Rethinking Sustainability
How less could be a whole lot more
6 January 2025
Key Messages
▪ All of us – individuals, companies, the financial sector and policymakers, need help make the green transformation happen. The contribution of the financial industry should be limited to the adequate consideration of climate and environmental risks, and the provision of sufficient financial and insurance services.
▪ Policymakers need to adopt a new approach. The effectiveness of steering capital flows through the financial sector is too low and too cost-intensive with complex and comprehensive stipulations The transition to a green economy should emanate more from the real economy, supported by intelligent economic, environmental and climate policy and by placing more faith in companies once again
▪ Regulatory instruments should be highly efficient and the ensuing costs minimised. They should be helpful rather than obstructive. Sustainability regulation does not meet these criteria and urgently needs to be reviewed. This review should involve significantly slimming down the CSRD, making the application of the EU Taxonomy voluntary, interpreting transformation plans as a general orientation, and resolving the challenges of ESG ratings
▪ Climate-related topics, long at the top of the regulatory agenda, are increasingly giving way to environmental needs, such as preserving biodiversity. A standardised definition of the metrics involved, comparable to the Greenhouse Gas Protocol, are not yet in place and need to be developed swiftly. The framework here should not repeat the same regulatory errors of the past. It should focus on accuracy, proportionality and practicable approaches for the real economy.
General Context
Sustainable finance means the integration of sustainability criteria in the provision of all forms of capital, be it credit financing, equity financing, venture capital or insurance. ‘Sustainable’ is often interpreted as the alignment of the triad of environmental, social and governance (ESG) factors. The objective of sustainable finance is to incorporate the new physical and transitional risk drivers and steer capital flows from financial markets exclusively into sustainable forms of investment. The motivation behind this approach is the urgent need to transform our economy to make it more ecological.
A real economy interpretation of the green transformation
We need to succeed in transforming our economy. Finding an approach that works well must form the basis of this transformation German industry is sceptical whether the current approach of sustainable finance is effective Policymakers, financial supervisory authorities and financial institutions are setting too much store on the approach of steering capital flows into sustainable investments to master the challenges of the green transformation We believe that this indirect approach in its current form is not effective enough, much too complex and, ultimately, involves too much effort for too little impact. We need a change of course. The main focus must be on climate, environmental and economic policy measures that tackle change where it takes place.
It is quite correct that all of us, policymakers, industry, the financial sector and citizens, need to contribute to the transformation. The focus should, however, be on the real economy. We believe that the contribution of the financial industry should principally be the incorporation of new sustainability risks in its criteria for the provision of capital, and the provision of adequate and appropriate financial and insurance services. The effectiveness of additionally controlling capital flows using current green financial instruments and regulations is often low. Rather, economic policy solutions are needed to finance the investment projects of the transition, where economic risks are still very high The financial industry can take on a supporting role here. With the right economic and climate policy framework, corporate financing needs in the form of equity financing, venture capital or borrowed capital will be met by a range of financial service providers willing to provide the required capital A good policy framework will also include suitable risk-sharing instruments from development banks at national and European level to increase the risk-bearing capabilities of companies and their financial service providers
Regulatory instruments should only be applied if they have proven to be highly effective and keep the ensuing costs low. They need to support rather than obstruct companies. The current framework for sustainability in finance fails to meet these criteria, which calls for the swift development and implementation of substantial amendments. This paper sets out a row of proposals to achieve this. Ultimately, the main problems in the corporate financing of the green transformation are the economic and climate policy framework and the infrastructural constraints. To remedy this situation, the public sector must take a more active role in making the necessary investments in infrastructure (power grid, hydrogen grid, etc.), economic policy and development banks must provide for greater risk reduction, the banking industry needs to take on a supporting role, and venture capital and private equity made more available. These are the points that need to be resolved and sustainable finance is not the answer here.
Reconsider the concept of controlling capital flows with policy
There are various approaches for steering and shaping the green transformation. The European Union has opted for the market-based mechanism of emissions trading in combination with a wide array of further energy and climate policy instruments, increasingly, over the last few years, in the form of detailed regulations Alongside the European Green Deal and its numerous legislative initiatives, the EU has also honed in on using the leverage of financial markets. The basic idea behind this approach is to progressively direct the funds of financial service providers exclusively to sustainable investments based on a dense and complex regulatory framework defining ‘sustainable’ Designed to act as an incentive, this approach also forces the hand of companies in the real economy and in the financial sector by turning financing into a bargaining chip, sooner or later.
