By Mette Dalgliesh Olsen, Partner, Raison Consulting, June 28th 2024
Over the past few years, companies worldwide, especially in Europe, have been hit by a heavy wave of new regulations aimed at driving greater transparency and, ultimately, enhanced performance on critical sustainability matters.
In the EU, the ‘sustainable disclosure trinity’ consisting of the Sustainable Finance Disclosure Regulation (SFDR), the EU Taxonomy, and the Corporate Sustainability Reporting Directive (CSRD) has created the perfect storm, hitting companies across public and private markets with unprecedented and complex sustainable disclosure requirements from several angles.
The implementation challenge is undeniably significant, and the learning curve is steep, even for the largest companies. In 2023, a KPMG survey of 750 large-cap companies globally stated that 75% of respondents felt unprepared to meet the growing regulatory requirements within their jurisdictions. A new 2024 survey from PwC of 546 European companies within the scope of CSRD for FY2024-FY 2025 suggests that while some companies are starting to eye potential benefits from the legislation, many still grapple with the legislation’s inherent complexity, lack of data, lack of resources and tight deadlines, to name a few.
Growing discontent and push-back from the corporate community
In this context, it is important to remember that both companies and investors have called on regulators to harmonize sustainability performance and disclosure standards for decades, citing fragmentation as a common cause of inaction. Even so, it seems that some companies are starting to feel they are getting more than they bargained for.
A recent whitepaper by our colleagues at SB&CO identified the multitude of challenges involved in implementing CSRD from several in-house sustainability and finance practitioners. The challenges raised range from the overall vagueness of the guidance from the EU Commission on cardinal points to the opportunistic behaviors displayed by some advisors and assurance companies with conflicting self-interests in making the regulation more complex than it needs to be. In parallel, large multinationals such as Coca-Cola are publicly voicing their discontent with the CSRD and other sustainability-related regulations on LinkedIn under the hashtag #pleasemakeitstop.
Many valid points are raised in much of the corporate practitioner push-back, including on CSRD: CSRD, which is probably the most ambitious piece of sustainability-related regulation in the world, is also relatively half-baked on many accounts and will undoubtedly imply a massive strain on both headspace and resources for most companies. At a recent ESG and Sustainability Reporting Summit, it was e.g. estimated that a fully CSRD-compliant report would take 4.5 FTE over a 9-12 month period – a steep incline in the meager corporate resources that have historically been allocated to most-things-sustainability (including disclosures), especially when comparing to financial disclosures.
On the other hand, as we know from key pieces of legislation in other domains: the benefits of new legislation take time to fully materialize. If the ambition genuinely is to place sustainability disclosure at the same level as financial disclosure, we should not forget the time and resources invested in evolving and professionalizing the financial reporting discipline to where it is today.
Are growing compliance requirements stifling real progress on sustainability?
Beyond the painful implementation challenges in these early inception years, there is a graver underlying concern in the response from the corporate community, which warrants more attention. At the core of this concern is the notion that there is a fundamental trade-off between growing regulatory requirements and “real sustainability work”. Or put differently: that new regulatory requirements such as the EU CSRD take away the time and effort that companies could have invested in driving real progress and much needed innovations on critical sustainability challenges.
“Sustainability teams are heading towards breaking point. They are spending so much time navigating reporting, disclosure, and materiality requirements (and studying interoperability guidance!) instead of helping businesses to scale up and deliver urgent sustainability work, including decarbonization, circularity & nature restoration.” – Joe Frances, VP, Coca-Cola
At a fundamental level, this concern challenges the very purpose of these regulations, which build on the exact opposite assumption: i.e., that growing transparency and other forms of sustainability regulations will, over time, lead to real improvements on critical sustainability matters and that the financial markets will increasingly reward the companies that manage to do so. Should this assumption turn out to be false, the regulations will indeed have failed on a massive level.
The Compliance/Innovation Nexus: What do we (really) know?
But let us first take a step back: For the past few decades, the sustainability profession has been characterized by a plethora of voluntary disclosure and performance standards and initiatives with very little regulatory intervention. As emissions and resource depletion continue to soar across most industries, one could perhaps argue that this approach, too, has been ineffective in course-correcting towards a more sustainable, equitable, and just future.
Even so, it is too simplistic to conclude that because market dynamics alone have been unable to fix all our sustainability woes, the significant influx of regulations rolling over notably the EU will. It is, however, equally too simplistic to conclude that growing compliance requirements, by default, will squash all forms of market-driven innovation and initiative on sustainability or, in the worst case, render companies impacted by such regulations less competitive.
