The impact of ESG reporting on manufacturers

The introduction of mandatory ESG (Environmental, Social, and Governance) reporting is set to have significant implications for engineering businesses. Keith Davidson, Environment Partner at law firm Irwin Mitchell discusses how the upcoming ESG developments, starting in 2024, will fundamentally change the business landscape for engineering companies.

Recent and expected ESG developments

Although the term ESG (Environmental, Social and Governance) has been commonly used since 2004, it has not been a priority issue for most SMEs. ESG is used as a measure of socially responsible investing and for the last two decades ESG has primarily concerned international financial market participants such as investment funds, banks, insurers, pension funds and listed companies. 

Significant changes are on the horizon. The business landscape is set to undergo a transformation in the coming years due to three key developments:

• The introduction of the first-ever internationally comparable accounting standards for accounting periods beginning in January 2024, so companies worldwide will be judged according to their ESG performance.

• Mandatory ESG reporting has been introduced for large companies in the EU from 2024, and the rules will gradually extend to non-EU enterprises that do business in the EU.

• Increased legal obligations to manage supply chain ESG performance, specifically addressing Scope 3 greenhouse gas (GHG) emissions from upstream and downstream value chains.

New global standards for sustainability and climate-related disclosures

On 26 June 2023, the  International Sustainability Standards Board (ISSB) launched two international disclosure standards that become effective for accounting periods beginning on or after 1 January 2024: IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2 Climate-related Disclosures. IFRS S2 requires the reporting of Scope 3 GHG emissions.  

It is up to each country to endorse IFRS standards. The UK is currently consulting on the creation of UK Sustainability Disclosure Standards (SDS), which will address this matter. A decision is expected by July 2024. The Department for Energy Security and Net Zero launched a call for evidence in December 2023 to help inform the government’s decision on whether to endorse the ISSB’s standards in the UK.

Increased mandatory ESG reporting 

Since 2015, the Non-Financial Reporting Directive (NFRD) required reporting of certain non-financial and diversity information by very large public-interest entities in the EU with more than 500 employees. 

The CSRD entered into force on 5th of January 2023 and extends mandatory ESG reporting for a much broader group of companies. This includes non-EU companies that do business in the EU. 

The CSRD is being implemented in phases. 

• The first phase started in January 2024 and is applicable to listed companies in the EU with over 500 employees already subject to NFRD, with reports due in 2025. 

• The second phase will start on 1 January 2025 and will be applicable to EU companies with at least two of the three following criteria (a) more than 250 employees, (b) a net turnover of more than 40 million Euros and/or (c) a balance sheet of more than 20 million Euros, with ESG reports due in 2026 on 2025 data. 

• Third country undertakings (including UK companies) with net turnover above 150 million Euros in the EU and who have an office or subsidiary in the EU must report in 2019 based on 2018 ESG data. 

CSRD organisations need to report according to new European Sustainability Reporting Standards (ESRS) which includes Scope 3 value chain emissions.

Corporate Sustainability Directive

On 14th of December 2023, a consensus was reached between the EU Council and Parliament on the Corporate Sustainability Due Diligence Directive (CSDDD), which requires companies to identify and prevent actual and potential adverse human rights and environmental impacts. 

The new due diligence duty extends to large companies’ own operations and their subsidiaries and supply chains. The CSDDD will apply to EU enterprises with over 500 employees and a global annual turnover exceeding 150 million Euros and non-EU enterprises and parent companies with over 150 million Euros generated in the EU. There are lower thresholds (250 employees and 40 million Euros) for ‘high impact sectors’ – textiles, clothing, footwear, food manufacture, agriculture, construction and mineral extraction. 

Failure to prevent or end adverse impacts can result in contractual relationships with suppliers being terminated. National supervisory/regulatory bodies will have the authority to impose penalties on companies not complying with due diligence processes with potential fines up to 5% of the company’s global turnover. There is also the risk of civil liabilities where NGOs and trade unions will have five years to bring a claim. 

Although an agreement of the draft text has been reached, there is not yet an agreed date for the application of CSDDD and the final text could still be changed. It is forecasted that CSDDD will enter into force during 2024 and will start to apply to large companies around 2027.

Requirement for doing business

CSRD requires the management of Scope 3 value chain GHG emissions and CSDDD will introduce a new due diligence duty to minimise adverse environmental and human rights impact throughout a company’s international supply chain. Larger companies subject to ESG and carbon reporting will request evidence of climate action and ESG performance from its  value chain.

Failure to produce ESG policies and strategies could result in SMEs losing key customers and missing out on new business opportunities. It’s no longer a ‘nice to have’, ESG will become a requirement for doing business. 

Access to finance 

ESG performance is expected to have a substantial impact on access to finance in the future. Compliance with ESG standards will increasingly be requested and monitored by lenders, investors, competitors, civil society organisations and employees. 

Management systems

To get prepared for CSRD and CSDDD, companies will need to ensure that there are proper governance procedures and processes in place to measure and manage ESG issues. A management system approach will ensure continual improvement. Engineering companies are well placed for this approach as many have already implemented ISO: 14001 and ISO: 45001.

Due diligence in transactions

There will be increased demand in M&A transactions for ESG desktop searches and audits as part of technical due diligence and the need for ESG and climate clauses in legal documentation.

ESG real estate strategy

A large part of a company’s impact on the environment and the enjoyment of its workforce relates to the quality of its real estate assets. There will be an increased demand for ‘grade A’ accredited space and ‘Net Zero’ buildings and every stage of the property’s lifecycle from design, acquisition, occupation and disposal will need to consider sustainability issues. There will be a greater use of green leases and the focus needs to shift from data sharing to collaboration between landlords and tenants in terms of planning and costing of works.

Companies will be judged on ESG pledges

CSR (Corporate Social Responsibility) policies were often seen as a polish for corporate reputation. Now that ESG metrics and disclosure standard have been agreed in ESRS and IFRS and ESG performance can be compared between companies, ESG reports will be subject to greater scrutiny and ESG commitments must be put into action.