ESRD: A quantum leap towards climate-ready business governance
· 10 min read
Europe has emerged as the fastest-warming continent on Earth, as per the World Meteorological Organization, a stark reality that unfolded in 2023. [1] This alarming trend necessitates immediate and drastic reductions in carbon emissions to align with the Paris Agreement. Simultaneously, the need for effective climate adaptation action has become urgent. The EU's sustainable finance agenda is making strides with the introduction of the ESRD, which is set to be implemented from the start of 2024. In contrast, the ESG war has gained momentum in the United States, with the passage of anti-ESG legislation.
The new standards regulation is a part of the EU Sustainable Finance Plan that aims to promote green capital channels for a net-zero economy; it marks a milestone in strengthening future-proof businesses for climate adaptation and resilience by enhancing a transformational corporate governance shift. It increases corporate accountability within the EU and thereby symbiotic financial and impact materiality. The ESRD enables companies to integrate a dynamic materiality approach to cope with the 'tragedy of the horizons'; in the face of uncertainty and volatility it will be business critical. Moreover, it empowers investors to think globally and locally, fostering a high level of interoperability and paving the way for a global ecosystem move.
The understanding of the ESRD's impact within the EU is a foundation for exploring its potential influence on global climate finance requirements. By 2030, international climate finance needs are projected to rise from approximately $1 trillion to $5 trillion or more. The EU Green Deal actively spur capital allocation channels to invest in sustainable technologies and practices, and businesses committed to transitioning to a decarbonised economy. By tackling both their carbon price devaluation and greenwashing risks' exposure to their financial asset portfolio, the EU green framework enables better investor decision-making.
The strategic enhancements under ESRD reshape corporate governance and redefine investor engagement with sustainable practices. The four components of the Sustainable Finance legislative framework, namely the EU Taxonomy, SFRD, ESRD, and recently adopted CSDDD, achieve holistic consistency and effectiveness in transparency and transform business models for convergence towards a sustainable EU economy.
In particular, the European Sustainability Reporting Standards (ESRS) strengthen the existing rules on non-financial reporting (NFRD). [2][3] Besides, it is not just a name or a terminology change from “non-financial information” to sustainability reporting. It is a pivotal instrument to increase sustainability companies' performance and accountability for impact reporting, encompassing financial and impact materiality. Indeed, by translating the effects of ESG factors into monetary terms, the ESRD gives significant value to the relevance of sustainable business. As a result, financial and impact materiality earn equal equality in importance. Disclosing climate risks is now a requirement for companies to access capital.
Furthermore, the new extended regulation seeks for more forward-looking to report on the company’s transition towards sustainable business models. Sustainability issues, especially climate physical and transition risks, can put at risk the viability of the company if they are not appropriately addressed. They can seriously impede a company’s business model.
Under ESRD, reporting companies must provide information about their strategy, targets and the role of the board management. Moreover, these issues can strongly impact reputation and brands, an increasingly important part of company value. Thus, it enables an evolution from a defensive business strategy to embrace sustainability as a driving force for business opportunities. Indeed, now more than ever, resilience and competitiveness are crucial for businesses to create a genuine impact.
Even when businesses set adaptation targets, they often need more frequent and measurable commitments. Consequently, ESRD empowers governance bodies to design an effective transition plan, climate-proofing their businesses to increase their adaptation and resilience. It helps boards set a medium- to long-term resilience strategy, shape investment priorities, and frame budget priorities for capital expenditure. Every company should start by screening its operations, assets and supply chains for specific climate risks before designing an adaptation plan with strategies to address each threat.
From an investor’s perspective, ESRD equips them to better evaluate companies' sustainability and long-term creation value.
In essence, corporate sustainability, transparency, and accountability are integral to a company's overall management quality and ability to compete successfully. The ESRD is not just a regulatory requirement; it is a transformative tool that embeds companies in effective adaptation action. It compels them to strive for a business model transformation, accelerating action for resilient and sustainable economies and communities through the concept of double materiality.
The EU’s Sustainable Finance brings a comprehensive stakeholder’s ecosystem perspective to the rise of the sustainable economic cycle. Indeed, the stakeholder perspective provides a critical input in determining materiality by serving as the most accurate proxy for experienced externalities. Thus, the ESRD mandates the concept of double materiality for sustainability reporting standards. It covers environmental, social, and governance issues, including climate change, biodiversity, and human rights.
In a nutshell, the materiality concept aims to translate into monetary terms the positive and/or adverse effects of ESG factors in the accounting arena. Through dual materiality, companies should disclose both how sustainability issues affect the company, i.e. create financial risks and opportunities for the company 'outside-in risks', and how the company affects society and the environment 'inside-out risks'.
Material financial information, under the ESRD, is now focused on the needs of primary users, i.e. investors, assuming that the needs of other stakeholders are satisfied either through impact materiality information or through the information needed by investors. A notable change is that companies are required now to report only on indicators that are material to them. Consequently, these indicators undergo a materiality assessment, including those related to climate change and other environmental aspects such as biodiversity and the circular economy. ESRS 1, “General Requirements”, sets general principles to be applied when reporting according to ESRS and does not itself set specific disclosure requirements. ESRS 2, “General Disclosures”, specifies essential information to be disclosed irrespective of which sustainability matter is being considered.
