Sustainability Policy Remains Center Stage in Europe
January 11, 2022
EU Regulatory Developments
2021 was a pivotal year for European sustainability policy, caught in the implementation of an ambitious agenda. This is expected to continue throughout 2022, when new rules will be finalized and others will enter into force, requiring companies to increase sustainability-related disclosures and due diligence requirements to further the EU Green Deal’s climate transition plans.
Regulators in other countries (such as the United Kingdom) are following suit.
Defining “Sustainable” Activities
After the entry into force of the Taxonomy Regulation (2020/852) in 2020, the European Commission turned to drafting the related “technical screening criteria.”  These criteria establish which industrial activities (and therefore which investments) may or may not qualify as contributing substantially to “climate change mitigation” and “climate change adaptation” (the first two of the Taxonomy’s six environmental sustainability objectives).
The economic activities affected by the screening criteria include sectors such as manufacturing, mining, energy and forestry.
The screening criteria were adopted following fierce debate in December 2021 (with a January 1, 2022, application date). At the forefront of the debate was whether nuclear energy and natural gas should qualify as sustainable – a question that was ultimately shelved in an effort to finalize the Taxonomy and remains to be covered by future amendments to the criteria.
Activities not recognized as “green” will increasingly face higher costs of capital and greater difficulty in attracting investments.
Measuring the Proportion of a Firm’s “Sustainable” Activities
In the spring of 2021, the European Commission finalized a separate set of delegated acts under Article 8 of the Taxonomy Regulation. These rules specify the way in which EU-based large companies and EU-listed companies will be expected to measure and disclose (starting in 2023) the proportion (percentage) of their activities that qualify as environmentally sustainable under the Taxonomy Regulation.
The rules depend on the type of business activity:
- Non-financial sector firms will be required to indicate in their annual reports the percentage of their turnover (revenues), capex and opex that are associated with sustainable (versus non-sustainable) industrial activities.
- For asset managers, the relevant measure to be disclosed will be the percentage of sustainable activities that are carried out by the firm’s portfolio companies (in proportion to the total value of its investments).
- For credit institutions, the disclosure will require the proportion of loan and investment exposures toward sustainable activities and borrowers (that is, the bank’s “green asset ratio” or GAR) as a proportion of the bank’s total covered assets.
These detailed Article 8 annual disclosure requirements (of which the above are only examples) will imply a continuous monitoring and measurement of a company’s business activities – particularly for financial sector firms, for which the financial exposures are by nature subject to continuous change.
Once in place, it is expected that the system will facilitate disclosures by investors and issuers further up a firm’s value chain.
Wider Sustainability Reporting Duties
Sustainability reporting by EU companies will be subject to a more general overhaul starting in 2024.
The European Commission unveiled its proposal for a new Corporate Sustainability Reporting Directive (which would repeal and replace the Non-Financial Reporting Directive in force since 2018) in the spring of 2021. The proposal is currently under review by the EU Parliament and Council and should be finalized in the first half of 2022.
The new Directive will markedly expand the scope of EU domiciled companies that are subject to non-financial reporting duties (from approximately 2,000 to over 50,000), by extending beyond the financial sector to all sectors of activity and at the same time lowering the applicable company-size thresholds. Further, it will abandon the current “comply-or-explain” framework in favor of a mandatory regime. Lastly, it will require all in-scope entities to have a proper “sustainability strategy” in place, including plans to ensure that their model and strategy are compatible with the limiting of global warming to 1.5°C in line with the Paris Agreement, with targets and an annual measurement of the progresses made.
For the first time, companies will also be required to assign and disclose the role of their administrative, management and supervisory bodies with respect to sustainability matters.
Financial Sector Disclosures
EU fund and asset managers have been subject to detailed sustainability reporting obligations since March 2021. These are destined to increase, as the application of the Sustainable Finance Disclosure Regulation (2019/2088) continues to phase in throughout 2022 and 2023.
In 2021, fund managers, including non-EU managers of alternative investment funds registered for marketing in Europe, were busy preparing their ESG policies and the pre-contractual disclosures on the sustainability of their portfolio companies, at the level of each fund they manage. Reinforced disclosure requirements apply to “impact” and “green” funds.
In 2022 and 2023, fund managers will also need to prepare for the first time their annual ESG reports, which must include detailed measurements of the principal negative impacts of their investments on sustainability factors over the previous year, and all actions taken or planned in order to remediate them.
Mandatory Supply Chain Due Diligence
In the spring of 2021, the European Parliament issued a detailed set of recommendations to the European Commission on a new Directive regulating corporate due diligence and accountability on ESG matters. The text of the draft Directive was originally expected before the end of 2021, and has since been delayed to 2022.
