The EU is drawing new rules for corporate due diligence and calling for input. Now is more than ever the time for companies to have their say before the die is cast.

Morgane Horn
Consultant

As early as 2023, EU companies and companies doing business with the EU may have to put in place robust measures designed to identify and address human rights and environmental risks and impacts throughout their operations and supply chains. Corporates will no longer be allowed to focus on short-term benefits at the expense of long-term sustainable value creation. Environmental and social interests will need to be fully embedded into business strategies.

This legislative initiative on mandatory human rights and environmental due diligence, expected to be tabled in Q2 next year, was announced by EU Commissioner for Justice, Didier Reynders, as a follow up to the EU Green Deal. It stands in the context of competitive sustainability contributing to the Covid-19 recovery, and the EU’s ambition to build resilience and strategic autonomy in EU supply chains while at the same time addressing sustainability and social impacts. The recent launch of the European Raw Materials Alliance illustrates this ambition.  

A public consultation on sustainable corporate governance is ongoing and will inform the Commission’s legislative proposal. Last week, the Council approved Conclusions on Human Rights and Decent Work in Global Supply Chains, calling for a proposal from the Commission for an EU legal framework on sustainable corporate governance, including cross-sector corporate due diligence obligations along global supply chains. And next week, the European Parliament’s Committee on Legal Affairs will vote on two EP reports on Sustainable corporate governance, and Corporate due diligence and corporate accountability.

Now that we have set the context, let’s take a look at some of the opportunities and challenges that the due diligence framework may present for companies.

What to expect

Although the framework is still being shaped, there are some clear indications already as to how the EU plans to address due diligence in supply chains.

The EU legislative initiative will set a combination of binding requirements for companies as well as company directors, moving beyond voluntary measures. As such, company law will play a pivotal role. It is not yet clear whether the Commission will propose a directive or a regulation – although a regulation would be coherent with the EU’s objective to harmonise existing Member State measures. 

The initiative will need to be coherent and consistent with the review of the Non-financial Reporting Directive, which already requires large companies to publish reports on policies they implement in relation to environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, and diversity on company boards. The EU Timber Regulation and Conflict Minerals Regulation, which establish sector and product group specific substantive due diligence requirements, will continue to apply, and will serve as examples for the legislative initiative.

The EU wants to take a horizontal i. e. cross-sectoral and cross thematic (covering human rights, social and environmental matters) approach to due diligence, supplemented by sectoral guidance to address specific challenges and sensitivities of different sectors.

The framework will rely on existing international standards on due diligence i.e the United Nations Guiding Principles on Business and Human Rights (UNGPs), the Tripartite Declaration of Principles concerning Multinational Enterprises and Social Policy (ILO MNE Declaration), and the OECD Due Diligence Guidance for Responsible Business Conduct (OECD Guidance). The new batteries legislation proposal published today incorporates these frameworks and should act as a blueprint for other policy areas.

The framework should apply to all companies, including SMEs (with special provisions), and should focus on Tier 1 suppliers i.e. direct suppliers to companies, rather than companies further down the supply chain.

Opportunities for businesses

The establishment of mandatory human rights and environmental due diligence would improve social conditions, including those of local communities along the supply chain, where voluntary corporate social responsibility initiatives have failed to protect people from modern slavery. Companies have already seen that any hint of a link to labour abuses in the supply chain – no matter how remote or accurate that link may be – can have serious implications for their EU reputation. Just this summer, the EP addressed a letter to the Commission calling for a ban on imports from companies allegedly using forced labour from Uyghur camps in China. This was quickly followed by 180+ organisations demanding apparel brands to stop using forced labour in the Xinjiang Uyghur Autonomous Region.

The due diligence framework would further contribute to preserving the environment from adverse business practices through more efficient use of resources, recycling of waste, reduction in greenhouse gas emissions, reduced pollution, to name a few. Concretely, mandatory environmental due diligence will oblige companies to demonstrate how they comply with EU ambitions on circular economy, decarbonisation or phasing out of hazardous substances as required under EU legislation on waste, water, industrial emissions, climate, chemicals, products etc. throughout their globalsupply chains.

But this does not need to be at the expense of companies’ profit or competitive advantage. In fact, if properly designed, an EU mandatory due diligence framework would allow for:

Legal Certainty: Companies would have more certainty and predictability about the adverse human rights, social and environmental impacts and risks resulting from their activities, and would in turn be in a better position to manage and mitigate these risks and impacts, including in their value chain. Company directors would also arguably have a broader understanding of the duty of care they are required to exercise when making business decisions. Current voluntary measures do not provide for legal certainty and predictability when conducting business abroad. Nor does the mismatch of different EU Member State frameworks, some more stringent than others. A harmonised EU framework should set clear definitions and clearly prescribe which individual actions must be taken by companies throughout the whole due diligence process, ensuring legal certainty and practicability on the applicable law, proportionate reporting requirements while respecting legitimate business secrecy.

