ESG Legislation And The Impact On SMEs And Supply Chains
Environmental, social, and governance (ESG) frameworks show stakeholders how well a business manages its ESG risks and opportunities relative to specific ESG criteria. The ESG concept extends beyond environmental issues, encouraging businesses to play an active role in the wider community. The importance of corporate ESG activity has grown such that it now features in European Union (EU) legislation; this article will consider how this affects SMEs and their supply chains.
Legislation – the journey
While legislation dealing with specific environmental issues has existed for decades, it took until 2014 to bring in targeted ESG legislation when the EU introduced the Non-Financial Reporting Directive (NFRD). This legislation obliged public-interest entities exceeding 500 employees to disclose certain non-financial information relating to ESG.
In 2021, the EU replaced the NFRD with the Corporate Sustainability Reporting Directive (CSRD). This extended the reporting obligations to morebusinesses while also introducing standardised reporting requirements, mandatory assurance, and digitisation of reporting.
CSRD – the challenges
In recent years, external factors such as the pandemic, the war in Ukraine, and rising inflation have all disrupted businesses and their supply chains. The introduction of the CSRD adds a further challenge.
ESG reporting legislation will likely create several challenges for businesses, including SMEs. These challenges include:
• implementing complex data systems to measure environmental performance such as water and electricity consumption;
• added costs of engaging professional advisers to devise ESG strategy and ensure that reporting meets regulatory requirements;
• additional resources needed to measure social and governance metrics such as employee turnover, board and employee diversity, and employee training;
• extra resources needed to collect ESG data from suppliers for the disclosure of information related to the supply-chain.
Supply-chain reporting – the challenges for SMEs
The CSRD applies to the following businesses:
• All companies listed on the EU regulated markets, including listed SMEs.
• All large companies that exceed two of the following three criteria:
1. 250 employees during the financial year;
2. a balance sheet total of €20m;
3. net turnover of €40m.
• Non-EU companies generating a net turnover of more than €150 million in the EU, and having a subsidiary in the EU that meets the criteria applying to EU companies or an EU branch with a net turnover greater than €40 million.
One of the requirements of the European Sustainability Reporting Standards (ESRS) that emanated from the CSRD, is for the above businesses to disclose carbon emissions in their annual reports.
When reporting, businesses must distinguish between different types of emissions classified as Scope 1, 2 and 3 emissions. Scope-1 emissions are direct emissions from owned or controlled sources. Scope-2 emissions are indirect emissions from the generation of purchased electricity. Scope-3 emissions are indirect emissions that occur in the reporting business’ supply chain.
It is often Scope-3 emissions in the supply chain that have the most significant impact on the eventual consumer product – Apple Inc. reported in 2021 that 99% of its emissions occurred in its supply chain. This explains why ESG legislation requires businesses to collect data from suppliers. In the process, SMEs that do not fall within the scope of the CSRD, may still need to provide ESG data to larger businesses that do need to report.
The impact on SMEs is clear: even if they do not need to report their own data, they will need to collect data in order to provide it to large customers large obligated to report on their supply chains. If SMEs fail to do so they may find themselves losing key customers. This presents challenges for SMEs in that they may not have:
• the necessary technology to provide high-quality data to their customers;
• the necessary resources to focus on ESG, resulting in poor-quality data;
• the ability to identify the relevant stakeholders in their own, often complex, supply chains.
Evolving stakeholder expectations
Consumers, shareholders, employees, regulators, and other key stakeholders now expect businesses to lead the way in protecting the environment, societies, and economies where they operate. This means stakeholders demand that businesses consider ESG factors in every area of operation, including supply chains, both upstream and downstream. This makes ESG data a key consideration for businesses, including SMEs, if we are to meet net-zero targets with respect to climate change. If all businesses, large or small, work together, this goal can be achieved without a significant impact on business operations, including those of many SMEs.
While ESG requirements may not have an immediate impact, failing to identify and manage the business risks that arise may result in future reputational damage, and operational and economic losses. However, the reverse is also true – businesses that are proactive may find they can use ESG to increase brand value by thinking creatively about the risks and opportunities both internally and in their supply chains.
About the author
Mark is a partner at Zampa Debattista, the Russell Bedford member firm in Malta. He is responsible for leading the ESG Advisory Department as well as the Client Accounting Department. The department assists SME clients with ESG reporting, gathering and reporting ESG metrics, and developing and defining ESG strategy.
Mark is an accountant and auditor, who graduated from the University of Malta in 2010. He spent the first seven years of his career at one of the Big Four firms in Malta, working mainly within the tax and audit service lines. Mark joined Zampa Debattista as a partner on 1 January 2022.