The EU wants business to be sustainable. But it must empower companies to do that

Since its inception, the EU has been confronted with numerous crises and debates on how to advance a plan for a united and peaceful post-war Europe. In essence, what began as an imperfect economic union with the ultimate ambition of political integration evolved and transformed step by step into an organization spanning policy areas from climate change, environment and human rights protection to external relations and security, justice, and migration.

One of the most important recent developments is the current discussion on the prospects and policy options towards promoting an agenda on how companies can be directed and controlled in a sustainable way: so-called sustainable corporate governance.

The wave of corporate collapses and scandals that fueled the outbreak of the 2008 global financial crisis has led to renewed public attention towards the way corporations conduct business. The social contract that implicitly binds the companies with the rest of society has come under greater scrutiny. Subsequently, the conversation around the need for a sustainable corporate governance framework found new impetus in the EU’s post-COVID-19 recovery plan, which revolves around building a green, digital and shock-resilient European economy.

For this reason, the EU wants to incentivize corporations to contribute more to this goal by formulating certain policy measures that will spur companies to focus more on their long-term development rather than short-term financial performance. As these measures affect the core of the EU’s Company Law framework, they pose critical questions on how far policies under pressure to “build back greener and better” can go.

As the European Commission is expected to adopt a legislative proposal on sustainable corporate governance until the end of 2021 and in light of the upcoming COP26, one issue is becoming all the more relevant: To what point the restrictions imposed on private-sector autonomy can extend in order to shape companies’ sustainability strategies.

In the context of the European Commission’s upcoming proposal, the European Parliament has adopted a non-legally binding report, setting out its recommendations for what a sustainable corporate governance framework could look like. The report underlines that the present voluntary corporate due-diligence regime – governed by the Non-Financial Reporting Directive (NFRD), which obliges large companies to disclose their policies regarding environmental protection, social responsibility, human rights, anti-corruption and board diversity – is hampered in its effectiveness by subscribing to the “comply or explain” principle.

For instance, large companies under the NFRD must, among other things, disclose diversity on company boards on grounds including age, gender or educational and professional background. But if these companies do not have any such policy in place, then the NFRD does not oblige them to put one in place; only to explain why this is the case. In the current climate, companies may well voluntarily choose to put a diversity policy in place. But, for example, under-represented female and LGBTI executives would benefit more from a mandatory due diligence mechanism that is enforceable, rather than the current framework’s reactive philosophy and weak accountability measures.

For this reason, the European Parliament report proposes the introduction of a human rights and environmental mandatory due-diligence mechanism that applies to all the large businesses, public-listed companies and high-risk SMEs operating within the EU, accompanied by an enforcement mechanism. Put succinctly, this means that companies will be mandated by law to establish and implement adequate processes with a view to prevent, mitigate and account for human rights, health and environmental impacts, including ones relating to climate change, both in the company’s own operations and in its supply chain.

However, the transition to a mandatory due diligence model should be carefully thought through. From a business perspective, a proactive and prevention-orientated approach, by incorporating environmental and human rights due diligence into the risk management process (risk identification, risk measurement and assessment, risk reduction measures) would be more fit for purpose – instead of enforcing legal sanction after the fact. This would still allow companies to go beyond what is already required in EU legislation to ensure responsible business conduct better aligned with sustainability.

Going too far in imposing a mandatory due diligence could lead to a suffocating sustainable corporate governance framework that undermines the real-world impact of the reforms. What needs to be done is to correctly diagnose the problems of the current regulatory framework and to take careful further steps to cure the defects by empowering corporations to deeply embed sustainability in their operational strategies; encountering, rethinking and mitigating the harmful social and environmental impacts of their actions (or, in some cases, lack of action).

In search for a path to progress, policy-makers should attempt to retain a degree of much-needed flexibility by providing discretion to corporations and their boards on how to succeed in integrating sustainability within their risk management processes and corporate governance agendas, rather than resort to overly rigid legal imperatives.