The European supply chain law is coming after all – What can we make of the compromise?

Nora Aboushady, Tilman Altenburg, Inga Carry, Jann Lay, Melanie Müller, Mark Schrolle, Frauke Steglich, Lea Strack, Tevin Tafese, Rainer Thiele
Jul, 2024
#EU / Western Europe
#Sustainability standards
#Corporate responsibility and lead firms
In December 2023, the EU Member States and the European Parliament agreed on a directive on corporate accountability along global supply chains – the Corporate Sustainability Due Diligence Directive (CS3D) (henceforth: CS3D trilogue agreement). Adoption by the EU Council on 9 February 2024 was considered a formality. However, Germany's veto threatened to derail the directive in the final phase and led to re-negotiations resulting in a new version published on 15 March 20­24 and formally approved by the EU Council on 24 May 2024 (henceforth: CS3D compromise).

In a previous statement published in February 2024, we[1] argued t­hat the Directive is an opportunity to reduce the negative effects of global production on human rights and the environment. We concluded that, while imperfect, the Directive is an important compromise that will allow European companies to move forward with a common objective, create a level playing field within the EU by setting a common standard and harmonising existing national legislations, and facilitate support for partner countries to improve the implementation of standards.

In the following, we outline the most important aspects of the CS3D and compare the final compromise with the earlier trilogue agreement and the German Supply Chain Act (LkSG) (for a more detailed comparison, see Table 1). We also highlight some of the most contentious aspects of the Directive and identify a number of research areas and questions regarding the effectiveness and impact of the Directive that will need to be addressed in the coming years.

CS3D Implementation Schedule

By adopting the CS3D, the EU is creating a comprehensive framework for corporate due diligence within the EU. The CS3D complements existing sectoral supply chain legislation, such as the Conflict Minerals Regulation and the EU Deforestation Regulation, as well as the Corporate Sustainable Reporting Directive (CSRD) and the EU Sustainable Finance Disclosure Regulation (SFDR). The Directive must be transposed into national law within two years, and a three-year long phase-in will begin by 2027 (see details below). Member States such as France and Germany, which have already adopted national legislation on supply chain due diligence, may need to make amendments to those laws in order to comply with the requirements of the EU Directive. The CS3D thereby seeks to create a level playing field of mandatory supply chain due diligence requirements for those EU and non-EU companies that fall under the scope of the Directive. Member States are, however, free to enforce stricter national supply chain due diligence laws that go beyond the requirements of the CS3D.

Scope of Companies Affected by the CS3D

Under the final CS3D compromise, the threshold for companies falling under the CS3D has been raised and the number of companies affected by the Directive reduced. From 2027, the Directive will apply to EU companies with more than 5,000 employees and an annual global net turnover of more than a €1.5 billion. Non-EU companies with an annual EU net turnover of more than €1.5 billion will equally be covered but will not be subjected to the employee threshold. By 2028, the scope will be extended to EU companies with at least 3,000 employees and an annual global net turnover of more than €900 million, and non-EU companies with an annual EU net turnover of at least €900 million. The third and final phase of implementation will start in 2029, when the Directive will apply to EU companies with more than 1,000 employees and an annual global net turnover of more than €450 million, as well as non-EU companies with an annual EU net turnover of more than €450 million.

While the earlier CS3D trilogue agreement included a provision for high-risk sectors (textiles, agriculture, extractive industries, and construction) with lower employee and turnover thresholds, the final CS3D compromise no longer distinguishes between sectors. The final CS3D compromise made further changes with respect to the financial sector. While the trilogue agreement foresaw financial services firms to be temporarily exempt from the Directive (with a review clause for a possible future inclusion) the final compromise settled on a near-complete exclusion of the financial sector. Financial companies will now only have to comply with the CS3D’s due diligence requirements when it comes to their upstream supply chain. The EU Commission is, however, required to submit a report to the European Parliament and the EU Council within two years of the Directive’s entry into force, evaluating the need for and impact of additional due diligence requirements for the financial sector. The decision to exclude large parts of the financial sector was the result of strong opposition from the industry and some Member States, who argued that including the financial sector would be disproportionate and hamper the flow of finance to the EU economy (Ségur-Cabanac & Powell, 2023).

The EU Commission estimates that the Directive will apply to around 6,000 EU companies (around 0.05% of all EU companies) and 900 non-EU companies (EU Commission, 2024; Gonzales Garcia, 2024). In contrast, the previous CS3D trilogue agreement was estimated to cover between 13-16,000 companies (around 1% of all EU companies) and 4,000 non-EU companies (Thomson, 2024; MacDonagh & Dietz, 2022).  Although small and medium-sized enterprises are not covered by the Directive, they could be indirectly affected as business partners in value chains (EU Commission, 2024).

The German Supply Chain Act started with a threshold of 3,000 employees when it entered into force on 1 January 2023, which was lowered to 1,000 employees one year later. However, unlike the CS3D, it does not include a minimum net turnover criterion. It is estimated to cover around 4,800 German companies (Initiative Lieferkettengesetz, 2021). It also includes the financial sector, albeit only for the upstream supply chain (see next section).

Scope of Applicability along the Supply Chain

The CS3D compromise requires in-scope companies to adopt and implement effective due diligence policies for “identifying and addressing potential and actual adverse human rights and environmental impacts in the company’s own operations, their subsidiaries and, where related to their value chain(s), those of their business partners” (EU Commission, 2024). The Directive includes a list of adverse human rights and environmental impacts, as well as a list of due diligence obligations.

