EU Proposal on Imported Deforestation Looks to Raise Supply-Chain Due Diligence

Exporters to Face Most Significant Expansion of Due Diligence

EU companies and those importing certain products and commodities into the bloc could face new reporting requirements as well as civil liabilities from the Corporate Sustainability Due Diligence Directive (CSDDD) proposal, which aims to address environmental and human rights violations across supply chains. The proposed law, the initial draft of which was introduced in February 2022 by the EU Commission, is positioned to affect corporates with substantial size or economic power in Europe (both EU and non-EU companies), along with those operating in what the directive defines as high impact sectors.

The proposal moved further along the legislative process when the EU Council finalised its draft in December 2022. The EU Parliament is due to set out its position on the proposal in 2Q23, after which the proposal can be approved or amended and enter an additional reading. While the CSDDD has several legislative hurdles to jump and is likely to see revisions before becoming

EU law, we explore some potential high-level impacts that could arise if and when the directive is implemented by EU countries.

According to the UN, deforestation and associated land use changes are responsible for around 10% of global GHG emissions. As such, supply-chain due diligence – like that proposed under the CSDDD – can be a tool in addressing adverse environmental impacts. However, given the difficulty of monitoring upstream supply-chain activities, complying with the CSDDD would be a significant burden for many companies exporting into the EU, with potentially material compliance spending implications for imported soy, beef, palm oil, wood, cocoa and coffee, along with several derived products.

Although financing activities have been removed from the mandatory scope of the directive,
Sustainable Fitch believes that lending practices will continue being increasingly influenced by supply-chain considerations, particularly with lenders facing greater scrutiny over the environmental and social externalities of loans.

Emerging Markets Are Most Exposed to Compliance Risks

With environmental and social protections already being in place within the EU, the CSDDD was created with the intention of addressing the adverse impacts that European imports have on the environment and society beyond the bloc’s borders. Based on the products and commodities covered in the proposed directive, Sustainable Fitch believes this places disproportionate focus on supply chains originating from emerging markets, with Brazil and Indonesia notably affected as major exporters of several of the commodities under review.
Criticism of the directive has focused on its associated compliance requirements and costs, which are expected to be significant given that it will require companies to produce due-diligence reports for all eligible products.

Effect of Compliance Will Vary Between Supply Chains
Although commodities will be equally subject to the requirements of the CSDDD, exposure to issues like deforestation and human rights concerns vary across different commodity supply chains. Similarly, regional considerations and differences in supply-chain structures also significantly influence vulnerability to these issues. As a result, compliance with the CSDDD will be felt differently across different commodities.

For instance, commodities with significant reliance on smallholder farming (i.e. producti on originating from many small-scale operations), such as cocoa and tea, are likely to feel greater strain from human rights requirements under the CSDDD, due to the prevalence of child labour in their supply chains. The International Labour Organization estimates that agriculture accounts for by the largest share of child labour, with 85% of all child labour in sub-Saharan Africa (SSA) being associated with the sector.

Due diligence over child labour is a complex issue in the case of SSA, as children are not directly employed but rather participate in work on family farms, which face little to no regulation, oversight and enforcement. For cocoa, tea and other commodities concentrated in SSA, avoiding compliance issues by moving away from suppliers in the region is an unlikely solution, meaning that spending on supply-chain monitoring and auditing may need to increase. We expect larger companies that have already started to establish such practices in their supply chains to be best positioned to absorb additional costs; smaller companies may struggle if the requirements come into force.

Some commodities may also see demand-side changes if producers cannot ensure compliance with the CSDDD. Before the recent Brazilian election, this may have been the case for Brazilian beef, which had become associated with deforestation and as a result had seen investor backlash, including divestments by some international investors. However, as Sustainable Fitch has noted, the election of Luiz Inácio Lula da Silva as president is likely to have significant implications for Brazil’s environmental policy. This is particularly the case with respect to Lula’s pledge to eliminate deforestation by 2030, which we believe would mitigate exposure to deforestation across Brazilian beef production, if it were to materialise.

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