What is ESG and why is it a hot topic?
ESG stands for environmental, social, and governance (ESG) considerations. These are the criteria used to establish how sustainable a company’s business model is. ESG is now in the spotlight as a result of a shift in societal norms towards increased protection of the planet and its people. The realisation that corporations have an active role to play in achieving this goal has led the European Union to propose comprehensive and coherent legislation.
NFRD / CSRD
In 2011, the European Commission first stressed the need for companies to transparently ad publicly communicate on the social and environmental impact of their business.
Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, was one of the first pieces of European Union legislation to touch on ESG matters, though only lightly. Directive 2013/34/EU was in turn amended by Directive 2014/95/EU of 22 October 2014 on disclosure of non-financial and diversity information by certain large undertakings and groups (the NFRD). NFRD introduced the obligation for certain large listed undertakings and/or their parent companies with more than 500 employees during the financial year to include a non-financial statement containing information on environmental, social and employee matters, human rights, anti-corruption and bribery in their management report.
The NFRD was transposed into Luxembourg law by way of the Law of 26 July 2016 on the publication of non-financial information (the 2016 Law) and is applicable since 1 January 2017. The provisions of the 2016 Law exclusively apply to large listed companies (credit institutions, insurance undertakings and listed entities on a regulated market in the European Union) with more than 500 employees and total assets of EUR 20 million and/or a net turnover of EUR 40 million, which considerably restricts its scope of application.
Answering calls from investors and society at large for more qualitative information to be published by companies on their social and environmental performance and impact, the European Commission opted to broaden the scope of application of non-financial reporting requirements with the adoption of Directive 2022/2464 of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/European Commission, Directive 2006/43/European Commission and Directive 2013/34/EU, as regards corporate sustainability reporting (the CSRD), which extended the requirements introduced by the NFRD to large companies other than financial market participants.
The CSRD imposes reporting obligations on the following companies:
- all listed undertakings in the EU (excluding micro-undertakings);
- all undertakings and/or their parent companies, which meet at least two of the following criteria in two consecutive financial years:
- EUR 20 million balance sheet total;
- EUR 40 million net turnover;
- an average number of 250 employees;
- non-European undertakings with a turnover over EUR 150 million in Europe in the last two consecutive financial years with at least one large EU-listed subsidiary or branch that generates a minimum revenue of EUR 40 million in the European Union.
Under the CSRD, companies will have to report on how sustainability issues affect their business and on the impact of their activities on society and the environment.
Luxembourg is required to transpose the CSRD into national law by 6 July 2024. To date, no bill of law has been proposed.
On 23 February 2022, the European Commission published the Proposal for a Corporate Sustainability Due Diligence Directive, amending Directive (EU) 2019/1937 (the CSDD). The CSDD aims to improve corporate governance practises, harmonise due diligence requirements in member states, increase corporate accountability and ensure coherence with other EU initiatives as well to improve access to remedies for victims of negative corporate behaviour.
Attached to the CSDD is an annex (the Annex) containing the criteria to assess where an action constitutes an “adverse environmental impact” or an “adverse human rights impact” by reference to various listed human rights and international treaties.
In the proposal for the CSDD it is pointed out that the various ESG initiatives of the EU are closely interrelated. The CSDD is meant to lead to the introduction of procedures in companies to identify adverse impacts and to allow companies to set up plans ensuring their business model and strategy are compatible with the transition to a sustainable economy and limiting global warming. These procedures and plans will then enable companies to report pursuant to their obligations under NFRD or CSRD. In the same way the CSDD will help companies subject to the Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088 of 27 November 2019) (SFDR) being financial market participants who are required to publish a statement on the principal adverse impacts of their investment decisions on sustainability. The CSDD is also meant to be complementary to the Taxonomy Regulation (Regulation (EU) 2020/852 of 27 November 2019) as it should help investors to identify sustainable companies and in turn the Taxonomy Regulation will help companies to identify sustainable economic activities. The CSDD also complements but does not replace a number of other EU legislative acts in relation to specific ESG issues (in particular Directive 2011/36/EU on human trafficking/ Directive 2009/52/EU on minimum sanctions against employers of illegal third country nationals/ Regulation (EU) 2017/281 laying down supply chain due diligence for importers of certain conflict minerals/Proposal for a Regulation on deforestation-free supply chains/Proposal for a new Batteries Regulation/ Sustainable Product Initiative/ Directive 2004/35/CE on environmental liability/the Fit for 55 Package).
