EU: PSF draft report on minimum safeguards under Taxonomy Regulation

On 11 July, the Platform on Sustainable Finance (“PSF”) published its long-awaited Draft Report on Minimum Safeguards – a crucial but under-represented element needed to claim alignment with the EU Taxonomy. 

The report at this stage is only in draft. The PSF is inviting stakeholder feedback until 6 September 2022 and aims to have a final report ready for submission to the European Commission later that month. The Commission may choose to follow the PSF’s recommendations, but is not bound to do so.

Despite being far from final, the draft report makes for interesting reading with three overarching points standing out:

1. The report leans heavily on the two soft law standards referenced in Article 18 of the Taxonomy Regulation – the UN Guiding Principles (“UNGPs”) and OECD Guidelines for Multinational Enteprises.
2. In assessing alignment, the report adopts a two-pronged approach, suggesting the use of both a procedure-based and an outcome-based test.
3. The PSF envisages the Corporate Sustainability Reporting Directive (“CSRD”) as playing a key role in allowing companies to demonstrate minimum safeguards alignment (“MS alignment”).

Defining “MS alignment”

Looking at the report more closely, it suggests that alignment with the minimum safeguards should be assessed by reference to four topics: (i) human rights, including labour rights; (ii) bribery and corruption; (iii) taxation; and (iv) fair competition - with the latter three stemming from chapters in the OECD Guidelines. As mentioned above, assessment of each of these topics is split between a procedural element and an outcome element. In contrast to the EU Taxonomy itself, which operates at economic activity level, the PSF report appears to suggest MS alignment be looked at from an entity perspective.

The procedural element looks at whether a company has in place adequate due diligence procedures, a key part of which will be whether the company reports on its policies, processes and practices on the relevant topic. In respect of human rights, companies would be well-advised to examine their existing due diligence processes as against the UNGPs and OECD Guidelines and acknowledge that diligence in this context goes beyond the identification of adverse impacts and extends from putting in place policies to taking action in respect of identified impacts, including getting involved in remediation.

The outcome element focuses on, as might be expected, final court convictions in relation to each of the four topics. However, this is taken further in the context of human rights - as the PSF suggests also taking into account adverse findings by National Contact Points (“NCPs”), which is the grievance mechanism built into the OECD Guidelines (see our separate briefing), as well as any lack of engagement with an NCP in relation to a complaint and lack of engagement with the Business and Human Rights Resource Centre (“BHRC”) on any allegations it seeks to raise with the company. The PSF suggests that not responding to the BHRRC for a period of three months would evidence non-MS alignment and would remain an indicator for a period of two years, whereas for the other outcome-based indicators they would remain indicators until such point as the company could evidence that it had implemented a due diligence system that makes a repeat of such breaches unlikely. This, the report suggests, would need to be evidenced, for instance through an external audit.

Current practice and proposed approach

The PSF report highlights some of the ways MS alignment is currently being assessed, including: (i) controversy screening; (ii) ESG ratings;; (iii) NGO reports; and (iv) UNGC membership. Commenting mainly on the first two, the PSF notes that controversy screening is flawed insofar as the existence of issues in and of themselves should not dictate MS alignment and that the focus should instead be on whether the company has in place the proper due diligence processes to identify, manage and learn from such issues. In that respect, the old adage “no news is good news” does not apply, as not finding any issues may instead be evidence that adequate due diligence procedures are not in place. Following this, the report notes that a number of ESG ratings are predicated on controversy screening and so the same flaws apply and expresses a preference for ESG ratings based on an assessment of whether and how a company has implemented due diligence processes.

In testing the procedural element of each of the topics, the PSF report makes a number of recommendations:

• Human rights, including labour rights: As mentioned above, a key focus of this will be company reporting. In addition, the PSF provides some examples of inadequate procedures, namely: (a) not taking into account specific human rights risks inherent to your business model; (b) operating in jurisdictions with systematic human rights violations but not addressing such risks; and (c) not addressing known risks associated with your sector.
• Bribery and corruption: Has the company developed adequate controls for preventing and detecting bribery?
• Taxation: Does the company treat tax governance and compliance as important elements of oversight and does it have adequate tax risk management strategies? The PSF report also notes that assessments of tax compliance extend to looking at tax avoidance through aggressive tax planning (i.e. complying with the sprit, not just the letter of the law).
• Fair competition: Does the company promote employee awareness of the importance of compliance with competition law and provide training to senior management on competition issues?

For the procedural element, there is a focus on reporting, seen through the report’s frequent references to the upcoming CSRD and the disclosures to be required pursuant to the EFRAG reporting standards. Given the CSRD is still three years from implementation (and will not necessarily apply in every instance), the PSF report suggests using other data resources to assess implementation of adequate procedures including the World Benchmark Alliance.

The PSF’s recommendations also vary depending on the nature of the entity being assessed. For SMEs, the assessment of the three non-human rights elements seems only to be tied to final court convictions and for human rights is tied to final court convictions and the establishment of a due diligence procedure proportionate to its size, leverage and human rights risks. Similarly, sovereigns and sub-sovereigns are treated differently, with the PSF suggesting only the human rights and bribery and corruption limbs would apply and pointing to the use of various proxies for their assessment (e.g. establishment of an accredited National Human Rights Institution, the EU Agency for Fundamental Rights guidance on implementation of a human rights framework for cities, use of the Transparency International Corruption Perception Index). The final special case is in the sphere of project finance, where the PSF report recommends that the project company (likely an SPV) be tested for MS alignment, unless there is a majority shareholder with a larger than 50% stake in the SPV, in which case that shareholder should be assessed.

Other and outstanding points

In addition to pointing to the CSRD, the report references the Sustainable Finance Disclosure Regulation (“SFDR”) and the Corporate Sustainability Due Diligence Directive proposal (“CSDDD”). The former is explicitly referenced in Article 18 of the Taxonomy Regulation and the PSF report points to the use of the five mandatory social “principal adverse impact” indicators as a guide for assessing MS alignment. In doing so, it notes that four of these are largely subsumed through alignment with the UNGPs and OECD Guidelines. The remaining indicator, exposure to controversial weapons, is not and the PSF suggests such exposure should mean companies are unable to count their activities as Taxonomy-aligned (although “exposure” is undefined in the report). The PSF also notes that the CSDDD could have a role to play in indicating MS alignment, although this is predicated on the CSDDD aligning with the UNGPs and OECD Guidelines. While acknowledging the CSDDD does not align with those standards in relation to financial institutions (by virtue of the allowances made in the CSDDD for such entities), it falls short of acknowledging that the CSDDD diverges from the UNGPs more generally in respect of entities caught by virtue of its introduction of the “established business relationships” concept. Interestingly, the report does go so far as to indicate that alignment with various EU Member State regimes will not be sufficient due to their limited scope (e.g. Netherlands, Germany).

While the PSF draft report covers a lot of ground, it also acknowledges further work is needed and that the recommendations will need to be revisited when the CSRD and CSDDD are finalised and implemented. Some of the outstanding points where further work is said to be needed include treatment of different types of conviction (i.e. more or less serious violations, trends of minor violations) and jurisdictions where human rights violations are not prosecuted or are state-led and stakeholders have a lack of access to justice (hampering the assessment of the outcome-based element of MS alignment).