Based on the recommendations of the EU Parliament, it is expected that the new regime will establish minimum due diligence requirements for large, listed and high-risk sector companies to identify, monitor, disclose and remediate the adverse impacts on sustainability factors down their entire “value chain,” including second- and third-tier suppliers, customers, business partners and subsidiaries. The Directive is also expected to establish rules on the accountability of companies’ Board members for the observance by companies of their due diligence obligations.
These rules also are likely to capture non-EU companies that sell goods or provide services within the EU, but probably not before 2024-2025.
In July 2021, the European Commission tabled yet another regulatory proposal on a new EU Green Bond Standard.
Just like the industry-born Green Bond Standard maintained by the International Capital Markets Association (ICMA), the EU’s standard was proposed as a voluntary standard, to which bond issuers would be free to adhere. In this case, however, the standard would attest the use of a bond’s proceeds for financing green projects aligned with the EU Taxonomy, which sets a higher, measurable and “premium” sustainability standard.
In November, however, the European Central Bank commented that the EU Green Bond Standard should become mandatory for EU issuers and all other bonds traded as “green” on EU regulated markets, after a transitional period.
ESG Pressures From Courtroom to Boardroom
Just as the regulatory landscape is changing dramatically across Europe and beyond, the disputes landscape is also undergoing a sea change, with corporations increasingly exposed to ESG liability as a result.
For the first time, in May 2021, a court imposed a duty on a company to “do its share” to contribute to climate change mitigation. The District Court of The Hague ordered Royal Dutch Shell plc to reduce its worldwide CO2 emissions by 45% by 2030 compared to 2019, in line with targets set out in the Paris Agreement.
The lawsuit was filed as a class action by Milieudefensie (Friends of the Earth Netherlands) and six other Dutch non-governmental organizations, plus approximately 17,000 individual co-claimants. Although Shell has challenged the ruling, it is required to comply pending appeal.
This case may usher in further claims against energy companies – and those in other sectors – to reduce their contributions to climate change. It is still unclear at this stage, however, whether other courts may follow suit and translate emission targets set by governments into concrete obligations for corporations.
Another evolving doctrine relevant for ESG liability is the concept of parental company liability. The UK Supreme Court for the first time decided in Vedanta Resources plc and another v Lungowe and others in 2019 that an English parent company may in principle be held liable for the activities of its overseas subsidiaries when it has been negligent in the subsidiaries’ oversight. Further decisions from the UK Supreme Court and from The Hague Court of Appeal in the Netherlands in early 2021 applied similar principles in the case of Royal Dutch Shell and the activities of the group’s Nigerian subsidiary. Decisions such as these may in the coming years open the door for potential claims against parent entities for issues that arise far up supply chains.
ESG pressures will also be felt outside the courtroom. In the boardroom, pressure from activist shareholders will continue, increasingly coupled with an environmental agenda.
In May 2021, activist investor Engine No. 1 emerged from its proxy battle with ExxonMobil having nominated three directors to the energy major’s board, hoping to develop a clean energy strategy. Later, in the fall of 2021, activist hedge fund Third Point argued that the Royal Dutch Shell group should break up, into legacy oil and chemicals lines and a green arm. Pressures from activists are expected to increase in the coming year.
As corporates look forward to the coming year, navigating the changing regulatory landscape while facing pressures in both the courtroom and the boardroom may feel like walking a tightrope. Adding to the mix investors and customers are increasingly focused on climate and ESG factors and companies that are responsive and proactive in disclosures and labelling may reap benefits in engagement and reputation. Board members will need to find a balance between the interests of shareholders interested in maximizing returns and those with an activist agenda or requiring consideration of social or other stakeholder interests.
 See the draft technical screening criteria that were formally adopted by the Commission in June 2021, available here. A “Taxonomy Compass” was also made available by the Commission (available here) to allow readers to browse through the draft criteria by sector of activity.
 Vedanta Resources PLC and another v Lungowe and others  UKSC 20, Judgment (April 10, 2019), available here. For further information on the decision and its implications for managing risk in multinationals, see the November 2020 article by Cleary Gottlieb attorneys, available here.
 For further information regarding the 2021 decision of the UK Supreme Court in Okpabi and others v Royal Dutch Shell plc and another, and the 2021 decision of The Hague Court of Appeal in Milieudefensie and others v Royal Dutch Shell Plc and Shell Petroleum Development Company of Nigeria Ltd, see the May article by Cleary Gottlieb attorneys discussing the decisions and ESG liability risks, available here.