The European Commission’s new approach to ESG due diligence and corporate accountability

Presented early on in the European Commission’s new mandate, the “European Green Deal” has been the foundation of its values-driven approach to sustainable corporate governance, achieving climate neutrality by 2050, and transitioning towards a more sustainable economic model.

The corporate due diligence and corporate accountability initiative (ESG Due Diligence law) is a key pillar of this ambitious approach and could have wide-ranging implications for companies across all sectors operating in the internal market.

This article sets out where the European Parliament stands on the proposed ESG Due Diligence law, key features of current proposals and a number of novel legal and commercial issues that businesses should consider engaging policy-makers on.

Where does the European Parliament stand?

Announced in April 2020 by Justice Commissioner Didier Reynders, the proposed European ESG Due Diligence law is intended to push companies towards decision-making that is focused on the longer-term and with reference to all stakeholders. This will address what the Commission perceives as the temptation by businesses and executives to focus on short-term financial returns at the expense of sustainable value creation: investment that is essential for the just transition to a low-carbon economy.

In a rather uncommon move for the only parliament in Europe that does not have formal power to propose new legislation, the European Parliament started working on its own legislative proposal in 2020. In September 2020, the Parliament’s Committee on Legal Affairs published a draft report that included draft text for a Directive. This shows the political importance of the topic in the Brussels policy-making arena.

Initially, the proposal was backed mainly by the political centre-left. Recently, however, decision-makers from across the political spectrum have backed a strengthened regulatory framework that would create additional ESG compliance requirements for businesses across their operations and supply chains as well as across all sectors of the economy.

In a vote on a legislative own-initiative proposal on 11 March 2021, the European Parliament resoundingly voted for binding EU rules that will aim to set a standard for responsible business conduct in Europe and beyond.

The thinking behind this proposal

While the European Commission is still finetuning draft legislation, which is expected by June 2021, the European Parliament has set an ambitious baseline to guide the Commission. While its position is non-binding, the European Commission has already indicated that this would be carefully considered in the process of drafting the legislation.

The proposed legislation will go beyond voluntary commitments and self-regulation and propose mandatory requirements that are likely to significantly tighten environmental, social and governance (ESG) compliance requirements for companies across their global value chains.

In the course of various public interventions over recent weeks, Commission officials, including Justice Commissioner Reynders, have hinted at several key elements of the legislation. The Commissioner has stressed that the proposal – most likely to take the form of a Directive – would aim to cover the entire supply chain and, possibly, be complemented by additional sectoral or national legislation.

The Commission will be looking across a number of domestic initiatives for inspiration when draftingthe new legislation. The 2017 French “Loi de Vigilance”, largely considered as pioneering mandatorydue diligence requirements in the European Union, has been described as key example for the Commission. The UK’s Modern Slavery Act has also guided policymakers’ thinking. In a similar vein, the German Government’s recent proposal for a Supply Chain Due Diligence law, currently in the early stages of the legislative process, will be closely watched by EU decision makers as they debate their own proposal.

The best indication as to what to expect from Brussels in June however, remains the legislation proposed by the European Parliament’s own-initiative report. An in-depth look at that report will give businesses an edge in their preparation for the new regulatory environment.

Key features of the current own-initiative proposal

Scope

Companies in scope will include, across all sectors:

• large European companies;
• all publicly listed small and medium-sized companies, as well as high-risk small and medium-sized companies; andlarge companies, publicly listed small and medium-sized companies and small and medium-sized companies operating in high risk sectors, not domiciled in Europe but who operate in the internal market selling goods or providing services.

ESG in substance

The ESG Due Diligence law will be wide-ranging, covering adverse impacts on human rights, the environment and good governance. The Commission will provide clarity on the types of business-related adverse impacts covered but current proposals suggest a very broad scope. For instance, in relation to:

• human rights: this should be understood as all internationally recognised human rights, including as expressed in the International Bill of Rights, international human rights conventions, ILO Declaration on the Fundamental Principles and Rights at Work, the ILO Core Conventions and regional human rights instruments;
• environment: this should include waste, pollution, greenhouse gas emissions, deforestation, air, soil and water quality, use of natural resources and biodiversity; and
• good governance: this should include corruption and bribery, responsibly lobbying and responsible taxation.

