Overview In the coming years, the European Union will implement 2 types of ESG regulation:
Mandatory Human Rights, Environmental and Governance Due Diligence
ESG Disclosure: the Sustainable Finance Disclosure Regulation
Two areas of development, in particular, are likely to have widespread repercussions for businesses:
Newly implemented obligations for ESG disclosures
Likely forthcoming mandatory human rights, environmental and governance due diligence
These measures involve both new obligations of disclosure as well as, potentially, substantive obligations to address ESG issues connected to companies’ businesses. Importantly, as well as compliance concerns, businesses will need to consider the attendant legal risks of publicly sharing human rights and environmental risks in their business operations and supply chain more widely.
Their implementation is likely to have significant effects for both companies domiciled in the EU as well as companies operating within the EU.
ESG Disclosure: the Sustainable Finance Disclosure Regulation
The EU’s regulation on sustainability‐related disclosures in the financial services sector (the SFDR) was adopted by the European Parliament and European Council on 27 November 2019 and applies to certain financial services sector firms from 10 March 2021. Broadly, the SFDR is aimed at ensuring asset managers, financial advisors, and other financial market participants take into account sustainability and ESG factors in their decision-making around investments and in the information provided about those investments.
The regulation is not focused on the investors themselves. Instead, the SFDR requires “financial market participants” (defined as investment firms carrying out portfolio management, certain insurance undertakings and qualifying venture capital funds, amongst others) and “financial advisers” to provide information about ESG matters in respect of their services and in the marketing of particular products. This approach is designed to promote investors’ ability to investigate companies’ approach to ESG, and to then act on the sustainability information provided.
At its core, the SFDR requires those market participants and advisers to identify and publish information about how they account for “sustainability risks” in their investment advice or decision-making.
A sustainability risk is defined as an ESG event or condition which does or could negatively impact on the value of the investment. Possible ESG risks are extensive – taking exposure to climate change as an example, this could include companies whose supply chains rely on low-lying farmland or at the other end of the spectrum, companies who may face new regulation by governments, like those within the airline industry. Equally, social risks could extend to considering potential risks through not just a company’s immediate operations but also its key supply chains, requiring knowledge of where its production takes place and the makeup of its workforces.
Article 4 of the SFDR requires financial market participants to publish on their websites a statement of how they take into account “principal adverse impacts” from ESG risks in their investment decision-making and a statement on how they do the due diligence to understand those risks.
While this obligation is slightly tempered for smaller companies, allowing them to either explain how they take these into account or if not, why they do not ( so-called “comply or explain” measures) for larger companies of over 500 employees these obligations are fixed and in effect as of 30 June 2021. Financial advisers are also required to publish a statement explaining how they account for adverse impacts on sustainability factors in their investment advice or insurance advice, also on a “comply or explain” basis.
Additional, more detailed periodic disclosure regimes are also set to come into place. The detailed nature of this guidance, and the expansive nature of the obligations it places on businesses, mean these rules are only proposed to be implemented on a rolling basis from 1 January 2022. Again, the level of information proposed to be disclosed in the periodic disclosure is clearly going to require many companies who fall within the regulation to undertake significantly more investigations into the makeup of companies in their investment portfolio and their exposures.
For products, an additional set of obligations applies where they are marketed as “ESG” or “sustainable” products. The SFDR essentially breaks down products into three categories:
(a) mainstream products (b) products “promoting environmental or social characteristics” (c) products promoting “sustainable investments”. For all products, the market participant or advisor must set out in pre-contractual disclosures how sustainability risks are factored into the investment or advice and provide an assessment of the impact of sustainability risks on returns.
For financial market participants, they must also disclose how they have assessed the product’s principal adverse impacts on sustainability factors.In each case, if this is not done a reasoned explanation must be provided. For categories (b) and (c), additional disclosures are required from financial market participants to show how those marketed objectives are met.
As well as pre-contractual disclosures, there are obligations about providing that and similar information on company websites and in periodic reporting. While many ‘green’ or ‘sustainable’ investments and funds may already provide some of this information, the standardised nature of the SFDR is likely to make it easier to compare products and also potentially for consumers and advocacy groups to hold them to higher standards. Many advocacy groups have long been critical of “greenwashing” efforts, in which companies are seen as providing false or misleading information about their environmental and climate policies and impacts.
Disclosures may well also result in claims for compensation for alleged ESG violations being asserted against the investment companies themselves, as well as the company committing the alleged violation. The SFDR is likely to be a continued point of focus for campaigning groups to use and careful thought will need to be given to compliance to minimise the risk of being targeted either with litigation or damaging public campaigns.
Although some member states have announced specific enforcement units focused on ESG issues, the majority of obligations in the SFDR are baked into existing disclosure obligations under other EU laws, such as the Directive 2011/61/EU on Alternative Investment Fund Managers and Directive 2014/65/EU on Markets in Financial Instruments. Enforcement of the disclosure obligations in these existing regimes are also primarily at a national member state level and have resulted in significant fines being imposed.
