Swift developments call for quick decisions

Context

Investors, legislators, non-governmental organisations and rating agencies all agree that greater transparency is needed with respect to companies’ non-financial reporting on environmental, social and governance topics (ESG). That can be achieved through uniform ESG reporting. However, opinions differ on how that reporting should be structured and implemented. Developments at national and international level have taken place in parallel and have only recently begun to intersect. We shed some light on the most important topics in the article below.

European Sustainability Reporting Standards (ESRS)

In April 2021, the European Commission published its proposal for a Corporate Sustainability Reporting Directive (CSRD) and reached a political agreement with the member states in June 2022. This is intended to replace the Non-Financial Reporting Directive (NFRD) of 2014 that is currently in force. The European Financial Reporting Advisory Group (EF-RAG) was tasked with drawing up the European Sustainability Reporting Standards (ESRS). The various expert groups are working at full speed, and the public consultation process for the drafts began at the end of April 2022. The binding date on which these standards enter into force will be the 2024 financial year for large public corporations (which are currently in scope of NFRD), 2025 for large non-public companies and 2028 for smaller public and Non-EU companies that generate more than EUR 150 million in sales in the EU. A separate reporting standard is planned for small and medium sized companies. All companies subject to the CSRD are also required to comply with the EU-taxonomy disclosures which have a different time-line and are partly already in force.

Many companies domiciled in Switzerland are certain to be impacted by CSRD, in part because an exemption is possible for subsidiaries included in a consolidated report, making compliance with the reporting requirements more efficient through the parent company. An exemption is not possible for companies with securities (debt or equity) traded at an EU-regulated market.

The CSRD has adopted a perspective that focuses on corporate responsibility. For this purpose, the EU has not only expanded the scope of reporting entities but also the content of the report. Also, the information on sustainability has to be included in the management report and be available in a digital format. The management as well as the supervisory board or board of directors will bear explicit responsibility for fulfilling the requirements. Furthermore, sustainability-related information will be subject to mandatory external limited assurance. The EU plans specific requirements concerning auditors’ experience and training and aims to move to a reasonable assurance requirement after a few years.

International Sustainability Standards Board (ISSB)

The International Financial Reporting Standards (IFRS) Foundation announced at the Climate Summit in Glasgow in early November 2021 that it was creating an International Sustainability Standards Board (ISSB). While EFRAG focuses on the needs of all stakeholder groups, the ISSB aims to produce disclosures that are mainly geared towards the capital market. Consequently, the standard to be developed should primarily answer the question of whether and to what extent sustainability aspects have an impact on the balance sheet and the income statement, meaning that investors in particular are likely to demand it. While the standard has not yet been drafted in full, it is set to be introduced at the same time as the ESRS and an effort is being made to ensure compatibility. The ISSB’s working papers are still heavily focused on climate-related implications at present, but are likely to broaden and include other ESG aspects over time.

The ISSB is strongly based on the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD), meaning that it focuses on opportunities and risks. That means the new standard impacts companies in two different ways. Firstly, the company can take preventive measures and mitigate negative financial consequences by reducing its climate-related risks, for example, or by discontinuing activities that are expected to result in losses. Secondly, this new transparency also brings to light opportunities. If a company invests in renewable energy sources, for example, it helps make current solutions marketable and scalable while also developing new markets or business areas.

Revised Swiss Code of Obligations (revCO)

The Federal Council enacted the new (implementation) provisions from the indirect counter-proposal of the Responsible Business Initiative (RBI) in the Swiss Code of Obligations (revOR) on 1 January 2022; they will be mandatory from the 2023 financial year onward. This introduces non-financial reporting requirements for large (more than 500 full-time positions and CHF 40 million in sales revenue or CHF 20 million in total assets) public interest entities. Companies subject to these requirements must submit a consolidated report on non-financial matters and have it approved by both the board of directors and the general meeting of shareholders. In this report, the company must explain its concepts and the measures it takes on environmental, social and labour issues, human rights and the fight against corruption, while also detailing the corresponding risks that arise as a result of its business activities and key performance indicators.