In practice, this approach is problematic in several respects. First, the European Union is relying on instruments that have not proven to be very useful in steering capital across large swathes of the economy. The EU Taxonomy, in particular, has fallen far short of expectations regarding its functionality as an instrument to classify sustainable investment. Second, investment decisions are not just based on the availability of financing but also on other parameters that determine factors such as profitability The costs of operating and producing in Germany, for example, are considerably higher than in other parts of the world (BDI 2024) It is not particularly useful to increase pressure on the business sector through financing or attempt to mobilise funds towards sustainable investments if the overall environment is not yet geared towards increased sustainability, or even prevents this, through a lack of infrastructure, for example. In many cases, this would be taking the second step before the first.
The use of green financial instruments to steer corporate financing towards the green transformation also has theoretical weaknesses. For example, the balance sheet does not show which assets have been financed with which instruments. The liability side finances the asset side as a whole This precludes a clear allocation of assets to liabilities, especially in the case of ongoing financing for current sustainable and less sustainable assets. The only working example here would be a company that acquires something like a sustainable machine using a green loan. Yet, in this case, it cannot be guaranteed that the machine would not have been acquired anyway with a normal loan. This represents the second conceptual weakness of this approach. Overall, it is not possible to prove that companies are motivated to make sustainable investments because of the availability of green financial instruments, or, to put it differently, whether green financial instruments lead to an additional uptake of financing and additional green investments (Krahnen et al. 2021)
Last but not least, indirectly steering the green transformation is a complex undertaking. Properly measuring the impact of ESG financing would be disproportionately cumbersome as it would have to involve the calculation along the entire value chain (Krahnen et al. 2021). Compared to measures directed at the real economy, this approach is much more complex and also entails higher litigation risks due to the potential for greenwashing.
Identify, name and resolve conflicting objectives
Sustainability efforts often lead to conflicting objectives, either within the thematically broad field of sustainability itself or in relation to other policy areas. Internally conflicting objectives primarily arise out of the EU Taxonomy. The basic idea of combining all six sustainability objectives is well-intended, but, in practice, leads to contradictions. The ‘do-no-significant-harm’ stipulation, i.e. that meeting one sustainability objective must not significantly harm the other sustainability objectives, can easily mean that a useful investment is not deemed to conform with the high requirements set out by these criteria.
Some electric vehicles, for example, or many of the green technologies needed for the transformation, such as wind turbines and efficient electric engines, cannot be classified as sustainable because they cannot meet the DNSH criteria.
Conflicting objectives with other policy areas arise, for example, in combination with European efforts towards more sovereignty and enhanced resilience. Production within Europe or the relocation of production back to Europe of modern pharmaceutical products and substances, for example, such as cytostatic drugs, is currently not possible under the EU Taxonomy because the DNSH criteria cannot be fulfilled. Similarly controversial situations have arisen in the combination of sustainability and the mining and defence sectors
Policymakers must get better at identifying, naming and resolving conflicting objectives. Considerations of these conflicting objectives must be included in the upcoming review of the regulatory frameworks. The policy objective of increasing sovereignty and resilience, for example, should be regarded as an independent objective and equally necessary and important as sustainability objectives. This would prevent the one objective being classified as less important and solutions would then have to be coherent and balanced between all objectives.
Correct the approach taken so far
The green transformation represents an extremely demanding challenge of our times. It is the road we must take, there is no alternative. And we must succeed in this challenge, the consequences of failing to make the transition to a green economy would be fatal. Yet, at the same time, we also need to recognise that there are other challenges alongside the ecological transformation that also need to be addressed and overcome, and that we need to create the right environment for the transformation to unfold
A national economy is at its most effective and in the best position to master structural changes if it is competitive and resilient. For the economy to be competitive and resilient, it must have the necessary flexibility and confidence to find and disseminate creative solutions. A regulatory framework is in the interests of all parties and supports development if it is designed in the right way. Attempting to politically micromanage economic developments by imposing an excessive amount of transparency regulations on companies has proven to be both ineffective and inefficient
The approach taken by policymakers so far to try to enforce the green transformation needs to be corrected. We need less politically forced and patchworked efforts to manage change through the financial markets and more market-based solutions for the real economy that provide incentives and are supported by intelligent economic, environmental and climate policy. The guiding principle in this correction of course should be to have more faith in business enterprises once again Those companies that are small and medium-size, firmly rooted into the regional structure and also make social contributions to local development should be particularly supported. Companies have understood that, without an ecological orientation, their business model will not be fit for the future.