Double materiality underpins the sustainable EU economy. Due to the rapid scale of the climate threat and its irreversible structural disruption, however, companies should navigate from short—to long-term horizons. They should also continuously adjust their strategy and trajectory to the evolving risk landscape. Thus, dynamic materiality is business-critical in the face of uncertainty and volatility.
For business leaders, a common challenge is how to align ESG strategies with shareholder expectations. The prevailing view among companies is that prioritising ESG issues can lead to value creation or the development of new revenue streams. Nevertheless, they face a dilemma between long-term sustainability goals and short-term business growth strategies. [4] For instance, when specific ESG initiatives have an extended return horizon, posing financial challenges in the short term.
The trade-offs are becoming more difficult due to the complexity of the climate equation, which requires its two components, i.e. mitigation and adaptation, to operate hand in hand. Its complexity also arises from its non-linearity, uncertainty with potential cascading risk, and is often unpredictable. There is also an interconnection between physical and transition climate-related financial risks. Indeed, according to the Global Risk Report 2024, the World Economic Forum (WEF) has identified extreme weather events, critical changes to Earth systems, and biodiversity loss as the top three global 10-year risks.
The ESRD acknowledges the dynamic interrelationship between impact materiality and financial materiality. It defines “the term “impacts” (…) refers both to actual impacts and to potential future impacts." What is material today may not be tomorrow, and what is not material today may be tomorrow. Materiality is, therefore, more fluid than ever before. The dynamic materiality reflects an evolving assessment of which ESG issues matter most, as the pace of change is accelerating due to new technologies and views forged in an interconnected world. As a result, many impacts on people and the environment may be considered ‘pre-financial’ in the sense that they may become material for financial reporting purposes over time”. [5][6]
Dynamic materiality could serve as a powerful additional tool to help business leaders navigate the “tragedy of horizons, » complementing the Double Materiality Assessment (DMA), enhancing surfacing structural trends and emerging risks, and identifying options for trajectories. It can illuminate the transition risk scenario exercises and scenario planning on a 10-year time horizon. Dynamic materiality allows companies to keep pace with changing societal expectations, regulatory landscapes, and emerging risks. It can assist businesses in identifying and prioritising issues that may become significant in the future.
By introducing the DMA, the ESRD takes an essential step towards integrating comprehensive impact assessments into corporate strategy, linking it directly to broader sustainability goals. It is a mandatory exercise to shape a sustainable business strategy in conjunction with the incorporation of the TCFD framework based on scenario analysis. In tandem with this, the World Economic Forum recommends integrating the impact value assessment approach into the DMA, relating to impact materiality. It provides insights into the relevance of sustainability in business and helps companies transform towards sustainability. [7]
In closing, double materiality forms the foundation for reporting, and dynamic materiality could help business leaders to better navigate the complexities of aligning Environmental, Social, and Governance (ESG) strategies with shareholder expectations and to balance short-term growth with long-term sustainability goals. In addition, the ESRD ensures a very high degree of interoperability between EU and global standards.
ESG factors are closely interlinked in our increasingly globalised and interconnected world. The ESRD helps investors adopt a more comprehensive approach by standardising data quality and detail, ensuring consistent and comparable sustainability reporting across Europe and beyond. As a result, EFRAG has achieved a high level of interoperability between the ESRD standards and other standards and frameworks, both financial and impact materiality. Interoperability in sustainability reporting prevents the need for double reporting and results in a user-friendly reporting system without undue complexity. It is crucial to streamline reporting processes, reduce burdens on entities, and enhance global comparability.
EFRAG standard-setting bodies aim to deliver transparent and comparable sustainability information by ensuring consistency in the language and approach. Close cooperative partnerships with the ISSB, GRI, TNFD, and UNEP-FI have ensured strong alignment in disclosure requirements, data points, standardised information for stakeholders, and supporting optimal interoperability. Whereas the International Sustainability Standards Board (ISSB) adheres only to financial materiality, the workstream partnership with EFRAG and ISSB, in particular, met the goal of providing high-quality climate-related disclosures on a global scale. It enhanced transparency about climate financial disclosure. Furthermore, guidance and Interoperability Index packages facilitate compliance with the complex developments in sustainability reporting and promote digital reciprocity. Finally, ESRD ensures a very high degree of interoperability between EU and global standards and prevents unnecessary double reporting by companies.
In conclusion, the ESRD marks a significant milestone in strengthening EU businesses for future climate adaptation and resilience. It is a pivotal tool for transforming business models.
It promotes symbiotic financial and impact materiality, thereby increasing corporate accountability within the EU. It fosters a culture of accountability and disclosure. Thus, the new regulation paves the way for companies to weave sustainability into their core business practices and decision-making. The ESRD also enables companies to integrate a dynamic materiality approach, which is critical for businesses to navigate the “tragedy of the horizons” while facing uncertainty and volatility. It illuminates the path towards their long-term viability for a more sustainable economy. Finally, it enables investors to think locally and globally, with high interoperability.
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[1] The complete report is available online at: climate.copernicus.eu/esotc/2023
[2] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32022L2464
[3] EFRAG, Towards Sustainable Businesses: Good Practices in Business Model, Risks and Opportunities Reporting in the EU, October 2021
[6] A 2020 WEF publication made reference to the notion of dynamic materiality. “What is financially immaterial to a company or industry today can become material tomorrow, a process called “dynamic materiality” WEF 2020
[7] https://www.weforum.org/agenda/2024/04/impact-valuation-sustainability/
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