Sustainable activity taxonomy and ESG reporting: Key changes in European regulation
European taxonomy of sustainable activities, non-financial reporting obligations and related screening criteria for economic activities – these are some of the key regulations that have a significant impact on the activities of large and small companies. Which industries are affected by the taxonomy, what benefits does the reporting obligation bring for companies and how will the topic of sustainable financing affect the business world in the future?
The sustainability concept has been present since the 1970s and, despite numerous discussions, conferences and proclamations, has until recently been used rather in the context of improving the image of companies, on a voluntary basis. In recent years, specific measures to promote sustainability elements have been adopted at the EU level.
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One of such measures is the taxonomy of sustainable activities set out in Regulation (EU) 2020/852 of the European Parliament and of the Council. This regulation dated 18 June 2020 focuses on the financial sector, through which it impacts a wide range of industries. In practice, it involves the integration of environmental, social, and governance aspects into internal and decision-making processes within the investment, banking and insurance sectors.
The topic of sustainable finance is thus becoming more prominent and contributes to the solution of current society-wide challenges such as climate change and negative impacts on individual environmental components. The main goal of the agenda is to promote investment in sustainable economic activities and to ensure sufficient capital for the transition to a low-carbon economy. Both public and private funds should be invested based on coherent concepts of environmentally sustainable economic activities, transparent information on the impact risks of the activities of individual participants, and the mitigation of these risks.
Screening criteria for economic activities
At the end of 2021, Regulation (EU) of the European Commission laying down the technical screening criteria for individual economic activities monitored within the aforementioned taxonomy came into effect. These criteria specify under which circumstances a particular economic activity falls within the taxonomy framework, and regulate nine areas in total (e.g. manufacturing, energy or construction and real estate activities).
These activities (as well as many others) are often closely linked to external financing. Institutions will thus have to take the new screening criteria into account when e.g. applying for financing within the assessment of sustainability of specific activities. The institutions themselves will then have to disclose the percentage of their total investments that flow into sustainable projects under these criteria.
Non-financial reporting and related obligations
The pressure on the sustainability of projects funded by external sources (usually by bank loans) is also linked to the future obligation of non-financial reporting. It is based on the Non-Financial Reporting Directive (NFRD), or its updated version, i.e. Corporate Sustainability Reporting Directive (CSRD) proposed in 2021. The updated directive extends the scope to all large companies as well as all small, medium, and large companies trading their securities on stock exchange (except for micro-enterprises).
The non-financial reporting, also referred to as ESG or sustainability reporting is nowadays a common practice for most large companies. The initiating factors are usually regulations or pressure from investors or other stakeholders. The reporting obligation brings a number of positives to companies, such as improved identification and ESG risk management processes, a basis for setting long-term strategy and objectives, a more efficient setup of internal management structures, a greater amount of analysed data, and increased employer attractiveness or an overall improvement in reputation.
Moreover, the updated regulation (CSRD) promises its own technical standards and more detailed instructions for companies to use in their reporting. Currently, companies can choose from several internationally recognised methodologies and frameworks that aim to unify the approach and deliver comparable data across sectors, similar to traditional financial reporting standards.
Recently, there have been several changes in this area as well. One of the most used frameworks is still the GRI standards (slightly updated in 2020). At the same time, the SASB and IIRC (Integrated Reporting) methodologies have been merged to form a new platform, the VRF (Value Reporting Foundation), which specialises in standards that link non-financial information with financial information. Another novelty is the formation of ISSB (International Sustainability Standards Board) under the auspices of the IFRS Foundation, which will also develop IFRS standards for non-financial reporting.
Future of the ESG reporting
Compliance with the set rules may have an impact on the possibilities of financing economic activities and specific projects, as well as on the possibilities of selling the developed projects in future years. The transformation of the monitoring of sustainable aspects of projects or companies from a voluntary basis to legal obligations is already underway. From our perspective, ESG reporting will continue to evolve mainly towards greater transparency, quantity, comparability and quality of data. The market developments show that the obligation will also extend to medium and smaller enterprises. Non-financial reporting will be a prerequisite for obtaining any external financing because financial institutions will not be able to grant funding to companies or projects that do not provide them with this information.