SUSTAINABLE FINANCE, TRADE FINANCE
EU tightens the ESG reins in supply chains
16 March 2022
The European Commission has proposed a new regulation to foster sustainability in corporate supply chains. If enacted, companies will be required to ensure that human rights are respected, and environmental impacts are reduced in their own operations and value chains. flow’s Desirée Buchholz examines what this means in practice
Supply chains are of particular importance when it comes to transitioning towards a net zero economy. According to the UK consultancy Carbon Trust, up to 90% of an organisation’s environmental impact lies in its value chain – either upstream (in the supply chain) or downstream (the product use phase).1
Other estimates are somewhat lower, suggesting that the so-called Scope 3 emissions account for around 70% of a company’s carbon footprint.2 This category captures all the greenhouse gas (GHG) emissions that a company cannot control itself – for example those associated with the transportation of raw materials or waste generated in supplier’ operations. Scope 1 on the other hand covers emissions that a company expels through its own operations while Scope 2 covers indirect emissions that are created by purchasing electricity, heating or cooling for a company’s own use.
Yet, no matter which data you take, one thing is clear: Companies seeking to reduce their carbon footprints need to engage with their suppliers and review the entire value chain.
Monitoring ESG in supply chains
This year, the focus on the environmental, social and governance (ESG) impact in supply chains will become even more important as outlined in the flow article Eight ESG trends to watch in 2022. This is driven by increasing investor demand and public expectations as well as by regulation.
Most recently, the European Commission (EC) published its long-awaited proposal for a directive on corporate sustainability due diligence. “This proposal is a real game-changer in the way companies operate their business activities throughout their global supply chain. With these rules, we want to stand up for human rights and lead the green transition. We can no longer turn a blind eye to what happens down our value chains,” commented Didier Reynders, European Commissioner for Justice when the EC presented its draft on 23 February.3
While the EC acknowledges that many companies have put in place due diligence compliance, it finds that voluntary action is not enough. “They focus on the first link in the supply chains while human rights and environmental harm occurs more often further down in the value chain,” the EC states. “This is why it is time to have clear rules in place.”4
“Directors of companies will be held responsible for putting in place and overseeing the company’s supply chain due diligence programme”
So, what does the EU plan involve? “The new legislation will extend companies’ responsibilities to their entire supply chains,” explains Lavinia Bauerochse, Global Head of ESG Corporate Bank, Deutsche Bank, and a member of the Corporate Bank Executive Committee. “Directors of companies will be held responsible for putting in place and overseeing the company’s supply chain due diligence programme.”
This duty refers to identifying and mitigating risks with respect to forced labour, child labour, inadequate workplace health and safety, greenhouse gas emissions or biodiversity loss. Moreover, the proposed directive also requires companies to set up a plan for ensuring that their business strategy aligns with limiting global warming to the 1.5 °C by mid-century target; thus, fulfilling the Paris Agreement.
Non-EU companies are affected too
The regulation will initially apply to companies that have upwards of 500 employees and global turnover upwards of €150m. Two years later, to this group will be added companies operating in “high impact sectors” such as textiles, agriculture, extraction of minerals that have more than 250 employees and a global turnover of at least €40m, which will also be subject to the law.
Once adopted by the European Parliament and the Council, member states will have two years to transpose the Directive into national law. In all, the new law will probably affect 16,800 corporates, the EU estimates – including 4,000 non-EU companies that have operations on the continent (see Figure 1).5
Figure 1: Companies affected by the new rules
“It is expected that the new rules will apply for group 1 from 2025 onwards and for group 2 starting in 2027,” says Bauerochse. “The EC proposal provides an indication of the scope and design of a human rights and environmental due diligence programme,” she adds. “Therefore, companies in scope need to start mapping and aligning their existing policies and procedures to the requirements, as well as identify gaps and areas for improvement ahead of the adoption.”
