After talking to many sustainability managers both in non-financial companies and among investors and asset managers the last year, the term “regulatory tidal wave” has been a recurring topic. Most commonly, the term is used to refer to the increased sustainability reporting requirements that are coming from the EU as part of their ambitious plan to increase transparency around sustainability performance in companies. 

‍

In this article, we will discuss some of the key upcoming changes in EU sustainability regulations, the motivation behind, and potential consequences of the regulations, as well as the early experience from working with companies using the frameworks to report. Finally, we will look into how software can be used to make reporting accurate and efficient, and to enable companies to act to improve their sustainability performance. 

‍

What are the most important changes in sustainability regulations?

To understand what are the sustainability regulatory changes in effect, let’s have a brief overview of sustainability regulatory changes coming from the EU’s side:

‍

SFDR: The Sustainable Finance Disclosure Regulation went into force in 2021 and applies to financial market participants like investors and asset managers. Especially for firms that offer green investment products, for instance green funds, they now have to report quite extensive information on the sustainability performance of their investments. This includes reporting on taxonomy alignment of the investments for funds either having environmental investment objectives or promoting environmental characteristics. In addition, all funds claiming to perform sustainable investments must track Principle Adverse Impact indicators for their investments to ensure that none of them are doing significant harm to any sustainability objective. One of the key goals is that end investors, for instance pension funds or retail investors, should be able to know how sustainable their investments are. For more detailed information about the SFDR, please see our previous article.

‍

CSRD: The Corporate Sustainability Reporting Directive went into force on the 5th of January 2023 and will replace the Non-financial Reporting Directive (NFRD) that currently applies to all large companies in the EU. The CSRD is imposing several new and important requirements to companies. First of all the CSRD will expand the scope of which companies are required to report on the EU taxonomy from not only listed companies, but also the large non-listed companies from FY2025. This is expected to increase the scope of companies required to report from about 11 000 to more than 50 000. In addition, the CSRD will impose a new reporting framework for non-financial companies, called the European Sustainability Reporting Standards (ESRS). Large, public interest non-financial companies will have to report according to the ESRS in 2025 for the financial year 2024. The standard dramatically expands the scope of what non-financial companies need to report on, including disclosure requirements related to both environmental, social and governance topics.The scope of the CSRD is further described in our blog.

‍

Taxonomy Regulation: While the PAI indicators and the ESRS are mainly focused around reporting and transparency, the taxonomy is also about classification of what are sustainable activities. The taxonomy regulation is thoroughly described in several previous Celsia articles. 

‍

The net effect of these new regulations and directives is a massive increase in the reporting requirements both for non-financial (“normal”) companies and for financial market participants. As Celsia’s Head of Sustainability, Cathrine Dehli, put it: “This is the biggest game changer on transparency and sustainability performance comparison for business I have ever seen.  

‍

Why do we need these new regulations and directives?

Before we go into the tech part of it, it is important to look a bit further into why we have these regulations. The EU has set an ambition of net zero emissions by 2050 and in order to reach this goal it is estimated that about 350 billion euro of additional investments have to be directed to sustainable activities every year during the next 27 years. To make sure to reach that goal, we first have to answer the question; what is actually a sustainable investment? This has been tougher than one might think. A study performed at the MIT Sloan School of Management found that when comparing some of the most used ESG ratings, they correlated with only 61%. In comparison, mainstream credit ratings correlate with about 99%. In other words, there is not a common understanding among ESG rating agencies around which companies are actually sustainable. The point here is not that ESG rating agencies are doing a bad job- it is rather that it has been, and still is, extremely hard to identify which companies are actually sustainable. 

‍

The study reporting these numbers also pointed out that regulators could do their part by harmonizing ESG disclosure between companies. In other words- making sure all companies report on the same frameworks. This is the mission the EU has set out on using this “regulatory tidal wave” as the most important tool to get there. 

‍

If the EU succeeds on its mission, it will make it significantly easier to compare the sustainability performance between companies. Forget the 61% correlation between ESG ratings- with comparable sustainability data available, we can expect the ratings and the general perception of sustainability performance to be much more harmonized. For investors, some of the key consequences will be that it will be easier to identify the investment options that are actually sustainable. In addition, sustainability reporting on their investment products as required by the SFDR will be simpler since the non-financial companies they are invested in will disclose the needed information publicly. 

