Commentary

From the ‘Unknown’ to the ‘Known’

Filip Gregor, Head of Responsible Companies at Frank Bold, explains how new EU due diligence laws can help companies, investors and society.

Human rights and environmental impacts in European companies’ global value chains present a major business risk as well as a challenge to fair competition. They are incompatible with the goals of the European Green Deal and EU Sustainable Finance agenda.

With these initiatives, the EU aims to redirect private and public funds to support the transformation towards a sustainable economy. However, business activities won’t meet sustainability requirements if their value chains remain linked to impacts such as deforestation or forced child labour.

The tool which can help companies overcome these challenges, ensure to protect people and planet  and increase access for sustainable financing is ‘due diligence’.

Human rights and environmental due diligence is a concept developed by the UN 10 years ago and supported by robust OECD guidance, aimed at helping companies to identify and address their impacts on people and the planet. Since then, it has been universally endorsed by sustainability leaders among companies and investors, reporting frameworks, governments as well as the EU itself, thus making it increasingly important for business.

However, companies can struggle to grasp what they are supposed to do and disclose, due to the proportionate nature of this concept, lack of clarity in law and diverging investors’ demands.

The European Union’s new Corporate Sustainability Reporting Directive (CSRD) will greatly contribute to addressing this challenge and will help satisfy the need for information on companies’ plans, actions and results by investors and broader society. Such clarity is also important for companies to avoid risks to their reputation and financial consequences.

The European Commission will propose new legislation on corporate due diligence in Autumn. However, in the meantime, the CSRD and the development of accompanying sustainability standards will play an important role in contributing to due diligence by defining related disclosure elements.

Due diligence is important to determine what the company needs to address; the CSRD will describe how the company should report it.

In this regard and specifically looking into reporting, due diligence helps companies to identify material social (S) and environmental (E) issues and information that they are expected to report on in addition to the standardised KPIs on their workforce and environmental performance. These KPIs will be addressed in our next article.

Due diligence in simple terms

Due diligence describes the actions taken by a company to both identify, analyse and act on actual and potential risks to people and to the environment, not simply within its own operations but in its supply chain and in the services it uses. It is connected to business risk management – but starts with understanding risks to people and to the environment.

It is built on proportionality – the right conduct depends on the severity of the impact, the company’s involvement with the impact and its own ability to address it. Furthermore, it is guided by the principles established in international standards such as the UN Guiding Principles on Business and Human Rights and the OECD Guidelines, in particular:

  1. Due diligence will vary in complexity with the size of the business enterprise, the risk of severe human rights impacts, and the nature and context of its operations
  2. Companies should identify and assess actual and potential adverse impacts associated with their operations, products or services, including by a business relationship (e.g. impacts that occur in supply chains)
  3. Appropriate action depends on:
    1. whether the company causes or contributes to the impact (then it must cease the contribution) or it is only directly linked to the impact by a business relationship (then it must seek to prevent or mitigate the impact)
    2. the extent of its leverage in addressing the impact
    3. whether there has been harm, in which case the company must provide for or cooperate in remediation to victims (UNGPs 15)
  4. Companies should track effectiveness of its response and account for it

Small businesses, if they are not exposed to high-risk supply chains, can carry out due diligence and report on it in a simplified format. They only need to show that they have assessed their value chain and screened for typical risks in their sector.

The bigger the involvement of a company with high-risk operations, supply chains and the bigger its leverage, the more detailed information it needs to provide to show it has acted with due diligence. In case the company itself causes or contributes to the impact, it must take determined action to cease it.

To take one example, following the OECD guidance and already agreed EU rules for investors, banks and insurers, financial market actors are now screening their support to mining or agri-business projects for their potential involvement in infringement of land rights, access to water or deforestation.

The OECD Watch complaints database contains examples showing that financing projects with negative environmental and human rights impacts signify a direct contribution to these impacts.

Violations of human rights or of the environment are often associated with larger companies and such egregious examples. But due diligence affects all companies and can arise from everyday issues, such as harassment in the workplace, misuse of the company’s products or services for unintended purposes, the right to speak out or to observe faith, unfair purchasing practices and privacy of personal data.

The impacts in the supply chain, however, are often beyond the company’s direct control. In such cases, the key consideration is what actions would maximise the positive outcomes for people or the environment and whether the company has exercised its best effort.

From a reporting perspective, companies need to be able to demonstrate that they know which risks and impacts they have or could potentially have on human rights and the environment in their value chains, that they are not contributing to any such impacts through their own actions and policies, and that they are exercising the best effort to maximise positive outcomes with regard to impacts to which they are connected, but over which they don’t have control. In cases where the company has caused or contributed to harm, companies are obliged by the concept of due diligence to enable remediation, and must thereby also report on the details of such remediation processes and efforts.

Good for business

The primary purpose of due diligence is to prevent and mitigate impacts on affected people and the environment, in particular those of systemic nature.

Most in business would never knowingly breach human rights or environmental norms. However, due diligence enables companies to properly assess relevant ESG risks and impacts that they would wish to avoid if they knew and which, if left unmanaged, would sooner or later lead to regulatory, investor, public or legal pressure, against the company. Similarly, companies and investors are already required to assess and disclose risks to their business stemming from sustainability factors in their sustainability reporting. This cannot be done without clarity on where the company and its supply chain may have adverse impacts on people and the planet.

