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05 Apr 2022

Economy

Relationship with the EU

The European Commission published its proposed, long-awaited and potentially highly significant directive on due diligence on 23 February 2022. The directive will impose a duty on major businesses to carry out human rights and environmental due diligence in their global value chains.

Although mainly aimed at EU businesses, the directive will also affect UK and other non-EU businesses which either have sufficiently large EU activities, have EU parents or are involved in EU supply chains. The costs involved may be significant.

Who does it apply to?

The directive applies to companies and some other legal entities, such as credit institutions, insurance companies and some pension funds.

It covers three groups, starting with EU entities with more than 500 employees and a net worldwide turnover of more than €150 million.

Second are EU entities with more than 250 employees and a net worldwide turnover of more than €40 million, if half or more of their turnover comes from certain ‘high impact’ sectors. These include the manufacture and wholesale trade of textiles and leather, agriculture, forestry, fisheries, food manufacture, mineral resource extraction and wholesale trade and manufacture of metal and other mineral products.

Finally come non-EU entities which generate a net turnover of more than €150 million in the EU or between €40 million and €150 million in the EU with at least half coming from the high impact sectors. This means that companies registered in England and Wales, Scotland or Northern Ireland must meet the directive requirements if they satisfy this test.

What does it require?

Companies covered by the directive must identify actual and potential adverse human rights violations and environmental impacts from their operations and supply chains, including established relationships with contractors, subcontractors, and partners.

Adverse impacts cover, for example, human rights issues such as inadequate workplace health and safety and child labour and environmental impacts such as loss of endangered species and greenhouse gas emissions.

Financial services must identify adverse impacts before providing credit, loan or other financial services. Where relevant, entities must consult potentially affected groups such as workers and other stakeholders.

Companies must also take appropriate measures to prevent or mitigate identified impacts. This includes having a prevention action plan with timelines for action, indicators to measure improvements, and measures to end or minimise adverse impacts. They must monitor the effectiveness of their operations and measures once a year, update their policy and report annually on what they have done.

Affected companies must have a due diligence policy which sets out their approach, with the processes and measures to be taken, and a code of conduct for employees and subsidiaries. The policy must be updated annually and be integrated into other corporate policies.

EU and non-EU entities with a turnover of more than €150 million must also make their business model and strategy compatible with transitioning to a sustainable economy and limiting global warming to 1.5 degrees celsius, in line with the Paris Agreement. They must identify climate change risks and impacts and include emission reduction objectives.

To reinforce the general approach, directors of EU companies will also be personally responsible for putting the various due diligence actions in place and considering relevant input from stakeholders and civil society organisations. They must also ensure the corporate strategy takes account of the adverse impacts identified and the measures taken to prevent or end them.

When things go wrong

Member states will have to establish supervisory authorities to make sure entities comply. Non-EU companies will be supervised by the authority in the member state where they have a branch or where most of their relevant net turnover is generated.

Businesses must have a complaints procedure where trade unions, civil society organisations and anyone affected by an adverse impact can raise concerns about adverse human rights and environmental impacts. Businesses may face fines imposed by a national authority based on turnover as well as civil liability.

How significant is the change?

Some, particularly larger, companies already use value chain due diligence voluntarily to meet international standards. Although the UK is moving to greater disclosure of sustainability-related information in companies’ accounts, it is not yet mandating due diligence exercises or requiring plans to remove or reduce adverse impacts.

The turnover criteria mean the directive is expected to apply directly to only around 1% of companies in the EU. Some have criticised the proposal for not covering enough companies and not going far enough. However, small and medium enterprises could be indirectly affected, for example if they have an established relationship with a larger business.

Indeed, a similar French regime has already led to around 80% of French companies having to implement at least some due diligence measures because they supply larger companies.

This is where the largest impact on UK business is likely to arise. UK subsidiaries of EU affected companies will need a code of conduct and to identify actual and potential adverse human rights and environmental impacts to feed into their group policy. UK businesses who have established business relationships with affected EU entities will also need to do this.

Fulfilling the obligations under the Directive may not be straightforward for UK and EU companies. Each member state will implement the Directive slightly differently and could impose higher standards. Further, each affected company will have a slightly different approach in what it asks its suppliers to do. So a company that supplies a number of different EU companies and/or is a subsidiary of an EU company could face varying requirements with the associated cost implications.

This is the first time the EU has proposed changes in the sensitive area of directors’ duties. ecoDA, the umbrella organisation representing national institutes of directors in Europe is not impressed, complaining the proposal is ‘unclear and unprecise’ on directors’ duties.

Although the directive may change before it is finally adopted, because of the significant change it will bring UK businesses need to start now to work out how they will be affected and what the EU businesses they work with are planning.

By Vanessa Knapp OBE, Visiting Professor at Queen Mary University London.

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