ESG legislation: the deep dive

It's no secret that the ESG space is highly regulated, a sign of the increasing importance of sustainable practices within the financial industry.

EU Regulation

To assess the position of financial institutions from an ESG perspective, a multitude of regulations, recommendations, and requirements have been developed by supervisory authorities and by delegated committees and task forces. ESG is about creating transparency in the sustainability of a firm's actions and investments. In addition to that: standardizing the way of reporting.

The basis of most of these documents originates from the report that was released by the Task Force on Climate-related Financial Disclosures (TCFD), a task force created by the Financial Stability Board (FSB), in 2017. This report states recommendations on what information companies should disclose related to climate-related risks, which became an international standard to benchmark against for supervisory authorities.

How should we interpret an umbrella term like 'sustainability'?

This is where the EU Taxonomy comes in: this body sets technical screening criteria that can be used to determine whether an economic activity can be considered sustainable, or in other words: Taxonomy-aligned. To do so, economic activities are ranked against six environmental objectives and classified in one of three categories: substantially contribute, do no significant harm (DNSH), or meet minimum safeguards.

The reporting requirements for financial firms and enterprises are captured through a wide range of regulations and directives. Within Europe these requirements include for example the EBA Pillar 3 framework, enforced under the Capital Requirements Regulation (CRR), and the Non-Financial Reporting Directive (NFRD), which is currently transitioning into the Corporate Sustainability Reporting Directive (CSRD). On a global scale there are more parties that have published reporting standards like the International Sustainability Standards Board (ISSB) and the Global Reporting Initiative (GRI).

EBA Disclosures

Reporting requirements for large, listed banks and investment firms in Europe are captured in the CRR and IFR. In article 434a of the CRR, the EBA is mandated to develop draft implementing technical standards (ITS) on Pillar 3 disclosures on ESG risks that specify a uniform disclosure format with related instructions. These ITS should be used to report on the disclosures defined in Part eight of the CRR and represent a Pillar 3 disclosure framework. The ITS are related to the other disclosure initiatives by following the recommendations from the TCFD reports, using the Taxonomy as starting point, and assuming reporting data is present through the reporting requirements of the NFRD/CSRD (more later). Currently, the ITS primarily consider the environmental aspects, with expectations of more extensive inclusion of the social and governance aspects in the future as well.

The final draft ITS have been released in January 2022 and include three tables for qualitative reporting on environmental, social, and governance risk, and 10 quantitative templates that cover transitional climate risk (template 1-4), physical climate risk (template 5), and mitigating actions (template 6-10). The requirements are summarized per template:

- Credit quality of exposures by sector: emissions and residual maturity; Gross carrying amount of loans/advances provided to non-financial corporates, counterparties' scope 1, 2, and 3 GHG emissions.

- Immovable property: Energy efficiency of real estate collateral in the loan portfolio expressed by means of kWh/m2 energy consumption, in terms of EPC label (if available).

- Alignment metrics for the banking book: Scope 3 emissions related to the alignment metrics as defined by the IEA for the net-zero scenario (NZE1050) per sector.

-Exposure to top 20 carbon-intensive firms: Aggregate gross carrying amount of exposure to top 20 most carbon-intensive corporates worldwide based on publicly available data sources.

- Exposure subject to physical risks: Exposure in the banking book to chronic and acute climate-related hazards broken down by sector and location using specialized data sources. Includes IFRS stage2 exposures.

- Summary of the Green Asset Ratio (GAR) KPIs: Summary of templates 7 and 8. Only considers exposure to non-financial corporations that are required to publish under the NFRD.

- Assets for the calculation of the Green Asset Ratio: Report on exposures by sector divided in total, taxonomy-eligible, and taxonomy-aligned under Article 8 of the EU Taxonomy.

- Green Asset Ratio KPIs: Exposure to each type of client distinguished in template 7. Includes distribution of real estate loans by energy consumption and EPC label.

- Banking Book Taxonomy Alignment Ratio (BTAR): Exposure to all counterparties, including non-financial corporations not required to publish under the NFRD. Extends on templates 7 and 8.