CSDD will apply to both European Union and non-European Union companies, subject to the following thresholds:
For European Union companies:
- all companies with more than 500 employees on average and a net worldwide turnover of more than EUR 150 million in the last financial year;
- all companies with more than 250 employees on average and a net worldwide turnover of more than EUR 40 million in the last financial year provided that at least 50% of this net turnover was generated in one or more “high impact sector”, being
- the manufacture of textiles, leather and related products, and the wholesale trade of textiles, clothing and footwear;
- agriculture, forestry, fisheries;
- the manufacture of food products and the wholesale trade of agricultural raw materials, live animals, wood, food, and beverages;
- the extraction of mineral resources regardless from where they are extracted (including crude petroleum, natural gas, coal, lignite, metals and metal ores, and quarry products), the manufacture of basic metal products, other non-metallic mineral products and fabricated metal products (except machinery and equipment), and the wholesale trade of mineral resources, basic and intermediate mineral products.
For non-European Union companies:
- all companies with a net turnover in the European Union of more than EUR 150 million in the financial year preceding the last financial year; or
- all companies with a net turnover in the European Union between EUR 40 million and EUR 150 million in the financial year preceding the last financial year with at least half of its worldwide turnover generated in one or more of the above-mentioned high-impact sectors.
Obligations under the CSDD
Under the CSDD, companies will be required to comply with obligations regarding actual and potential human rights adverse impacts and environmental adverse impacts (identified by reference to the Annex), with regard to their own operations, the operations of their subsidiaries, and the operations carried out by entities with whom the companies have an established business relationship in their supply chain. The meaning of “established business relationship” is quite broad and refers to a relationship with any legal entity with whom a company has concluded a commercial agreement or to whom it provides financing, insurance or reinsurance or that performs business operations for and on behalf of the company whether direct or indirect as long as it is expected to be lasting, in view of its intensity or duration and is not merely a negligible or ancillary part of the value chain.
The following is required from the companies:
- to introduce due diligence into all corporate policies and to adopt a due diligence policy, subject to annual reviews. Such policy should include a description of the company’s approach to due diligence, of a code of conduct to be respected by the company’s employees and subsidiaries, of the processes to implement due diligence;
- to take adequate measures to identify actual or potential adverse human rights and environmental impacts, generated by their business activities, in their subsidiaries and at the level of their direct and indirect business partners across the value chain;
- to prevent the identified potential adverse impacts or to mitigate those impacts, where prevention is not possible or requires gradual implementation;
- to establish and maintain a complaints procedure;
- to monitor the implementation and effectiveness of due diligence measures; and
- to publicly communicate on due diligence (where companies are not already subject to the NFRD or CSRD)
The CSDD requires the Member States to put in place laws implementing the obligations imposed by the CSDD and ensure that companies comply with the above-mentioned obligations by establishing a national supervisory authority to monitor compliance.
Consequences of non-compliance with the CSDD obligations on companies
Member States will be required to introduce rules on sanction for any breaches of national laws adopted pursuant to the CSDD, which are required to be effective, proportionate and dissuasive. The company’s efforts to comply with any remedial action required by a supervisory authority is to be taken into account as well as collaboration with other entities to address adverse impacts. Any pecuniary sanction shall be based on a company’s turnover.
