What is the EU’s corporate sustainability due diligence directive?

The EU’s corporate sustainability due diligence directive (CSDDD), currently making its way through the legislative process, is set to have major ramifications for many companies, including those in the financial sector.

At its heart, it requires companies to conduct due diligence on the potential and actual impacts across emissions in scopes 1, 2 and 3. In addition, companies must adopt and implement climate transition plans.

The CSDDD has been applauded as “a critical opportunity to accelerate the net-zero transition”. Adopted by the European Commission in February last year, the new regulations have been approved by legislators with a vote of 366-225, and will oblige companies to identify and address the consequences of their operations and supply chains on human rights and the environment.

There is still a question about whether financial services will be included, and will be determined through negotiations between parliament, the EU Commission and member states, often referred to as the trilogues. Emily Murrel of the Institutional Investors Group on Climate Change told Net Zero Investor the directive is a crucial piece of legislation for investors.

Murrel says it will set obligations that underpin transition plan disclosures “that will need to be made under the EU’s CSDDD with robust frameworks and processes, better-enabling investors to assess their holdings’ capacity to align with net zero and informing investment decisions and capital allocation”.

What does the CSDDD require companies to do?

Companies must mitigate risks, establish policies and procedures to address actual and potential impacts, publicly report their risk mitigation efforts at least once every year, and establish grievance mechanisms which enable employees and stakeholders to raise concerns.

The rules will initially apply to companies with over 500 employees and more than €150mn in revenue, extending later to companies with over 250 employees and €40mn revenue. Non-EU companies with revenues earned in the EU above the thresholds would also be required to follow the rules. The new rules will also include sanctions and supervisory mechanisms for companies that fail to comply, which may include fines or bans from public procurement in the EU.

An element that has changed during negotiations relates to the role of directors. Proposed rules on holding directors legally responsible for implementing and overseeing the due diligence processes do not feature in the latest draft. However, directors will still have a duty of care to “systematically integrate sustainability matters in their decisions” and directors working for companies with more than 1000 employees will have their bonuses proportionally linked to sustainability obligations.

Implications for regulators and companies

According to Heidi Hautala, vice president of the European Parliament, the CSDDD is “a cornerstone in a historic transformation that will redefine the responsibilities and obligations of businesses to respect human rights and the environment. It will effectively level the playing field by preventing competitive advantage from irresponsible business activity.”

Under the directive, companies will be required to produce climate transition plans aligned with the Paris Agreement and perform due diligence on climate impacts. This is a crucial element which attempts to close the loophole in voluntary disclosures. If successful, investors will subsequently gain insight into companies’ transition plans, as well as more transparent information at the asset level which will play a factor in investors’ decisions in decarbonising their own portfolio decarbonisation.

Additionally, companies that recognise climate change as a significant risk to their operations must incorporate well-defined emission reduction targets and goals into their business plans. Although not explicitly stated in frameworks like the Task Force on Climate-related Financial Disclosures (TCFD), this requirement serves to complement the TCFD’s focus on metrics and targets.

Since the commission published the proposal in February of this year, the TCFD has been developing its own framework, and the Kunming-Montreal Global Biodiversity Framework was agreed upon at the UN’s Cop15 conference. As a result, nature and biodiversity objectives may be expanded upon in the continuing talks.

What happens next?

Negotiations will continue in the coming weeks, with discussions between the parliament, the European Council, and the commission. The inclusion of financial services is expected to be a key point of contention. According to Banktrack, making this an optional choice for member states risks undermining the CSDDD’s impact given the scale and state of banks’ current human rights impacts and commitments.

Banktrack noted that “the world’s largest commercial banks are still consistently failing to fully implement their human rights responsibilities”, and that mandatory requirements are required to improve bank performance in this area.

US Treasury Secretary Janet Yellen has also voiced concerns about the potential “negative, unintended consequences”. There is a danger with the CSDDD that companies cut ties with any supply chain activities outside the EU due to fears of being penalised.

Ultimately these regulations, alongside the Sustainable Finance Disclosure Regulation and the Corporate Sustainability Reporting Directive, present opportunities and challenges for the financial sector. There is now a need for meaningful stakeholder engagement to scope ESG ownership and oversight, as well as analysis of data availability and quality.

But if the legislation is enacted as currently proposed, it will incentivise (as well as expose) company and investors portfolios if found to be non-aligned with the new requirements.