- Other: Optional to report on non-EU Taxonomy related mitigating actions.

Institutions that issue securities admitted to trading on a regulated market of a Member State are required to disclose this information from 28 June 2022 on an annual basis. However, since the EBA knows the data required for reporting on scope 3 emissions might not currently be present, they have initiated a phase-in period during which institutions only need to explain methodologies they are developing to measure and estimate the scope 3 emissions of counterparties and the data sources they are planning to use.

This phase-in period ends June 2024. Additionally, template 7 and 8, related to the GAR, need to be disclosed from 2024 onwards, and template 9, related to the BTAR, from June 2024 onwards. This is also the case for GAR and BTAR related exposures that are present in template 1 (CCM).

With the implementation of CRR 3 in January 2025, the EBA Pillar 3 disclosures will apply to all banks within one of the EU member states.

NFRD / CSRD / ESRS

Since 2014 the NFRD requires large institutions to disclose non-financial and diversity information. To be subject to the NFRD the institution needs to have more than 500 employees and operate within the territories of an EU member state that has adopted the directive into their national law. As of January 2023, however, the CSRD has entered into force. The CSRD can be seen as an extension of the NFRD in multiple areas. First off, the CSRD expands on the sustainability reporting requirements of the NFRD and requires reporting to be compliant to the European Sustainability Reporting Standards (ESRS). Secondly, the CSRD requires third party assurance from an independent auditor. Furthermore, the scope is expanded to more companies. This expansion takes place in four phases:

1. From 2025 onward companies subject to the NFRD will need to report on their 2024 financial year;

2. From 2026 onward large companies that are not currently subject to the NFRD will need to report on their 2025 financial year;

3. From 2027 onward listed SMEs will need to report on their 2026 financial year;

4. From 2029 onward international companies with a net turnover of 150 million or above in the EU and who meet the other CSRD requirements will need to report on their 2028 financial year.

Due to the expansion of this scope, the currently 11.000 companies subject to the NFRD will increase to 50.000 companies already in phase 2.

As mentioned before, CSRD requires companies to report according to the ESRS, which were adopted by the European Commission on the 31st of July 2023. The ESRS consists of 12 standards covering cross-cutting and topical standards on environment, social, and governance. The standards in the current version of the ESRS are sector-agnostic, meaning that they apply to all economic sectors. However, in addition to these sector-agnostic standards, sector-specific standards will be developed over the coming years. The scheduled implementation of these sector-specific standards has recently (February 2024) been delayed to June 2026 to allow companies to focus on the implementation of sector-agnostic standards first.

International Sustainability Standards Board (ISSB)

In November 2021 the International Financial Reporting Standards (IFRS) Foundation announced the formation of the ISSB at the COP26 in Glasgow. The ISSB was tasked with developing international reporting standards which they published in June 2023 and that entered into force for companies reporting under IFRS in January 2024. These standards (IFRS S1 and IFRS S2) are built upon the TCFD framework and intertwine with other global standards like the ESRS.

Still there are some differences between the ISSB standards and e.g., the CSRD. One example is that the CSRD is more extensive than the ISSB in that it requires a double materiality assessment. This means that under the CSRD companies are obligated to report on both the impact the company has on the climate as the other way around, whereas the ISSB requires companies only to report on the impact the climate has on them.

This difference illustrates how various stakeholders can influence reporting requirements. The CSRD is formed in close cooperation with the Global Reporting Initiative (GRI), an organization that is not only influenced by the business side but also by civil society groups. Through their point of view, the impact on the climate must play a central role in a company's reports. The ISSB on the other hand is the child of the IFRS and by that much more focused on the financial health and stability of the reporting parties that can be hampered by climate risks.

With 2024 being a crucial year in sustainability reporting it is interesting to see how companies will handle all requirements and what lessons we can learn for the future.

Do you need help interpreting and implementing these regulations and requirements for your business? RiskQuest can help you focussing on the data elements which should have priority depending on your situation. We are also experienced in ESG data vendor research and implementation in your data infrastructure.