ESG EXPLORER PODCAST / EPISODE 4

Beyond carbon and beyond borders: new European corporate sustainability directives mark ‘step change’ in ESG requirements

Sep 29, 2022 34 min
Hosts
John M. Valley

Partner, Corporate, Toronto

Lisa Mantello

Partner, Financial Services, Toronto

Guest
Ulrich Wolff

Corporate Partner, Frankfurt Linklaters LLP

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Earlier this year, the Council of the European Union agreed on two new directives that will form cornerstones of the European Green Deal and have far-reaching implications, affecting many Canadian businesses with operations in Europe or who are part of a global value chain delivering goods or services to Europe.

In this episode, Osler’s Lisa Mantello, a partner in the Banking & Financial Services group, hosts Ulrich Wolff, a Corporate partner at Linklaters in Frankfurt, to discuss how the new Corporate Sustainability Reporting Directive and Corporate Sustainability Due Diligence Directive mark a “step change” in ESG considerations, where the process goes from here, and how Canadian businesses that might be affected can get ready for the new compliance requirements.

This podcast contains up to 35 minutes of Substantive credit for lawyers in Ontario. Click here to record your time in the LSO portal.

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JOHN VALLEY: the first half of 2022, the Council of the European Union reached agreements regarding two directives, the corporate sustainability reporting directive and the corporate sustainability due diligence directive with far reaching implications, including for Canadian companies operating in Europe.

In today’s episode, Osler’s Lisa Mantello discusses the CSRD and the CSDD with Ulrich Wolff of Linklaters. Ulrich Wolff is a corporate partner in Linklaters Frankfurt office. He focuses mainly on mergers and acquisitions, and other transactional work and on advising corporations on their governance and general corporate issues.

He is part of the global ESG group at Linklaters. Ever since he studied at McGill and Universite de Montreal, he has had a keen interest in all things Canadian and has been working with the firm on many mandates around the world. Lisa Mantello is a partner at Osler in the financial services group and practices in all areas of finance. Lisa has significant experience in ESG finance, in Canada, and internationally. Over to you, Lisa.

LISA MANTELLO: Thank you so much. Ulrich, thank you so much for joining us today. We understand there’s been some recent EU developments in ESG that are far reaching and could potentially be applicable to Canadian companies operating in Europe.

ULRICH WOLFF: Yeah, thank you, Lisa. I’d like to put it into a little larger context. The corporate sustainability reporting directive, we refer to it as CSRD, and the corporate sustainability due diligence directives, both are new pieces of legislation from the EU. And there are two important cornerstones of the implementation of what the European Commission calls the European Green Deal.

There are a set of initiatives that aim to make the EU become net zero by 2015 but they go beyond carbon, they go right into the whole sustainability debate. They do mark a step change, both of them, in the ESG landscape. Until now, like a lot of other countries, the EU has tried to accomplish the sustainability agenda by largely relying on soft law, voluntary codes, disclosures, that kind of stuff.

Now the EU has moved to hard directives that will bring sanctions. Directives are, of course, have to be transformed into national law, but these too are actually hard law, not only soft law. The European Green Deal introduces new legislation in quite a lot of areas such as climate, environment, building renovation, biodiversity, agriculture, and innovation.

In order to reach the commission’s target vast amounts of capital. And that is the really important part, need to be redirected from traditional industries to greener, more sustainable activities. And investors who the commission relies on redirecting these funds need better information on which base their investment decisions can be made.

So they need relevant, reliable, and most importantly comparable climate and sustainability information. And this is what this is all about. The political background is to make investing in sustainable industries or in activities that are sustainable, more transparent, and more reliable.

The CSRD, the reporting directive, has a sister policy the CSDD, which is the due diligence directive. Originally, it was designed to be the corporate sustainability governance directive, so dealing with governance issue. And the proposal that we have on the table at the moment, which is not yet final, but we expect it to come into effect pretty much the way it is at the moment, covers due diligence and planning of the entire value chain of a company.

The proposal seeks to advance respect for human rights, the green transition, and it tries to create, again, a level playing field for companies within the EU. It is important to know that all of this binds in the so-called EU taxonomy regulation, which is a really boring regulation because it establishes a classification system that is the heart of everything and every part of the Green Deal goes back to the uniform taxonomy classification system, which is designed to have consistent reporting, consistent nomenclature, and prevent greenwashing and have a clearer picture for investors to make choices.

LISA MANTELLO: Thank you so much, Ulrich, that was a very good synopsis. So obviously, this is a big step in the ESG legislation in Europe. Just turning to the corporate sustainability reporting directive, can you tell us who this applies to, who will be affected by it?