Financial markets should focus primarily on new risk drivers, accompanied by regulation and supervision Only the information that is required for an adequate risk assessment should be requested. Sustainability information should always be included in the formulation of statutory stipulations with a good sense of proportion Close collaboration with the business sector and improved coordination between all regulating authorities involved (financial and real economy) will be essential for the development of a well-functioning and lean regulatory framework.
Corporate Financing
The amount of investment needed to bring about the green transformation as calculated in a number of studies is in the high double-digit billion range, per year, in the public and private sector combined This is a high volume of financing but should still be considered in detail. We see challenges in the financing particularly of those areas in which the profitability of business models has deteriorated to such an extent that they are becoming unviable. This can happen, for instance, through politically induced price increases of key inputs, the use of new technologies that are not yet commercially viable or disproportionately high upfront investments. Business models affected by such changes can lose their bankability as it makes them too high-risk for conventional financial service providers In all other cases, companies should be financially viable in general and able to finance their ecological investments using internal financing supplemented by loans. With bank balance sheets growing hand in hand, an increase in financing going forward should be well covered by the financial sector. Possible approaches here are retained earnings, borrowing on the market and instruments such as securitisation
The financial sector has taken sustainability on board
Sustainability aspects are now firmly incorporated in the provision of corporate financing. The leading driver behind this development has been regulatory measures, followed by corporate policy decisionmaking and reputation risk concerns In the EU, banking supervisors play a decisive role by setting out requirements to adapt internal risk management systems and by establishing special stress tests. In financial market regulation, the focus was initially on investment that was already sustainable, but has now shifted to investment for becoming sustainable, i.e. transition finance, at the latest with the Communication of the European Commission in mid-2023 (European Commission, 2023)
Sustainability has so far been interpreted differently by banks and insurance providers. The EU Taxonomy plays a very subordinate role here with homegrown methods or other tools used instead, including, e.g., the Science Based Target Initiative (SBTi), the Paris Agreement Capital Transition Assessment (PACTA) and the Carbon Disclosure Project (CDP), which focus primarily on the general strategic course of a company in the area of sustainability. Transformation plans are becoming more important here. There have been first attempts within the industry to harmonise the provision of ESG information by customers This is a good idea in general, but the success will depend on the number of banks and insurance companies that ultimately use the industry’s model. Furthermore, this can only be an interim solution. In the medium-term, the requirements need to be slimmed down
Many of the climate investments taken so far have been on the smaller side and financed by a company’s own cashflow. These are typically measures such as increasing the energy efficiency of buildings, lowering the carbon footprint of fleets or electrifying parts of production. Larger-scale lighthouse projects have mainly been bank-financed with the form of financing selected not only according to the amount of financing required but based on the individual company’s existing financing mix and size The financing benefits of sustainable investments are currently limited. In bank financing, sustainable investments can get interest rates that are a few basis points better, depending on the bank and the product (e.g. higher benefits visible in pass-through development loans), but the ‘greenium’, e.g the financial advantage of green capital market products, is barely visible
In their selection of green financial products, corporate treasurers tend to opt for use-of-proceeds products in which the funds may only be used for sustainable investment. Progressively less popular, on the other hand, are sustainability-linked products because of the difficulties involved in selecting the
metrics. Relevant key performance indicators (KPIs) are used to measure improvements in the borrower’s sustainability profile. For green corporate bonds, the leading standard by far is the International Capital Market Association (ICMA) standard The EU Green Bond Standard based on the EU Taxonomy plays a very subordinate role in this field as well Excessive regulation under the EU’s Markets in Financial Instruments Directive (MiFID II) and Insurance Distribution Directive (IDD) has made the distribution of green capital market products very complex and selling them more difficult.
Avoid repeating past mistakes in transition finance
While shifting the focus from sustainable finance to transition finance is a step in the right direction, the approach of trying to steer the green transition through finance remains the same. Consequently, the problems of this approach outlined in the first section of this statement still apply At the same time, there are concerns that shifting the focus to transition finance will also entail new standards and reporting obligations. The objective of the new alignment must be to give companies sufficient scope to structure their own transition and to support them by providing the right economic and political environment. A Corporate Sustainability Reporting Directive (CSRD) slimmed down to relevant KPIs for the presentation and implementation of transition projects can provide orientation, a healthy dose of transparency and enable a certain degree of comparability. Regarding the use of financing instruments, companies should be free to choose between products with sustainability criteria and conventional instruments
Position transition plans as general orientation
Alongside the duty to produce qualitative and quantitative sustainability information, another regulatory project has recently become increasingly popular – the transition plan. The transition plan has been made a requirement in various regulations and is designed to provide information on the individual company’s roadmap towards sustainability Although this is basically a good idea as it allows companies to present their own sustainability efforts in an individualised way, it has been made unnecessarily complicated in the regulations. The CSRD, the Corporate Sustainability Due Diligence Directive (CSDDD), the Industrial Emissions Directive (IED), the Capital Requirements Directive (CRD) and the provisions of the EU emissions trading scheme all feature a transition plan However, the contents required of the transition plan are not aligned and differ in each case. There are also differences in the scope of application.
