By June 30, 2024, the second PAI statement at the entity level must be published. As you may recall from last year, it takes a lot of time to receive all PAI data on time, so start early!
Fortunately, since last year, a glimmer of hope has appeared: as of January 1, 2024, the Corporate Sustainability Reporting Directive (CSRD) has come into force. The CSRD and its technical implementation, the European Sustainability Reporting Standards (ESRS), are expected to make ESG data much more readily available. But is this really the case? In this article, we investigate whether the CSRD addresses the “PAI data problem.”
Since it’s almost a year ago that you reported on the PAI indicators under the SFDR, let’s briefly explain the obligations again. Financial market participants with fewer than 500 employees and financial advisers have the option to consider the principal adverse impacts (“PAIs“) on sustainability factors at the entity level in their investment decisions. Financial market participants with more than 500 employees do not have this choice and must consider PAIs at the entity level. A PAI occurs when the investment results in ESG harm.
If PAIs are considered at the entity level, this means that the company must report with quantitative data on various mandatory and voluntary ‘indicators of adverse effects on sustainability’ (“PAI indicators“). PAI indicators provide structured, quantitative insights into the principal negative effects of investments on sustainability factors. To report on PAI indicators, you need data. You can read more about the various PAI indicators in this article. Here, we already mentioned that it would be difficult to obtain all the data, but this is what the ESAs expect. In practice, we have also seen a significant lack of data. Is this problem addressed by the CSRD? We have investigated this for you.
The CSRD obliges certain companies to report on (i) the impact that the company has on ESG issues and (ii) the financial risks and opportunities faced by a company as a result of exposure to sustainability risks.
The list of sustainability issues that companies must report on closely aligns with the definition of ‘sustainability factors‘ set out in the SFDR. This is intended to prevent a discrepancy between the information users need and the information reported by companies. At least, these are the words of the European Commission in the explanatory notes on the CSRD.
Unfortunately, this is not the case in practice. Several problems arise causing many financial institutions to still struggle with a data gap:
Limited scope of CSRD
The CSRD applies only to listed companies and large companies from the EU. This means that small or medium-sized EU companies do not have to report under the CSRD. The same applies to companies outside the EU unless they have a listed subsidiary in the EU. So if you mainly invest outside the EU or in SMEs, you will still need to search for data yourself.
Not all data points are mandatory
In the ESRS, further details are provided on the topics that a company must report on. For instance, where possible, the PAI indicators from the SFDR are directly incorporated into the ESRS. This should ensure that you can relatively easily extract the data you need under the SFDR from the company’s sustainability report. Unfortunately, this is not entirely the case. This is due to the ‘double materiality test’ on the one hand and the gradual implementation of certain disclosure requirements of the ESRS on the other hand.
Double materiality test
The double materiality test is the starting point for identifying significant sustainability issues that the company must report data on. Double materiality has two dimensions: impact materiality (how the company influences climate and society) and financial materiality (how climate and society influence the company).
Only if a subject from the ESRS is of material importance, does the company need to report on that subject. This makes double materiality the criterion for determining whether information should be included in the sustainability report. An interesting fact is that in the draft ESRS, the data points required to prepare the PAI statement under the SFDR were considered mandatory material. However, the European Commission deviated from this in the final version. They chose to make the SFDR data points dependent on the dual materiality assessment as well. It also determines the number of data points and performance indicators that must be reported. In practice, this means that a company may publish a sustainability report based on the CSRD in which not all PAI indicators are included because the reporting company does not consider them material.
Phased implementation
The reporting obligations are implemented in phases. For example, companies with fewer than 750 employees in the first and second years (depending on the sustainability theme) they are required to report may omit certain data points. Additionally, for all companies, in the first reporting year, data on scope 3 greenhouse gas emissions may be omitted. For the first two years, ESRS E4 (biodiversity), S2 (employees in the value chain), S3 (affected communities), and S4 (consumers and end-users) may also be omitted. This means that the data for the PAI indicators included in these deferred ESRSs will only become available later.
Has the European Commission completely disregarded the SFDR obligations then? Fortunately not. For data points derived from the SFDR, the company must explicitly declare why the relevant data point is not material. Additionally, companies must prepare a table listing all SFDR data points, indicating where they can be found in the sustainability report or stating that they are ‘not material.’
In the overview below, you can see where the PAIs from the SFDR reappear in the (thematic) ESRS. Please note that the data points may not always match exactly but align with the sustainability topic. Furthermore, this problem of non-matching metrics is addressed in the revised SFDR RTS.
As you have read, despite the CSRD, a data gap still exists. However, this does not mean that information will not become more findable and available due to the CSRD. Especially after this information is required to be published in the European Single Access Point (‘ESAP’). The ESAP is a central database that will include, among other things, sustainability information. Additionally, there are two SFDR consultations ongoing. The first assesses the existing SFDR framework, with the consultation text mentioning many new mandatory PAI indicators. The second consultation evaluates whether the entire SFDR framework should be revised; from a transparency framework to a labeling system. The workability and effectiveness of the SFDR are thus critically examined, and hopefully, this will lead to better alignment between the SFDR and CSRD.
The idea behind the CSRD and ESRS, namely that they would serve as the final piece of the transparency framework and provide missing data for financial market participants, proves to be more complex in practice. This is because not all companies need to report under the CSRD, data points are subject to the principle of double materiality, and the CSRD is phased in. Although an important step has been taken towards providing ESG data, larger steps still need to be taken to ensure proper alignment of the transparency framework.
We closely monitor developments and keep our clients informed through our monthly newsletter. Do you need advice? Or assistance in drafting a PAI statement? Feel free to contact us without obligation!