ULRICH WOLFF: Well, first of all the corporate sustainability reporting directive as a concept is not entirely new since 2017 already, particularly large EU companies, already had to report on material risks that existed in relation to certain non-financial aspects of their business, in particular in relation to environmental concerns.

Now, the EU agreed to a final text of a corporate sustainability reporting directive which will revise and extend these rules. And we expect the CSRD to enter into force by the end of 2022, so very quickly now. It must then be transposed into national laws as all directives have to, they’re not directly applicable like regulations, and all member states have to do that.

The CSRD expands significantly the reporting obligations and it expands the scope in terms of who has to report quite significantly. The application and entering into force will take various stages. On the 1st of January 24, large public interest companies who already now have to report under the existing non-financial reporting directive will have to report under the new rules.

Then in January 25, organizations that not presently have to report, which will fall under the CSRD, will have to start reporting there. Roughly speaking, companies with the following criteria, a balance sheet of total of 20 million euros, a net turnover of 40 million, and an average number of employees during the financial year of more than 250. That is EU businesses.

Then in 26, listed smaller companies listed in the EU will become covered by the scope. And then starting January 28, and that is a most important for the Canadian and North American companies, non EU companies generating a net turnover of 150 million in the EU, or those who have at least a subsidiary that has that size will start to be covered by the directive

LISA MANTELLO: Thanks Ulrich. So how are companies that are not from EU countries, how will they be affected by the directive?

ULRICH WOLFF: Well, that’s direct and indirect effects. If these companies have a subsidiary or branch in the EU and that subsidiary or branch or a group of them exceed on a consolidated level these numbers, the threshold of 150 million turnover, the subsidiary must then report as of, as I said, 2028.

Quite frankly, it is at the moment a little bit unclear whether it is sufficient to publish sustainability reports in that case on the level of the EU based subsidiary or group only, or whether it is required to publish all the data and sustainability reports on a consolidated level on the upper entire group level.

So in the case of a Canadian company with EU subsidiaries, does the Canadian company as a whole with all its subsidiaries worldwide have to report under the directive or can we do it on the sub EU group? The text is not yet completely clear and the American Chamber of Commerce has already publicly addressed this question in a letter to the EU institutions. And there might or might not be further clarifications on which level the reporting takes case.

LISA MANTELLO: I really hope there is some clarification because obviously, for non EU companies, that will be a very big difference depending on if it’s at the subsidiary level or at the group level.

ULRICH WOLFF: Absolutely. And that will shape the reaction, but that’s why I think we should raise it relatively early on and we should follow this discussion quite closely both as advisors and as people responsible for reporting and sustainability reporting. But even regardless of whether the 150 million threshold is exceeded, I think an EU company may rather quickly be affected by the reporting requirements because even if they themselves are not covered, the EU subsidiaries, if they’re big enough, may be covered.

And of course, if you have an EU subsidiary that is listed on an EU Stock Exchange, you’re covered from 2024. And I think the most important for me is indirectly, you will be covered as part of the value chain of EU companies that may have to report. Keep in mind that if an EU company reports, it needs all kinds of information on sustainability issues.

And if part of their value chain is in Canada or in North America or in other countries, they will want the relevant information, the relevant data, the relevant description from their value chain and will start including appropriate clauses in their supplier contracts or in their supply contract to be able to actually collect that data. So in any event, non EU companies, because of the large trading power that the EU has, will have to deal with the directive in one way or another.

LISA MANTELLO: It does seem that if you are looking all the way up the value chain with respect to someone who has to report, that does seem like many, many non EU companies will be affected by this directive.

ULRICH WOLFF: I think you’re completely right and that is why I think the opportunity to raise in this podcast is quite timely because as you know, the whole thing when we implement it will bring a lot of internal changes and in internal processes that need to be looked at and change and rejigged.

LISA MANTELLO: So only now that we know that this could be quite a significant reporting requirement for non EU companies as well as EU companies, can you tell us specifically about the requirements in terms of content?

ULRICH WOLFF: Yeah, it’s quite far reaching. And if you look at why the EU is doing it, it is to further transparency and openness for investors in the European markets. It’s obvious that it’s rather a broad set of things that have to be done. In scope companies would have to report information on all sustainability matters relevant to their own operations and most importantly, and that’s a big change, on their entire value chain.

Value chain, in the nomenclature that is used here, is not just the supply chain, it includes the business relationships upwards and downwards. So environmental, social, and employee matters need to be reported. Human rights is covered, anti-corruption, anti-bribery matters, and dealings with government.

