What a stock picker should understand about the new mandatory corporate sustainability (CSRD) reports, part 1.

CSRD reports, or sustainability reports, will be part of mandatory annual reporting in the future. The reporting as a whole is very complex, and the aim of this new series of articles is to explain the key aspects of CSRD reporting for stock pickers.

What is a sustainability statement

The first mandatory sustainability statements will be introduced in the 2024 financial statements in Finland and a year later in Sweden (if there are no significant changes to legislation). These reports, prepared by companies and based on reporting standards, will be published as part of the management reports. In Finland, for the year 2024, the reports will be published mainly by large main list companies, and then gradually also by other companies. The reports should outline the risks, opportunities and impacts related to sustainable development that are relevant to the reporting company. Within the relevant sustainability issues, the company should report on, among other things, its strategy, policies, actions, targets and metrics.

Although the range of sustainability matters evaluated is broad, only material matters should be reported

Only sustainability matters that are material to the company should be reported. Materiality is determined by the company's management, subject to certain conditions. We will discuss mapping materiality in a separate article later. Examples of issues to be reported include:

• Major risks and opportunities related to environmental aspects and, on the other hand, environmental impacts. The aspects will vary widely depending on the company's operating model. For example, there may be an overview of the estimated risks associated with climate change and their economic impact. Similarly, the report should include information on the environmental impacts of the business and their extent.
• Human rights risks in the supply chain and measures to manage them.
• Employee well-being, safety and engagement, as well as human resources practices.
• Corruption risks, bribery risks and the ethical business process. What risks are assessed to exist in the company's operating sectors and countries, and how these risks are managed.

Reports are subject to limited verification

In theory, sustainability statements are thought to serve the capital markets and provide investors with better quality and more relevant sustainability information. Auditing is seen as improving the quality of information. In practice, an audit can improve the quality of some of the data to be measured (numerical KPIs and process description). However, we see threats to the selection of material information when traditional audit firms assess companies' processes in relation to environmental issues, human rights risks or, for example, risks of soil contamination and concentrations.  These topics, like many others, are very specific and often require a separate long period of specialized training and practical application experience. Inexperience and lack of procedures can bring irrelevant issues to the forefront, or vice versa, which can confuse the whole picture.

Material economic impacts should also be reflected outside the sustainability analysis

The sustainability statement is part of investor communication and should include the most relevant sustainability issues. It must therefore be consistent with other investor communications. In practice, an investor should review the materiality analysis section of the sustainability statement and the risks, opportunities and impacts listed there. Potential risks that might emerge include e.g., risks to security of supply related to climate change or risks from new legislative initiatives. On the other hand, this section can provide some perspective on the impact of the business opportunities presented related to the green transition.

However, if the issues raised are not highlighted in other investor communications, we can presume that the magnitude of the actual economic impact is relatively small.

Information on estimated environmental or social impacts is subjective and needs to be examined critically

In the case of environmental or social impacts presented by a company, it is important to consider how the impact assessment has been carried out: science and its measurement methods are evolving, and the results of environmental impact assessments vary significantly depending on the methodology. Impacts are therefore always subjective, relative and, in many cases, subject to methodological changes. Science is not a sufficient justification if it is not applied in the right way and in the right context.

Debates about the carbon sink of forests or the sustainability of electric cars are prime examples of this. When interpreting impacts, the reader has to do a lot of background research to understand the rationale behind the impact and whether the rationale is sound. A separate article on the complexity of impact assessment will also be published later.

We expect reporting to evolve in the future

All in all, a stock picker should be prepared for the fact that at this stage, the new sustainability statement does not yet provide significant additional information on the overall responsibility of the company. Financially material issues have already previously had to be reported as part of investor communications. Sustainability is value-based, so the scale of impacts and what is material in terms of impacts remain for the investor to assess. For some, sustainability means using green energy; for others, it means not having a supply chain in dictatorship countries.

What will be of interest to companies' income statements, and by extension the economy as a whole, after the turbulent year 2024 is the increase in reporting costs, which is likely to be relatively significant, both in terms of administrative costs and auditing.