And here is the real crux: What do we really know – scientifically and empirically – about the impact of growing compliance requirements on a company’s ability to drive performance improvements and innovations on material sustainability matters?
The answer is: Not a lot. In fact, the nexus between compliance and innovation in the context of corporate sustainability remains a vastly under-researched topic.
Take our crude drawing here as an example. The red line suggests that the relationship between compliance and innovation is an inverted one, mirroring the concerns raised by some corporates. The underlying assumption: the more regulatory requirements companies have to deal with on sustainability, the less innovation on (real) sustainability we’ll all get.
The green line suggests that the relationship between compliance and innovation is – or could be – a positive one. The underlying assumption: the more requirements, the higher the potential innovation on sustainability matters. This notion is similar to the “Porter Hypothesis”, coined some 30+ years ago, challenging the conventional wisdom of neoliberal economists by hypothesising that the impact of well-designed environmental regulations can lead to enhanced performance on environmental matters and, over time, increase firm competitiveness.
How companies respond to new sustainability regulations makes a key difference
The jury is still out on whether the massive influx of new sustainability regulations in the EU and beyond will drive positive outcomes on critical sustainability matters or, in the worst-case scenario, negative ones.
Importantly, there will always be external and context-specific factors at play with any new regulation, including how the regulation itself is crafted and sought implemented by policymakers. Here one can of course argue that CSRD and other pieces of sustainability legislation are fundamentally flawed, too complex, too hastily implemented, too ambitious or not ambitious enough, lacking in incentives or penalties etc.
However, one thing we do know from the few existing studies that have studied the relationship between compliance and innovation within e.g. the environmental domain is that endogenous factors in the form of how effectively companies absorb and respond to these regulations have a significant influence on which way the curve will bend.
As one example, an empirical investigation of the oil and gas industry of Australia found that firms faced with high levels of environmental regulatory burdens were more likely to introduce product and service innovations, as well as innovations that were either new to the industry or new to the firm. The study also found that for this effect to manifest itself, important firm-level characteristics are at play, including the companies’ capabilities to go “beyond compliance”, the role of internal and external knowledge networks and R&D capacity.
A more recent study supports the notion that for companies to leverage new sustainability regulations to drive innovation and performance enhancement, critical in-house knowledge (‘absorptive capacity’) must be built up and shared across key functions rather than siloed within individual teams.
Three company-specific factors worth considering (at least)
As the sustainability profession is moving from a voluntary, market-driven discipline to a heavier regulated compliance discipline, we would argue that much more thinking and (self)investigation is required on how companies can create conducive conditions to bending the compliance-innovation curve within their own organisations with the ultimate objective of achieving positive cross-fertilization between the two.
As a starting point, we generally urge our corporate clients to consider at least three conducive factors which may help turn the growing influx of regulations from a short-term pain to a longer-term gain:
- Think beyond compliance: It is starting to become a bit of cliche for many sustainability advisors and practitioners as new regulations are taking up time and headspace in most companies and dominating conversations with senior executives. But here is the thing: nothing great has ever come out of doing the bare minimum. To bend the compliance-innovation curve, companies must apply a strategic mindset and forward-looking response to new regulatory requirements, asking not just “what do we have to do (to avoid getting penalized)?” but increasingly “what could we do (to reap greater rewards)”?
- Gradually build capacity: We see it all the time: many of the companies subject to substantive regulations like CSRD simply lack the resources and knowledge to transpose new requirements (e.g., on disclosure) into meaningful performance improvements, let alone innovations. Unfortunately, there is no easy short-cut to addressing this issue: Companies will need to invest in gradually building up the required internal capabilities and absorptive capacity to enable new requirements to be embedded into the company’s strategy, culture, and business processes.
- Leverage insights across silos: Finally, it matters immensely how companies organize themselves around new sustainability requirements. As an example: Siloing the critical knowledge gained from e.g., a CSRD-aligned double materiality assessment within a single team or outsourcing it to an external consultant without a clear route for internal anchoring is a recipe for failure and unlikely to lead to any real changes at the strategic or operational level. Fortunately, there are lessons to be learned from other regulatory domains – think quality management – where companies have faced similar interplays between compliance, performance and innovation and can learn from past successes and failures on organisational design.
We are always keen to learn more about what works and what doesn’t from current and future clients and collaborators so don’t hesitate to reach out and share your perspectives at info@raison-consulting.com or follow us on LinkedIn: https://www.linkedin.com/company/raison-consulting-com/