The EU and the Future of Non-Financial Reporting

In a historic vote on April 15, the European Parliament adopted the most significant corporate social responsibility measure, anywhere, to date.  Once passed at the European Council and country level, the directive will require certain large "public-interest" organizations operating in the EU to report on the environmental, social (including human rights) and governance (together, ESG) impacts of their work.  What exactly affected companies' non-financial reporting will look like in practice has yet to be determined, as the directive does not mandate the inclusion of specific language or information; however, the potential impact of the law is clear.

As The Chicago Tribune put it in its coverage of the EU law:  “Investors looking for companies with good environmental, social and governance track records will [now] find the job easier....”  In other words, capital is at stake and, among other things, non-financial reporting requirements will make it more difficult for investors to plead ignorance--and, therefore, avoid questions of potential divestment--when it comes to the social responsibility (or not) of the investments in their portfolios.  Divestment is a powerful tool, and large funds have made clear that they are increasingly willing to put their money where their mouths are when it comes to certain ESG issues.  For instance, in early May, in the face of mounting pressure from the student body, Stanford University’s Board of Trustees announced that it would divest from all holdings in the coal industry.  Norway’s Sovereign Wealth Fund is another well documented socially-responsible investor that, from time to time, will divest from holdings in particularly problematic industries, such as cluster munitions, nuclear arms and tobacco.  (The Business & Human Rights Resource Center has, unsurprisingly, put together a helpful compilation of other ESG-related divestments.)

Yet, the long road to the EU law resulted in a broad compromise and, as such, the directive has certain shortcomings.  For starters, the law utilizes the so-called “comply or explain” standard common to certain European compliance regimes, which holds that companies need not comply with the law’s requirements if they can sufficiently explain why they didn’t.  There is also no single standard against which behavior is measured (and no specific reference, for instance, to the U.N. Guiding Principles on Business & Human Rights).  Rather, companies may use international, European or national guidelines as they themselves deem appropriate.  Likewise, the law applies only to large “public-interest” entities with more than 500 employees, and will impact roughly 6,000 companies operating in the EU, as opposed to the 17,000 as initially proposed.  (According to the European Coalition for Corporate Justice, just one in seven large companies in the region will be required to report.)  Finally, as Caroline Rees of Shift points out:

[A]bsent clear and thoughtful supporting guidance, it is quite possible that the human rights reporting of many companies will continue to reflect what is easiest, rather than most meaningful, to report.... Each company could interpret the law in a manner that most closely fits its current practices, rather than adapting its practices to meet the underlying expectations of the legislation.

By far the most sweeping, the EU law is not the first non-financial reporting requirement on the books.  Denmark has an ESG reporting law, as does the U.K.  In the U.S. there are the Burma reporting requirements and the conflict mineral reporting requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (more commonly known as Dodd-Frank).  For their part, the Dodd-Frank conflict mineral rules, which require all SEC issuers to report on whether their products contain “conflict minerals” used to finance atrocities in the Democratic Republic of Congo, have recently been scaled-back in the courts, prompting the SEC to issue a partial stay of the portion of the law requiring companies to certify their products as “conflict free” (or not).

The SEC left in place other reporting requirements (as did the D.C. Circuit in its April decision), but the first company reports have been strongly criticized for their weakness.  According to watchdog group Global Witness, most of the initial conflict mineral reports lack sufficient detail to ensure that adequate diligence has been performed on the companies’ supply chains.  In other words, the reports cannot be trusted.  This outcome has the potential to be more damaging than having no reporting requirements at all.  A report that erroneously certifies a company’s products as “conflict free” gives the company and potential investors ostensible cover, even if contradictory evidence is uncovered by watchdog groups.

So what are we to make of the EU’s non-financial reporting requirements?  Sure, they could be stronger, clearer and broader in scope, and if the Dodd-Frank requirements are any indication, there is always the chance that the rules will be walked-back over time.  However, it certainly appears that the broader trend is toward integrated reporting, as investors become savvier and companies -- like Ikea and Unilever, which came out in favor of the EU directive--more openly concerned with ESG issues.  Moreover, the business case for corporate social responsibility is widely accepted.  In a recent study by PwC, 74 percent of surveyed CEOs agree that “measuring and reporting non-financial impacts contributes to their business’ long-term success.”

In other words, the EU law is an important step forward.  Social change is incremental, and a sweeping law is more likely to suffer a premature death than a less ambitious compromise.  The European Parliament should therefore be applauded for its efforts and other countries ought to look to the EU as an example for the future.

Image credit: Flickr/itzafineday

Michael Kourabas is a lawyer and business development professional currently working for an international law firm in New York. His experience includes international human rights, CSR, and educational policy work in both the private and public sectors.