ESG: A long road from E to S
Isabelle Lebbe, Gennyfer Peeters and Antoine Portelange of Arendt & Medernach shine a spotlight on the oft-overlooked ‘S’ in ESG, and analyse the various relevant regulations European businesses should be aware of.
ESG has been on everyone's lips for some years now and sustainable finance is consistently at the top of the priority list for governments, decision-making bodies, and financial regulators. Whereas sustainable investing used to be a niche field, estimates now suggest that ESG assets could reach $53 trillion by 2025, representing nearly one third of global assets under management.
There are many reasons for this paradigm shift in the financial sector. These include: an obvious climate crisis, the global health crisis, the materialisation of non-financial risks all over the globe, and younger and female investors joining the financial markets. Nonetheless, lawmakers have certainly played their part, especially in Europe. Political commitments have set sustainability targets and initiated many subsequent directives and regulations, including:
Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (SFDR);
Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (EU Taxonomy);
Revision of the framework of Directive (EU) 2011/61 (AIFMD) and Directive (EU) 2009/65 (UCITS Directive);
Updates to the delegated acts for Regulation (EU) 575/2013 on prudential requirements for credit institutions and investment firms (CRR), Directive (EU) 2014/65 on markets in financial instruments (MiFID II), Directive (EC) 2009/138 on the take-up and pursuit of the business of Insurance and Reinsurance (Solvency II Directive) and Directive (EU) 2016/97 on insurance distribution (IDD) frameworks; and
Regulation (EU) 2019/2089 amending Regulation (EU) 2016/1011 on low carbon benchmarks and positive carbon impact benchmarks.
What is striking about these myriad legislations is that they create the impression that ESG is limited to environmental aspects, so that it could easily be formulated with a capital “E” and lower case “S” and “G”. This impression is only partially untrue: there are in fact many existing rules and articles within the regulations that are dedicated to human rights matters, or internal standards or codes of conduct. However, they are either secondary compared to environmental matters or simply non-binding.
Yet the “S” in ESG is central and essential to the transition of our society. Sustainability due diligence has become an important aspect of investment decisions, corporate finance and business strategies, and will most likely gain in influence and importance in the coming years.
Moreover, whereas investors clearly see social investments as an investment opportunity, they also recognise the risk of being associated with human rights abuses if they neglect the social component of their investments.
This article will focus on this second letter of ESG, the second layer of the regulatory package which strives for greater sustainability in the financial world. It will start by describing the recent but still limited developments in the field of human rights and social due diligence, before discussing the upcoming rules and the challenges that will inevitably accompany them.
Where are we now?
Passing over the obvious conventions, such as the 1948 Universal Declaration of Human Rights, many principle-based regulations and standards have been adopted over the past 70 years by international institutions and organisations. Most of these are internationally recognised and complied with in most developed economies.
They include, for example, the 2011 UN Guiding Principles on Business and Human Rights, which promotes consideration of human rights in company codes of conduct, and the 2011 OECD Guidelines for Multinational Enterprises regarding corporate social responsibility and monitoring of business relationships.
However, because these conventions and guiding principles are currently only soft law, they are not binding and are only applied by companies and states which voluntarily decide to adhere to them.
In today’s European regulatory landscape, social and human rights matters already have a strong presence, whether in a narrow way on very specific subjects, or indirectly, as one of the layers in a more generic framework.
Directive (EC) 2009/52 is an example of the first type. It provides for minimum standards on sanctions and measures against employers of illegally remaining third-country nationals, adopted specifically to address the many problems caused by undeclared work.
The second way of integrating social aspects into the European regulatory framework is less obvious but more wide-ranging.
In the asset management world, the two main regulations regarding sustainable finance are the EU Taxonomy and the SFDR. From a corporate standpoint, the new directive on corporate sustainability reporting will also be cited.
As a reminder, the EU Taxonomy seeks to create a classification tool to help investors and companies make informed investment decisions on environmentally friendly economic activities. The EU Taxonomy therefore focuses on the “E” pillar but nevertheless provides for minimum social safeguards.
To be considered a “sustainable investment” under the EU Taxonomy, an economic activity must contribute substantially to one or more of the environmental objectives set out in the regulation, ensure that it “does not significantly harm” any of the other environmental objectives and comply with minimum safeguards. As such, the EU Taxonomy provides that economic activities should not only have a positive impact on the environment, but also be carried out in compliance with the above standards. These are the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the International Labour Organisation (ILO) declaration on Fundamental Principles and Rights at Work, the ILO’s eight fundamental conventions and the International Bill of Human Rights.
