Companies face immense challenges when it comes to environmental, social, and governance (ESG) issues—including emerging regulations and guideposts worldwide—sparking the need to improve ESG reporting practices. The underlying goal is a shift to more rigorous reporting to drive corporate behavioral change. This nudges companies toward more sustainable business models, accelerating the transition to a more sustainable future. While such ESG obligations affect all facets and participants, they present a particular challenge for boardrooms.
Regulators and other institutions continue to develop standards to quantify impact and how to best communicate efforts to improve ESG actions. As a result, ESG has become part of the business core. Managing ESG is no longer just the domain of sustainability departments, but also an essential responsibility for boardrooms. Board directors are responsible for ensuring ESG becomes an integrated part of doing business. And that requires strategic thinking, risk management, policy, governance, and reporting—all of it ultimately aimed at ensuring long-term, sustainable value creation for an organization. A company board can shape ESG policy that incorporates a long-term vision into business decisions beyond shareholder maximization, considering all stakeholders, the big-picture viability, and the resilience of the company.
Upcoming European Union (EU) ESG regulations will greatly impact companies and boards worldwide. So let’s explore the corporate governance implications of two important EU initiatives, the Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CSDDD).
| In continental Europe, it’s common to approach a company’s business as a community of interests where labor and capital work as harmoniously as possible. This is also known as the “stakeholders model,” which focuses on how the interests of stakeholders involved are affected and the long-term vision of the company. It’s important to realize stakeholders in terms of the CSRD is very broadly defined. They are both users of sustainability statements and the individuals or groups affected by the companies’ activities and its direct and indirect business relationships across its value chain. The defined stakeholder concept is so wide that even nature is considered a silent stakeholder, adding to the complexity of keeping all stakeholders in mind during decision making (ESRS 1: General requirements).
Conversely, there’s a “shareholders model,” where by definition the interest of the company coincides with that of the shareholders, causing them to be seen as owners of the company. This model focuses mainly on value maximization for the shareholders. |
CSRD Compliance on the Horizon
The CSRD has far-reaching implications for corporate sustainability reporting, both within Europe as well as for companies globally. On January 5, 2023, the CSRD came into force in Europe, and it will be phased in for most EU companies and some non-EU companies. Part of the new standards requires large public interest entities to publish a management report containing sustainability information for the first time in 2025 (over fiscal year 2024). Gradually other large organizations will also need to comply with CSRD (see Table 1).
Working on behalf of the European Commission, the European Financial Reporting Advisory Group (EFRAG) has drafted standards based on the CSRD. These European Sustainability Reporting Standards (ESRS) outline 12 CSRD reporting standards. Of these 12, the first two are “cross-cutting,” providing interpretation for application of the “topical” reporting requirements in the remaining 10 standards. The topical standards include five environmental standards, four social standards, and one governance standard (see Table 2).
The scope of the sustainability information to be shared under the CSRD and ESRS is rather broad. In addition to information on ESG factors, the management report should also explain how the information was obtained and the extent to which the organization’s strategy and business model considers potential risks posed by sustainability issues. Thus, the CSRD has implications well beyond disclosure. The CSRD also imposes specific requirements on corporate governance. Article 19a-2b requires the company to report its time-bound sustainability targets, including a description of the progress the company has made to achieve them. The company also must include a statement of whether its environmental targets are based on conclusive scientific evidence. Furthermore, article 19a-2c requires a description of the role administrative, management, and supervisory bodies play regarding sustainability matters. It also requires disclosing the expertise and skills they have or the access to such expertise and skills.
The CSRD also introduces a general EU-wide audit (limited assurance) requirement for reported sustainability information.
Even companies outside the scope of the CSRD, such as those a part of the value chain of a business that’s subject to reporting under the CSRD, might experience its effects. For example, a company within a company’s supply chain might be asked to share information that the reporting company is required to disclose. This creates a need for ESG policies for companies not directly under the scope of the CSRD.
CSDDD Is Designed to Change ESG Behaviors
In addition to the CSRD, the European Council and the European Parliament reached a preliminary agreement in late 2023 on the CSDDD, and modifications from European legislators followed. We will discuss the draft dated March 13, 2024, of the Council of the European Union. On April, 24, 2024, this draft of the CSDDD was approved in the European Parliament.
