When it comes to sustainable finance, there is no bigger talking point than EU policy in 2021. Three years ago, the European Commission’s iconic Action Plan on Financing Sustainable Growth laid out 10 objectives to reduce economic risks and foster sustainable finance – most famously, the Taxonomy and sweeping disclosures regulation for investors and companies.
While most of the work so far is centred on climate change, there are quieter efforts to tighten rules on social issues such as human rights and diversity. And those efforts won’t remain quiet for much longer.
Sustainable corporate governance
One of the biggest initiatives currently being driven through Europe’s parliament is a proposal for a law requiring all businesses operating in the EU to conduct due diligence on human rights, the environment and governance across their value chains, with a view to holding firms accountable for any abuses that take place.
The Sustainable Corporate Governance Directive was put forward by the European Commission’s unit for Justice and Consumers, and is viewed as the last piece of the Action Plan – both literally and figuratively – because it comes under the Plan’s final objective, Action 10, which is dedicated to “sustainable corporate governance”, and has been fairly neglected until recently.
As they stand, the plans will require “companies to take measures to address their adverse sustainability impacts, such as climate change, environmental, human rights (including workers and child labour) harm in their own operations and in their value chain by identifying and preventing relevant risks and mitigating negative impacts”.
It is also considering forcing “company directors to take into account all stakeholders’ interests which are relevant for the long-term sustainability of the firm or which belong to those affected by it, as part of their duty of care to promote the interests of the company and pursue its objectives”.
In addition, it wants “to define and integrate stakeholders’ interests and corporate sustainability risks, impacts and opportunities into the corporate strategy – following appropriate procedures – with measurable and time-bound, science-based targets where relevant and according also to the company’s size and activity, and to implement such strategy through proper risk management and impact mitigation procedures”.
The current proposal covers Limited Liability Companies, but an initiative by the Legal Affairs Committee, approved by Parliament in March, wants it to cover all corporations operating in the EU internal market, including banks and investors.
Although the Commission is under no obligation to adopt that suggestion, Lara Wolters, the Member of European Parliament overseeing the initiative, said at a recent webinar that the Commission “has committed to not put our report into a drawer somewhere, but to base legislation on it, to at least to come up with an official proposal on due diligence.”
The Directive was set to be adopted in June, but is now expected after the summer. A Commission spokesperson told RI it was “working on the proposal intensely”.
In the meantime, things are moving full steam ahead for the ‘social taxonomy’.
When the legal agreement was reached on the creation of an EU taxonomy, the deal included a requirement for the European Commission to tell Council and Parliament how it should be expanded in future to cover social issues. The deadline for that recommendation is later this year, so there is currently a raft of experts putting together guidance for the Commission on what a ‘social taxonomy’ could look like.
Those advisors are part of the Commission’s Platform on Sustainable Finance, which includes investors, data providers and other specialists, and has been advising Europe’s policymakers on the taxonomy more broadly. It will put its initial suggestions out to consultation in coming weeks, with a view to finalising the recommendations after the summer, ready to present to the Commission.
The purpose of a social taxonomy – just like the green taxonomy – is to establish a comprehensible and shared way of defining what a socially sustainable activity or company is, and Antje Schneeweiß, managing director at German church investment group Arbeitskreis Kirchliche Investoren and head of the subgroup overseeing the Platform’s work on a social taxonomy, thinks there are many reasons why investors should support it.
She says that, just as climate became mainstream when the risks associated with it crystalised, “when you think of the due diligence laws coming up, I think there will be an investor case for a social taxonomy”.
Cedric Merle, Green & Sustainable Finance Expert at French bank Natixis, says he’s a recent convert to the idea. “One year ago, I was a bit sceptical about the feasibility and willingness to create one, but things have changed, notably because of Covid,” he says, referring to the increased awareness around social issues as a result of the global pandemic. However, he believes “investors are not generally that aware of the social taxonomy – they are very busy trying to understand the green one”. The upcoming report from the Platform will change this, though, he adds.
A leaked version of the Platform’s report, seen by RI, splits the social taxonomy into ‘vertical’ considerations – related to business activities – and ‘horizontal’ ones – related to entity-level performance on social factors.