Value chain due diligence strategy

Companies will need to undertake ongoing diligence with respect to potential or actual adverse impacts on human rights, the environment and good governance across their value chain. Significantly, “value chain” is intended to cover direct or indirect business relationships, upstream and downstream, and companies will need to identify whether and how their operations and business relationships cause or contribute to or are directly linked to any of those potential or actual adverse impacts.

If companies identify relevant risks they will need to develop, make publicly available and annually update a value chain due diligence strategy that:

• outlines the identified risks;
• discloses relevant information on their value chain, which may include names, locations, types of products and services supplied, and other relevant information concerning subsidiaries, suppliers and business partners in its value chain;
• adopts and indicates all proportionate and commensurate policies and measures with a view to ceasing, preventing or mitigating potential or actual adverse impacts; and
• prioritises mitigation in line with the UN Guiding Principles on Business and Human Rights.

Due diligence strategies will also need to be uploaded to a centralised European platform.

Stakeholder engagement

Companies will need to carry out meaningful stakeholder engagement when establishing their due diligence strategies.

Grievance mechanisms

Companies will need to provide access to a grievance mechanism to allow stakeholders to raise concerns about actual and potential adverse impacts. This may be through their own mechanisms or in collaboration with sector and industry based mechanisms. Grievance mechanisms should operate both as an early warning mechanism for risk-awareness and as a mediation system to resolve disputes.

Grievance mechanisms will need to be aligned with the UNGP Effectiveness Criteria and include protections for rights of children.

Supervision and enforcement

A novel supervision and enforcement regime is contemplated which would require Member States to designate national competent authorities to supervise compliance with the requirements.

National authorities will have the power to undertake investigations, including on the basis of concerns raised by stakeholders. This will mean supervision of due diligence strategies and the design and functioning of grievance mechanisms.

If non-compliance is identified following an investigation, companies will be given an opportunity to implement corrective and remedial actions. However, where irreparable harm is identified this may lead to a temporary suspension of activities linked to that harm or a ban on operations in the internal market.

National authorities will coordinate at the European level to ensure convergence of regulatory, investigative and supervisory practices, share information, and monitor their performance. The EU will publish an annual due diligence scoreboard based on the information received by national authorities.

Sanctions and civil liability

Legislation will provide sanctions for non-compliance. This may include fines calculated on the basis of a company’s turnover, temporary or indefinite exclusion from public procurement, state aid, public support, including schemes relying on Export Credit Agencies and loans, seizure of commodities and other appropriate administrative sanctions.

Civil liability regimes under national law should ensure that where companies can show that they took all due care in line with the Directive to avoid any harm that arises, or that the harm would have occurred even if all due care had been taken, they should not be held liable for that harm.

Private sector input will be essential

Requirements under the European proposals will significantly change the risk profiles of businesses in scope. Businesses now have an opportunity to share experience and best practice with law-makers. The proposals outlined above raise a number of novel legal and commercial issues that businesses will need to engage policy-makers on, including:

• What is the appropriate interaction between oversight of local risks compared with global or systemic risks and how would this operate in practice?
• How will the requirements support the development of trade, investments and supply chains in high-risk jurisdictions?
• How will this proposal interact with existing and proposed due diligence, mitigation and disclosure requirements under sustainability and climate-related disclosure as well as environmental laws?
• The importance of distinguishing between process-oriented and outcomes-oriented liability provisions.
• The importance of local access to justice and rule of law protections for an effective operating environment, especially in high-risk jurisdictions.

The Brussels institutions have ramped up their ambition, but the law-making process is still in its early stages. Executives should consider their approach in the wider context of several recent EU regulatory initiatives on sustainable corporate governance, sustainable finance, and non-financial reporting.

We must be realistic about the final scope of this legislation. Lawmakers are being extremely ambitious, but the output must be workable. In that regard it is prudent to consider what due diligence systems are already in place - some of which may not need to be revised because they are working effectively already.

The shift to mandatory ESG compliance raises many questions: not only whether the level playing field would be in danger given a potential competitive advantage for companies who do not need to comply or fall outside the jurisdictional reach of EU enforcement, but also how these mandatory requirements will take shape.