The European Union recently adopted the Sustainable Financial Disclosure Regulation (SFDR) following the entry into force of the Non-Financial Reporting Directive (NFRD), two pieces of legislation that mandate rigorous environmental, social, and governance (ESG) disclosures for the benefit of investors. The Securities and Exchange Commission (SEC) under Chairman Gensler also appears poised to extend mandatory company reporting into the realm of ESG, touching on issues such as greenhouse gas emissions and human capital management. However, systemic differences will remain between EU ESG disclosure requirements and their American counterparts, and it is important for executives to understand these differences in order to avoid both compliance issues in the different jurisdictions as well as reputational damage and potential challenges from investors.
ESG Reporting in Europe
The European Union has made ESG issues cornerstones of its regulatory regime in recent years. The EU’s Sustainable Financial Disclosure Regulation (SFDR) was passed earlier this year, which followed the Non-Financial Reporting Directive (NFRD). NFRD came into effect in all EU member states in 2018, and spells out how firms must report non-financial information to investors.
These two pieces of legislation are the current centerpieces of the EU’s ESG disclosure obligations. The NFRD requires publicly held firms to report non-financial ESG performance criteria, as well as to issue principle adverse impacts (PAIs). The SFDR lays down sustainability disclosure obligations regarding investments for end-investors in financial markets. The EU appears poised to double down on this strategy of mandated corporate sustainability reporting with the Corporate Sustainability Reporting Directive (CSRD), which extends both the scope and rigor of the NFRD, and could be adopted by the end of 2022.
The EU has carved out a role as the standard-setter for ESG disclosure rules. A downside of this strategy has been a large mass of complexity and regulations that European firms themselves struggle to understand. For firms that operate in both the American and European markets, consulting experts in this field will be vital to ensure successful compliance and reputational protection.
ESG Reporting in America
The American government has taken a heightened interest in ESG disclosure recently, with SEC Chairman Gary Gensler stating that both investors and company executives are demanding consistent and decision-useful disclosure regulations regarding climate risk, human capital, and corporate governance. The Financial Accounting Standards Board (FASB), which the SEC authorizes to set accounting standards for American businesses, plans to release its own sustainability disclosure requirements in early 2022. Future SEC disclosure changes are likely mirror those outlined by FASB, as former acting SEC Chair Lee stated “…future SEC rules governing ESG reporting would likely resemble those that FASB lands on,” likely bringing about significant modifications to America’s existing disclosure regulations.
Chairman Gensler has also expressed respect for the TCFD’s (Task Force on Climate-related Financial Disclosures) recommendations, which have been endorsed by the EU’s financial regulators as the Task Force consists of members across the G20. If Chairman Gensler does move American ESG disclosure regulations towards the TCFD’s recommendations, this would represent a significant step towards alignment of the ESG disclosure regimes between the two economies.
The Two Markets, Compared
Despite the actions that may be taken by the SEC, significant differences will continue to exist between the U.S. and the EU on ESG disclosure regulations. Normatively, the EU’s disclosure regime is highly systematic, centralized, and mandatory. Comparatively, American ESG standards are less stringent, more “laissez-faire,” and more “bottom-up”. While it appears there will be a minimum level of mandatory disclosure instituted in both economies that will likely be significantly aligned, the EU’s guidance will likely be more rigorous and expansive than its American counterpart. This is evidenced, for example, by the NFRD’s “double materiality” clause, which requires European firms not only to disclose how climate change impacts a company, but also how that company impacts climate change to investors. Whereas the SEC only requires companies to disclose how climate change may impact them, and not vice versa. Obtaining expert guidance to correctly navigate these different regimes will be crucial for multinational firms’ future success.