The regulatory requirements regarding transition plans must be harmonised urgently. In this process, the regulators of the financial sector and the real economy need to coordinate better as the requirements do not just affect companies of the real economy but also banks. The requirements of the IED should be abolished as they entail enormous administrative effort particularly for mid-size enterprises Plans currently need to be compiled for each IED facility in Germany (about 9,000) with information on how the industrial facility will contribute to a sustainable, clean, circularity-oriented and climate neutral economy by 2050. The specifications for the transition plans must not require companies to reveal competitively sensitive information. This could be, for example, a detailed representation of the project pipeline of which only a part will be realised. Looking at the requirements in relevant economic regions will help in the development of an adequate approach. Furthermore, the transition plans should only be updated in the case of significant change to the parameters or in a strategic cycle of three to five years. An annual update, as called for in part by the financial industry, is not practicable for the real economy. As a general rule, transition plans should serve as an orientation rather than be binding and too detailed. Such plans must preserve flexibility in planning and strategic
decision-making. Subsequent amendments for different reasons must not increase the risk of litigation. The same applies to the financial strategies.
The realisation of planned transition investments does not, in practice, tend to fail due to a lack of internal or external funding but rather because the preconditions for making new fuels and their infrastructure available and deploying them cost-efficiently are not given. The ramp-up of alternative economic activities often suffers from the chicken and egg problem, as it requires upfront investment from the public sector or private companies before the products or fuels can be deployed These investments often only pay off in the case of high potential demand, which is uncertain. As with every scale-up, high investment risks need to be shouldered, particularly if the risk reduction using various development measures is inadequate. The realisation of transition plans thus often depends to a large extent on whether investments overall have created the necessary preconditions.
Resolve challenges with ESG rating
ESG ratings are becoming increasingly significant. However, they are not unproblematic on account of the highly complex and broad nature of the sustainability information covered, which also makes the ratings difficult to compare. The new regulation on ESG rating activities tries to address some of the problems that have emerged. It aims to make the methods used by rating agencies more transparent. Rating agencies can still choose which rating methodology they apply, but it has to be systematic, objective, continuous and subject to validation. Concerns remain that these amendments will not have the intended result as the differences in the various methodologies remain large and preclude comparability. There are rating agencies, for example, that do not apply the double materiality perspective. The materiality analysis also produces different results that do not necessary correspond with the company’s own results. A further problem is the data used. Only a certain percentage of the data can be taken from the CSRD and its interpretation standards The rating agency collects the rest of the data independently or asks the company. There is no uniform procedure for this either. Last but not least, companies are often negative about the rating methodologies used and their lack of transparency and clarity
Considering that the weight of ESG risks is set to continue growing, a discussion is needed on how to resolve current shortcomings. The regulatory approach adopted for credit ratings seems not to be suitable for ESG ratings. No stipulations or restrictions regarding methodology have been set down for credit ratings. The main objective of credit ratings was to create transparency and clarify the methodology applied. As the assessment of a company’s creditworthiness appears to be much less complex than assessing the sustainability profile of a company, a different regulatory approach may be required which imposes more stringent stipulations on rating agencies.
