ESG - A European Response

What is ESG?

The ever-increasing multiplicity of issues and accompanying legislation and regulation that are now badged 'ESG' may mean that, for some, so much now falls within the scope of ESG that it can mean everything and therefore nothing. 

While ESG still remains a useful umbrella term for a variety of business issues, ESG is better employed as a term to describe the process by which a business assesses its impact on 'people' and 'planet' and then how following this exercise the business' decisions and actions are governed, reviewed, and implemented to achieve 'profit' in light of the anticipated impact. ESG is thus better categorised as a term to describe the process by which a business looks at its impact assessment and moulds its resultant strategy. 

A variety of regulations and measures emanating from Europe stress how ESG impact assessment and strategy should be embedded into all business activity. Increasingly we are seeing ESG reporting obligations, initially demanded of financial institutions, reaching out and impacting upon all significant sized businesses. This article looks at three such measures.

Common Supervisory Action

In late 2022 The European Securities and Markets Authority (ESMA), the EU’s financial markets regulator and supervisor, announced that its strategic supervisory priorities would include ESG disclosure alongside market data quality. This was part of a concerted drive by the EU to promote sustainable finance by fostering transparency and comprehensibility, scrutiny and supervision. This will in turn imbed sustainable finance into daily supervisory work and the supervisory culture.

Important in this context is the introduction of common methodologies and a taxonomy, to ensure that what is being described can be accurately measured across differing jurisdictions and by requisite authorities. To advance this, in late 2023 ESMA launched a Common Supervisory Action (CSA) with National Competent Authorities (NCAs) on ESG disclosures under the Benchmarks Regulation of June 2016 (BMR) and The Regulation of the EU Climate Transition Benchmarks 2019. The 2019 Regulation specially introducing benchmarks for decarbonisation and emissions reduction to limit climate warming to below 1.5% of the pre-industrial age by 2050. The BMR deals with disclosure and reporting on both the carbon footprint of underlying assets and wider ESG disclosure which requires a 'benchmark statement' disclosing whether the company is pursuing ESG objectives and how their methodology reflects such ESG factors. 

The CSA in 2024/25 will focus on supervised benchmarks administrators, located either in the European Union or in a third country, that have acquired an authorisation, registration, recognition or endorsement of their benchmarks under the BMR.  The goal of the CSA will be to assess compliance of the supervised Benchmarks Administrators with the ESG disclosure requirements in the BMR. The CSA will cover the following aspects: 

• disclosure of ESG factors in the benchmarks statement and in the benchmarks methodology; 
• specific disclosure requirements regarding climate benchmarks methodology. 

The aim is to share experiences of practices across the competent authorities, consistent and effective supervision of the ESG disclosures of supervised administrators across the Union, and enhance the comparability of the information provided to users of benchmarks.  The CSA contributes to enhancing transparency and addressing greenwashing, one of ESMA’s Union Strategic Supervisory Priorities for NCAs, with a view to protecting investors and further supporting the development of a credible ESG market. 

Corporate Sustainability Due Diligence Directive

The move to widen ESG reporting and disclosure obligations to all significant sized businesses has seemed to be an unstoppable direction of travel in the EU. In December 2023 the EU released the final text of its Corporate Sustainability Due Diligence Directive. The CSDD Directive sets out due diligence obligations requiring companies to identify, prevent, mitigate, and remediate actual and potential adverse impacts on people and the environment, looking to both subsidiaries and those in the supply chain, irrespective of where based. It will also require companies to set out their climate transition plans, how they will move towards net zero by 2050.

The obligation to undertake due diligence is a continuous one, so that a company's ESG impact on people and the environment can be assessed and action taken in a timely appropriate manner, and integrated into all corporate processes.

However, after years of negotiation, at the eleventh hour, opposition voiced by Germany, then joined by France and Italy to certain key elements of the CSDD Directive led to delay and a period of intense negotiation between EU Member States.  On 15 March 2024 a stripped back version of the CSDD Directive was agreed and on 24 April this was approved in the European Parliament. It is hoped that final approval by the permanent representatives of the Member States will be obtained in May 2024. Like all directives it is the responsibility of each Member State to enshrine the effect of the directive in domestic legislation within 2 years of final approval, meaning commencement as early as May 2026. 

Companies based in non-EU countries engaging in substantial business activities within the EU will find themselves subject to the CSDDD's provisions. This means that regardless of their geographical location, if their operations have a notable footprint within the EU, compliance with the directive becomes imperative. Such businesses must navigate the intricate requirements outlined by the CSDDD to continue trading seamlessly within the EU market.

Moreover, entities conducting business with larger enterprises already subject to the CSDDD will indirectly feel its reverberations. The due diligence obligations imposed on these larger entities will cascade down their supply chains, affecting smaller partners and suppliers. Consequently, even companies operating on the periphery of the EU market must familiarize themselves with the Directive's mandates to ensure continued collaboration with larger entities.