More generally, due diligence is becoming a norm in business-to-business relationships in sectors dependent on global value chains. The ability of companies to demonstrate to their buyers that they have a sound due diligence system will become an increasingly important asset, helping companies to retain their business partners and to grow.

Moreover, the focus on human rights and due diligence presents an opportunity for business. Shift has described specific examples of how companies have used this approach to progress in their business in “15 cases of how companies are boosting their contributions to the Sustainable Development Goals by putting people first”.

However, the results of the 2020 Corporate Human Rights Benchmark show that too many companies are still failing to meet human rights due diligence expectations and that negative impacts are mostly felt outside the company headquarters in developing countries. Out of the 229 companies assessed, 104 had at least one allegation of a serious human rights impact in 2020.

Right response for Europe

The legislative momentum on due diligence is high. France, Norway and Germany have recently adopted legislation that makes companies legally responsible for due diligence, in reaction to high-profile cases of mass harm including the Rana Plaza textile factory fire accident, the Belo Monte Dam collapse, and the increasing speed of deforestation linked to agricultural commodities. This has also prompted the European Commission to start preparing a proposal to harmonise the EU legal framework, with the European Parliament voting overwhelmingly in favour of this initiative.

Human rights and environmental due diligence also plays an important role in well-advanced European and global movements towards what has been called a sustainable financial system. The EU is implementing a comprehensive sustainable finance strategy to mobilise over €1 trillion of public and private investment to support sustainable activities in order to meet the goals set in the European Green Deal. The legislation specifying criteria for sustainable activities and financial products (the EU Sustainability Taxonomy and the Sustainable Finance Disclosure Regulation), require that activities and financial products marketed as sustainable must be backed by appropriate due diligence. This has been established as a needed safeguard to prevent the risks of adverse impacts being merely pushed away to supply chains. The principle of due diligence will also be reflected in the development of EU Green Bonds and Social Bonds.

Due to its proportionate nature, reporting on due diligence sounds easy in principle, but clear reporting standards are what will make it easier for companies in practice. Today, while a majority of companies are ready to report their high-level commitments and policies, the actual due diligence process is disclosed by only 20%, and less than 4% provide relevant KPIs on their progress.

The lack of clear standards risks greenwashing and puts companies whose business models are not intrinsically connected to systemic human rights and environmental problems at a disadvantage – in particular low-risk SMEs, as well as responsible companies that are implementing due diligence. Without clear transparency standards, it is difficult for investors, banks and insurers to distinguish between such companies, and as a result they implement widely diverging approaches and indicators.

At the same time, international investors understand the investor case for mandated human rights and environmental due diligence. Last April, 105 investors representing US$5 trillion in assets under management signed a statement calling on governments to develop, implement, and enforce mandated due diligence requirements for companies.

Ensuring CSRD provides clarity and certainty

The increased obligations of financial actors raise the pressure on companies to disclose information on due diligence. To address the lack of clarity, the European Commission proposes in the new CSRD that a reporting standard should be developed and adopted alongside the Directive on how companies should report on their due diligence, principal adverse impacts, and actions.

To overcome the challenges that companies and investors are facing in this area, such a standard should specify the following key elements of due diligence disclosures:

  1. How to report on the identification and assessment of impacts, in a way that takes into account that companies’ exposure to risks of such impacts varies greatly
  2. What should be described about the identified impacts, regarding business context and relationships involved in the impact, affected people and their engagement
  3. Criteria for reporting on the effect of the company’s policies and actions on the impacts
  4. Sectoral specifications for human rights and environmental issues and KPIs, which companies should assess and report on, in order to better focus, simplify and standardise the information (e.g. high-risk commodities in food & beverage; working conditions in the supply chain in apparel, end-users and consumers’ privacy in ICT, communities’ pollution and access to water in extractives).

Conclusion

Environmental and human rights due diligence is coming to businesses of all sizes and structures. Although the headlines often focus on major disasters or scandals associated with a few multinational companies, all companies can unintentionally have adverse impacts on people and the planet in their value chains. Due diligence is the tool which turns the ‘unknown’ into the ‘known’ – and guides the company on what it can reasonably be expected to do about it.

In this article, we have shown that current moves in Europe and internationally to require environmental and human rights due diligence, can and will benefit businesses. They are necessary to manage risks, support fair competition, define boundaries for how far business can use ‘best efforts’ in any particular situation and to avoid negative action on the company itself from business partners or regulators.

We have highlighted how the current debate on an EU Corporate Sustainability Reporting Directive is critical to ensure the right disclosure requirements for due diligence by the company and must be complementary with the European Commission’s own forthcoming initiative on mandatory due diligence. We have also identified the ways in which European Sustainability Reporting Standards, accompanying the Directive, can assist due diligence. These can be the tool helping companies to understand how they can identify potential risks and adverse impacts, which sectors might be chosen for more specific standards, and how the company’s own actions in response can be assessed and then reported.

With a widely accepted framework for due diligence, the responsibility for environmental and human rights should not be pushed down the value chain unreasonably, but enable all companies to understand and take proper responsibility for the social and environmental impacts of their business.

The full original article was published as a part of Frank Bold’s series of 2021 monthly briefings focusing on sustainability reporting. It can also be accessed on the Alliance for Corporate Transparency website.

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