You may run or own a small or medium-sized business. You are very likely aware that sustainability reporting has become a topic of intense focus in the business world. You may also think it doesn’t apply to a business of your size. But that’s where you would be mistaken.
To be sure, mandatory sustainability reporting based on the latest EU regulation will only apply to roughly 50,000 large companies out of over 30 million European enterprises. This may come as a relief to non-listed small and medium-sized companies (SMEs), which account for 99.8% of all companies in the EU. The US Securities and Exchange Commission (SEC) and the IFRS Foundation have also announced that for now all non-listed SMEs are out of the scope of mandatory sustainability reporting.
But this is only true from a purely legal perspective. SMEs may be outside the direct scope of new mandatory sustainability reporting rules, but they will be impacted by a trickle-down effect. In practice, SMEs around the world will have to start reporting environmental, social, and governance (ESG) data. If you are not prepared for this, you might soon be out of business.
Consider the following example. A small German tax advisory firm with fewer than 50 employees and an annual turnover of a couple of million euros received a letter from a multibillion-dollar revenue multinational corporation based in Germany asking for a variety of data on ESG matters. The small tax advisory firm had never thought about collecting and reporting this type of data, as it was outside the scope of current and upcoming legislation, both in Europe and globally. However, the big German multinational needed that data to prepare its own reporting, particularly on carbon emissions.
You might think that this just applies to European-based companies, but in fact the trickle-down effect of regulation goes much wider.
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In 2022, Turn, a small San Francisco-based circular materials company with 30 employees, was contacted by five multinationals located in the US and Europe asking for a range of ESG data. Turn was required to reply to long questionnaires about its ESG practices and metrics for procurement procedures. “It is exciting to see that our clients care about these issues as much as we do,” said Ryan Everton, the company’s founder. “We do our best to collect the data they require as most of these indicators are items that we track as a sustainability-focused business. However, we know that other small businesses struggle with the depth of these surveys as they are not typically tracking ESG data, since it is not mandated for businesses of our size here in the US.”
Listed European and American multinationals will be obliged to report ESG data in the coming years as a result of regulations that make sustainability reporting mandatory. The current focus is on carbon emissions, but this is just the tip of the iceberg.
In our conversations with SMEs, we often hear that they are interested in sustainability matters, but they still think that they are not really affected by current trends, practices, and the legal landscape of mandatory sustainability reporting. This reasoning, perhaps understandably, is born out of the idea that legal guidelines only apply to large companies, not smaller ones. For instance, the EU Corporate Sustainability Reporting Directive (CSRD) approved at the end of 2022, and the accompanying reporting standards developed by the European Financial Reporting Advisory Group (EFRAG), apply only to firms that have a significant size (the CSRD defines “large undertakings” as companies with a net turnover of €40m, a balance sheet total of €20m, and 250 employees on average over the financial year), to non-European firms with significant operations in the EU, and to medium-sized and listed firms on EU regulated markets. This is the most far-reaching, legally binding sustainability reporting framework in existence.
And despite the law’s apparent focus on large companies, SMEs are actually part of the equation. The reason is that large firms under the scope of corporate reporting schemes will require data from their value chain firms to be able to comply with existing regulation. Some large firms even go beyond mere compliance and have adopted ambitious sustainability targets that also affect their supply chains. For instance, EDP, a Portuguese utility, is aiming to have 75% of its suppliers adopt decarbonization and gender equality goals by 2030. This means that SMEs in its value chain would not only need to measure their carbon footprint (compliance) but also establish their own decarbonization targets.
And there are further new European regulations and instruments covering value chains, such as the European Supply Chain Act, the EU Taxonomy, and metrics applicable to banks such as the Banking Book Taxonomy Alignment Ratio (BTAR) and the Green Asset Ratio (GAR). In the same vein, the SEC has proposed regulation that will require public companies to disclose their Scope 1, 2, and 3 greenhouse gas emissions. The complete value chain of targeted corporations will therefore be covered, and this will necessarily include SMEs.