‍

For the non-financial companies, the increased transparency could make it easier for the most sustainable companies to distinguish themselves from their competitors. While many companies could claim to be sustainable previously, it will now be easier to distinguish the true sustainability leaders from the rest, potentially increasing both access to cheaper funding and customers for the green companies. Previously, there has also been a challenge for many companies that they are faced with a broad set of data requests from both their customers and investors. As one of the heads of sustainability we talked to put it; “The different customers and investors are asking for more or less the same information, just in a bit different formats. This makes it more than a copy-paste exercise and we spend a lot of time just providing data instead of using the resources on actually improving our efforts”. With more consolidated reporting requirements, the EU expects companies to be faced with less ad hoc data requests, saving time for many sustainability professionals. 

‍

How big will the reporting burden be for companies?

As illustrated in the above sections, there could be many benefits for both non-financial companies and investors resulting from increased reporting requirements. However, there is no secret that many companies also find the increased requirements overwhelming. Gathering the data, providing documentation and consolidating metrics to report on is an extensive exercise. According to the European Commission’s own estimates, the cost of reporting on the taxonomy is expected to be around €20,000 – 50,000 per year for EU companies required to report. The estimates for ESRS reporting goes even higher, with an estimated annual cost of €40,000 – 320,000 according to EFRAG. There is no doubt that these are high numbers, and in order to ensure wide adoption of the reporting standards beyond the companies that are regulatory required to report, e.g SMEs, it will be important to reduce the costs. Here, tech can play an important role. 

‍

To understand how tech facilitates and improves reporting , let’s first have a closer look at what the challenges are for companies in their reporting. Through assisting more than 100 companies in their alignment assessments for the EU taxonomy, and screening EU taxonomy eligibility for more than 1500 companies, we have made some key observations: 

‍

1. Complex requirements from the EU. We have been in contact with several hundred companies the last two years, and have yet to meet a company that did the full reporting without any type of external help from consultants or lawyers. 
2. Challenging to organize the process. Since the new frameworks cover many topics and are also linked together with financial reporting, parts of the organization that have not collaborated that much before now have to work closely together. 
3. Consistency in the framework is key. When all these parts of the organization are involved we have also experienced it as key that everyone interprets the criteria consistently and input data in a structured format. 
4. Mandatory reporting- important to get it right. As sustainability reporting is going from voluntary to mandatory, the requirements for accuracy are also increasing.
5. Documentation is hard. One of the top challenges that we have seen is also to gather all documentation to support the assessment. 

‍

Main trends emerging for sustainability reporting

Combining the observations with insights on what is coming from the EU, we see four main trends emerging in sustainability reporting: 

‍

More ESG topics to report on

Previously, many companies have been able to cherry-pick when choosing which sustainability indicators to report on. Many have been focused on some social and governance indicators, and perhaps scope 1 and 2 greenhouse gas emissions. Both the taxonomy, SFDR and the ESRS introduce a broader range of topics to report on by including topics like climate change adaptation, biodiversity, circular economy and pollution as well. The expanded scope will continue to increase the number of employees in a company involved in sustainability reporting, ranging from the financial team to operations, management and technical personnel with detailed knowledge of the projects or plants. In total we see that companies are typically involving 2-5 times as many employees in the reporting process compared to previous sustainability reporting efforts. 

‍

Convergence of sustainability and financial reporting

Since sustainability performance is getting closer linked to access to capital and also transitioning from being voluntary to mandatory, we see that the requirements for accuracy have increased dramatically. In addition, the CSRD will in the future impose a requirement for external audit of sustainability reporting. As a result, many companies start treating sustainability reporting more like financial reporting, both when it comes to process setup and who is responsible. Audit trail is also becoming increasingly important since the most forward leaning companies want to have their reports audit-ready already now. 