A Level-playing field: both vis à vis competition with third countries, and among EU companies. A horizontal approach to mandatory due diligence across the EU would replace the current patchwork of different national rules and obligations, streamlining requirements across the board. It would level the playing field and ensure that the good guys increase their leverage in the value chain, and avoid that other companies freeride on their efforts. SMEs would have better chances to be part of EU supply chains. And provided that the EU applies the same requirements to third country companies trading with the single market, EU companies would not be at a competitive disadvantage.

More money! A non-negotiable framework applicable to all companies would incentivise progressive corporations to go above and beyond. As civil society’s awareness around responsible business conduct grows, mandatory rules would allow frontrunners to keep their competitive advantage stemming from new customers and customer loyalty. Better environmental and social performance would attract diligent investors. It would boost innovation (e.g. sustainable technologies) and productivity and may even increase employee loyalty and performance. A well-designed due diligence framework should also reward compliance through procurement or other financial incentives to motivate businesses to do more and go beyond minimum requirements. 

Challenges for companies

A poorly designed due diligence framework on the other hand, may result in more hurdles for EU companies and add to their challenges:

Implementation: The complexity and diversity of supply chains make the implementation of due diligence systems and scaling up of processes a challenge. Human rights and environmental due diligence requires companies to put in place continuous processes to identify risks and adverse impacts on human rights, health and safety and the environment, and to prevent, mitigate and account for such risks and impacts in their operations and through their value chain – this is complex to put in place and requires a practical and pragmatic framework, flexible enough that it can be applied and tailored to different industries and business sizes (e.g. SMEs). A one size fits all hardly seems possible.

Competitive disadvantage: For EU businesses to remain competitive on the open market, mandatory due diligence rules would have to equally apply to third country companies doing business with the EU. The challenge will be for the EU to define on what grounds to subject these companies to such obligations (e.g. subject to turnover generated in the EU? To the type of activity carried out in the EU?) To avoid penalising smaller companies with fewer resources, special provisions and proper guidance would have to be put in place for SMEs.

Less money: An overtly complex and burdensome framework of mandatory rules could become a procedural burden and result in increased administrative costs (e.g. new staff required to handle new obligations), litigation costs, indirect costs linked to higher prices in the supply chain, costs liked to drawbacks. It could decrease attention to core business activities, potentially leading to an increase in employee turnover and a negative stock performance. Buyers may find it difficult to find suitable suppliers which may cause lock-in effects (e.g. exclusivity period/no shop clause) an also have negative impact on business performance of suppliers.        

Enforcement:Regulations without sanctions are ineffective. For a mandatory due diligence framework to deliver on its promise, an efficient enforcement mechanism is needed. However, the scope of accountability and liability of companies should be clearly defined and should not be designed in a way to discourage businesses from engaging with risky markets. This would defeat the very purpose of improving the economic and social conditions of local communities. Corporates alone cannot be expected to audit and control the entire value chain (sometimes 10+ thousands of direct suppliers) – collaboration between corporations, governments (e.g. competent national authorities) and civil society is key.

Conclusion

The mandatory due diligence initiative is one aspect of a growing trend in the EU to scale up efforts to further embed sustainability commitments in trade.

Last month, the Commission launched a trade complaints portal to denounce violations of sustainable trade commitments in the EU’s trade agreements and under the Generalised Scheme of Preferences. And this week, the Council adopted a decision and a regulation establishing a global human rights sanctions regime, allowing the EU to sanction serious human rights violations and abuses worldwide, regardless of where they occur, by targeting the individuals, entities and bodies responsible – including state and non-state actors – with asset freezes and travel bans.

Businesses can no longer afford to wait to position themselves on responsible business conduct. They must do so now and ensure that they establish robust human rights and environmental protection processes throughout their supply chains.

This goes beyond ensuring that they are prepared against legal sanctions – this is a reputation game and a matter of meeting consumer and investor expectations. And we know that what starts in the EU, doesn’t stop there. Responsible business conduct continues to gain momentum in the eyes of EU legislators and policymakers, and as a frontrunner in sustainable policy, the European Union has made its intentions clear: it wants to lead by example and set the standard globally.