The recent adoption of the European Union’s Non-Financial Reporting (NFR) regulations has touched off a firestorm of comment and debate over its potential global impact. These rules require publicly traded companies to disclose material impacts on the environment. They draw particular attention to Scope 3 emissions— all indirect emissions (upstream and downstream) that a company doesn’t directly own or control. Consequently, too many firms are negatively affected by unintended consequences from policies. That is doubly so for firms in developing countries that are engineered for export to European markets. This article examines the impact of the finalized NFR regulations and the burden they’ll undoubtedly create for all stakeholders.
The NFR regulations are changing the game for how companies should be thinking about sustainability reporting. European investors and policymakers are beginning to shift their capital away from the Majority World—regions that supply raw materials for European products—back to the EU. This sudden shift to remote learning raises a huge equity concern. It could impose a significant compliance burden on smaller firms and those with more complicated supply chains.
Understanding Scope 3 Emissions
Scope 3 emissions embody the largest hurdle for companies looking to adhere to NFR requirements. These emissions include all upstream and downstream indirect emissions in a company’s value chain. They pop up at every stage, from during the extraction of raw materials to all through the use of sold products. Since firms do not own these emissions and firms only account for emissions that they control, accounting for scope 3 emissions can be difficult and messy.
As it stands, under the draft European Sustainability Reporting Standards (ESRS), the reporting of Scope 3 emissions is treated as optional. That is to say, while businesses are incentivized to publicly report this data, they have no legal obligation to be held accountable. This discretionary nature of emissions regulations is the main hurdle that companies face. This is especially the case for small and medium enterprises (SMEs) which represent more than 60% of corporate emissions in the EU. Lacking concrete standards, these companies find it difficult to offer substantive assessments of the economic and material impacts of their operations.
Surveys indicate that investors find it difficult to assess data in a meaningful way. This challenge is born out of concern — concern about the quality and quantity of environmental information. Investors may overlook key environmental issues when evaluating future fund investments. This is largely due to the difficulty of finding consistent and reliable information on Scope 3 emissions.
The Economic Ripple Effect
The scope of the NFR regulations extends well beyond European borders. Actors from the Majority World are often the ones extracting these raw materials for European companies. Or maybe they just don’t realize how much they could be indirectly impacted by these regulations. For European investors, the priority right now is ensuring compliance with NFR standards. Even more so, they might pull back capital from the jurisdictions that have stricter or more complex reporting requirements.
This rapid capital shift is a particular challenge for developing economies that are dependent on foreign investment. Preventing migratory backflow of people to the EU imposes long-term economic costs in these home regions. Thus, stakeholders need to have a serious, coordinated conversation about how NFR regulations affect global supply chains. By leveraging insights gained from seeing the holistic nature of their operations, firms can get smarter about how they navigate the tectonic challenges presented by these regulations.
Companies that can’t afford to move their operations onshore still have to include Scope 3 emissions. NFR compliance can be an inordinate financial burden. This burden too frequently brings significant compliance headaches, particularly for businesses that have complex supply chains. These firms find it difficult to even know what data to collect or how to meaningfully report their environmental impacts, making compliance with ESG requirements an increasingly uphill battle.
The Need for Collaboration and Support
In order to make NFR regulations more effective, industry professionals push for more communication between all parties involved. This proactive engagement with relevant SMEs, policymakers, and environmental organizations can help form a regulatory landscape that is more implementable and approachable. Through collaboration, stakeholders can create clearer guidance that helps firms report their climate impacts correctly and consistently.
Reducing the burden of reporting requirements on SMEs is vital. These more granular businesses don’t have the same bandwidth or capital to delineate the complicated reporting structures. This targeted type of support will build the capacity of SMEs to engage in sustainability reporting and help them to continue being competitive actors in the marketplace.
Moreover, creating customized educational materials on Scope 3 emissions will go a long way toward easing the intimidation that often accompanies the reporting process. Firms will gain from improved guidelines and best practices that allow them to better assess their value chains. Improved visibility around climate risks will be critical for investing intelligently and the development of a sustainable, environmentally focused economy.