‍

Rapidly evolving frameworks & best practices

The EU has moved fast in the implementation of the new frameworks and has also provided several rounds of guidance on best practice interpretation of the frameworks. The result is that companies need to pay close attention to the latest updates to ensure that the reporting is following best practices. Most companies are solving this by either investing their own time or working with consultants or software tools to make sure their frameworks are always up to date. 

‍

The rapid implementation of new standards and best practices could also promote more collaboration between companies. While being sustainable is a competitive advantage, reporting correctly on sustainability is something everyone is interested in their peers doing right. Hence, sustainability reporting is an area well suited for collaboration between companies. We already see some good examples of this among the companies we work with, both in the form of public webinars, industry specific seminars and competitors coming together to share best practices for reporting. 

‍

More SMEs will report, hit through investors 

Among the non-financial companies, only enterprises with more than 500 employees which are of public interest (e.g listed) are required to report on the taxonomy until now. Nevertheless, there are about 10 times as many SMEs compared to enterprises using the Celsia tool as of now. The main reason for this is that SMEs are indirectly hit by the reporting requirements through their investors which have to report. In addition, we see that many SMEs focusing on sustainability want to report voluntarily to prove their good performance. 

‍

The adoption of the reporting frameworks by SMEs is one of the factors driving the need for radical reduction in cost, time and complexity of reporting since the smaller companies normally have much less resources to spend on reporting than larger enterprises. 

‍

How to use tech to make reporting more efficient

In Celsia, we strongly believe that tech can help mitigate the previously mentioned challenges to make the sustainability reporting, tracking and management as accurate and efficient as possible. Due to the increased requirements for accuracy, we believe that the future of sustainability software is not “all-in-one” solutions, but rather a stack of dedicated tools solving different needs in tracking of sustainability data. This could for instance include having one tool for carbon accounting, another for tracking of human rights concerns in the supply chain and a third for tracking the recycling rate of the company’s product. With a set of dedicated tools, it is vital that they have good integrations with each other to ensure smooth data flow and avoid extra work when it comes to gathering and aggregating data for reporting. 

‍

With the trend of an increasing number of employees from different departments collaborating in the reporting process it is also important that the software tools facilitate efficient collaboration. This includes the ability to communicate inside the solution, but also that the solution ensures that everyone participating in the process is on the same page in the interpretation of requirements and what kind of data they need to input. The latter can be solved in many ways by the tech tools, for instance by educating the users through supplying contextual information or by having good mechanisms to detect wrong input. 

‍

Finally, there is no doubt that the use of artificial intelligence (AI) is going to be of increasing help in sustainability reporting in the years to come. Several software providers (including Celsia) are already starting using large language models (LLMs) to speed up data gathering, synthetization and reporting processes.

‍

Some identified early uses of such models have been:

‍

• Reading of documentation, making the assessments more automated and audit more efficient. 
• Cleaning of data, e.g mapping financial data to specific taxonomy activities. 
• Provision of guidance on interpretation of the regulations. 
• Providing feedback on improvement areas within sustainability based on documentation of existing efforts. 

‍

These are just a few examples- there are many more areas where AI could be of good help in the reporting process. It is important to use such AI models for what they are- tools for making the reporting more efficient, not sources of truth. Nevertheless, there is no doubt that these models have the power to radically streamline the reporting process going forward so companies can spend less time on reporting and more time on actually becoming more sustainable. The use of AI in sustainability reporting and management will be the topic of an upcoming Celsia webinar where we will elaborate on the different uses of AI and discuss the solutions we are developing. Stay tuned!

‍

Conclusion

There is no doubt that the latest EU regulations and standards imply huge changes to what is being required from companies’ sustainability reporting. If the EU succeeds with their goals for the regulatory changes, both companies and investors could benefit from standardized reporting resulting in increased transparency and less ad hoc data requests from users of sustainability data. While some companies find the reporting requirements overwhelming in the beginning, it is all about getting started- it will become much easier the second time. With the current trends of more ESG topics to report on and increased requirements for accuracy, we also see that first movers have an advantage since they are able to prove their sustainability efforts to a larger extent than their peers which are yet to take the new regulations and standards into use. To make the reporting and management process both accurate and efficient, Celsia believes that dedicated tech solutions will play an important role. 

‍