The Corporate Sustainability Reporting Directive
The provision of sustainability information is a useful component in structuring the green transformation, helping companies map and implement their efforts towards sustainability and also providing important information for the assessment of sustainability risks. It is nonetheless of decisive importance that the associated requirements are feasible and work on the ground, that the scope is proportionate and the content relevant. The CSRD reporting standards, the European Sustainability Reporting Standards (ESRS), barely adhere to these fundamental principles of good regulation at all The standards require reporting on up to 1100 data points. Almost 70 percent of these are narrative points which are more time-consuming and less comparable. The costs of meeting these reporting
obligations are high for smaller companies, who can be affected both directly and indirectly through the trickle-down effect Regarding the points that companies are required to report on, we doubt whether this is the information which would have been chosen as relevant to decision-making by players from the real economy and the financial sector. The approach appears to be rather more academic
Reduce data points and complexity substantially
To make the presentation of sustainability information more simple, clear and intelligible, the scope of reporting needs to be slimmed down substantially, reducing the large number of very time-consuming narrative indicators in particular. The scope of application should be narrowed to companies with over 500 employees. It is not practicable to oblige companies with between 250 and 500 employees to already report in accordance with the large Set 1 of the ESRS. Sector-specific standards should also be eliminated. The focus should be exclusively on meaningful data that is relevant to decision-making and is also actively used and administered by the company in practice. This will require a different approach (top-down approach) to define impacts, risks and opportunities (IROs) and develop measures, objectives and policies on this basis. On a high level, overarching corporate strategies should be developed and IROs identified for the major topical standards, encompassing all stakeholders. This would then form the basis for the formulation of cross-cutting objectives and measures. Smaller-scale IROs and measures should only be reported on as an exception, if deemed particularly relevant. In addition, the data points must be clearly grouped under the respective ESRS topics The data points are currently not immediately assignable to the sub-topics of the ESRS, leaving a large scope for interpretation which creates uncertainty, a lack of comparability and reduces usability significantly. This greatly restricts the benefits of using the sustainability reports and, at the same time, makes them very time-consuming to create.
The principle of materiality assessment, whereby issues that are not significant can be omitted, is correct and should be upheld. This principle protects the sustainability report against being diluted by insignificant issues. However, to correctly identify what is material and what is not still requires in-depth knowledge about specific impacts along many steps of the value chain. This approach thus means that companies face challenges they cannot resolve as they are not able to obtain the necessary information. The value chain approach needs to be cut back substantially to remedy this situation. Compiling a comprehensive materiality assessment along the whole value chain is a huge administrative undertaking even for larger companies Alongside the company’s own business operations, the assessment should therefore only cover direct suppliers (tier 1). In addition, the materiality assessment needs to be simplified and more focussed on key performance indicators. Companies would then only have to identify the really major drivers of their ESG impact which would also enable better and more active management thereof. Sustainability reports would be less diluted and companies could focus on those areas that are important for them and that hold the most leverage.
To further reduce complexity, the scope of consolidation should be harmonised in financial and sustainability reporting. Companies are often requested by auditors to include in the sustainability report participations that are not consolidated in the management report. As there is no data available for these enterprises, the data either needs to be newly obtained or estimated. The costs far outweigh the benefits of this approach. The scope of consolidation should be the same for sustainability reporting and for financial reporting, thereby omitting insignificant subsidiaries. Furthermore, the group exemption clause in the CSRD should be extended to include, without exception, all group-wide subsidiaries irrespective of size, listed or non-listed, to free them from the obligation of separate reporting if the parent company publishes a CSRD-conform sustainability report. Larger listed
subsidiaries currently have a separate reporting obligation, even if the purpose of the company is extremely limited, e.g., special purpose vehicles (SPV) for the issuance of bonds in the EU. This obligation imposes unnecessary additional burdens on EU companies without creating any additional benefit for the users of the sustainability reporting. The language requirements also need to be changed. Depending on the reporting level, the report has to be written in German or in English. The company should be free to decide which language to use as it is in the best position to judge the effort involved and which language is more useful in its particular case.
A central problem of sustainable finance in general is the large number of different reporting obligations, containing many instances of unclear or ambiguous definitions and delineations that are not legally watertight. The objective should therefore be to merge all sustainability-related reporting obligations into a single report. This move would simplify the procedure and eliminate duplicate and overlapping reporting obligations (the once-only principle). The sustainability report under the CSRD with its principle of materiality would be the most suitable for this purpose.
In future, all large companies will have to include a CSRD report in their management report in the European Single Electronic Format (ESEF). This poses a technical problem for large companies that do not prepare their annual financial statements according to IFRS but according to the German Commercial Code (HGB). The CSRD report is structured according to the ESRS taxonomy that is being developed. The CSRD report also references figures from the annual financial statements according to the HBG (e.g., annual result or revenue) which are based on a different taxonomy, the HGB taxonomy, and prepared in Extensible Business Reporting Language. The European Financial Reporting Advisory Group (EFRAG) has so far only developed reconciliation tables to address the interconnectivity problem between the IFRS and the ESRS taxonomies It now needs to address the interconnectivity problems between the ESRS taxonomy and the taxonomies of national accounting regulations and develop appropriate solutions with speed and urgency.
