The European Parliament is expected to finalise a legal text for the EU’s Corporate Sustainability Due Diligence Directive (CS3D) this week.

The legislation, provisionally agreed last month, will be a game-changer for companies around the world when it comes to how they are held accountable for the human rights and environmental harms associated with their business activities.

There has, however, been confusion about what the new rules will mean for asset owners and managers. Early reports focused heavily on the exclusion of the finance sector from the agreement following months of aggressive lobbying by industry bodies.

But in reality, only Pillar 1 pension institutions or social security schemes are completely exempt from CS3D. Most other financial institutions, including IORPs, are covered. The first tier of entities that will have to comply with CS3D are those with more than 500 employees and €150m in turnover, which may restrict its direct application to occupational pension funds, however.

“From what we know about the current draft text, what’s actually been excluded is the requirement to do due diligence on financial assets, which relates to downstream lending and investment activities,” explains Simon Brennan, who runs Deloitte’s EMEA unit for sustainability regulation.

That decision was made on the basis that it was impractical to expect investors to be able to assess all the securities in their portfolios and loan books in the same way as businesses can when they sign contracts with suppliers.

The provisional agreement does include a review clause, however, meaning that as part of the technical negotiations, legislators will decide on a time and process for reconsidering the inclusion of the finance sector.

In the meantime, there are still many ways in which CS3D will affect investors.

Due Diligence

To start with, they will have to perform environmental and human rights due diligence within their own operations.

Many European investors already incorporate the OECD Guidelines for Multinational Enterprises on Responsible Business Conduct and UN Guiding Principles on Business and Human Rights – which both underpin CS3D – into their investment policies, on a voluntary basis.

In the Netherlands, the majority of the Dutch pension sector has signed up to a 2018 agreement to implement the OECD guidelines.

“So the first thing these investors need to do is establish what they’re already doing, because, while the move to mandatory rules is important, it doesn’t mean the concepts themselves are new,” says Brennan.

It does mean, though, that investors will have to stop using certain suppliers if they breach the rules outlined in the Directive.

Transition plans

Investors will also have to develop climate transition plans.

“As with everything else at the moment, the technical details aren’t yet available, but the agreement in December requires entities to adopt and put into effect a plan that’s compatible with meeting the goals of the Paris Agreement,” says Hazell Ransome, a senior policy analyst at the Principles for Responsible Investment.

She adds that “it’s clear the financial sector is covered by those requirements,” and that the implications are “huge”.

“Possibly the most interesting angle is the information that investors will start to get from their portfolio companies”

Simon Brennan, head of Deloitte’s EMEA unit for sustainability regulation

Many of the larger firms and financial institutions having to comply with CS3D will already have climate transition plans in place, based on expectations from the Taskforce on Climate-related Financial Disclosures, the EU’s Corporate Sustainability Reporting Directive and other national laws.

But CS3D is the first legislation to mandate the implementation of the plan, not just its development and disclosure.

New stranded assets?

As well as the measures that relate directly to investors, there are implications for their investee companies.

“Possibly the most interesting angle is the information that investors will start to get from their portfolio companies, and what pension funds and asset managers plan to do with it,” says Brennan.

“Eventually, it will probably just become useful data for monitoring companies, but there will be a point at which investors will receive all this information for the first time, and will learn a lot all at once. So they need to think about how they plan to respond to what they find out,” he adds.

“It will enable more effective stewardship and engagement work on these issues”

Greta Koch, a policy advisor negotiating CS3D on behalf of the European Parliament

Brennan says that, if the flows of information generated by CS3D (and bolstered by data disclosed under the Corporate Sustainability Reporting Directive) cause new risks to crystalise for portfolio companies, it could create “a kind of stranded-asset-type risk”.

Investors may want to exit those companies – they may even have to, if the EU adds financial assets to the due diligence requirements in future. If that happens at scale, it would be likely to impact valuations in the market.

Enforcement risks

If the provisional agreement remains unchanged between now and April, when it’s due to be adopted, it will permit supervisors to fine companies up to 5% of their global turnover.

Speaking on a webinar last week, Greta Koch, a policy advisor negotiating CS3D on behalf of the European Parliament, said there has been “a lot of discussion on sanctions”.

“What we have now is a so-called ‘maximum sanction of minimum 5%’, so the highest possible sanction should at least be 5%.” She said this left “a lot of leeway”, and that member states were unlikely to apply the maximum penalty in most cases.

Ransome feels optimistic about how these potentially hefty fines and new risks will affect investors, pointing out that companies will have “significant time to prepare for CS3D, so they should be able to mitigate risks before enforcement comes in”.

Ultimately, she thinks the due diligence that portfolio companies will have to carry out as a result of CS3D will reduce risks for investors, not increase them, and assist with their sustainability assessments.

“It will also enable more effective stewardship and engagement work on these issues,” she suggests.

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