In a recent vote, the EU Parliament backed a legislative initiative paving the way for a new EU directive on Corporate Due Diligence and Corporate Accountability. As part of this initiative, lawmakers called for the urgent adoption of an EU-wide regulation that will require companies to identify, address and remedy the environmental, social and governance (ESG) risks in their supply chains. A new law is expected to follow in the coming months.
Mounting pressure from multiple stakeholders has put the ESG agenda in the spotlight. A recent survey conducted by NAVEX Global has revealed strong adoption of ESG initiatives across businesses: 63% of respondents said their companies are planning to increase their spending on ESG in 2021. With the COVID-19 pandemic accelerating global supply chain restructuring, it might be a perfect time to “build back better” with a focus on sustainability.
Why Is the Current Approach Not Working?
The idea that organizations should be held accountable and liable when they harm – or contribute to harming - the environment, human rights or good governance principles has been around for decades. To date, however, while several mandatory frameworks have been introduced, these tend to focus on specific industries, member states or individual facets of major ESG concerns. In general, companies are only encouraged to take responsibility for supply chains on a voluntary basis.
Examples of current mandatory regulations include:
- The Timber Regulation (EU Regulation 995/2010, entered into force in 2013), which requires the operators who place both imported and domestically produced timber and timber products on the EU market for the first time to exercise due diligence.
- The Conflict Minerals Regulation (EU Regulation 2017/821, entered into force on 1 January 2021), which aims to promote responsible sourcing by laying down supply chain due diligence obligations for EU importers of 3TGs originating from conflict-affected and high-risk areas.
- The EU Non-financial Reporting Directive (Directive 2014/95/EU). This requires large companies to include non-financial statements in their annual reports from 2018 onwards and disclose their policies on environmental protection, social responsibility, anti-corruption and bribery, treatment of employees, respect for human rights, diversity on company boards and due diligence procedures throughout the supply chain.
- The Dutch Child Labor Due Diligence Bill (entered into force in 2020). It requires companies from anywhere in the world that deliver their products or services to the Dutch market twice or more in a year to identify, prevent and address the issue of child labour in their supply chains.
- The French Corporate Duty of Vigilance Law 2017, which requires large French companies to develop and implement publicly available vigilance plans with regard to the companies they control, as well as their contractors and suppliers, to identify and prevent risks to human rights and the environment.
Most of the notable EU-wide voluntary initiatives focus on supporting sustainable garment, textiles, leather, and related supply chains across the producing countries. For example, the Trade for Decent Work Project, established by the EU in conjunction with the International Labor Organization (ILO), aims to improve labour relations and working conditions in EU trading partner countries.
But a wealth of evidence from academia, government bodies and activist groups suggests that the existing, isolated approaches lack effectiveness. With the absence of enforcement mechanisms, voluntary initiatives are not always followed. The fragmentation of existing frameworks creates inconsistencies across industries, causing confusion about what constitutes best practice due diligence and how processes should be implemented. There is a clear need for binding cross-sectoral legislation to create single, legal standard of care.
The EU Parliament’s Proposal - What We Know Now
Several options for future legislation have been identified. Initially, the proposal was due to focus on primarily addressing human rights, but the scope has since been expanded to include broader social and environmental issues. The draft directive proposed by the EU Parliament provides some visibility into which key points the lawmakers are targeting.
The future directive is expected to apply to all large companies, as well as listed high-risk small and medium-sized businesses, based in the EU. Technical assistance and financial support should be provided to SMEs to help them fulfill their obligations. Non-EU companies that wish to access the EU market will also have to comply with the requirements established in the directive.
Due Diligence Strategy
Companies are expected to establish and implement a due diligence strategy to identify and assess in an ongoing manner whether their operations “cause, contribute to or are directly linked to any potential or actual adverse impacts on human rights, the environment or good governance”. ESG priorities reflected in the due diligence strategy should be in line with the overall business strategy.
Lawmakers are keen to ensure that due diligence strategies encompass the entire value chain, all the way to the primary source. Modern supply chains are highly complex and they often include multiple tiers. Companies are expected to have a complete universe of third parties mapped out, encouraging direct suppliers to engage with those further down the chain.
"'Value chain' means all activities, operations, business relationships and investment chains of an undertaking and includes entities with which the undertaking has a direct or indirect business relationship, upstream and downstream, and which either: supply products, parts of products or services that contribute to the undertaking’s own products or services, or receive products or services from the undertaking."
Enforcement of the EU directive will take place in the Member States, with competent national authorities designated to issue sanctions proportionate to the severity of the infringements. Companies breaching due diligence rules would face civil liability unless they show that they have acted with all due care. The sanctions may be calculated based on the company’s turnover and may include temporary or indefinite bans from public procurement or state aid, asset seizures and other administrative sanctions.
What you can do to prepare
As with many other EU-wide directives, after adoption, there would be a two-year transposition period before the legislation comes into full force. This is a great opportunity for companies to anticipate the change, prepare and get ahead of the curve in their ESG efforts. To meet the ever-increasing expectations and better understand your exposure to supply chain risks, consider taking the following key steps.
1. Assess Your ESG Standing
This initial stage will provide a general understanding of the supply chain risks specific to the nature and context of your operations, including geographical risk, sector materiality and your supply chain complexity assessment. Consider:
- How many of your suppliers operate in high-risk countries?
- How many tiers do you have in your supply chain?
- How is the supply chain engagement managed internally?
- What was your ESG performance in the last five years?
Look to cover these general questions in order to highlight any red flags and steer the focus of the due diligence process.
2. Quantify Your Risk
Liaise with your direct suppliers to collect the data and encourage them to engage with their own suppliers (i.e. tier 2 suppliers to your company), effectively creating a cascade of ESG management through the supply chain.
- Focus on both external supply chain risks coming from third-party suppliers, as well as internal risks relating to supply chain management.
- Engage with key decision-makers and impacted stakeholders to have their feedback and insights into ESG risk areas that might exist.
To streamline your risk management efforts, consider an IT solution to collect supplier data and quantify your risk.
3. Develop a Roadmap for Improvement
Once you’ve mapped out your supply chain and have good visibility into which operations and suppliers create the most pressing risks, you’ll need to create an action plan or a roadmap for ESG supply chain improvement. This will ensure there is ongoing monitoring and active management of any risks, while encouraging actual performance improvements.
You should strive to go beyond legal compliance, strengthening your relationships with suppliers through regular interactions and rewarding their improvements with more business. The ultimate objective is to arrive at a well-defined third-party due diligence process with an ESG component included in the standard procurement process.