Legal briefing | 20 Sep 2024 |

Travers Smith's Sustainability Insights: The impact of the Draghi report on ESG regulation

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A regular briefing for the alternative asset management industry.

Last week, the European Commission published a report on the future of European competitiveness, prepared by Mario Draghi, a former president of the European Central Bank. The wide-ranging report is critical of EU policymaking in several areas, while urging more ambition in others. It includes detailed – and, in some cases, radical – recommendations focused on three key themes: the need to encourage innovation, especially in advanced technologies; the opportunities created by the imperative to decarbonise; and a need to increase European security, including by reducing supply chain dependencies.

The regulatory burden faced by EU companies, especially SMEs, is spotlighted in the report's Foreword, and sustainability regulation is discussed in Part B's detailed recommendations. The report asserts that "the EU’s sustainability reporting and due diligence framework is a major source of regulatory burden, magnified by a lack of guidance to facilitate the application of complex rules and to clarify the interaction between various pieces of legislation."

Although various regulations are discussed, the Corporate Sustainability Reporting Directive (CSRD) is identified as a particular culprit. Draghi cites various estimates of the significant costs for all companies in scope, but highlights the impact on unlisted mid-caps. The report also points out that there are costs for the below-threshold businesses that are not covered by the CSRD, because of the need for in-scope companies to report on their supply chains.

This is not a backlash: it would be wrong to assume that Draghi's criticisms endorse a significant roll back of the European sustainability reporting and due diligence framework – and the European Commission is unlikely to read it as such. In fact, Draghi is most concerned by the impact on small and medium-sized companies.

The EU's approach to environmental regulation almost inevitably involves some overreach because the European Commission applies the "precautionary principle". Simply put, that principle means that, where there is an identified risk of harm, the legislators will err on the side of caution – even if that means imposing costs on businesses and individuals that may turn out to be more than necessary.

The Draghi report acknowledges that approach, but argues that the principle of precaution should be balanced against a "principle of innovation". In the area of sustainability regulation, Draghi argues that the Commission should re-focus on mitigation measures for SMEs, but also extend them to "small mid-caps". These "hidden champions" are a driver of innovation and employment, but are often forgotten in EU lawmaking. (While the definition of "small mid-caps" might be a matter for debate, it is noteworthy that the UK has decided to apply its enhanced climate disclosure rules to private companies with over £500 million in turnover and 500 or more employees, significantly higher than the EU's CSRD thresholds.)

The report certainly bolsters the case for the Commission's existing commitment, part of its long-term competitiveness plan, to reduce the burden of reporting requirements for companies by 25%. Indeed, Draghi argues that the plan should go further for SMEs, suggesting that policymakers target a 50% reduction.

In fact, the Commission argues that it has already significantly reduced burdens: it points to a delay to sector specific standards under the CSRD; an increase in the thresholds for SMEs, scoping many out; and the application of a materiality qualifier for most CSRD data points.

But piling on burdens and then mitigating them hardly seems like a recipe for future competitiveness. The issue is more fundamental: the European Commission has not presented good evidence that the scope of its interventions – which go significantly beyond those elsewhere in the world – will deliver substantial real-world benefits. There is a clear risk of "policy-washing" if the EU claims more impact from its policies than it can deliver.

        
    
"… piling on burdens and then mitigating them hardly seems like a recipe for future competitiveness."

The case for standardised non-financial reporting by companies is clear, of course. There are identified market failures that would inhibit comparable, high-quality data being made available to stakeholders, and academics agree that mandatory reporting can support the green transition. However, as one academic study put it: "the potential for unintended consequences from a [sustainability] reporting mandate is large, especially if the mandate’s scope is broad (dual materiality). We need more research to better understand these trade-offs as well as how and why firms respond to specific reporting requirements."

The precautionary principle is not a blank cheque, and the extension of comprehensive and highly prescriptive mandatory sustainability reporting to private companies – whose investors do not need the same level of granularity – requires a leap of faith that companies and their stakeholders will respond in a way that furthers EU policy goals, especially as regards issues other than climate. It is true that many alternative asset managers need the data points to comply with their own reporting requirements, most notably under the Sustainable Finance Disclosure Regulation (SFDR) – but that only begs the question of whether that reporting framework is itself decision-useful for the investors in a private fund.

International Sustainability Standards, developed by the ISSB and in the course of adoption in a large number of countries, adopt a more cautious approach than the CSRD. But even there, in its response to the UK's call for evidence on ISSB adoption, the BVCA has emphasised the need to think carefully about the impact on unlisted companies, suggesting a phased, "climate first" approach.

It is perhaps more likely that due diligence requirements – which require action to mitigate harms and not just disclosure – will lead to behavioural change, and the EU has been working hard on such a regime. At least initially, the EU's Corporate Sustainability Due Diligence Directive (CS3D) will only apply to the largest 5,000 or so EU companies, but will affect many more indirectly. Unfortunately, the lack of clarity and the complexity of the provisions is also likely to impose more cost than necessary to achieve the policy goal.

Most importantly of all, and as clearly described in the Draghi report, it is unrealistic to expect the private sector to change behaviour in a way that will materially move the needle on sustainability goals, most notably decarbonisation, unless public policy leads the way. In that regard, the new European Commission's continued focus on decarbonisation has been endorsed by Draghi, and many of the specific recommendations in that section of the report – including an Energy Union and a new Industrial Strategy – are likely to resonate with the Commission President, Ursula von der Leyen.