The information that needs to be made available includes, for example, how much CO2 a company emits and how its business model is compatible with limiting global warming in accordance with the Paris Agreement. The reporting must cover not only sustainability risks faced by the company itself, but also the impact of its own business on broader ESG objectives.

This risks to the company and risks by the company is called the double materiality. The question that is raised widely is the standards under which the reporting has to take place. There is a European financial reporting advisory group, EFRAG, and the commission has made this responsible for developing standards, European reporting standards for sustainability issues.

We all know that there’s other bodies that are in the process of developing reporting standards. And one of the things that we have to look at is will the European EFRAG standards be stand alone standards or will they be coordinated with other standard setting bodies? And that is not yet clear.

If you read between the lines, the idea is to come up with European standards that are as far as possible aligned with other sustainability reporting standards. Whether that is achievable is another question. The issue behind that is for companies that may be caught by different reporting standards, can we make them so compatible that we don’t have two, three sets of completely different reports, which would actually then muddle up the water and make the transparency, which is the aim of all of this, less complete.

LISA MANTELLO: And Ulrich, the double materiality that you mentioned, I realize it’s a new concept to the European directive, but how does that compare globally? Are other jurisdictions implementing similar requirements?

ULRICH WOLFF: Well, it depends very much on the country. I mean, so far, every country seems to have their initiative, the UK has reporting initiatives, so has Canada and North America. But they vary quite a bit. I think what is quite unique is that the entire picture should be painted under the European reporting directives, not only what is my ambition, what is my company’s risk of climate change, but also what do my products do to climate? So I think it is much more far reaching than what I see in other countries.

LISA MANTELLO: It definitely does sound that way. So given that it is more far reaching and that we’ve established that this will definitely apply to some Canadian businesses, what’s your advice to Canadian businesses on how they can prepare for this, how they can prepare to comply?

ULRICH WOLFF: Well, I think the first thing is to follow the discussions and the standard setting not only out of interest, but I think the EU has made it its aim to very much transform its economy into a much more sustainable economy. So the EU is, by it’s own admission, trying to be a front runner in this.

And often, front runners like, for example, in data protection become standard setters. So what the EFRAG standards do and what the reporting directive tries to achieve may actually be an example for other countries and their laws. On top of it, every country will have their own reporting and we want to not report in one country under certain standards that may differ and then by reporting differently in another country, muddle the water and expose ourselves to greenwashing claim.

So what would I do if I were a Canadian business? I would start making sure that there is a process for adequate data collection and reporting of sustainability data. Either the one that I will eventually have to produce or the data that I will have to produce to my suppliers and business partners.

That setting up of good reporting systems takes time. We see it in a lot of clients that they are starting early on to see who is responsible for collecting what data? How do we get it from third parties? How do we present it? So one should start early. Companies should also examine whether different divisions can cooperate better for the purposes of sustainability reporting.

We see often that the same issues are covered by different parts of the same company. So internal reporting lines should be reviewed. Also, and we’ll come to that as a part of the due diligence directive, the responsible bodies and positions in a company need to have the sufficient expertise, knowledge, experience, in sustainability. And companies should probably think about whether they have the required expertise and that expertise is covering the entire body of the business.

LISA MANTELLO: Yes, I would definitely imagine that compliance departments for companies that will be subject to this will be expanding and Canadian companies will be looking for the correct expertise and examining whether they do have that in order to meet these requirements.

So Ulrich, would you suggest that Canadian businesses, if they have analyzed and determine that they will be subject to this, should they start preparing for this now? I think there is still an ability to comment on it, but should we assume this is its final form?

ULRICH WOLFF: I think for the reporting directive, the trilogue has taken place and therefore, we expect the text to be exactly what we will see enacted. For the corporate sustainability due diligence directive, which is much more far reaching effect and probably more direct effect, again, it’s a bit further out.

But we should all expect this to be European law at the end of the year. And then of course, there is a period where all the National legislators have to transform that directive, which

Is only a framework, into their domestic laws. So in the end, we will know where we stand exactly anywhere from 22. And I think once the directive is in place, we know pretty much what the local governments will do and we should actually then take the time to put our systems in place to satisfy either our own reporting requirements with ample opportunity to put it in place or actually be prepared for those in our value chain that may require information from us as a business in Canada.

LISA MANTELLO: Thanks Ulrich, that is very good advice. So Ulrich, you did mention that there is a corporate sustainability due diligence directive. This is the sister policy to the corporate sustainability reporting directive. And is the application of the due diligence directive the same as the corporate sustainability reporting directive?

