Dean Hickey, Author at The Fashion Law

What Companies Need to Know Now that the EU Has Adopted the CSRD

January 18, 2023 - By Dean Hickey

On November 28, 2022, the Council of the European Union adopted the proposed Corporate Sustainability Reporting Directive (“CSRD”), clearing the final hurdle to the CSRD becoming law in the European Union. Member states have 18 months to incorporate the provisions of the CSRD into national law following its publication in the Official Journal of the European Union. The latest in a series of directives on non-financial disclosure, the CSRD follows from the 2014 Non-Financial Reporting Directive (the “NFRD”) and builds upon it by expanding the scope of companies that the law applies to and imposing more detailed reporting requirements on in-scope companies.

Primarily, the CSRD will apply to: (1) all “large” EU companies; and (2) all companies listed on EU regulated markets (except micro undertakings). Companies will be considered “large” if they exceed at least two of the following criteria: balance sheet total of €20 million; net turnover of €40 million; and/or an average of 250 employees during the financial year. The CSRD also applies to listed small and medium-sized enterprises; however, these SMEs will be subject to lighter reporting requirements and will benefit from an opt-out until 2028. (Many fashion/apparel companies come to mind here.)

Companies that are not European but that are operating in the EU (whether listed or not) may also be subject to the CSRD if they meet certain thresholds and/or if such companies have at least one subsidiary or branch in the EU and a net turnover of more than €150 million generated in the internal market. If the non-EU company has an EU subsidiary, the CSRD will only apply if the subsidiary is either large or listed – and is not a micro undertaking. If the non-EU company has an EU branch, the CSRD will only apply where the branch generates a net turnover of more than €40 million.

What do the new rules require?

One of the key features of reporting under the CSRD is that in-scope companies will have to report on a double materiality basis. In other words, they will have to report both how their business impacts – and is impacted by – Environmental, Social, and Governance (“ESG”) issues. Overall, the CSRD introduces extensive sustainability-related disclosures, although they vary marginally according to the type and size of in-scope entity.

Matters that companies will need to report on include resilience of the company or group’s business model and strategy in relation to sustainability risks; sustainability strategy and transition plan(s); how the company’s business model and strategy consider its stakeholders’ interests and its impacts on sustainability matters; sustainability targets and policies; any incentive schemes linked to sustainability matters; indicators relevant to its sustainability-related disclosures; and a description of the due diligence processes with regard to sustainability matters and actions taken to remediate or mitigate potential adverse impacts in its supply chains.

Additionally, companies’ reports will have to be accompanied by a limited assurance opinion. This is first time we have seen a general EU-wide audit requirement for sustainability information, and this is likely to set the direction that other jurisdictions will follow.

Reporting standards for in-scope companies

This is still somewhat in flux, as the relevant EU sustainability reporting standards still need to be adopted by the European Commission – the Directive requires these to be adopted by June 2023. The European Financial Reporting Advisory Group (“EFRAG”) has submitted its first general set of European Sustainable Reporting Standards (“ESRS”) to the European Commission. EFRAG will now turn to the drafting of sector-specific ESRSs, which are required to be adopted by the European Commission by June 2024.

By June 2024, the Commission will also adopt the sustainability reporting standards for non-EU companies caught by the CSRD. It is currently unclear to what extent these standards will align with or diverge from the ESRSs.

What about timing?

The application of the directive will be phased, with obligations starting to apply at different times depending on the type of entity. Reporting in 2025 for the financial year 2024 will be required for companies caught by the CSRD that are already subject to the NFRD. Reporting in 2026 on the financial year 2025 will be required for large companies caught by the CSRD that are not currently subject to the NFRD. Reporting in 2027 on the financial year 2026 will be required for listed small and medium companies (except micro undertakings). And finally, reporting in 2029 on the financial year 2028 will be mandated for non-EU companies with net turnover above €150 million in the EU if they have at least one subsidiary or branch in the EU exceeding the thresholds mentioned above.

THE BIGGER PICTURE: The CSRD goes some way to meeting the demands of an increasingly ESG-focused investment community that demands hard data setting out the risks and opportunities arising from sustainability issues. Arguably, the CSRD marks the beginning of a new dawn of comprehensive ESG reporting and monitoring in the EU.