Another technical aspect that needs amendment to facilitate compliance regards the so-called ‘preparation-based requirement’ currently envisaged by Germany and which, in our opinion, should be abolished. According to this requirement, the electronic reporting format is prescribed for the preparation and not just the publication of the management report making the electronic file the legally binding document. This would have significant legal consequences without providing users with any comparable benefit. The readability, availability and uniformity of different devices and the acceptance of electronic ESEF files does not equal that of PDF files. Technical errors are also more frequent. The implementation in practice of the ‘preparation-based requirement’ in Germany is likely to be different to that in other countries which will also lead to competitive disadvantages for German companies. The dual German system of preparing the management report combined with the ‘preparation-based requirement’ is not practicable. A ‘publication-based requirement’, i.e. an obligation to publish the report in ESEF, would provide the same benefits for users and allow companies to freely select their internal processes for the preparation of their management report.
Make allowances for small and medium-sized enterprises (SMEs)
The sustainability reporting obligations of a company do not just encompass the company’s own business operations but also include information on the value chain, upstream and downstream. This makes for considerable difficulties in the identification and evaluation of risks, opportunities and impact Reviewing the whole value chain, in some cases right up to the last supplier or end consumer, is problematic for companies, also on account of data availability. Small and medium-sized companies that are only indirectly obliged to report are frequently not in the position to meet the many different
reporting obligations. This situation is not acceptable and can be resolved by substantially narrowing the definition of the value chain cap in the CSRD to significantly reduce the trickle-down effect.
The CSRD in its current form stipulates that reporting standards should not stipulate disclosures that require undertakings to obtain information from small and medium-sized enterprises in their value chain that exceeds the information to be disclosed in accordance with the sustainability reporting standards for listed small and medium-sized undertakings (LSMEs). However, the reporting standards for LSMEs are not much less extensive than the already published counterpart for large companies (ESRS Set 1). As non-listed SMEs usually do not have comparable resources, limiting the information to be disclosed to the disclosure requirements of LSMEs is not narrowing the scope of disclosure sufficiently It would be more suitable to use the European-wide voluntary reporting standards for non-listed SMEs, the VSME, as setting the scope for obtaining information along the value chain. This would enhance standardisation and simplification, thereby reducing the trickle-down effect The VSME should cover most of the normal data required. With this restriction in place, larger companies can no longer be requested to obtain information from SMEs in their value chain that goes beyond the information to be disclosed under VSME. At the same time, the VSME would have to be promoted to achieve broad acceptance, for example through a consultation by the European Commission prior to publication
Facilitate phase-in
As the initial introduction of such an extensive piece of legislation involves many challenges, it should be introduced with various facilitating measures A major concern for German industrial enterprises is the extensive consideration of the value chain. In the first three years of sustainability reporting, a company should be permitted to omit information on the upstream and downstream value chain that cannot be obtained with reasonable effort Without the availability of a voluntary reporting standard, VSME, published by the European Commission, it can be assumed that information from the value chain cannot be obtained with reasonable effort. As a logical consequence, for the reporting years 2024 and 2025, and, at least, until the publication of the VSME, disclosure requests for information along the value chain should not be possible This would prevent legal uncertainty and reduce the efforts required of companies that are not directly subjected to reporting obligations. After publication of the VSME, companies subject to sustainability reporting that request information from along their value chain should be able to, either, refer to the restricted reporting obligations of their business partners under the VSME in the place of the missing information, or, make estimations based on transparent assumptions. The VSME should be adopted swiftly to provide for legal certainty. At the same time, this point also needs to be clarified in the CSRD.
A further necessary measure to reduce teething problems during phase-in is to make the reporting obligations under the German Supply Chain Due Diligence Act (LkSG) voluntary until the implementation of the CSDDD. In addition, all companies should be able to substitute their reporting obligations under the German Supply Chain Due Diligence Act with their first CSRD report. Non-listed companies with over 1000 employees should not be subject to sustainability reporting obligations until these companies fall under the CSDDD. The German Supply Chain Due Diligence Act should be aligned with the CSDDD regulations by the time these come into effect to give companies and suppliers adequate time to prepare and reduce their administrative load Particularly the risk-based supply chain approach of the CSDDD and the CSRD needs to be harmonised early on. It does not really make sense that non-listed companies with over 1000 employees have to produce a report under the German Supply Chain Due Diligence Act once for the reporting year 2024. They should be exempted from this reporting obligation as large listed companies are.