ULRICH WOLFF: First incident looks very similar. It’s again, 150 million net turnover in the EU test, so the same number. It goes a little further because there’s a set of business lines industries that seem to be particularly sustainability relevant, like extraction of minerals and food production, where the turnover that is required is only 40 million in the EU provided that at least 50% of the worldwide net turnover of that company is in those high risk sectors.

Again, here currently not entirely sure how groups should be viewed in the context of the due diligence directive. The indications in the recital there seem to suggest that if these turnovers have been reached, then the entire company, even if it’s a foreign corporation, falls within the scope of application of the CSDD.

And that means not only in relation to the subsidiary based in the EU or a branch, but in relation to the entire parent undertaking. So we think it’s a little further. It makes sense that it’s a little bit further because the due diligence directive has a much more direct influence or aims to dive much more directly influence the running of a business.

So this is the same discussion that the American Chamber of Commerce has raised. But we think we’ll have to watch this spot and see whether, in fact, the EU is going that far and once the entire value chain even outside of the EU, to be covered by the directive.

LISA MANTELLO: So that also does sound potentially overreaching, if it can apply all the way up the supply chain.

ULRICH WOLFF: Absolutely.

LISA MANTELLO: So given that is a possibility and it does sound as though many Canadian businesses will be in scope under the due diligence directive, can you tell us a little bit about those requirements?

ULRICH WOLFF: So the corporate sustainability due diligence directive goes very much into the governance of companies. And the good news is that the main corporate governance test, i.e. the liability of directors, is expressly excluded or only governed for EU companies. But it imposes three main requirements.

One is the environment and human rights due diligence obligation along the value chain. It’s not just supply chain, it really is value chain. So you have to see what the impact of your production process and your distribution process and the disposal of your goods is on the environment or other sustainability issues.

The value chain is defined as the production of goods or the provision of services by a company, including the development of the product or the service and the use and disposal of the product as well as the related activities of upstream and downstream established business relationships of the company.

So this is very far reaching. The value chain includes resources, transport, production, packaging, sales, disposal of the product. The company’s corporate activity must be reviewed within its own business division, within the business divisions of subsidiaries, and in relation to established, that’s the term used in the directive relationships, that is business relationships, of a certain duration that the company has with suppliers and others.

And it covers things ranging from human rights, environmental due diligence, it encompasses the integration of the policies of the company, the identification of adverse human rights and environmental impact, and it prescribes that the company has to take appropriate measures to prevent such an impact and ultimately bring the impact to an end and maybe the relationship to suppliers to an end. It also obliges the companies to have a complaint procedure and act on and encourage reporting obligations.

LISA MANTELLO: So that seems quite broad. Can you give us some examples, perhaps with Canadian companies, how these obligations would work?

ULRICH WOLFF: Well, for example, let’s take a Canadian textile company. It must ensure, in particular and most prominently, by including contractual clauses with their business partners that it’s suppliers elsewhere in the world do not engage in child labor or slavery in their own production process.

And it’s not just enough to put it in a nice wording for which the commission will by the way draft example clauses like precedent clauses, but it has to actually go out and appropriately monitor that these clauses are actually being adhered to. That could be by site visits or by monitoring these processes throughout the world.

LISA MANTELLO: That was going to be my next question. So just putting in a rep and a covenant that you’re going to ensure that you are not infringing on child labor laws, that that’s not sufficient for these purposes?

ULRICH WOLFF: No, but you have to monitor it and you have to report on a regular basis and you have to see what the real impact is. So you have to monitor it, so you can’t just put it in a clause, ask your lawyer to put a nice lovely clause in your supply agreement, you have to follow up.

On the other hand, I’ve mentioned that it’s the established relationships. So what is carved out is the ad hoc purchase of, let’s say, steel. You do one ton of steel purchase somewhere, that’s not an established ongoing relationship and the directive seems to suggest that you are not responsible for that ad hoc purchase and responsibility lies with the supplier.

LISA MANTELLO: So we understand that, as you mentioned, the proposed laws are coming into force in mid of 2023, which is fast approaching given how expansive and potentially overreaching some of these directives are. What’s your advice to Canadian businesses on complying with the due diligence requirements?

ULRICH WOLFF: I think the first important thing is to understand your own value chain. That means actually knowing who supplies what, from where does my product go? And see to whether or not you have appropriate contractual clauses in these supply agreements and sale agreements to make sure that you can live up to the standards.

LISA MANTELLO: So Ulrich, what are the main obligations that the companies would face under the CSDD?