Enforcement of the CSDDD will be multifaceted, combining administrative supervision and civil liability measures. At the State level, EU Member States will appoint supervisory authorities tasked with monitoring compliance and meting out sanctions for non-compliance. These sanctions could range from fines to compliance orders, depending on the severity of the violation.

Furthermore, at the European level, a network of supervisory authorities will facilitate coordinated enforcement efforts across member states. This collaborative approach aims to harmonize enforcement practices and ensure consistent application of the directive's provisions. Importantly, individuals or entities adversely affected by non-compliant companies will have recourse to seek compensation for damages incurred—a mechanism designed to uphold accountability and protect stakeholders' interests.

The CSDDD incorporates robust penalties to dissuade non-compliance and incentivize adherence to sustainable business practices. Companies found in breach of the Directive may face fines proportional to the severity of their infractions. Notably, these fines can be significant, with provisions allowing for penalties of up to 5% of the offending company's net turnover. Such financial repercussions underscore the EU's commitment to holding businesses accountable for their environmental and social impacts.

In instances where companies fail to pay imposed fines, the provisional agreement includes injunction measures aimed at compelling compliance. Moreover, compliance with the CSDDD may emerge as a criterion for the awarding of public contracts and concessions—a development that further underscores the Directive's influence on corporate behaviour.

The CSDDD will eventually apply to companies (other than those within the financial sector) incorporated in the EU with more than 1000 employees (originally it was to be 500 employees) and a net global turnover of more than €450 million (originally it was to be €150 million). These changes have at a stroke removed two thirds of the companies originally anticipated to be covered by the reach of the CDDR. 

The CSDDD will then be phased in over the course of the next five years. Companies with 5,000 employees and €1,500 million turnover will be impacted in 2027. Companies with 3,000 employees and €900 million turnover will be impacted in 2028. Companies with 1,000 employees and €450 million turnover will be impacted in 2029.

In addition, the approved text provides for multi-year delays in the event that the CSDDD is expanded, giving smaller firms more time to prepare for change.

A mechanism by which trade unions could use the Courts to police non-compliance was removed and obligations regarding waste management narrowed.

You can also find more information on the CSDDD in our article: “The EU Corporate Sustainability Due Diligence Directive: The countdown to compliance has begun”.

Corporate Sustainability Reporting Directive

The CSDD Directive dovetails the existing EU’s Corporate Sustainability Reporting Directive (CSR Directive), which tackles audit and reporting obligations on ESG matters. Initially, the CSR Directive applies only to EU companies, with large EU companies now subject to the obligations imposed. In due course the reach of the CSR Directive will expand, eventually applying to non-EU Group companies that have an EU place of business by financial year 2028.

However, the CSR Directive has also been subject to challenge, leading to the Council and the European Parliament reaching a provisional deal in February 2024 on a new directive. This directive provides revised time limits for the adoption of sustainability reporting standards for certain sectors and for certain third-country undertakings and thereby sees amendment of the CSR Directive. The move will give more time for companies to prepare for the sectorial European Sustainability Reporting Standards (ESRS) and for specific standards for large non-EU companies, which will be adopted in June 2026, two years later than the originally scheduled date.

As set out in the Directive, 'Sector-specific sustainability reporting standards are seen as especially important in the case of sectors associated with high sustainability risks for or impacts on the environment, human rights and governance, including sectors (including oil, gas, mining and coal) and the relevant activities within those sectors. When adopting sector-specific sustainability reporting standards, the Commission should ensure that information specified by those sustainability reporting standards should be proportionate to the scale of the risks and impacts related to sustainability matters specific to each sector, taking account of the fact that the risks and impacts of some sectors are higher than for others. The Commission should also take account of the fact that not all activities within such sectors are necessarily associated with high sustainability risks or impacts. For undertakings that operate in sectors particularly reliant on natural resources, sector-specific sustainability reporting standards would require the disclosure of nature-related impacts on and risks for biodiversity and ecosystems.'

Navigating the Road Ahead: Toward Sustainable Business Practices

As these various measures comes into effect, businesses, both within and beyond the EU, must proactively adapt to the evolving regulatory landscape. Prioritising sustainability and integrating responsible business practices into supply chain operations are no longer optional but imperative for long-term viability and success.

For companies based outside the EU seeking to access its lucrative market, compliance with the measures may in certain circumstances be a regulatory obligation but in almost all cases it will be a strategic imperative. By aligning with the principles behind these measures, businesses can enhance their reputation, mitigate risks, and foster stronger relationships with stakeholders.

Ultimately, we are heading into a new era of corporate accountability, one where sustainability is not merely a buzzword but a fundamental pillar of business strategy. Embracing this paradigm shift is not only prudent but essential for companies aspiring to thrive in an increasingly conscientious global economy.