Companies that may fall within the scope of the CSRD should consider starting their analysis now by mapping out which entities will be caught by which provisions of the CSRD (as, depending on the size of the relevant entity, the reporting obligations may apply at different times) – this would likely involve engaging with financial reporting teams to assess whether relevant thresholds are met (or might be met, if business performance changes over time). Beyond that, they should consider carrying out a gap-analysis exercise to understand what additional information and processes may be required, and assigning tasks to internal teams, designating responsibility for gathering information and establishing appropriate reporting lines, promoting collaboration between different EU entities where required and putting in place appropriate governance structures to oversee the new reporting obligations.

And while they are still at the draft stage, companies are encouraged to improve their familiarity with the ESRSs to understand what additional information will need to be disclosed.

Companies operating across multiple jurisdictions may be concerned about the risk of having to comply with similar-but-different reporting requirements. The CSRD includes an equivalence mechanism – in practice, this will mean that if the non-EU parent of an EU subsidiary reports in accordance with ‘equivalent’ reporting standards to the ESRSs (and that EU subsidiary is included within the consolidated report), certain reporting exemptions will apply. Given that the CSRD and corresponding ESRSs are already more ambitious than most other standards, it may be difficult to see which other standards will be considered “equivalent.” For example, the nascent International Sustainability Standards Board – which the UK intends to adopt as baseline standards for sustainability reporting – does not require a double materiality approach, and therefore are unlikely to be considered “ESRS-equivalent.”

However, there is an ongoing collaboration between International Sustainability Standards Board and EFRAG, so it remains to be seen whether an agreement can be reached and the extent to which the two standards will be interoperable.

Dean Hickey is an Associate focusing on Sustainability and Climate Change at Slaughter and May.

Lucy Scaramuzza is an Associate at Slaughter and May.

Business

The Increasingly Important Link Between Corporate Purpose & ESG Risk Management

December 1, 2022 - By Dean Hickey

The Financial Reporting Council (“FRC”) recently published a briefing entitled, In Focus: Corporate Purpose and ESG, this spring as a companion piece to the Creating Positive Culture – Opportunities and Challenges report, which was released in December 2021. The FRC’s briefing looks to draw out what it views as an “inherently interlinked” relationship between a company’s purpose, values, and culture and its environmental, social, and governance (“ESG”) objectives. While the idea of linking corporate purpose with ESG is not new, it is notable that the FRC has decided that it now warrants a publication in its own right.

The briefing builds upon the “Principles” and “Provisions” included in the FRC’s UK Corporate Governance Code (“CGC”), in particular, “Principle B,” which states that a “board should establish the company’s purpose … and satisfy itself that [it] and [the company’s] culture are aligned.” The CGC – which is aimed at premium-listed companies – is intended to provide a framework for good corporate governance. The CGC is not mandatory, but the FRC does require that those companies to which the code applies either “comply” or “explain” should they elect to depart from the CGC.

Most readers will be familiar with the concept, succinctly articulated in the FRC’s briefing, that corporate purpose can serve as a “moral anchor” for a company. Readers may also be familiar with the potential risks in the event that a business finds itself without a strong corporate purpose and thus, exposed to changing tides of “cultural drift.”

In its briefing, the FRC goes to considerable lengths to stress that the adoption of a corporate purpose does not “come at the expense of profit.” Rather, it provides examples of successful “purpose-led” businesses across a number of sectors. While not a panacea, a well-embedded corporate purpose can help to foster a culture where decision-makers not only take into account short-to-medium term objectives, as may be articulated in a company’s strategy, but also consider the impact of their decisions in the longer-term and through the lens of the values which flow from a well-articulated corporate purpose.

An organization that has a value-centric culture, supported by appropriate corporate governance arrangements (i.e., which ensure board-level accountability) can provide a fertile ground for consideration of ESG-issues, including, for example, climate-related risks. Where decision-makers are empowered to consider and monitor an organization’s progress on ESG-issues, both at a strategic and operational level, they will, ultimately, be best placed to determine whether any mitigation is required to protect the long-term value of a company. This is clearly in the interests of all stakeholders.