Under the SFDR, for an investment to be considered a “sustainable investment”, it must:
Contribute to a sustainable objective (environmental or social);
Do no significant harm (DNSH) to the other objectives; and
Be issued by a company that follows good governance practices.
Regarding the “contribution” to an environmental or social objective, the SFDR does not mandate a minimum contribution, a strict or limited list of acceptable sustainable objectives or specific criteria regarding the quality or nature of the issuer of the investment. As such, financial market participants are responsible for setting their own sustainable objective(s) and targets, allowing them to assess the relevant contribution to those objectives. This leads, in practice, to most market participants opting for environmentally sustainable objectives.
There are two criteria for demonstrating that an investment follows the DNSH principle:
How indicators of “principal adverse impacts” (PAI) are considered; and
How the relevant investment complies with minimum safeguards.
On the integration of PAIs, the SFDR framework merely requires market participants to explain how the PAI indicators have been considered.
In this context, the regulatory and technical standards included in the Commission Delegated Regulation (EU) 2022/1288 supplementing the SFDR (SFDR Level II) lay down indicators for adverse impacts on sustainability factors (or PAIs) from investments in investee companies, sovereigns and real estate assets. Table 1 of Annex I of the SFDR Level II lists all the indicators and expressly includes several indicators for social and employee matters, respect for human rights, and anti-corruption and anti-bribery. This includes the “lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises”.
As regards “minimum safeguards”, the SFDR Level II provides that the description of how investments follow the DNSH principle should: “whether the sustainable investment is aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights”.
The last directive came into force on January 5 2023: Directive (EU) 2022/2464 regarding corporate sustainability reporting (CSRD). This directive aims to modernise and strengthen the rules on sustainability aspects in company reporting.
Companies subject to the CSRD will have to report on various sustainability-related topics in accordance with the European Sustainability Reporting Standards developed by the European Financial Reporting Advisory Group. In that context, companies within the scope of the CSRD will have to report on several social issues, starting with information linked to equal treatment and opportunities for all, such as diversity, inclusion of people with disabilities and measures against violence and harassment in the workplace. They will have to provide significant information, with details of all incidents and the measures taken to resolve the issues. Reporting will also have to include issues linked to forced labour, child labour and human rights more generally. Companies will also have to publish their equal pay gap.
The three examples above demonstrate an initial transition towards making human rights due diligence mandatory and enforceable.
EU social taxonomy
Since its inception, the EU’s sustainable finance strategy has comprised environmental and social aspects. Indeed, social investments are not only necessary when achieving the sustainable development goals in the UN’s 2030 agenda, they are also essential for creating the social internal market promoted by the EU.
In this context, the European Commission gave the Platform on Sustainable Finance (PSF) a two-year mandate in October 2020, with the task of advising on whether the EU Taxonomy should be extended to social issues. In February 2022, the PSF released its “Final Report on Social Taxonomy”, in which it presented a potential structure for a European social taxonomy.
In the report, the PSF suggested that the social taxonomy would take over most of the structural aspects of the environmental taxonomy, namely:
The development of social objectives;
Types of substantial contributions;
Minimum safeguards, without being identical to the environmental taxonomy.
Indeed, the environmental and social taxonomies would also have their own specific features.
The PSF identified three groups of stakeholders that may be affected by economic activities, identical to those identified in the context of the CSRD, and built the social objectives around those three categories:
Decent work (including for value chain workers). This objective would support the decent-work agenda developed by the ILO. This is built on four pillars: employment creation, social protection, rights at work and social dialogue;
Adequate living standards and wellbeing for end-users. This is actually a twofold objective to (i) protect end-users against products and services that present increased risks to health and safety, and (ii) give end-users access to products and services essential to basic human needs (health, food, and education); and
Inclusive and sustainable communities and societies. According to the PSF, this objective will be achieved if (i) negative impacts on communities and societies are addressed and avoided, and (ii) basic economic infrastructure is made available to certain “target groups”.
For each of the three main objectives, the PSF proposed different types of substantial contributions: avoiding and addressing negative impact, enhancing the positive impact inherent in economic activities, and enabling activities.
Like the environmental taxonomy, the PSF believes that the social taxonomy should have its own DNSH criteria. Their objective would be to ensure that, when an activity contributes to one of the social objectives set out in the social taxonomy, it is not harming any other objectives in the social taxonomy.
