The Initiative aims to grant investors, consumers, and other stakeholders a clearer picture of companies’ non-financial performance.

By Paul A. Davies and Michael D. Green

On 30 January 2019, the European Commission began a consultation process on a potential initiative to revise and improve the Non-Financial Reporting Directive (NFRD) (the Initiative). The Commission has not yet decided the form that the Initiative will take, but it aims to improve the NFRD’s ability to give investors access to non-financial information (including on environmental, social, and governance (ESG) factors and sustainability) about companies.

What Is the NFRD?

Since 2018, the NFRD has required certain large listed companies, banks, and insurers to publicly report information on a broad range of ESG matters on an annual basis. The Commission supplemented these reporting obligations with two sets of non-binding guidelines: one in 2017, aimed at helping companies report relevant, useful, and comparable information, and one in 2019, aimed at helping companies report climate-related information and integrating the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

Why Does the Commission Feel the Need to Change?

The principal aim of the NFRD is to enable the investment community, consumers, and other stakeholders to evaluate the non-financial performance of large companies, and to encourage those companies to develop a more responsible approach to business.

However, the non-financial information needs of the recipients (particularly investors) are increasing significantly and quickly. This increase has been driven in part by the acknowledgment of the importance of ESG factors (such as resilience to climate change) in the long-term performance of assets, but also by the ever-increasing amount of ESG-related financial products available on the market (e.g., green and social bonds) and the growth in ESG-related regulations. This increased demand for high-quality ESG disclosure from companies has led to greater scrutiny of the NFRD’s effectiveness and an assessment of whether the NFRD is meeting its objectives.

The Commission appears to believe that the NFRD has not been as effective as hoped, and therefore has launched this consultation process on the Initiative. In particular, the Commission has identified a number of issues with the NFRD, that it believes the Initiative will resolve:

(a) The inadequate availability of public information as to how non-financial and sustainability issues impact companies, in particular that: (i) currently reported non-financial information is not acceptably reliable or comparable; (ii) companies fail to report relevant non-financial information, and instead often report irrelevant metrics; (iii) some companies that stakeholders would like to see report non-financial information are failing to do so; and (iv) non-financial information that is reported is often hard to find

(b) Companies are incurring unnecessary costs in deciding which information to report and monitor, partly due to the vast number of conflicting disclosure requirements and standards that currently exist.

These issues have led to a situation that the Commission deems unacceptable. The Commission is of the view that investors’ inability to take sufficient account of ESG-related risks, and therefore an inability to price these risks into assets, has led to a systemic economic threat. In addition, companies cannot be held to account on their impact on society and the environment, particularly (but not exclusively) on climate change.

The Aims of the Initiative

Given the issues identified above, the purpose of the Initiative is to rectify the problems that, in the Commission’s view, market forces have not been successful in solving. The market is currently characterised by a number of voluntary standards, which are often overlapping and inconsistent, and have not proved capable of complementing the NFRD in a manner that the Commission deems satisfactory.

Whilst the form the Initiative will take has not been decided, the Commission has identified three possible options that will be analysed for feasibility:

(a) Continuing the current approach of issuing non-binding guidelines to supplement the NFRD, similar to those issued in 2017 and 2019. This could entail revising the existing guidelines, or publishing new ones.
(b) Exploring the use of standards, including endorsing an existing set of standards (similar to the approach taken in the 2019 guidelines, which incorporated the TCFD recommendations).
(c) Revising and strengthening the NFRD through several possible means, including specifying in more detail the information companies are required to disclose, or strengthening the enforcement regime and promoting greater supervisory convergence.

Looking Ahead

The Initiative marks the review of the NFRD that was promised for 2020 under the EU Green Deal, as part of a strategy to strengthen the foundations for sustainable investment. Responses to the consultation on the Initiative must be received by 27 February, and the feedback will be summarised and published alongside the Commission’s response later in the year. The Commission has also pledged to organise a further open online public consultation, specifically on the possible revision of the NFRD, in the first quarter of 2020.

Alongside the public consultations, an impact assessment is being prepared to support the development of the Initiative and help inform the Commission’s decision. The impact assessment will incorporate two studies on the current impacts of the NFRD and current market practices, with regard to sustainability ratings providers.

Latham & Watkins will continue to monitor developments in this area.

This blog post was prepared with the assistance of James Bee in the London office of Latham & Watkins.