ULRICH WOLFF: I think the main obligations are manifold. They have to have a strategy in relation to sustainability, they have to monitor the strategy, they have to assess the impact, they have to have a complaint procedure, and they have to make sure that if there is undue impact, that issues are being remedied.

But interestingly, in the CSDD, and somehow not even fittingly, it is the spot where the EU has put the requirement to put a climate action plan or sometimes referred to as a climate transition plan. The plan for each company must set out and show a strategy ensuring the company’s business model is compatible with the transition towards a sustainable economy by aligning it with the Paris Agreement, that’s the 1.5 degree limitation.

And it needs to contain CO2 emission reduction target if relevant. Of course, this is now in line with the IPCC recommendations and sets out that this plan needs to be made. So this is what I referred to earlier as hard law. While at the moment, a lot of companies quite rightly have committed to these targets now when this comes into effect have to actually produce a climate transition plan.

For European based companies and subsidiaries, an interesting Clause Article 25 of CSDD specifically mandates now that the companies director must consider the consequences of their decisions for environmental and human rights when determining their decisions and the interests of the company.

So what happens here is through this directive, a clear commitment away from pure shareholder governance or shareholder interest governance to a more broadly based stakeholder interest is mandated for European companies. That is for a corporate lawyer like me quite an interesting innovation.

I should mention, there’s always an administrative body that supervises what the companies are doing and they have the opportunity to– and obligation to issue administrative fines, so it can actually cost money. And there is a obligation to the member states in the directive that they ensure that civil liability is imposed in their member state.

LISA MANTELLO: Thank you, Ulrich. But I wanted to make a comment on that this is more of a stakeholder approach in the impact on all stakeholders as opposed to just the impact on shareholders in the business.

ULRICH WOLFF: Yeah, when it goes to that age old question, is the interest of the company the shareholders’ interest or is defined by reference to a much broader stakeholder interest? And the directive, basically for EU companies and that will not apply to non EU companies, mandates that our national laws are being changed to make clear that the interests of the company in the Company Act is now looked at through the lens of a wide sustainability consideration.

So they have to take into account it’s not just nice to look at, but it’s a must, for a director to take a decision, must always take into account the wider sustainability considerations. And that it becomes the interest of the company. So that’s far away from the Chicago Law School ideas of shareholder capitalism.

LISA MANTELLO: Right, exactly. [LAUGHS] OK. Thank you, Ulrich, the directives definitely do seem to be looking at a broader stakeholder approach and what’s in the interest of all stakeholders as opposed to just the shareholder. So that is very interesting that that is the route that this is going.

So now that we have quite a bit of information about both directives and we understand them better, I do understand that this was quite controversial politically in Europe and now I see why. So is there any chance that either of the proposals will change?

ULRICH WOLFF: Well, I think the reporting directive is pretty much final. Then of course, you will have to see what the transformation process brings, that’s always a question some countries might want to gold plate their implementation, others might do the bare minimum.

But I don’t think the CSRD, although it still has to go to the legal linguistic review, will change much. I think that’s a given. The CSDD, the due diligence directive is much earlier in the legislative process. The European Parliament and council will need to scrutinize it and will it take some time to do that? It’s likely that there’s going to be amendments and they will have to be discussed with the commission.

Given the political sensitivity of the proposal, the widely divergent views among member states and EU institutions as well as the industry, I think we have to expect quite intense negotiations beyond next year. On the other hand, it’s quite interesting to note that both Germany and France have already put in place due diligence laws as national laws, so they’re already halfway there.

So we don’t expect a lot of pushback from Germany and France, but yes, I think there will be intense discussions. And I think anyone who deals with these issues in their companies is well advised to follow them. And we’re happy to jump on another podcast when we know more about it.

LISA MANTELLO: Absolutely, we will be on the lookout for what occurs in the legislative process in Europe on both of these directives. Ulrich, thank you very much. This was very informative and it really gives us a great sense of what’s happening in Europe with respect to both the reporting directive and the due diligence directive. And this has been great in terms of information for preparing our Canadian businesses.

And Ulrich from Linklaters will be at Osler live and in-person for an ESG webinar sometime this fall, so please look out for that. Thanks very much.

ULRICH WOLFF: You’re welcome. And I am looking forward to coming to Toronto.

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From evolving regulatory requirements and investor activism to the physical effects of climate change on business operations and more, Osler’s newest podcast, ESG Explorer, looks at the developments and issues affecting your business. Alongside knowledgeable guests from Osler and across the business world, John Valley, Osler partner, Corporate and Chair, ESG, guides listeners through the critical topics modern organizations are facing.

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