EU now requires companies to meet long-term climate challenges

The European Commission has presented a proposal on large European companies’ obligation to exercise corporate sustainability due diligence. The new proposal has three parts, and each part is more controversial than the one preceding it: an obligation to exercise due diligence, new rules for enforcement of this obligation and a clarification of directors’ duties.

“It is a groundbreaking new proposal because it places an obligation on EU companies to act in a sustainable way, whereas previously, they only had an obligation to report on their actions – if they indeed took any action at all. But it is even more controversial that the proposal opens the possibility that companies that do not act as suggested by the directive may be liable for damages, just as it seeks to clarify directors’ duties in relation to the environmental and human rights impacts of their companies,” says Karsten Engsig Sørensen, professor from the Department of Law at Aarhus BSS, Aarhus University, who specialises in EU company law.

New rules on reporting

The least controversial part of the new proposal is EU companies’ obligation to exercise due diligence for their own activities, activities of their subsidiaries and activities in their value chain.

Previously when a large Danish company with a subsidiary in Bangladesh did its sustainability report, it only had to report on the environmental and human rights impacts that the company itself deemed significant enough to share with the world.

Going forward, the company will be under an obligation to exercise due diligence. This means that the company must investigate any adverse human rights and environmental impacts; and not just impacts of its own activities and of its subsidiaries around the world, but also impacts of its regular suppliers. It will also have an obligation to consider, prevent and mitigate its adverse impacts. That is, prevent or remove these risks if within its power – and if not, to minimise them as much as possible.

“The context of the proposal is that voluntary standards on responsible business conduct have increased EU companies’ contribution to the sustainable transition, but not to a sufficient degree. This is why the European Commission seeks to introduce an obligation for companies to take active steps towards the green transition, and why it will no longer be enough just to report on activities,” says Karsten Engsig Sørensen.

New rules on enforcement

However, this is not the most controversial aspect of the proposal.

It is more controversial how the European Commission will simultaneously introduce a way to enforce these new obligations, divided into three parts. First of all, a new complaints procedure will ensure that people who are affected by the adverse human rights or environmental impacts of a company – for instance a child working in the company’s factory in Bangladesh – can submit a complaint to the company in question. And if the child worker is not capable of submitting such a complaint, a representative might do so on their behalf, for instance a trade union or an NGO.

“In addition, the authorities will be required to act if anyone presents them with a reason to suspect that activities with an adverse impact on human rights or the environment are being carried out in a company. Furthermore, authorities in EU member states will be allowed to investigate whether companies meet their obligations, and if not, the authorities will have the power to administer fines and impose other sanctions,” says Karsten Engsig Sørensen.

Finally, the European Commission has added civil liability to these enforcement rules, meaning that for instance a farmer in Bangladesh who have had his/her fields ruined by pollution from a company can claim compensation from said company.

"Before, the farmer would usually have to claim compensation in Bangladesh, seeing as this is where the company damaged his/her fields. But the new proposal aims to change this. The European Commission proposes that such a claim against a Danish company should be settled in Denmark in accordance with Danish law, no matter where the offence has been committed or where the damages have occurred. This is done in the hope that some people will claim compensation and thus help enforce the due diligence obligations of the companies,” says Karsten Engsig Sørensen.

New rules for management

As the last – and most controversial – aspect of the proposal, the European Commission has proposed a clarification of directors’ duties.

“In Denmark, we do not include a description of the overall duties of directors in our company law. We assume that the primary duty of the directors is to act in the interest of the shareholders, and in certain cases, the interest of the creditors. But now, the European Commission has proposed that these obligations should not only consist in earning money for shareholders and taking care that creditors do not unnecessarily lose money, they should also include an obligation to serve other interests – or at least take them into consideration. This means that when directors make decisions in the interest of a company, they must also consider how such decisions will impact human rights, climate change and environmental issues in the short, medium and long term,” Karsten Engsig Sørensen explains.

This has stirred up some strong feelings within business and industry. Many people point out that this proposal is in direct conflict with the way companies are managed in our part of the world. Opponents of this proposal also fear that it will make management focus too little on making a profit, so that directors might dismiss bad financial results by referring to a company’s sustainability efforts.

“People fear that this proposal might make it difficult to hold management accountable to their shareholders. In contrast, supporters say that the proposal is far too non-committal if you want to succeed with the green transition,” Karsten Engsig Sørensen notes.

A new era?

When the European Commission first announced in a report prepared for the Commission by the consultancy firm Ernst & Young that it would use company law to an unprecedented degree in order to ensure more sustainable business operations, it was met with forceful criticism from many sides. Part of the criticism concentrated on how the report assumed that companies were too short-sighted and focused on profit due to mechanisms built into existing company law. According to critics, this assumption was not valid. On this basis, Karsten Engsig Sørensen and his German colleague Florian Möslein wrote the article "Sustainable Corporate Governance: A Way Forward.”

"We argued that it was possible the report’s conclusions about existing company law were too drastic. But we also have to acknowledge that politicians are committed to do something about the environment and human rights, and that company law may well play a part in this. Instead of a specific set of directors’ duties, we proposed implementing procedural rules to ensure that the management of a company would work towards the desired goal, in this case more sustainable business operations. And this is exactly what the European Commission has done by introducing the due diligence obligation,” says Karsten Engsig Sørensen.

The Council of Europe will now discuss the proposal. According to Karsten Engsig Sørensen, this is the hard part, because this is when member states must give their accept of the proposal. After that, the European Parliament will process the proposal, but seeing as the Parliament has already requested rules like these, it is expected to be in favour of the proposal.

“I expect that the last part on directors’ duties will be removed from the final directive, which will probably only contain the part on due diligence and enforcement. This will cause some people to say that the proposal is not ambitious enough to bring about the necessary green transition, and other people will say that the proposal has gone too far. We must hope that the right balance has then been struck. Only time can tell,” he concludes.

• The proposal has three parts: Due diligence, enforcement and directors’ duties.
• This proposal applies to European companies with more than 500 employees on average and a net worldwide turnover of more than EUR 150 million worldwide.
• It also applies to European companies with more than 250 employees on average and a net worldwide turnover of EUR 40 million if they operate within a high-impact sector, for instance the manufacture of textiles, agriculture or the wholesale trade of agricultural raw materials.
• Finally, it applies to non-European companies that are listed on EU-regulated markets and have the same number of employees and the same net worldwide turnover that obligate European companies in general.
• Read the proposal in full here