The DNSH criteria will, in principle, be linked to the economic activity, except for matters that cannot be linked to that activity (such as transparent and non-aggressive tax policy). In this case, minimum safeguards will be put in place to avoid shortcomings.
The various texts already in force mainly rely on transparency regarding sustainability aspects in the market. They tend to converge on one principle: those who do not wish to be part of the sustainability transition must be fully transparent about this (and, as a result, few financial market players have opted for that position).
It seems that Europe is ready to move one step further and tackle another crucial element: improving corporate due diligence. Nowadays, companies and large groups can have numerous affiliated entities with various suppliers based in many areas of the world. Carrying out good quality due diligence on this very large supply chain is essential for identifying and mitigating adverse impacts on sustainability factors.
However, there is currently a clear lack of binding standards obliging companies to conduct sound due diligence. This allows every corporate issuer to select how and to what extent they want to scrutinise their value chain.
To fill this gap, the European Commission finally submitted the long-awaited proposal for a Directive on Corporate Sustainability Due Diligence and amended Directive 2019/1937 (CSDDD) on February 23 2022.
In the explanatory memorandum of the CSDDD, the European Commission admits that: “voluntary action does not appear to have resulted in large scale improvement across sectors and, as a consequence, negative externalities from EU production and consumption are being observed both inside and outside the Union.
“Certain EU companies have been associated with adverse human rights and environmental impacts, including in their value chains. Adverse impacts include, in particular, human rights issues such as forced labour, child labour, inadequate workplace health and safety, exploitation of workers, and environmental impacts such as greenhouse gas emissions, pollution, or biodiversity loss and ecosystem degradation.”
The directive would be an important evolution in the transition from soft law to hard law as it integrates many principles that can be found in the recommendations and international standards mentioned above. The CSDDD expressly refers to the principles of “human rights due diligence” as formulated in the UN Guiding Principles on Business and Human Rights, leaving no doubt regarding the European Commission’s intention to align the law with the principles familiar to the market.
In a nutshell, the CSDDD lays down concrete obligations for companies’ own operations and the operations of their subsidiaries and their value chain (including contractors and subcontractors). It even establishes accountability through the introduction of a reform of the corporate liability regime.
The CSDDD will apply to EU-based companies which have either:
More than 500 employees and a net worldwide turnover of more than €150 million; or
More than 250 employees and a net worldwide turnover of more than €40 million, where at least 50% of this net turnover derives from activities in a “high-risk” sector (i.e. textiles, renewable natural resources extraction or extraction of minerals).
It will also apply to certain non-EU companies if they generate more than €150 million of their net turnover in the EU, or more than €40 million, of which at least 50% is from high-risk activities.
As pointed out in the European Commission’s Q&A on the proposal, SMEs do not fall within the scope of the CSDDD. However, they will probably be indirectly affected by the directive because failure to respect sustainability concerns could risk their exclusion from the supply chain. SMEs will also have to provide their own ESG-related data to the larger companies which do fall within the scope of the CSDDD.
All companies falling within the scope of the CSDDD must ensure performance of “human rights and environmental due diligence” by carrying out concrete actions laid down in Articles 5 to 11 of the CSDDD. These can be summarised as the following obligations:
Integrate due diligence into policies;
Identify actual or potential adverse human rights and environmental impacts;
Prevent and/or mitigate potential and actual impacts;
Establish and maintain a complaints procedure;
Monitor the effectiveness of the due diligence policy and measures; and
Communicate publicly about due diligence.
The intention is to integrate human rights and sustainability considerations into corporate governance and management structures, as well as into daily business operations, by carrying out due diligence. The identification and mitigation of negative human rights, environmental and social impacts should become part of the core decision-making process of companies.
To ensure that these rules are complied with, the CSDDD introduces important duties for the directors and managers of affected companies. These range from overseeing the implementation of due diligence processes to organising the integration of human rights and sustainability considerations into the company’s business model.
EU member states are also expected to implement effective and dissuasive sanctions.
Finally, the CSDDD would introduce a new type of civil liability regime, as companies failing to comply with their due diligence obligations could be held liable for damages. This liability regime, combined with strong sanctions, is likely to incentivise companies to adapt their policies and strategies to ensure that they are always aligned with the required standards.
Like the initial shift towards the integration of ESG criteria in the financial world, regulatory developments focusing on social and human rights matters will be a major challenge in the coming years. However, this challenge can be seen as an opportunity for those actors who stay informed and anticipate these developments. New financial services will emerge, some players will strive to be identified as frontrunners and all of this will offer interesting prospects.