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Opinion

25 Nov 2022

Author:
Signe Andreasen Lysgaard, Danish Institute for Human Rights

Deciphering EU regulation on finance and human rights - the sum and its parts

The EU’s ambitious Sustainable Finance and Corporate Sustainability policy agendas are establishing the contours of an ecosystem of regulation with the potential to substantially scale up respect for human rights by businesses and financial institutions. A mix of noble objectives underpin this development - to close the SDG funding gap, to combat greenwashing and to craft a sustainable internal market, among others. While few will disagree with these objectives, some concerned parties have described the current development as “an avalanche” of regulation. While that might be an overstatement, a number of interlinked measures are in the pipeline and many stakeholders are struggling to connect the dots and see the full picture. Taking a human lens to some of the more prominent regulatory developments will further alignment with business and human rights standards and can decrease administrative burdens and improve their individual and collective impact on people.

Regulatory incentives and increased transparency

From January 2023 companies with taxonomy eligible activities must report on their taxonomy alignment. The Taxonomy regulation is known for its environmental focus and for introducing a classification system for environmentally sustainable economic activities and corresponding disclosure obligations on financial market participants (FMPs) and real-economy companies. It also includes an often overlooked human rights element in its so-called ‘minimum safeguards’. For an investment to be considered sustainable as per the taxonomy, the investee company is required to respect human rights in accordance with the UN Guiding Principles on Business and Human Rights (UNGPs), which can serve as a vehicle to scale up business respect for human rights. In October this year the Platform on Sustainable Finance published a report which clarified that investors must engage with portfolio companies on their human rights processes and performance if they are to align their portfolios with the taxonomy. The report also sends a strong signal to ESG rating agencies that marketing old controversy screening products as ‘minimum safeguards services’ will not cut it.

Alongside the taxonomy are two additional disclosure-oriented regulations which seek to further incentivise investors and their portfolio companies to improve human rights practices:

The Sustainable Finance Disclosure Regulation (SFDR) introduces human rights related reporting requirements for Financial Market Participants (FMPs). Through Regulatory Technical Standards, the SFDR requires FMPs to publish sustainability statements which involve reporting on five mandatory social indicators (so-called PAIs) related to the human rights performance and processes of portfolio companies. In addition, product level reporting templates require FMPs to report on whether and how investments align with the UNGPs.

In this way the SFDR prompts investors to consider and report on human rights performance across their portfolios, as well as at the level of individual financial products. However, whereas the taxonomy regulation and the platform report reinforce the UNGPs, the five social indicators are not as neatly aligned. Despite this, meaningful reporting under the SFDR will require significant scaling up of human rights due diligence efforts by investors as well as their portfolio companies and prompt investors to share data relating to human rights management and performance across investees.

The second disclosure-oriented regulation is the Corporate Sustainability Reporting Directive (CSRD), which mandates disclosure on human rights risks and impacts of eligible companies and could be a real gamechanger in terms of driving data flows related to human rights processes and performance from companies to investors and other stakeholders.

This information will be key to filling the data gap on ‘the S’ in ESG (environmental, social and governance) investing that investors have struggled with for years, thereby enhancing investors’ ability to consider a company’s social performance as part of investment decisions as well as in their active stewardship.

A step change: human rights due diligence obligations on companies and investors

Whereas the taxonomy, SFDR and CSRD can be seen as softer instruments seeking to encourage better human rights performance and reporting, the Corporate Sustainability Due Diligence Directive (CSDDD) takes the agenda to the next level by putting substantive performance requirements on companies and FMPs – enforced through administrative supervision and civil liability.

While FMPs are in scope of this requirement, there is currently a debate about whether or not to keep it this way. Some argue that FMPs are struggling to meet the wave of regulatory requirements related to sustainability as is, while others question how a meaningful due diligence process could be carried out across complex products and asset classes.

It is clear, however, from the World Benchmarking Alliance’s latest report that keeping the financial sector in scope is crucial.

The report found less than 10% of the 400 institutions assessed disclose the processes they have in place to identify human rights risks and impacts within their own operations, and less than 3% within their financing activities, suggesting their journey to UNGP alignment has only just begun.

It speaks volumes that many investors themselves argue they should be covered by the CSDDD and that the number of covered entities should in fact be increased in a recent statement coordinated by the PRI, the Investor Alliance for Human Rights and Eurosif.

Getting it right

Bringing each regulation into full alignment with the UNGPs not only improves the quality of the measures individually, but also provides a method for ensuring policy coherence. As these regulatory initiatives are finalised and brought into force, we need as much attention on the details of each measure as we do on the joint eco-system they form. If we get this right at EU level, we could be on the threshold of a new and more robust era of rights-respecting business and finance.

By Signe Andreasen Lysgaard, Strategic Advisor, Danish Institute for Human Rights, member of EU Platform on Sustainable Finance 2020-2022