“Nowhere in the world is this accountability more material and relevant than in Asia: the sourcing capital of global supply chains”
“The EC proposal will likely become an important regulatory driver for the switch towards accountability of firms vis-à-vis their global supply chains,” says Kamran Khan, Head of ESG, Asia Pacific at Deutsche Bank. “Nowhere in the world is this accountability more material and relevant than in Asia: the sourcing capital of global supply chains.” In 2020, 22.4% of all EU imports came from China alone, which is the EU’s main import partner.6 Countries like Vietnam, Malaysia and Thailand are also major sourcing destinations.7
According to him, “the days when companies could conduct annual audits of their highest risk suppliers and confirm that there was nothing wrong with their entire supply chain are in the past,” he continues. “Today, companies need evidence-based, data-driven monitoring systems to confirm continuous and end-to-end sustainability of their supply chains. Importantly, the proposal will also clarify the sustainability standards Asian companies will have to achieve to operate in Europe.”
EU wants to avoid fragmentation
It seems likely that the new rules will further increase the workload on companies when it comes to ESG monitoring and reporting. Complying with growing sustainability requirements is already one of the top trends impacting the treasury function, a recent survey among senior corporate treasurers conducted by Economist Impact showed.8
Yet, the EU also highlights the benefits of the proposed regulation. According to Brussels, its planned directive would provide a “harmonised legal framework in the EU, creating legal certainty and a level playing field”.9
Indeed, fragmentation could become a problem within the EU. Germany, for example, passed a supply chain act in June 2021, which stipulates that domestic companies, as well as foreign companies based in Germany, will be responsible for compliance with human rights and environmental requirements in their supply chains. Companies with more than 3,000 employees will be subject to the law from January 2023 and companies with more than 1,000 employees must comply with these requirements from January 2024.10 France has already introduced a similar law in 201711, and other EU member states like Belgium, the Netherlands, Luxembourg, and Sweden also plan to develop national supply chain due diligence regimes.12
“The disclosure will highlight the weaknesses in the state of sustainability of the supply chains. In my view, this is where sustainability-linked supply chain finance structures will demonstrate their strength as they incentivise sustainable behaviour”
“Voluntary efforts by a few corporations to promote sustainable behaviour in their supply chains have not yielded a perceptible uplift,” observes Anil Walia, Supply Chain Finance Payables EMEA at Deutsche Bank. “The new regulations will require the procurement function to get a deeper knowledge of the supply chain, the processes within their supplier base as well as the origin of the goods.”
According to Walia, this will create a standardised approach to measurement, monitoring and disclosure. “The disclosure will highlight the weaknesses in the state of sustainability of the supply chains. In my view, this is where sustainability-linked supply chain finance structures will demonstrate their strength as they incentivise sustainable behaviour. I expect a strong increase in the number of such transactions,” he says.
The social dimension is gaining importance
To date, discussions around sustainability often focus on reducing greenhouse gas emissions (“E”), yet social factors (“S”) are becoming more important. This is not only mirrored by the proposed corporate sustainability due diligence directive – which puts great emphasis on labour conditions – but also by the new EU social taxonomy. Following the example of the environmental taxonomy, which was introduced in 2020, the social taxonomy is set to provide a common definition of socially sustainable activities.
On 28 February, the European Commission’s Platform on Sustainable Finance published its final report.13 “While the report itself is not an official legislative proposal, the taxonomy could, for example, help to standardise the Social Bond market which grew by nearly 20% in 2021, after a sevenfold increase to US$147.7bn in 2020.
The suggested structure of the social taxonomy proposes three objectives:
- Decent work for all (including value chain workers)
- Adequate living standards and wellbeing for end-users
- Inclusive and sustainable communities and societies
The taxonomy will therefore be closely aligned with other legislative projects like the planned corporate sustainability due diligence directive. As companies need to ensure that human rights are respected within their value chain, the taxonomy promises to provide guidance.
1 See https://bit.ly/3KMCbXo at carbontrust.com
2 See https://bit.ly/3teUgHF at deloitte.com
3 See https://bit.ly/3Ifs4IS at ec.europa.eu
4 See https://bit.ly/3i885RT at ec.europa.eu
6 See https://bit.ly/3MYtKKy at ec.europa.eu
7 See https://bit.ly/3i9OXme at ec.europa.eu
8 See Treasurers are facing key ESG challenges at flow.db.com
9 See https://bit.ly/3tfOcyu at ec.europa.eu
10 See https://bit.ly/3ibMx6N at bundesregierung.de
11 See https://bit.ly/3KMD2Hp at supplychaindive.com
12 See https://bit.ly/3If5GiI at ec.europa.eu
13 See https://bit.ly/3q9j3Ln at ec.europa.eu
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