Tsvetelina Kuzmanova / May 2023
The European Union is taking regulatory steps to better integrate sustainability into corporate governance. Its aim is to ensure that companies and financial institutions address harmful impacts to people and the planet throughout their value chains. To this end, transition plans are emerging as the main instrument in companies and regulators’ toolbox for addressing sustainability concerns, assessing and mitigating climate risks, and futureproofing businesses’ operations.
Disclosing such plans is already included in several financial rules, such as the Corporate Sustainability Reporting Directive (CSRD). Another significant development in this regard is the EU Corporate Sustainability Due Diligence Directive (CSDDD). Currently in the making, this seeks to address negative environmental and human rights impacts, and to promote the climate transition through requiring mandatory transition plans. Who the legislation will apply to is still being negotiated, but around 13,000 European and 4,000 third-country companies could have to disclose this information, making ripples outside of the EU as well. While applicable only to large companies, transition plans are expected to eventually become a crucial reporting requirement and a risk management tool for more businesses.
Staying competitive in the global subsidy race
These negotiations come at a strategic time, as countries worldwide are engaging in a subsidy race for clean tech industries. The EU’s Green Deal Industrial Plan (GDIP), introduced earlier this year as a counter-offer to the US Inflation Reduction Act, could redraw the global landscape for sustainable financing. While China has long dominated public financing for clean tech, other jurisdictions like India, Japan, Canada, and Korea are now entering the race.
To maintain competitiveness in the clean tech markets, European industries need to engage the entire economy in the transition process and future-proof their business models. Legislative and regulatory measures, such as requiring transition plans, are crucial to promote transition thinking and practices within the private sector. This will enhance transparency for consumers and visibility to investors alongside scaling up targeted finance. Companies without transition plans and long-term strategic thinking risk facing legal uncertainty and falling behind competitors who have better planned their decarbonisation process. To better assess the risks, opportunities, and investment needs of this process, it is necessary to establish time-bound transition targets for industries — and disclose them.
Role of the financial sector
A key question on the transition of financial institutions and their portfolios remains. Currently, one of the most contested issues around CSDDD is whether it will also apply to the financial sector. In their position on the directive, the Council of the EU has proposed exempting most of the financial sector players, such as asset managers and investors, limiting mandatory due diligence obligations to financial services only. The European Parliament position, to be voted next week, is more inclusive. But it also faces opposition within different circles.
Those that oppose including the finance industry argue that such expectations are unrealistic. Asset managers, for instance, do not have the power to require companies in their portfolio to assess and address adverse impacts. Paradoxically, the financial sector, especially institutional players such as equity investors, would be particularly well-placed to engage with the companies whose shares they own. Banks, asset managers, and insurers have immense power which can be used for positive change. Excluding them would not only hamper addressing negative impacts and transition efforts. It would also tilt the playing field, disproportionately placing the burden on companies at the receiving end, and in more loan-based financial markets such as in Central and Eastern Europe.
A significant source of opposition appears to be certain business lobbies within Europe and from non-EU countries, such as the US, who will be affected by the legislation. Nevertheless, investor groups including Eurosif, Principles for Responsible Investment, and the Institutional Investors Group on Climate Change are in favour of having the entire financial sector, including asset managers and institutional investors, conduct sustainability due diligence and address sustainability risks and impacts. Taking a risk-based approach, all financial institutions would prioritise risks and impacts relevant to their business models, mandates and portfolios.
The EU means ‘business’ in climate action
Overall, the CSDDD represents a significant opportunity for the EU to advance sustainability in corporate governance and drive the transition toward a more sustainable future. By promoting the drafting and disclosing of transition plans, Europe can take a leading role in achieving climate neutrality and sustainable development. Mandatory sustainability due diligence — for companies and all financial institutions alike — would not only signal the need to address sustainability issues in the wider economy, but also enable financial institutions to enhance their resilience and ensure long-term financial stability. The European Parliament will vote on its CSDDD position on 1 June , in plenary, after which the legislation will go into interinstitutional negotiations. This is the chance for Parliament to get the directive right - and enhance European businesses’ readiness for the low-carbon economy of the future.