In an era where global interconnectedness shapes the landscape of business and sustainability, Europe stands at the forefront of championing Environmental, Social, and Governance (ESG) principles. As corporations grapple with the imperative to align their operations with ethical, environmental, and social standards, the European Union has been implementing the most comprehensive robust ESG laws around the globe. The EU’s so-called Green Deal comprises climate, energy, transport and taxation policies that aim at reducing net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels.
In addition to being more comprehensive than the policies by other countries, what also sets the regulations under the Green Deal apart is their oftentimes extraterritorial impact, extending far beyond the borders of the European Union. So, while EU legislation generally applies in the EU only, the effect of several ESG laws is that Malaysian companies will nevertheless fall under their scope in practice.
Not even being aware of the various Green Deal rules puts Malaysian companies at a considerable disadvantage. This short write-up aims to shed light on the more important ones: here are three ESG-related laws from the EU that every Malaysian company should know about:
The Corporate Sustainability Due Diligence Directive
The Corporate Sustainability Due Diligence Directive (CSDDD) is a proposed EU directive aimed at fostering sustainable and responsible corporate behaviour, particularly in relation to human rights and environmental considerations. This directive seeks to ensure that businesses address the adverse impacts of their actions, including those within their value chains both inside and outside Europe. Although not passed yet, the EU Council and the EU Parliament have agreed on the content of the CSDDD and we expect it to be passed sometime in Q1 or Q2 2024.
The CSDDD will apply to large EU and non-EU companies operating in the EU internal market. It will cover large EU companies with a net global turnover of over EUR 150 million and more than 500 employees, as well as non-EU companies with similar EU-wide revenue. It will also encompass EU and non-EU companies operating within certain high-impact sectors like textiles, agriculture, extraction, and manufacturing, with lower turnover and employee thresholds.
Companies will be required to identify and address potential and actual adverse human rights and environmental impacts across their own operations, subsidiaries, and value chain. This includes verifying compliance by direct and indirect business partners and engaging with the value chain to prevent, mitigate, or end adverse impacts.
Directors of EU companies will have duties that include setting up and overseeing due diligence processes and integrating these into the corporate strategy. Directors will need to consider human rights, climate change, and environmental consequences in their decision-making.
Companies will be liable for damages if they fail to prevent potential adverse impacts or end real adverse impacts, leading to damages. Affected persons will have the right to sue the EU company directly in Europe; they do not need to initiate proceedings in the country they are based in. Additionally, the CSDDD sets forth fines reaching up to 5% of a company’s worldwide turnover.
What is the impact for Malaysian companies
Among all the EU Green Deal legislations, the CSDDD arguably has the most significant impact on Malaysian companies. In the future, EU companies falling under the scope of the CSDDD will likely be quite cautious about their business partnerships. Failing to fulfil due diligence responsibilities across the entire supply chain, from raw materials to the final sale to customers, could prove to be very costly. This may result in civil damages and hefty fines imposed by regulators. To illustrate, if a European company has an annual turnover of EUR 10 (approx. MYR 50 billion), the maximum fine could reach EUR 500 million (or MYR 2.5 billion).
European companies are expected to exercise greater caution in choosing their business partners. When there is a potential risk within the supply chain, European procurers are likely to opt for a “safer” supplier rather than a company with possible environmental or human rights concerns. This applies to both direct and indirect suppliers. For many Malaysian companies, this could mean “demonstrate CSDDD compliance or risk losing business with the EU altogether.”
Conversely, there is a significant opportunity for Malaysian companies that embark on the sustainability journey and prioritize compliance with all the requirements outlined in the Annex to the CSDD. Malaysian companies showcasing their compliance will be viewed as low-risk (sub-)suppliers, making it much easier for them to engage in business with EU procurers.
The Corporate Sustainability Reporting Directive
The Corporate Sustainability Reporting Directive
(CSRD) is an EU directive that came into force on 5 January 2023. It modernises and expands the scope of sustainability reporting for companies in the European Union. The CSRD aims to improve the availability and reliability of sustainability information, thus fostering a culture of transparency regarding companies’ impacts on people and the environment.