The purpose of the CSDDD is to promote sustainable and responsible behavior by large companies with operations in the EU. But it also concerns the impact of the company along the entire chain of activities (mainly upstream business partners and possibly downstream activities) that relate to the environment and human rights. The CSDDD can apply to both EU and non-EU companies, depending on the number of employees and turnover threshold (applicable to companies with 1,000 employees and a turnover exceeding €450 million per year). The financial sector is temporarily excluded from its scope. Although the direct scope of the CSDDD is relatively limited, it indirectly affects many more companies by looking at the entire value chain of organizations.
To comply with the CSDDD, companies must exercise appropriate risk-based due diligence on the environment and human rights. Thus, companies should formulate due diligence policies on these topics. For instance, they can adopt and implement a transition plan for climate change mitigation to ensure a company’s business model and strategy are compatible with the transition to a sustainable economy. And companies must update said transition plan every 12 months.
The board must also report on due diligence policies. In addition, the CSDDD requires organizations to identify and assess actual and potential adverse impacts of their activities on the environment and human rights. This requirement applies to companies and the activities of their subsidiaries or established business partners if related to their chain of activities. Companies are also expected to prevent or mitigate potential adverse impacts while eliminating actual adverse impacts.
ESG, Governance, and Directors’ Duties and Liabilities
Compliance with ESG regulations is a business imperative. In Europe, directors are increasingly being held accountable for their ESG actions and decisions—either in court or public debate. So, management must include ESG governance and compliance leaders. The CSRD doesn’t formally impose requirements for companies to implement ESG policies. But the sustainability disclosure requirements make ESG policies necessary while increasing the demand for competent management to implement them.
Even though the CSRD formally imposes only reporting obligations on the company, noncompliance with these obligations can impact directors’ duties and liabilities. After all, disclosing more sustainability information might, in the broadest sense, expose poor ESG decision making of companies and their directors. Greater ESG transparency might lead nongovernmental organizations, journalists, and activists to scrutinize company activities, holding them more accountable for their insufficient ESG initiatives. So, while companies continue taking steps to become more sustainable, they can’t overstate their impact because ESG reporting, much like financial reporting, requires companies to follow the rules—or suffer risks.
On the other hand, the CSDDD explicitly creates a path for legal accountability. A company can be held liable for damage caused to a natural or legal person, provided that the company intentionally or negligently failed to comply with CSDDD obligations, ultimately causing damage. However, a company can’t be held liable if the damage was caused only by partners in the business activity chain.
Finally, directors in many European countries face the risk of liability for noncompliance with ESG regulations in accordance with national laws on directors’ liability.
How to Deal with ESG Governance
ESG is becoming a mandatory exercise for directors. It needs to be incorporated into decision making, strategic thinking, and performance management for a company to remain relevant and resilient. As such, ESG management and governance need to be prioritized in boardroom discussions, whether directors like it or not.
ESG factors are part of doing business. Organizations need to weave ESG into their strategies, risk management, decision making, and performance management to maintain their value-creation capabilities. The CSRD regulation, and the underlying ESRS, provide guidance for what topics companies must cover and how to approach them for reporting and control. The CSRD and CSDDD help level the playing field, supporting companies that are ahead in furthering their ESG efforts.
ESG policies must be worked into the fibers of each organization to help drive day-to-day business operations and decision making. To ensure directors are following their ESG responsibility, they need to be up to date on the latest ESG regulations and other ESG-related or sector-specific laws. Companies must ensure ESG information is robust and trustworthy, and disclosed with care. IMA’s Statement of Position on Sustainable Business Management provides nine principles that identify how companies should deal with sustainable business information.
Although the impact of ESG regulation might seem daunting, ESG is not a burden. It provides the opportunity for organizations to transition toward a sustainable, future-proof business model that meets the expectations and needs of a variety of stakeholders. In the long run, this will support a company’s value-creating capabilities. ESG can generate profit, lead to sustainable growth, and secure long-term prosperity for people and companies.