International Application
The SFDR clearly applies to companies within Europe. However, it may well reach into US businesses, and those located in other jurisdictions. The European Commission has not clarified its position on whether it applies to non-EU companies who operate in the EU or who market funds into the EU, although there has been a widespread assumption that it will. Further, many large companies in Europe are owned by parent companies in the US, who may be affected even by a more limited EU-scope regulation, and internationally, companies who have EU-based investors are likely to face requests for their ESG data and other ESG information in order for those investors to comply with the regulation.
The SFDR should also be looked at as the ‘first mover’ amongst regulations of this kind. Similar types of regulations are being considered in the US and the UK.
The UK has indicated that it will adopt the recommendations made by the Task Force for Climate-related Financial Disclosures (TCFD) to make climate-related financial disclosures mandatory for certain firms by 2025, positioning itself as a market leader in this area.
On 24 March 2021, the Government launched a consultation on mandating climate-related financial disclosures by publicly quoted companies, large private companies and Limited Liability Partnerships (LLPs). The Financial Conduct Authority in the UK has already introduced a new listing rule on climate-related disclosure for commercial companies with a 'premium listing' on a UK stock exchange to require the provision of information on those companies’ exposure to climate change risks and opportunities. These efforts suggest UK regulations in this area could be extensive, and may well be guided by a desire to be seen as going beyond European standards.
Mandatory Human Rights, Environmental and Governance Due Diligence
The second area of prospective regulation concerns mandatory “due diligence” measures for human rights, environmental and governance concerns – essentially equivalent to ESG. The idea of due diligence legislation is linked to the UN Guiding Principles on Business and Human Rights, in which “human rights due diligence” is used to refer to a process of assessing the actual and potential human rights impacts of a companies’ operations, integrating and acting upon the findings, tracking responses, and communicating how those impacts are addressed.
Centrally, these obligations are not limited to the companies own business operations but extend to those risks caused by, contributed to or directly linked to the business’ operations – incorporating businesses linked by relationship, and wider supply chains.
A proposal for a new directive covering mandatory due diligence is expected at the end of Q2 2021. The commitment to a proposal builds on a wide range of discussions and reports at an EU level, including a public commitment by EU Commissioner Didier Reynders in April 2020. The major question since then has been the scope of the proposal. Here, the European Parliament has stepped into the breach to push forward momentum for a comprehensive and wide-reaching initiative.
As a starting point, the European Parliament is not responsible for initiating legislation. It will be for the European Commission to specify the scope of the proposed directive. However, the European Parliament can put pressure on the Commission, and its draft Initiative indicates the current trends of discussion in Europe and given its landslide support in the Parliament (passing by a vote of 504-79) it may have some influence on the Commission’s text.
The Parliament’s proposal involves both an obligation to conduct due diligence and a liability provision for companies which fail to do so. In terms of the due diligence obligation, the Parliament has proposed that it would apply to all large companies operating in the EU and to any publicly listed or “high risk” small and medium enterprises.
This would explicitly catch internationally domiciled businesses. As well as the obligation to actually carry out due diligence, the obligations on these companies would include creating a due diligence strategy and publishing a mapping of their entire value chain which (taking into account commercial confidentiality), “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”.
Value chains cover all business activities as well as direct or indirect business relationship, upstream and downstream, making this an extensive exercise, particularly as it is to be carried out yearly and is just one aspect of the due diligence strategy. Other aspects include obligations to ensure companies’ business relationships in turn have human rights standards and policies in place, including throughout their linked supply chains. The Initiative also envisages that companies will provide internal grievance mechanisms (consistent with current obligations under the UN Guiding Principles). Alongside these very extensive obligations would sit mechanisms for providing remedies for any harms arising from human rights, environmental or good governance failures.
Again, the Initiative is ambitious in scope providing that companies “harm arising out of potential or actual adverse impacts ... that they, or undertakings under their control, have caused or contributed to by acts or omissions” unless the company can prove that it acted with due care and took all reasonable measures to prevent such harm. That carve out in essence creates a type of safe harbour provision for companies who undertake due diligence in line with the proposals.
However, there may still be a teething period while what constitutes reasonable compliance is worked out, as the various ways human rights, environmental and governance harms can emerge throughout different companies’ value chains will differ immensely meaning due diligence strategies will also validly differ in scope and focus.
For companies that are only “directly linked” to harms, they are obliged to cooperate with the remediation process to the best of their abilities. The schema of differentiating between causing, contributing and being directly linked to ESG harms is directly drawn from the UN Guiding Principles and has not always been straightforward to apply.
This would be monitored by member states, and there are various provisions for investigations, supervision and penalties for companies.
Conclusion
The SFDR and mandatory due diligence measures coming out of Europe are likely to significantly affect how businesses approach ESG issues.
The SFDR is part of a particular wave of consumer-focused regulation around ESG issues. Rather than directly requiring businesses to change the way they work, the objective is for the transparency obligations to promote changes in business practices and to promote accountability (for sustainability claims in particular). Those disclosures are likely to lead to increased scrutiny of businesses decision-making around ESG issues, with implications for both legal risk and reputational risk.
The best way for businesses to address these concerns – as well as to future proof against upcoming due diligence legislation – is to take action to address ESG concerns and to comply with guidance such as the UN Guiding Principles on Business and Human Rights.
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