The European Union’s Corporate Sustainability Reporting Directive (CSRD), which entered into force in January 2023, marks a new era for ESG reporting across Europe (and globally). CSRD is the latest in a wave of new rules being contemplated and enacted as regulators across jurisdictions look at ESG issues and seek to hold companies (including PE sponsors) to account.

As the CSRD regime is phased in across the EU over the coming years, detailed sustainability reporting will become a key part of portfolio company reporting and will present opportunities for sponsors. However, concerns of exaggerated or misleading sustainability claims remain (see PE on Red Alert for Greenwashing in Light of UK Developments), and the requirement to publish more ESG-related content further increases the risk of adverse greenwashing findings. PE firms should prepare now for the major changes ahead, and for additional demands on portfolio companies.

State of play

As part of the European Green Deal, the CSRD reporting system aims to increase corporate transparency and channel investment towards companies that undertake “sustainable” activities. The CSRD is ambitious and materially enhances ESG reporting requirements, with potential for gold-plating and extension by individual EU Member States. Specific reporting requirements will be set out in forthcoming European Sustainability Reporting Standards.

Application to PE

Many sponsor-owned companies will fall under the new reporting system, which applies to all “large” EU companies that meet two of the following three criteria:

• having 250 or more employees;
• generating a turnover of at least €40 million; or
• recording a balance sheet total of at least €20 million.

The CSRD also captures most companies listed on EU-regulated markets, in addition to groups that generate at least €150 million in the EU, and which have at least one “large” subsidiary or a branch of certain size in an EU country. Even if companies do not meet the criteria, businesses of all sizes are expected to face increased ESG reporting requirements, and should anticipate increased data requests from customers and value chain partners that fall within the scope of the new regime.

Considerations for PE

Establishing which portfolio companies are within the scope of the CSRD, and from when, is key. CSRD imposes requirements to undertake assessments and gather and report on significant volumes of ESG data.

In-scope companies will likely need to engage with advisers to assist with limited assurance obligations. Over time, these limited assurance requirements may be elevated to reasonable assurance obligations, but even the limited assurance requirements could materially increase requirements for in-scope companies to establish internal controls for ESG data. Challenges associated with obtaining such assurance may delay the publication of final accounts and management reports. Examination of ESG data and CSRD exposure should form part of due diligence — remedial work to bring a company up to speed will likely be time-consuming and expensive, while a strong ESG profile could also drive value.

Opportunities

A wealth of technology tools are emerging to help companies (including PE portfolio companies) with their reporting requirements and data management — a development that may also provide investment opportunities for sponsors as the regime progresses. The CSRD is likely to materially evolve the ESG ecosystem, as ESG datapoints will become an imbedded part of due diligence, the monitoring of portfolio company performance (e.g., through the EU Taxonomy Regulation), and PE firms’ own ESG reporting obligations (such as under the EU’s Sustainable Finance Disclosure Regulation (SFDR)).

Interaction with other regulations

PE firms should also consider the EU’s Taxonomy Regulation, under which companies are expected (through CSRD) to determine the percentage of their revenues, capital expenditure, and operating expenditure that aligns with activities that the EU defines as being sustainable. For PE firms that seek to market their ESG credentials (including through SFDR), the performance of their portfolio companies under the EU Taxonomy will be of significant interest to LPs and potential investors. The data from CSRD may also support PE firms in meeting their SFDR disclosure obligations and dealing with LP requests under SFDR.