The introduction of the CSRD in Germany will also increase the possible scope for penalties. Risks of penalties could arise, among other things, in the first few years concerning the materiality analysis. The insufficient data currently available for the assessment of opportunities and risks will mean that materiality analyses are not carried out objectively and discrepancies could arise between the identification and assessment of the opportunities and risks by the company, on the one hand, and by third parties, on the other. Enforcement and penalties should therefore be kept minimal in the first few years of reporting until the clear formulation of the ESRS In view of the wide scope of reporting and the level of complexity, companies need to be given a period in which they can collect experience and in which the imposition of penalties is limited This should also apply to auditors. Currently, auditors tend to err on the side of caution and audit more in-depth to minimise litigation risks Until the European Commission adopts auditing standards and a legally watertight interpretation of the regulations for the preparation of the reports, auditors should also not be subject to more stringent requirements, or higher enforcement or penalty risks
The EU Taxonomy
The EU Taxonomy is another building brick of sustainability reporting and has been conceived as an instrument to classify ecologically sustainable investment on the basis of economic activities. It is set to play a significant role in the channelling of capital flows towards sustainability, alongside the EU’s Sustainable Finance Disclosure Regulation (SFDR) In addition to being based on economic activities, another special feature of the EU Taxonomy is that it combines all six sustainability objectives These are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. The ‘do-no-significant-harm’ (DNSH) principle is designed to prevent one objective being fulfilled to the significant detriment of any of the other five objectives. While this may sound like a good idea in theory, in practice, it is highly complex and leads to cases in which ecologically sound activities fail to be classified as conforming to the Taxonomy.
The EU Taxonomy poses a number of larger challenges for industrial enterprises. The very strictly formulated and complex regulations are highly cumbersome to implement and do not provide a wideranging benefit that justifies the effort. The EU Taxonomy was originally designed to provide clarity in the thicket of regulations surrounding sustainability and be a help to companies. Although there are companies that use the EU Taxonomy to support the development, presentation and implementation of their sustainability efforts, the very large majority do not reap any advantage from the EU Taxonomy Instead of a help, it is largely regarded as a burden.
Make application voluntary
One difficulty is the well-intended approach to only require sustainability criteria to be developed for a prioritised selection of economic activities. In practice, however, this incompleteness means that only a few companies can map the main part of their business operations using the EU Taxonomy. For all other companies, it reduces the benefits of sustainability reporting but keeps the costs of implementation high because they are still obliged to illuminate their other business operations according to relevance to the Taxonomy without applying the materiality principle This incompleteness substantially reduces the strategic relevance of the EU Taxonomy. The reduced relevance of the EU Taxonomy is also visible in the financial industry and is compounded by its binary design (conform versus nonconform), the highly demanding criteria, the low meaningfulness and comparability of the taxonomy indicators, the inadequate handling of investments and company units outside of the EU,
and its methodological weaknesses, such as the linking of calculation methods with the national energy mix. To remedy this unfortunate situation of obliging companies to apply a tool designed to assist them but which, in actual fact, only helps a very few, the application of the EU Taxonomy should no longer be mandatory but become a voluntary reporting option. This would allow all companies to freely choose whether they use the EU Taxonomy for the presentation and implementation of their sustainability efforts or a different, more suitable tool.
Amendments should be undertaken to improve the usability of the EU Taxonomy for those companies who want to use it. For a start, the reporting forms should be made easier to read, less complex and more compact and the separate reporting forms for gas and nuclear activities abolished as they do not provide any additional benefit Further amendments should include developing a materiality principle, clarifying unclear legal terms, resolving ambiguities in the requirements and simplifying the DNHS criteria. The indicator disclosure requirement regarding operational expenses (OpEx) should also be withdrawn. The EU Taxonomy should only be expanded to include more economic activities when all necessary amendments have been made.
Move away from the principle of exclusions
The debate on sustainability does, in some instances, lead to motions to make exclusions on the basis of either ideological motivations or stark generalisations, whereas a more differentiated approach would be more appropriate In general, all economic players should be given the possibility of making their business operations more sustainable. A brown taxonomy, brown listing or general exclusions should be avoided, especially in the case of products or processes that have been approved by a national or European authority.
Acknowledge and address the challenges of social aspects
Social criteria are a component of the ESG horizon and are currently addressed under the EU Taxonomy through minimum safeguards and the implementing standards of the CSRD. In the area of financial market activities, the Social Bond Principles of the ICMA are at the forefront of the standardisation of sustainable socially-oriented financial instruments. Even though the ‘S’ in ‘ESG’ is there for good reason, there should be no further regulatory measures for this category. It is important to focus on the major issues. For reasons of urgency, the focus should be on climate-related issues
We should also remember that the implementation of the minimum safeguards so far has shown that social aspects are very difficult to capture and assess using objective criteria. Social criteria are not only inherently difficult to measure but are always subjective as diverging values and cultural backgrounds play a central role. In the social components of the EU Taxonomy, the legislator has not managed to make the initially vaguely formulated requirements more precise The continuing uncertainties on the part of companies and auditors have given rise to a heterogenous interpretation and implementation which stands in contradiction to the objective of a taxonomy.