Moreover, Member States need to ensure that companies are liable for damages resulting from their failure to comply with the due diligence obligations under the CSDD. In this respect account shall be taken of contractual assurances obtained as long as accompanied by measures to monitor compliance if the adverse impact results from the activities of an indirect partner with whom the company has an established business relationship (unless it was unreasonable to expect that the safeguards implemented by the company would be adequate to prevent, mitigate, bring to an end or minimise the extent of the adverse impact).
In the company’s favour remedial action, investments made, targeted support provided as well collaboration with other entities to address adverse impacts will be taken into account. However, the civil liability of the company will be without prejudice to the civil liability of its subsidiaries or business partners for the same claims. In addition the company is also to remain liable under EU or national laws providing for liability in situations not covered by the CSDD or for stricter liability.
Member States are under a duty to ensure that the laws transposing the CSDD into national law will be of overriding mandatory application even if, by reference to international conflict of law principles, the law applicable to the claims is not the law of a Member State.
Consequences of non-compliance with the CSDD obligations on directors of companies
CSDD also imposes duties on the directors of a company (being very broadly defined as members of any administrative, management or supervisory body or if there is no such body, the CEO and the deputy CEO or persons who perform similar functions). These relate to on the one hand the directors taking into consideration the consequences of their decision for sustainability matters in the short, medium and long term. In this respect Member States need to ensure that their laws sanction any breaches of these duty of care provisions.
On the other hand directors are required to put in place and oversee the due diligence actions foreseen by the CSDD with input from stakeholders and civil society organisations and report to the board of directors in this regard.
The European Parliament is set to adopt its final position in May 2023, with the CSDD likely to be approved by the end of 2023. Companies’ obligations under the CSDD will likely not enter into effect before the financial year 2025.
What are the practical implications of CSRD and CSDD for companies?
The main goal of the above-mentioned directives is for the EU to have sustainable economic development with no negative environmental and social impact. Therefore, we highly recommend that companies already start bringing their business models and strategies, internal policies and regulations in line with the high standards of sustainability described in the CSDD and its Annex.
Main challenges for the companies:
- to create sustainable business strategies and internal policies;
- to ensure that board members systematically consider the impact of their decisions on the environment and human rights;
- to ensure comprehensive data collection across their value chains on environmental and human rights matters;
- to have policies monitoring constant compliance with sustainability requirements;
- to set up non-financial reporting.
The main criticism of the CSRD and CSDD is that these directives will impose far stricter standards in the EU than are applicable in the rest of the world and especially in countries that are the main competitors of the EU economy (US, China etc). Compliance will also require substantial investment in resources and an overhaul of internal processes.
While the directives are only aimed at larger companies, the same standards will need to be adhered to in smaller and medium sized businesses whether situated in or outside of the EU by reason of the obligations placed on the large companies to impose standards all the way down the value chain.
Companies may incur civil liability for any failure to comply (even if not amounting to negligence) with obligations to prevent a potential adverse impact or bring any impact that should have been identified to an end (even if they could not have prevented the impact because they do not control the relevant business).
These factors will have an impact on the competitiveness of EU companies in a time when such companies are already dealing with other negative economic factors (war in Europe, inflation, interruption in supply chain by reason of the war and the pandemic etc). In turn this might lead to greater unemployment, difficulties in sourcing raw materials, further interruptions in supply chains, increase in prices of consumer goods and disengagement from certain developing countries.
Some assistance for the implementation of the directives may be obtained from organisations that are setting up standards and reporting frameworks, such as the following:
- GRI Sustainability Reporting Standards (GRI Standards);
- Sustainable Development Goals (SDGs or UN SDGs);
- Integrated Reporting (IR) Framework developed by International Integrated Reporting Council (IIRC);
- ISO 14001, the international standard that specifies requirements for an effective environmental management system;
- UN principles for responsible investments (PRI);
- Sustainability accounting standards board (SASB);
- International Finance Corporation (IFC) Performance Standards;
- Carbon Disclosure Project (CDP) Guidance;
- Streamlined Energy and Carbon Reporting (SECR); and
- Task Force on Climate-related Financial Disclosures (TCFD).