Hence, even if SMEs are not required to report data de jure, they will be pressured to do so de facto by large buyers of their products and services. The ripple effect will ensure that disclosure regulations affect SMEs that supply multinationals all over the world. This scenario will kindle a seismic transformation in the way SMEs incorporate sustainability policies, practices, and data – and the way in which they report on it. Sustainability will finally apply to everyone, everywhere in the business world.
In light of this, it is not surprising that the vast majority of SMEs are not yet prepared for the measurement and reporting of sustainability data. In fact, surveys show that even some big firms are not. But we are about to start the largest-ever planetary exercise in ESG data collection. Those SMEs that cannot react fast enough will be replaced by others that are ready. For a large company, waiting for a small supplier to be able to report ESG information would carry a risk of violating the regulations.
Sustainability reporting should be routine, predictable, and standardized. Companies should avoid designing homemade tools that fit their purposes but hamper peer comparability or combining elements from different reporting frameworks for their own convenience. Instead, they should use existing reporting standards as these ensure that data is systematically collected from value chains and therefore comply with the terms of existing regulation. If the legal landscape requires large companies to report ESG metrics from their value chains, existing reporting frameworks provide mechanisms to collect that data in a standardized way.
Some large firms even go beyond mere compliance and have adopted ambitious sustainability targets that also affect their supply chains
For SMEs already part of their value chains, large companies should shift the narrative from a simple question of compliance to that of a more mutually beneficial process. In their engagement with their suppliers, they should reinforce the idea that improving sustainability practices and reporting them publicly increases these firms’ competitive edge, boosts their reputation, and attracts investors. This has been confirmed by research.
For SMEs not yet part of their value chains, firms should integrate corporate sustainability factors into procurement processes and decision making. Sustainable procurement should integrate specifications, requirements, and criteria that are compatible with the firm’s reporting needs.
For SMEs, sustainability reporting is about staying in the game. Their survival depends on their ability to provide products and services to larger clients. And if these clients require them to disclose sustainability metrics, they will need to make painstaking efforts to attend to these requests.
SMEs and larger firms should therefore agree on the essential sustainability indicators that it is reasonable to expect SMEs to report. SMEs should also expect to receive guidance from larger firms on what tools and methodologies could be used to calculate those metrics. Even if larger companies follow standardized sustainability reporting frameworks, the indicators to be collected may vary according to geography (where there may be issues of data availability) and industry (where materiality comes into play). While some SMEs might be asked to report on greenhouse gas emissions or energy intensity, others might be required to disclose meaningful workforce indicators.
SMEs may also wish to take a step forward and adopt a more consistent and standardized reporting framework. For instance, although research has highlighted the complexities of applying Global Reporting Initiative standards for SMEs, other reporting standards such as the UN Global Compact are much simpler and can be used by any organization – large or small, private or public, in all sectors and geographies. Those SMEs that invest in high-quality sustainability data collection and reporting will gain competitive advantages in the future – particularly when they depend on, or want to enter into, business with big firms that have to apply the CSRD or other mandatory sustainability regulations.
But who will take on the job of reporting SMEs’ sustainability data? Multitasking SME owners facing the day-to-day challenges of keeping their businesses afloat are unlikely to be able to take on this additional responsibility. The task will therefore doubtless fall to their accountants; and this transition in their role from pure accountants to consultants will be the largest shift in their craft since the automation of bookkeeping in the 1950s.
SMEs will come under enormous pressure in the coming years as they will need to meet the growing expectations of their sustainability-conscious clients, comply with their bank’s ESG-related credit conditions, share information on their corporate sustainability practices to their investors and, as we have seen, supply non-financial data to their big B2B clients. SMEs are still not legally required to do this, but non-adherence could dangerously reduce their number of potential clients and markets. Those that do not prepare for a significant change in their data collection and reporting practices therefore risk going out of business.
And we cannot exclude the possibility that eventually every single business worldwide will report sustainability data, just as they do today for financial data. We are heading towards a future in which sustainability reporting is for all types of companies – small, medium, or large.
27 November 2023 • by Michael Skapinker in Finance
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