September 25, 2023
JAKARTA – Two recent developments in the European Union will affect ASEAN, namely the Corporate Sustainability Reporting Directive (CSRD) and the draft of Corporate Sustainability Due Diligence Directive (CSDD). There is a criterion within both of these those directives that requires non-EU companies to comply with EU conditions.
The CSRD has been in force since January of this year while the CSDD, if passed, may come into effect in 2025.
The CSRD requires companies to report on their sustainability performance, including their social and environmental impacts. Meanwhile, the CSDD obliges companies to conduct due diligence toward their environmental and human rights impacts. As such, the two documents are highly interlinked; the due diligence processes introduced by the CSDD are expected to inform the sustainability reporting required by the CSRD.
Under CSRD, non-EU companies may be required to disclose detailed sustainability information that concerns both internal and external impacts and should therefore involve not only the company’s perspective but also the perspectives of its stakeholders and the world at large through “double materiality”.
The European Financial Reporting Advisory Group (EFRAG) is still discussing how to conduct assessments, including on double materiality, under CSRD.
CSRD applies to non-EU companies that are connected to the EU market in some way, such as ownership of a subsidiary in the EU, the existence of a branch in the EU or being a subsidiary of an EU company. There are other thresholds in which the CSRD applies, for example, in the case of an EU subsidiary, which needs to be considered a “large entity” or a public interest entity. Technically, the legal obligation would be on the entity located in the EU.
If a subsidiary is in the EU, then its non-EU parent company may need to prepare consolidated sustainability reports which could involve disclosure of the details of group-wide operations outside the EU. Another application of the CSRD applies if a non-EU company has a branch in the EU. If certain turnover criteria are met, the branch would then be required to publish a sustainability report of the individual company or its parent company.
For subsidiaries of an EU company, there are obligations imposed on the EU company so that its “…reporting at group level provides an adequate understanding of the risks for, and impacts of, their subsidiary undertakings”. This means that the EU parent company will request sustainability information from its subsidiaries worldwide.
There are other situations in which non-EU companies could be indirectly affected by the CSRD, for example, if it is part of a value chain connected to the EU market and is requested by the purchaser to disclose certain information. This is because the CSRD requires companies to identify, assess and act to reduce the risks and impacts on sustainability in their value chain.
The draft CSDD is wider in scope, detailed in terms of process and broader in terms of application compared to the CSRD. The CSDD applies directly to non-EU companies that operate within the EU market. Companies with a turnover of 150 million euros (US$161 million), or Group 1, and 40 million euros, or Group 2, would be required to comply with the CSDD.
Interestingly, the lower threshold (group 2) would apply to companies provided that at least 50 percent of worldwide net turnover comes from the textile and garment, agriculture, forestry, fisheries, food beverages and natural resources extraction industries. Presumably, the EU sees those companies as having a higher risk of environmental and human rights violations.
As with the CSRD, the CSDD will require certain compliance within the value chain, and therefore suppliers to companies that are subject to the CSDD would be required to provide information. In other words, they would indirectly be required to comply. Should their business partners fail to adequately mitigate their human rights and environmental risks, Article 7(5) of the CSDD requires companies to refrain from contract extensions, suspend commercial relations or even terminate their business relationships.
Part 1 of the CSDD Annex listed numerous international human rights agreements ranging from labor rights to child rights, including the rights enshrined in the International Covenant for Civil and Political Rights and the International Covenant on Economic, Social and Cultural Rights.
Part II on the other hand listed numerous international conventions such as the Stockholm Convention on Persistent Organic Pollutants, the Minamata Convention on Mercury and the Convention of Biological Diversity. Group 1 companies (>150-million-euro turnover) are also required to identify the extent to which climate change is a risk for or an impact on the company’s operations in line with the Paris Agreement (Article 15). It is also worth noting that the EU seeks to align its internal policies with the CSDD, among which are the Batteries Directive (to be replaced by the Batteries Regulation) and the draft regulation on deforestation-free products.
Indonesia recently disputed the EU’s measures related to palm oil at the World Trade Organization. The CSRD and CSDD, however, are much broader and much more comprehensive than any other measures that have ever been imposed by the EU with regards to trade and the environment.
Beyond the EU, CSRD and CRDD will become the gold standard for sustainability audits. Even if not caught directly within the directives, multinational corporations and international financial institutions could use and apply the standards voluntarily across their value chains.
The Indonesian downstreaming agenda, ASEAN’s extractive industries and ASEAN’s exports to the EU may be affected by the directives. On the one hand, ASEAN companies need to increase their capacity to conduct Environmental and Human Rights Due Diligence (EHRDD), and on the other hand, compliance with the directives may require certain facilities to be built.
For example, Part 2 of the CSDD Annex mentions various conventions related to chemical management. ASEAN countries may not have the capacity to detect and dispose of many of the chemicals mentioned in those conventions.
While “large undertakings” targeted by the directives may readily comply with the directives, capacity in ASEAN value chains might be limited. There must be a way that the compliance costs for those indirectly affected by the directives can be minimized. This may depend on the type of assurances acceptable in the EU.
These directives rely on the assumption that the EU will have significant market power to increase the bar on environmental and human rights standards for developing-country businesses that are connected to it. Indeed, the climate crisis makes it extremely difficult to ignore environmental concerns. However, if the compliance cost is prohibitive, businesses and countries that prefer to ignore those concerns may simply opt to strengthen ties with trade partners that are less concerned about environmental and human rights standards.
Regardless, ASEAN and Indonesian companies will need to start thinking about how to comply with these higher sustainability rules. This is important, not only because it will be imposed on companies exporting to, or related to, the EU market through equity and lending, but also because these initiatives will become the benchmark for global sustainability standards beyond the EU market because of heightened climate change concerns.