The CSRD applies to a broad set of large companies, as well as listed small and medium-sized enterprises (SMEs). It also extends to non-EU companies with significant activity in the EU. Approximately 50,000 companies are expected to be impacted by the CSRD. When it comes to Malaysian companies, they would likely be affected in two ways:
Subsidiaries of Malaysian companies in the EU
Unless they are listed, only large subsidiaries of Malaysian companies in the EU are affected. Any subsidiary of a Malaysian company falls under the scope of the CSRD if it meets at least two of the following three criteria:
Malaysian companies operating in the EU
Non-EU companies, which generate an annual turnover in the EU exceeding EUR 150 million (for each of the last two financial years) and that have at least one EU subsidiary (large or listed on an EU regulated market) or EU branch (with more than EUR 40 million net turnover in the preceding financial year) are also covered by the scope of the CSRD.
Companies must disclose information regarding sustainability-related impacts, risks, and opportunities. The reporting covers a wide range of topics including environmental, social, human rights, and governance issues. The disclosures must be both qualitative and quantitative, forward-looking and retrospective, and cover short, medium, and long-term aspects.
Companies subject to the CSRD will report according to the European Sustainability Reporting Standards
(ESRS), developed by the European Financial Reporting Advisory Group
(EFRAG). The ESRS involves reporting on sustainability topics using a “double materiality” approach, which considers how sustainability issues impact a business and how the operations of the business affect people and the planet.
The CSRD introduces mandatory assurance for reported sustainability information by an independent service provider. The information will need to be digitally tagged according to a digital taxonomy, ensuring accessibility and ease of locating the information. Unlike other reporting frameworks, the CSRD requires the disclosure of sustainability information within a dedicated section of the management report, which is part of the annual report.
The application of CSRD will take place in stages starting from 1 January 2024 for companies already reporting under another EU legislation. By 1 January 2028, non-EU companies with EU subsidiaries or a branch in the EU will need to report according to the CSRD.
EU companies obligated to disclose information under the CSRD need data from their suppliers. We are already witnessing contractual provisions being adjusted accordingly and this will likely become standard going forward. If a supplier is unable to provide the information required by an EU procurer, that company might be hesitant to engage in future business.
Nevertheless, this situation can also be viewed as an opportunity. Malaysian companies that are well-prepared to disclose the necessary information to meet the requirements of an EU procurer will have a distinct advantage and will be prioritized by the procurer.
The Carbon Border Adjustment Mechanism
The Carbon Border Adjustment Mechanism
(CBAM) established by the EU is designed to regulate greenhouse gas emissions embedded in certain goods imported into the EU. Its principal goal is to put a fair price on the carbon emitted during the production of carbon-intensive goods that are entering the EU via imports:
Having started in a transitional phase from 1 October 2023, CBAM aims to prevent the risk of carbon leakage that could occur when companies relocate production from the European Union to countries with less stringent environmental regulations, thereby undermining the EU’s climate efforts. In other words, CBAM aims to ensure that whatever product is imported into the EU is treated the same way in terms of greenhouse gas emissions as products directly stemming from the EU.
CBAM aligns the EU’s internal carbon pricing with that of third-country producers and thus levels the playing field (otherwise, companies from the EU, which must pay for carbon emissions, would be at a considerable disadvantage). However, the EU’s intention is also to encourage third countries exporting to the EU to decarbonise their production processes.
In its initial phase, CBAM targets only imports in the five most important emissions-intensive sectors: cement, iron and steel, aluminium, fertilisers, and electricity and hydrogen. The full implementation of the CBAM will commence on 1 January 2026. At this point, importers will need to declare the quantity of goods imported into the EU in the preceding year and their embedded greenhouse gases (GHGs), and then surrender the corresponding number of CBAM certificates.
The extraterritorial effect of the EU Green Deal – why Malaysian companies are significantly impacted by what happens in the EU
Various EU legislations under the European Green Deal, such as the CSDDD, the CSRD and CBAM, exert influence far beyond the EU’s borders, showcasing practical extraterritorial effects. Although the specific directives and regulations governing ESG practices aren’t explicitly applicable outside the EU, their impact is (or at least will be) felt in Malaysia.
Companies involved in EU business or collaborating with EU entities find themselves compelled to align with these ESG standards, as the inability to meet the required standards or provide necessary information could result in EU companies discontinuing business with them. This interconnectedness establishes compliance as a de facto requirement for sustaining commercial relationships, not only in Malaysia but also globally.
Prof. Dr. Harald Sippel is admitted to the Austrian Bar as Rechtsanwalt and to the Malaysian Bar as a Foreign Lawyer. He heads Skrine’s European Desk and regularly provides advice to European and Malaysian companies on matters of ESG.