EU sustainability rules: ESG disclosure and supply chain due diligence regulations affecting non-EU companies

For local perspective on the latest developments from the EU, this article was written for this issue of the Torys Quarterly by our peers at Linklaters LLP.
 

ESG disclosure and reporting under the CSRD

The CSRD was adopted at the end of 2022 and entered into force on January 5, 2023. The Directive aims to strengthen the current EU rules on social and environmental reporting that were introduced in 2014 by the EU Non-Financial Reporting Directive (NFRD). The provisions of the CSRD still need to be implemented into the national legislation of the Member States, which will determine the full scope and extent of the sustainability reporting requirements. The new reporting regime will require the in-scope companies to report on environmental, social and human rights and governance factors across their value chain.

The main features of the CSRD are as follows:

• Mandatory European sustainability reporting standards (ESRS): In-scope companies will need to report against the ESRS developed by the European Financial Reporting Advisory Group (EFRAG). A first set of ESRS is expected to be adopted by the EU Commission by June 30, 2023.
• New assurance requirement: The Directive introduces, for the first time, a general EU-wide audit (assurance) requirement for sustainability information, to help ensure that reported information is accurate and reliable.
• Extension of scope of application: The CSRD extends the scope of the current regime from large public interest entities to all large companies and all EU-listed small or medium-sized companies, except EU-listed micro-enterprises¹. Application of the CSRD will be phased in from 2025 (for financial years starting on or after January 1, 2024) to 2029 (for financial years starting on or after January 1, 2028).

Many non-EU companies will be affected by the new regulations, in particular in the following cases:

• Reporting obligation of EU subsidiaries: EU subsidiaries of non-EU companies that qualify as a large company or EU-listed small or medium-sized company are required to report on a non-consolidated basis under the new regulations.
• Reporting obligation of non-EU parents: As of 2029, non-EU companies with a net turnover of more than EUR 150 million in the EU and having (i) a large or listed subsidiary in the EU or (ii) a branch with a net turnover of more than EUR 40 million in the EU are required to prepare a non-financial report at a consolidated level.
• Reporting obligation of non-EU issuers: Non-EU issuers being companies which have equity or debt securities listed on an EU regulated market can also be caught by the scope of the CSRD.

Different exemptions are available, if the in-scope company is already covered by a sustainability report using “equivalent” standards. Guidelines on this equivalence test will be developed by the Commission.

However, important questions remain about the interoperability of the ESRS with other sustainability reporting standards. The International Sustainability Standards Board (ISSB) is expected to publish the final version of its climate disclosure standard and general disclosure requirements in June 2023. Although the ISSB standards will not themselves be legally binding, a few jurisdictions (including Canada) are expected to adopt substantially equivalent standards and other countries may follow. As it is currently not foreseeable which sustainability standards will be classified as equivalent to the CSRD, companies need to be prepared to issue sustainability reports based on different legal requirements.

Human rights and environmental due diligence requirements under the CSDDD

In February 2022, the EU Commission published its proposal for the CSDDD. The proposal is currently under negotiation and could be adopted in final form in the second quarter of 2023. When adopted, Member States will then have to transpose the Directive into national law within two years (or four years, for companies involved in high-risk sectors, see below) of the Directive coming into force. The CSDDD would require in-scope EU and non-EU companies, including financial services (though with specific provisions and caveats), to:

• carry out due diligence on human rights and environmental impacts of their own operations, their subsidiaries and their entire value chains (e.g., direct and indirect suppliers);
• prevent, mitigate or bring to an end any identified adverse impacts;
• monitor the effectiveness of their due diligence policies and measures; and
• publicly communicate what they are doing on due diligence.

The Directive may introduce financial penalties, including civil liability, for companies that fail to comply with these obligations.

Many non-EU companies will be caught by the new regime. According to the proposal, the following companies will be directly affected by the new regulations:

• EU companies: EU companies fall under the scope of the Directive, if they have (i) more than 500 employees and a net worldwide turnover of more than EUR 150 million or (ii) more than 250 employees and a net worldwide turnover of more than EUR 40 million, provided that at least half of the net turnover is generated in a high-risk sector (e.g., the manufacture of textiles and food products, agriculture, extraction of mineral resources).
• Non-EU-companies operating in the EU: Non-EU companies fall within the scope of the Directive if they (i) have a net turnover of more than EUR 150 million in the EU market or (ii) a net turnover of more than EUR 40 million in the EU market and at least 50 % of the net worldwide turnover is generated in a high-risk sector.

Companies that do not fall within the Directive's direct scope of application may nevertheless be affected by it, if they must give contractual assurances to their business partners that fall directly within the scope of the Directive.

Some EU member states, such as Germany and the Netherlands, have recently introduced their own human rights due diligence regime in advance of the new EU-wide rules, while France is starting to see litigation arise in respect of the due diligence requirements in its 2017 duty of vigilance law.

What do companies have to consider?

The changes coming in through the CSRD and the CSDDD will undoubtedly have a significant impact on sustainability disclosure and reporting and on value chains of many Canadian and U.S. companies. Research shows that over 10,000 non-EU companies are estimated to be subject to the new reporting regime under the CSRD—about 30% of them U.S. companies and 10% Canadian². As a first step, companies that do business with the EU should identify those entities in their group that may be subject to the new regulations. The application tests are complex and should be worked through on an entity-by-entity basis.

Companies subject to the directives will have to adapt their existing systems and processes to source, validate and provide the necessary information. A significant amount of capacity-building and preparation will be required to comply with these new requirements. The CSDDD requires, in particular, changes to procurement processes and contract terms, e.g., for supply contracts, and the creation of grievance mechanisms to provide effective access to remedy. For many businesses across the globe this will require very significant changes to the way they currently operate, transact and report, and how they interact with their business partners.

Ulrich Wolff is a Corporate & ESG Partner in Linklaters’ Frankfurt office, advising businesses worldwide in their transactions. As a member of Linklaters’ German and international ESG working group, he is particularly involved in climate protection and sustainability-related matters and supports clients in the necessary transformation processes.

Dr. Julia Grothaus is a Dispute Resolution & ESG Partner in Linklaters’ Frankfurt office. As head of the German ESG team and core member of the global ESG Team, Julia coordinates Linklaters cross-practice ESG activities, and assists clients in mitigating the liability risks associated with the ESG megatrend (greenwashing, climate change litigation, human rights, supply chain due diligence etc.).