Due diligence as a precondition for green financing. What does it mean for business?

Human rights and environmental impacts in European companies’ global value chains present a major business risk as well as a challenge to fair competition. The EU aims to redirect private and public funds to support the transition towards a sustainable economy. However, business activities won’t meet sustainability requirements if their value chains remain linked to impacts such as deforestation, forced or child labour. ‘Due diligence’ is what is needed to ensure that companies overcome these challenges, protect people and the planet, and increase access to sustainable financing.
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 such as  GRI, governments as well as the EU itself. The European Commission will present a proposal for new due diligence legislation in the first quarter of 2022. 
This “ESG due diligence” is fast becoming an important part of business transformation. However, companies often struggle to get a grasp on what they are supposed to do and disclose, due to the lack of clarity in law and diverging investor demands. 
The European Commission’s new Corporate Sustainability Reporting Directive (CSRD), currently being discussed, will greatly contribute to address this challenge and will help satisfy the need of investors and broader society for information on companies’ plans, actions and results. Such clarity is also important for companies to avoid risks to their reputation and financial consequences.

ESG due diligence helps prevent risks

Due diligence describes the actions taken by a company to identify, analyse and act on actual and potential risks to people and the environment, not simply within the own operations, but also in the supply chains of companies, and in the services they use. Due diligence is a relevant tool for all companies and can help to identify issues such as harassment in the workplace, misuse of the company’s products or services, or privacy of personal data.
The bigger the involvement of a company with high-risk operations and 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. Supply chain impacts, 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 to do so.

CEE companies fail to meet human rights due diligence

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. However, recent research by the Alliance for Corporate Transparency, led by Frank Bold, has shown that current reporting on due diligence is insufficient, especially in CEE countries, where more than 90% of assessed companies fail to report on their human rights due diligence process. 
Human rights due diligence plays an important role in well-advanced European and global movements towards a sustainable financial system. The EU is implementing a comprehensive sustainable finance strategy to mobilise over 1 trillion EUR 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

EU reporting standards will help both companies and investors 

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, and 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. 
In practice, financial institutions attempting to integrate due diligence assessments into their decision-making use very different methodologies and indicators, or depend on rating agencies and consultancies.  
In order to remove this confusion and fragmentation, the EFRAG Project Task Force on EU Sustainability Reporting Standards is developing common reporting standards, similar to those used in financial reporting, following a mandate by the European Commission. These standards are intended to clarify what information companies should disclose about due diligence, main negative impacts and actions taken to address them.
We follow the development of the standards directly as members of the EFRAG Project Task Force.

Frank Bold and ESG services

In Frank Bold we have direct experience of the European institutions, where our lawyers have been involved in the development of the EU framework around sustainability reporting and the EU Taxonomy.
Our work builds on many years of experience in sustainable construction, working with developers, real estate funds, and energy companies. We provide guidance on both the legal and technical sides of ESG issues
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