EU ESG regulations in 2022: Is it worth being a frontrunner?
CEOs of small and mid-cap companies need to make a strategic decision: develop and implement ESG reporting now, or later when required by law?
What we know today about incoming EU ESG regulations
Wiesbaden, January 7, 2022. At the level of EU governance, the EU taxonomy and the Sustainable Finance Directive Regulation (SFDR) are two core pillars urging business owners to conscientiously embrace ESG reporting.
The EU taxonomy classifies which economic activities may be recognized as sustainable. While driven by the EU’s objectives of the European Green Deal and its climate targets for 2030, the intention of this regulatory requirement is to provide a ‘black and white’ classification system for which economic activities will be allowed to be elevated to ‘sustainable’ status. Although some activities are readily classified, controversy exists around nuclear and gas energy generation for example. Once companies and their activities can be accurately described as [x%] sustainable, market participants can make more informed decisions when it comes to capital allocation.
The first phase comes into effect on January 1, 2022, where companies and financial institutions voluntarily report on qualification for the taxonomy (taxonomy eligibility). During the second phase (2023), companies report on their alignment with the taxonomy and financial institutions report on eligibility. Finally, by 2024, both companies and financial institutions shall report on their alignment to the taxonomy.
The SFDR came into force in March 2021, requiring financial market participants to make entity-level disclosures about (i) the integration of sustainability risks as well as (ii) the potential positive sustainability outcomes. The format of the disclosure is by standardized descriptions on websites, in prospectuses and periodic reports. As the scope of the SFDR is more narrowly defined to financial advisors and financial market participants, this legislation is of particular interest to direct capital market players.
More detailed reports of ESG-focused products, i.e. the distillation from entity-level disclosures to product-level disclosures are stated to take effect from 1-Jan-22.
While capital providers have different levels of sensitivity and appetite when it comes to meeting their own sustainability targets, we already find ourselves in a world where investors are more demanding than the ESG legislation.
What this means practically for your company
Over the course of 2022, legal disclosure requirements at the EU level will continue to evolve. So why not wait and see how the regulation pans out, and then catch up when the time comes? Meeting requirements takes considerable homework – understanding how ESG reporting works and then setting up the correct internal systems for efficient data and information collection. Preparation is a two-fold exercise: firstly one of internal due diligence to understand exactly where your company falls when it comes to quantifying its activities (e.g. total CO2 emissions) and secondly, learning how to report and communicate this information effectively.
When it comes to communicating ESG information, there are two guiding forces in the market: the standard-setters and the rating agencies. While the EU does not mandate reporting standards, congruence exists around standards set by actors such as the SASB, WEF and TCFD. In conjunction with these standards, ESG-specific rating agencies such as Sustainalytics and MSCI act to assess both quantitatively and qualitatively the ESG reporting quality of market players. (See our last post on ESG rating agencies here). While standard setters and rating agencies effectively provide guidance on how to communicate ESG information, the orientation and data collection phases necessary prior to being able to report on ESG should not be underestimated.
The spirit versus the letter of the law
According to the letter of the law, small and mid-cap companies are not currently required to report on ESG. Despite the certainty that in future they will be required to, especially as companies grow, disclosure is not a regulatory obligation today in the EU for companies with less than 500 employees.
Fundamentally, the spirit of these regulations is to move to an increasingly transparent economy. One where markets become more efficient by decreasing the cost of capital for activities with more longevity and increasing the cost of capital for businesses whose externalities have not been priced in accurately – e.g. excessive pollution. As investors, institutions and allocators of capital commit themselves to multi-year financing contracts, they are aware that contracts committed to today may be subject to new reporting requirements tomorrow. As such, it is observable that allocators of capital are more demanding than the letter of the law.
Do you want to orient yourself on how to think about your first ESG report? Then cometis is your right contact: Feel free to get in touch!
Michael Diegelmann: Founder and Board Member
Michael Diegelmann has taken over 50 companies public and has gained experience in over 250 investor relations and ESG projects. He has been active in the field of capital market communications since 1997 and is a proven expert in ESG topics.