Auditors
The adoption of regulation on sustainability aspects enlarges the role of auditors. The new reporting obligations subject to auditing contain many vague formulations which leaves the exact interpretation up to the discretion of the auditor. Auditors often do not take on this role in quite the way that companies would like them to. The auditing methodologies used are highly divergent across Germany, and even more so across Europe. This problem could be addressed by introducing a European auditing standard. Furthermore, there appear to be differences in the depth of the auditing German auditors,
more often than not, appear to be too thorough. While auditors should, of course, be subject to particularly stringent requirements and set very high standards of diligence themselves, a debate is needed to ascertain the level of detail needed to make our economic system leaner and simpler. Auditing will be a major factor here.
Auditing under the CSRD will be a particular challenge in the first few years, at least, on account of its size and complexity. The CSRD gives companies the option to choose assurance services providers other than statutory auditors to avoid capacity bottlenecks and the high costs of external auditing. Companies in Germany should also be able to choose freely between the options for auditing set down by the EU of statutory auditors or other assurance services providers.
Biodiversity
Climate-related topics have defined the regulatory agenda for a long time, but environmental needs, such as preserving biodiversity, are now moving to the forefront. Biodiversity is often at the heart of these concerns. Preserving biodiversity is one of the six objectives of the EU Taxonomy. Alongside many different biodiversity strategies and programmes on German, European and international level, the CSRD and EU Nature Restauration Law also address the preservation of biodiversity. There are also a large number of voluntary frameworks related to biodiversity, such as the Taskforce on NatureRelated Financial Disclosure Recommendations (TFND) and the environmental standards of the Science Based Targets Networks (SBTN) Companies today are expected to have a sound understanding of the impacts and interdependencies of ecosystem services and the impacts not only of their own business operations but also those of their value chain. The financial sector is also increasingly incorporating environmental risks and their transmission mechanisms, developing scenario analyses and risk measurement methods to try and quantify the possible impact of environmental risks on financial risks such as credit risk.
Develop standardised metrics
Attempting to qualitatively assess and quantitatively measure the possible impacts of environmental risks on business models is a highly complex endeavour. The most meaningful level of assessment is often not the corporation itself but the individual production locations. This means that a large amount of data and information is required in sustainability reporting making an overall evaluation difficult. The quality of data in this field is currently not optimal. Much of the required data is still difficult to access. With no uniform metrics, the evaluation and comparison of the available data is almost impossible. Standardised metrics have to be developed with urgency, along the lines of the Greenhouse Gas Protocol, and should be prioritised and advanced by both the federal government and the European Commission.
Learn from mistakes
Compared to the assessment of climate risks, the assessment of environmental risks and possible loss of biodiversity is still in its infancy. Furthermore, the subject is much more complex and the interdependencies are less direct and more manifold. All these factors, together with the experience gained with reporting obligations relating to sustainable finance so far, will need to be taken into consideration in the development of future regulation on this subject. Particular attention should be paid to the effectiveness of possible regulations and the principle of proportionality.
Sources
BDI: Study commissioned from BCG and IW (2024). ‘Transformation Paths for Germany as an Industrial Nation | Key points for a new industrial policy agenda’ (full version) September.
European Commission (2023). Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the regions. ‘A sustainable finance framework that works on the ground’ Strasbourg 13 June
Leibnitz Institute for Financial Research (SAFE) (2021). ‘A primer on green finance: From wishful thinking to marginal impact’. SAFE White Paper No. 87. October.
Publishing Information
Federation of German Industries (BDI)
Breite Strasse 29, 10178 Berlin
Germany www.bdi.eu
T: +49 30 2028-0
German Lobby Register Number: R000534
Editors
Sven Schönborn
T: +49 30 2028-1551
s.schoenborn@bdi.eu
Julian Winkler
T: +49 30 2028-1574
j.winkler@bdi.eu
Louis Brutschin
T: +49 30 2028-1604
l.brutschin@bdi.eu
BDI Publication Number: D 2022
This report is a translation based on the German statement ‘Nachhaltigkeit anders denken | Wie weniger deutlich mehr sein könnte’ of 17 Dezember 2024.