The indicators required are not prescribed by law and the issues subject to disclosure are kept relatively vague. Many companies that already disclose information on sustainability apply the Global Reporting Initiative (GRI) standard. These largely satisfy the current NFRD obligations on which the provisions are based. Swiss lawmakers did not provide an obligation to have the report externally assured, but did include a formal responsibility on the part of the board of directors.

Ordinance on climate reporting

The Swiss Federal Council announced on 18 August 2021 that the climate risk disclosure will be regulated in a supplementary implementation ordinance. This ordinance was sent to the consultation process on 30 March 2022 and should also enter into effect for the 2023 reporting year (see “Ordinance on climate reporting in the consultation process”). Like the European and international standards, the ordinance is based on TCFD.

Climate risk disclosures will require a fresh approach to presenting non-financial risks. In the past, these disclosures related to energy and water consumption figures or carbon emissions broken down by source (scope 1, 2 and 3). In the future, entities will have to adopt a more traditional risk management approach, and use scenarios to measure the financial consequences of different measures and the extent to which the climate goals have been achieved. An increase in carbon prices, for example, can fundamentally change a company’s position on the capital market. Likewise, the physical repercussions of climate change can result in impairments of balance sheet items.

Supply Chain Act and the EU’s Corporate Sustainability Due Diligence Directive

Germany introduced a comprehensive Supply Chain Act in 2021, and other countries in the EU are following suit. On 23 February 2022, the European Commission published its proposal for a Directive on Corporate Sustainability Due Diligence (EU supply chain guidelines), which included an annex and factsheet. The proposal mainly focuses on existing legislation enacted by France and Germany, and is consistent with the European Green Deal and the UN’s Sustainable Development Goals. These guidelines are intended to incorporate human rights and environmental concerns more closely into business activities and corporate governance. Based on the revised Swiss Code of Obligations, the focus in Switzerland is on child labour and conflict minerals (see the “Ordinance on Due Diligence and Transparency Regarding Minerals and Metals from Conflict Areas and Child Labour”).

The new legal provisions require companies to demonstrate due diligence. That includes identifying, ending, preventing, reducing, monitoring and reporting the negative impact on people and the environment. Companies must reveal the risks they are exposed to, as well as what they plan to do to mitigate against those exposures and in which timeframe. The new transparency requirements call for active supplier management with systematic information collection and effective monitoring. These measures will be particularly challenging for highly interconnected companies, because some dependencies will be very hard or nearly impossible to eliminate.

Time as a factor

Efforts to develop sustainability standards continue to pick up momentum. At the European level, EFRAG has published numerous working papers for the upcoming ESRS, including five so-called sector-independent cross-cutting standards. The corresponding consultation will last from May to early August 2022. On 31 March 2022, ISSB published the first two exposure drafts on the future global baseline of sustainability reporting for the official consultation process (until the end of July 2022). It plans to release the finalised standards by the end of 2022 once feedback has been incorporated.

Non-financial reporting in Switzerland will become mandatory from the 2023 reporting year on-wards. The EU’s Corporate Sustainability Due Diligence Directive is set to be finalised in 2023 and transposed into national law by each EU member state within two years of its adoption. Despite the fact that the CSRD has been postponed, the regulatory pace remains very brisk and is forcing those responsible to prepare the necessary information and processes as quickly as possible.

Fresh approach recommended

Many companies will not be able to avoid the new ESG transparency requirements. The following are a few recommendations that might help when discussing upcoming decisions:

• First of all, the reporting frequency must be increased and monitoring systems with interim reviews introduced. This begs the question of which steps of the process can be automated, with information gathering being one example.
• ESG reporting calls for an approach that doesn't depict perfection, but rather shortcomings and corresponding countermeasures. After all, companies will not be penalised for disclos-ing a deficiency but for withholding it.
• This kind of awareness calls for functions which are capable of thinking and acting in more than just black or white but also in shades of grey – in other words, in terms of scenarios and hypotheses.
• From a purely legal perspective, CEOs, CFOs and Audit Committee members are responsi-ble for non-financial reporting and can be held accountable for it. Failure to comply with this obligation could have legal consequences, for example in the form of lawsuits.
• The detailed contents of a sustainability report are gradually taking shape. In the world of figures and standards, that is unusual. Companies which are looking to act in compliance with the rules must be willing to adapt their behaviour to the evolving situation (and stand-ards).