This is different from the first two pillars of the taxonomy, climate mitigation and adaptation, which focus exclusively on the greenness of business activities. Merle warns that the new approach could cause confusion if it’s not expressed clearly.
“The EU needs to be cautious about the way they put the criteria to make sure they don't ask different things that are opposed,” he says. Much of the pushback against the EU’s Action Plan has stemmed from these kinds of scrambled demands – with investors frequently complaining that requirements and data points don’t align across the various new disclosure rules, causing confusion, additional cost and the risk of accidentally not complying with the regulation.
But when it comes to the social taxonomy Schneeweiß says there won’t be a clash between the two proposed dimensions, telling RI: “Yes, horizontal and vertical are very different, but they will never oppose each other.”
The document stresses the need for the social taxonomy to “be as symmetrical as possible with the Environmental Taxonomy’s architecture and functioning, to avoid companies being overburdened by having to consider two completely different systems”. However, while the climate-based pillars of the taxonomy are rooted in science, the Platform suggests the UN Guiding Principles on Business and Human Rights (UNGPs), amongst other standards, should “take the place of science”.
John Ruggie, the architect of the UNGPs, says that while the social taxonomy might become a useful tool, it has “a very long way to go”.
“It was easy to say that it should be based on international standards, including human rights. It’s a lot harder to translate that into specific rules,” he tells RI. “And so far, the process itself is a bit of a mess. But, as Bismarck said: If you like [laws and] sausages, don’t watch how they’re made”.
Minimum social safeguards
But even before the social taxonomy is developed, investors are still required to consider social issues. Article 18 of the Taxonomy regulation states that “procedures implemented by an undertaking that is carrying out an economic activity [needs to align] with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights”. In other words, there are social safeguards built into the green taxonomy, too.
There is still a lot of confusion around what those social safeguards really look like – especially whether it will be the social performance of the business activity that is assessed, or the policies and performance of the entity carrying out the activity. Initial rhetoric from the EU’s advisors suggested it would be focused on business activities, but current indications in the regulatory documents suggest lawmakers will focus on entity-level performance.
The discussion is still ongoing about which one of these is preferable for investors. Schneeweiß says an entity-focused assessment could “make it easier to define criteria for the minimum safeguards”. There is also more information available on entity-level policies, which would arguably make it easier to undertake a credible assessment.
On the other hand, if business activities are only taxonomy-compliant if the company running them has no other social safeguarding issues elsewhere in their business, this could shrink the investment universe – especially when it comes to multinational firms with different business operations all over the world.
A report providing greater clarity on the minimum social safeguards is due by the end of 2021, but the leaked documents seen by RI warn that data providers should not just screen for past controversies or allegations in order to approve an investment on social safeguarding grounds. Instead, they should ensure “proactive alignment” with the requirements.
Lee Clements, Head of Sustainable Investment Solutions at FTSE Russell, says it’s crucial to have clarity on the exact data that will be required for the safeguards. “We would encourage the EU to look at the data and information typically outlined by SASB, other accounting methodologies, or ESG models”, he says, in order to avoid fragmentation and incorporate existing data flows.
More clarity is needed on how data should be applied, he adds. “If they want to go down the route of quantizing the degree of social safeguards and then measuring those, it will be very interesting but very challenging. And it will be a topic that will flow into the social taxonomy.”
Above everything else, everyone interviewed for this article wanted to see clear synergies between the various social requirements being developed.
“It's super complex and there’s a need to clarify,” said Natixis’ Merle. “We need simplicity – a bit more systematism”.
Christoph Klein, Founder and Managing Partner of German-based investment house ESG Portfolio Management, agrees. “Nobody likes to work twice, it could create confusion. If you have a ‘Social 1’ and a ‘Social 2’, then you may have conflicting results because methodologies or metrics are different. It is so complex already”.
Schneeweiß acknowledges “that there needs to be complementation and coordination” of the initiatives, “but it is difficult,” she concedes.
RI asked the European Commission if, having seen the fall-out from unaligned requirements under the green taxonomy and the Sustainable Finance Disclosure Regulation, it planned to take a more coordinated approach to developing social rules.
“We are aware of the ongoing work on the Sustainable Corporate Governance initiative and the need to ensure proper coordination,” said a spokesperson.