The Race to Sustainability: The EU Is One Step Ahead With New Sustainability and Due Diligence Rules

From a global pandemic to ever-soaring temperatures, our experience with unparalleled social and environmental crises will affect our society for years to come. In response, the EU has placed itself at the forefront of sustainability efforts, with ambitious climate laws and a 2050 deadline for carbon neutrality.

Financing this transformation is at the top of the political agenda. Thus, in the EU, a unique sustainable finance framework has emerged. This has resulted in sustainability moving from a niche debate to an essential part of any modern business strategy and communication.

With the recent conclusion of the negotiations on sustainability reporting, coupled with ongoing efforts to deliver new due diligence rules, EU rules are far more advanced, and significantly more burdensome, than any other jurisdiction. Not only will these new rules have significant compliance costs, but they will have far-reaching implications on brand value, reputation and the attraction of capital.

So, what is in store for companies and business leaders and how should they prepare?

SUSTAINABILITY REPORTING REQUIREMENTS

Disclosures on sustainability metrics have increasingly been at the forefront of political and industry debates. In the EU’s policy context, legislators finalised a landmark piece of legislation in June 2022, the Corporate Sustainability Reporting Directive (CSRD).

The new rules introduce more detailed reporting requirements to ‘large’ companies and companies listed on EU regulated markets. The rules will also apply to some of the largest non-EU companies with a physical presence in the EU. Controversially, foreign companies will likely face slightly more burdensome obligations, as they need to report at the consolidated level of the parent company regardless of where this parent is located.

Companies will need to disclose extensive information, including sustainability indicators relating to the business model, strategy, management, risks, policies and even details on its supply chain. This will include more specific and extensive reporting rules for specific sectors–in particular those areas viewed as ‘high-risk’ in terms of environmental or social harm.

The new legislation generally maintains the EU’s unique principle of ‘double materiality’, meaning that companies in the EU are required to report on how sustainability issues affect them from both a financial and non-financial perspective. Although the EU is trying to ensure cohesion with ongoing international work–the International Sustainability Standards Board (ISSB) in particular–the CSRD remains a fully independent regime which may materially diverge from international rules. This could result in duplicative reporting requirements and higher compliance costs for companies.

EU’S STANDARD FOR RESPONSIBLE BUSINESS CONDUCT

In response to mounting political pressure, work is also underway in the EU on an ambitious project tackling responsible business conduct, called the Corporate Sustainability Due Diligence Directive (CSDDD). These rules will require companies to ensure that their own business operations, and their supply chains, comply with extensive human rights and environmental sustainability criteria.

Although still months from completion, the rules are expected to have significant implications on the operational and business activities of most companies already under the scope of CSRD, as well as large and medium-sized companies operating in high impact sectors, such as textile, agriculture, mineral extraction and trading.

Due Diligence is generally left to voluntary commitments and self-regulation. However, this proposal overhauls this notion completely. Companies will be required to identify, prevent, mitigate and account for their adverse human rights and environmental impacts. They must also have adequate governance, management systems and measures in place. In addition, the CSDDD intends to expand the duty of care for company directors, so that they are required to consider the long-term impact to human rights, climate change and the environment when making decisions.

PRACTICAL AND POLICY IMPLICATIONS

Failure to comply with these new rules will result in significant administrative sanctions, and possibly even civil liability. However, perhaps even more significantly, the resulting information has reputational consequences which will be scrutinized by civil society–who are expecting companies, as well as investors, to be held to higher standards.

Investors are increasingly weighing up sustainability performance alongside financial performance. Not only is the demand for sustainable investments skyrocketing, but many are concerned about the longer-term viability of investments and are cautious of increased public scrutiny. They will be voting with their wallets and only increasing pressure on regulators and companies themselves to improve the sustainability performance of companies.

These new rules will tie into a complex framework of EU regulatory initiatives on sustainable finance. This framework is expected to expand significantly over the next few years. The consequences of this work will dictate how business is conducted in the EU.

However, in time this will spread. Although the EU may have more advanced rules for the time being, we are already seeing similar regimes and rules popping up around the world. This may even result in even more ambitious and far-reaching legislation. Europe may be ahead for now, but the rest of the world is close behind.

Sustainability is no longer an ‘add on’ or ‘nice-to-have’, but a prerequisite to operating a competitive and successful business. It is thus essential to keep up to date with these developments and react accordingly.