Stepping back and considering the FRC’s briefing in a wider context, it is possible, to see it as part of a wider movement in the corporate landscape. Increasingly, businesses are departing from the orthodox approach centered on “shareholder return maximization” towards one of “stakeholder value creation.” This emerging shift has come about in response to concerns that “shareholder primacy” as a model for corporate governance leaves businesses ill-equipped to respond to ESG-related risks.

Even the UK’s own model of “enlightened shareholder value” – as drafted in Section 172 of the Companies Act 2006 – has been found to be limited. The UK’s approach of allowing directors to consider the interests of other stakeholders – beyond shareholders (insofar that the interests of the former align with the latter) – is creaking under growing pressure from investors and consumers. Consequently, corporations in the UK and across the “developed” world are increasingly turning to market-based “soft law instruments” (i.e., the OECD’s Principles of Corporate Governance) to fill perceived voids in mandatory or quasi-mandatory corporate governance frameworks.

As the stark reality of the limitations on national governments to curb GHG emissions, tackle modern slavery in supply chains, and address entrenched inequalities becomes increasingly clear, the need for businesses to step up is more apparent than ever. Similarly, just as expectations on businesses have risen, a growing chorus of voices in the business community is calling on governments to do more. In the UK, for example, the “Better Business Act” campaign is lobbying to amend the law to embed purpose and stakeholders’ concerns into all businesses by default.

Legislators across the globe have long struggled to keep pace with societal change and reflect this in law. As such, it may be a while before we see substantive legal changes which codify a “stakeholder value creation” model. Nothing in the UK’s existing legislative framework, however, prevents a client from considering whether their existing corporate purpose can be said to be “ESG-aligned” and whether it cascades through its culture to its strategy and long-term objectives.

Dean Hickey is an associate at Slaughter and May in London, where his practice focuses on Sustainability and Climate Change.

Business

Amid Increasing Scrutiny, How Brands Can Counter the Risk of Greenwashing

August 11, 2022 - By Dean Hickey

The UK’s Competition and Markets Authority’s (“CMA”) has recently announced that it has launched investigations into a number of fashion retailers to determine “whether the firms’ green claims are misleading customers.” This latest development comes hot on the heels of news from the U.S., that Swedish retail giant H&M has found itself on the receiving end of a class action complaint as it is alleged to have engaged in greenwashing (and more specifically, false advertising), by making use of “inaccurate and misleading” information in marketing the offerings of its “Conscious Collection.”

Fashion retailers have woken up to the need to be – or at least appear to be – “green” in order to grow, or even retain, their market share. However, tapping into this new market is not without risk. In going “green,” fashion retailers have exposed themselves to additional scrutiny and accusations of greenwashing. The problem of greenwashing is not exclusive to this sector, and in fact, the CMA’s announcement should be taken as a wake-up call to all businesses marketing “green” or “sustainable” products.

The Business Case for “Sustainable” Products

The provenance of a product is increasingly viewed as a key determining factor in what we buy and from whom (at least in theory). Until recently, “price” was the key factor for consumers making purchasing decisions. Today, consumer behavior has partially shifted. While price is still a factor, the change in behavior has come about as consumers are increasingly interested in and aware of the negative impact of the apparel industry on the climate front and of over-consumption. While the law of demand still exists, changes in generational spending power have seen the demand for sustainable products become increasingly inelastic. Products that purport to be “sustainable” are likely to command a premium over those that do not have the same “green provenance.” Or to put it another way, there is less consumer price sensitivity for sustainable products. As such, the obvious attraction to retailers in bringing sustainable product lines to the market is clear.

Products that are marketed as sustainable without clear evidence to support these claims or where the evidence is somewhat contrary can be said to be indicative of information asymmetry – a form of market failure. In effect, the absence of data prevents customers from making informed decisions due to a lack of information or the supply of inaccurate information. Tackling this potential detriment to consumers is a clear driver for regulators.

Greenwashing and the Supply Chain

The need for verifiable and timely data is a common thread that runs through all six of the key principles in the CMA’s “Green Claims Code.” Robust data is also vital to mitigating against the risk – and avoiding the perception – of greenwashing. Often, in long and complex supply chains, this data will be generated by a number of third-party suppliers. Where there are deficiencies – in data and/or performance – that could adversely impact the claimed sustainable credentials of a product, remedial action must be taken. Given increased awareness among consumers and regulators, alike, it appears that businesses can no longer afford to make claims as to a product’s “sustainability” credentials without an intimate knowledge of each step in that product’s supply chain.

