure requirements and to do so, apply the classification laid out by the taxonomy. This relationship is illustrated in figure 2.

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(11)

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Companies that are not subject to these regulations are exempt though they may voluntarily use the EU Taxonomy.

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CBAM

The Carbon Border Adjustment Mechanism (CBAM) is a carbon tariff on carbon intensive products imported by the EU (12). It is part of the European Green Deal mentioned earlier. Its goal is to avoid carbon leakage, meaning that emissions reduction efforts of the EU are offset by increasing emissions outside the EU through relocation of production or increased imports of less carbon-intensive products. A common carbon pricing would ensure a level playing field for businesses.

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The mechanism applies to importers of products in six carbon intensive sectors, namely aluminum, cement, iron and steel, electricity, hydrogen and fertilizers. Which emissions need to be included and how they are calculated depends on the type of product (see table). There is a distinction between simple goods which require exclusively input materials and fuels and complex goods which have embedded emissions. For complex goods, it is necessary to also account for the embedded emissions of input materials (precursors) consumed during production.

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The mechanism came into force in October 2023. There is a transition phase until 2026 during which emissions reporting is required without the need to purchase certificates. The goal is for this to serve as a learning period for all stakeholders and refine the policy. From 2026, the reported emissions also need to be verified by an accredited verifier.

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(13)

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CBAM is built on the European Trading Scheme (ETS) and will subject covered imports to the same carbon price imposed on internal producers under the EU ETS. However, importers can deduct any carbon price paid in the country of origin from the CBAM certificates they have to purchase.

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From 2026 to 2034, free allowances under the ETS granted to EU manufacturers will be phased out. So far, most of the industrial emissions were covered by free allowances to avoid carbon leakage which will no longer be necessary under CBAM (14).

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Closing

If you have questions or feedback, let us know. If you are looking for a powerful and easy to use solution to help you with your carbon accounting as part of your efforts to meet regulatory requirements, get in touch with us.

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