Identifying weaknesses in complex, multi-national supply chains is not always straightforward – and neither is delivering substantive change. Getting suppliers to incite change first requires an analysis of the root cause of an issue. Particular consideration should be given to latent and emerging risks associated with regulatory and geopolitical change.

Purchasers should proceed cautiously before commencing an investigation into the sustainability practices of a supplier and/or prior to triggering relevant provisions in a supply contract. Legal advice should be sought at the earliest possible opportunity and retained throughout the investigation. Where it is appropriate to do so, an investigation could be expedited by coordinating with a supplier and reaching mutual agreement on the scope of matters falling within the purview of the investigation.

For those businesses wishing to avoid the perception of greenwashing, the introduction of “ESG” clauses into supply chain contracts, while useful, is not a solution in and of itself. Boilerplate penalty clauses and/or right to suspend or terminate a contract will have little positive effect in practice. Given the considerable investment in supply chains, positive reinforcement is likely to be the preferred (and more effective) option over punitive action. In order to unlock change, both parties to a contract can benefit from bespoke “ESG” clauses. The clear advantage of bespoke drafting is the ability to accurately reflect the singular features and inherent challenges in a specific supplier/purchaser relationship. This valuable context can then pave the way for detailed consideration of the appropriate contractual mechanisms and frameworks to foster open dialogue between with a clear focus on addressing material issues through pragmatic and sustainable solutions. This approach much more likely to deliver change and maintain or enhance dealings between a purchaser and supplier.

The Evolving Landscape

The announcement of new CMA powers and the hardening of its enforcement posture, paired with a customer base that is increasingly educated and climate-focused has inflated the risk of greenwashing to the point where businesses ignore it at their peril. The situation is further compounded by moves that are afoot within the EU that have the potential to fundamentally redraw the boundaries of corporate responsibility in supply chains.

For example, the European Commission set out its proposal for a Corporate Sustainability Due Diligence Directive (“CSDD”) in February. In brief, the CSDD is looking to modify corporate behavior by increasing responsibility on certain EU and non-EU businesses for the upstream and downstream activities in their supply chains. In-scope businesses will be required to identify actual – and potential – adverse human rights and environmental impacts and where necessary, take steps to prevent, mitigate and/or bring an end to the activities giving rise to the harm. The requirements set out in the CSDD will apply not only to a business’s own operations (and those of its subsidiaries) but also to organizations within a value chain where there is an “established business relationship.”

The CSDD represents a seismic shift from a relatively passive approach involving transparency through disclosures to something which will require proactive intervention. Businesses will soon be expected to exercise vigilance and move swiftly in addressing any material social and environmental impacts that may arise from their own operations or those within their value chain. The drafting of the CSDD reflects the EU Commission’s policy preference for targeting big business. The rationale behind this choice is that large organizations are well suited to bring about change by leveraging their existing influence.

The CSDD is currently going through the EU’s legislative process where it may be subject to amendments. It is worth noting that the draft proposal enjoys significant support from both within the European Parliament and among influential EU members. As such, it is likely to emerge from the “trilogue” more or less intact.

The explanatory memorandum to the CSDD suggests that approximately 4,000 third-country entities will be in-scope. Of this 4,000, it is reasonable to assume that a significant proportion will be based in the UK. The impacts are likely to be felt beyond this immediate pool, as businesses that may not be directly involved, might face commercial or contractual pressure to provide data to customers who are themselves subject to the provisions in the CSDD. Alternatively, some businesses that might not yet be directly or indirectly impacted might heed the change in the EU as a warning and consider that it is “better to jump than be pushed” and see voluntary adoption of CSDD or “CSDD-lite” requirements as a prudent course of action to both provide assurance on the performance of their supply chains and guard against possible accusations of greenwashing.

The second part of this series will explore another side of greenwashing, specifically, at the investee-company level and explore the risks posed to all investors where a misallocation of capital is driven by inaccurate or misleading “ESG” disclosures.

Dean Hickey is an associate at Slaughter and May in London, where his practice focuses on Sustainability and Climate Change.