The initial CS3D trilogue agreement covered the entire value chain, both upstream and downstream; the CS3D compromise limits due diligence obligations to the “chain of activity”, which means that companies’ obligations in the downstream supply chain still comprise distribution, transport, and storage of their products, but exclude recycling, disposal, or waste management. With regard to the upstream supply chain, both the initial trilogue agreement and final compromise follow a risk-based approach, i.e. companies are required to conduct a risk analysis and carry out due diligence along the entire upstream supply chain, from their direct to their tier-n suppliers, but with a focus on the most serious and probable risks (Art. 6 para. 1a). Furthermore, suppliers located within the EU only need to be checked in case they themselves source goods from outside of the EU.

In contrast, the German Supply Chain Act only considers the upstream supply chain. It too demands companies affected under the law to undertake a risk-based analysis of their own activities and locations as well as their direct suppliers (upstream). Indirect suppliers only need to be checked if there is substantiated knowledge suggesting a violation of a human rights-related or environment-related obligation, or in the event of a change in business activities (e.g., new sourcing country).

Environmental Due Diligence and Climate Change

The CS3D forms part of the European Green Deal and therefore also includes climate protection measures. It obliges companies to adopt and implement (“through best efforts”) a climate transition plan in line with the 2015 Paris Agreement, the transition to a sustainable economy, and the objective of achieving climate neutrality under the European Climate Law Regulation. Parent companies may adopt climate transition plans on behalf of their in-scope subsidiaries. Transition plans must be updated annually and include a report on progress of implementation. In contrast to the earlier trilogue agreement, the final CS3D compromise no longer obliges companies to link the implementation of their transition plan to financial incentives for members of their administrative, management or supervisory bodies (GleissLutz, 2024).

The German Supply Chain Act focuses on human rights, contains only minimal provisions for environmental due diligence, and does not include any requirements for climate change action.

Civil Liability, Penalties, and Jurisdiction

Member States are required to lay down rules on penalties for infringement of CS3D obligations. Companies can be fined up to five per cent of their global net turnover. Additionally, the EU follows a “naming and shaming” approach, whereby companies’ violations of CS3D obligations and the corresponding penalties are made public for at least five years.

In addition to fines, the CS3D also entails a clause on civil liability. According to the final CS3D compromise, companies can be held liable for intentional or negligent breaches of obligations and where damages were caused to a natural or legal person. Companies are then obliged to remediate and compensate victims of human rights violations. However, they cannot be held liable if the harm was caused only by their (direct or indirect) business partners in their chain of activities (Baker McKenzie, 2024).

Member States must ensure that damages claims can be brought forward within a minimum limitation period of five years. Claims can be made either by natural or legal persons or by trade unions, NGOs, and other human rights institutions on behalf of the victim(s). Although the burden of proof remains with the claimant, courts can issue evidence disclosure orders requiring companies to produce supporting and relevant documents.

Following strong opposition from the private sector, the German Supply Chain Act does not entail an independent basis for liability claims, also because in Germany, corporations are generally not subject to criminal liability. In the event of a breach of due diligence obligations, the Federal Office for Economic Affairs and Export Control (BAFA) can impose an administrative penalty of up to €800,000 or a maximum of two percent of a company’s global annual turnover. Companies can also be excluded from public tenders for up to three years. In addition to claims being brought forward by the person(s) whose rights have been violated, the German Supply Chain Act also creates a statutory “special representative action”, which allows domestic NGOs or trade unions to file suit in their own name or on behalf of victims (Initiative Lieferkettengesetz, 2021: 17).

Enforcement

Member States are required to establish a national authority tasked with enforcing the CS3D, initiating inspections and investigations of companies, and imposing fines and other necessary injunctive measures. Additionally, the EU Commission will set up a European Network of Supervisory Authorities, composed of representatives of national authorities, to facilitate cooperation among Member States.

The BAFA has been designated as the national agency tasked with the enforcement of the German Supply Chain Act and will likely also be tasked to enforce the CS3D. When incorporating the CS3D into German law, the German Supply Chain Act will have to be adjusted. Introducing the additional criterion of net turnover will likely alter the scope of German companies affected under the new law. National transposition will also require changes to the sanctions regime including a provision for civil liability as well as a more comprehensive list of human rights, environmental and climate-related obligations for companies.

 

Critical Issues and Future Research Areas

In summary, the CS3D compromise reduces the number of covered companies, excludes the financial sector, and limits downstream supply chain responsibilities compared to the original CS3D trilogue agreement. These changes, together with the weakened enforcement of climate transition plans and the absence of civil liability provisions, highlight several controversial areas and underscore the contentious nature of the final CS3D compromise.

The current Directive is a political compromise. Most of the arguments brought forward by the various interest groups – from business to political parties and human rights activists – in the debate on the regulation are plausible: On the one hand, it will raise costs for business and lead to reallocation and diversion effects of trade and investment flows. On the other hand, it will improve working conditions in and the environmental performance of some supplier firms  .  However, the orders of magnitude of these effects are unknown and how precisely these magnitudes are influenced by conditioning factors, including the structure of supply chains and the risk and (environmental and human rights) conditions in the supplier countries. .   What will be the actual cost implications for in-scope companies and how will they react to these additional costs? What exactly will be the impacts on workers and environmental outcomes at different tiers of global supply chains? What is the order of magnitude of the diversion effects that can be attributed to the CS3D?

This is where future research can contribute to an evidence-based discussion of the CS3D and its effectiveness and efficiency by providing insights into its real-world impacts   – intended and unintended. Only with this kind of evidence can we know whether the current Directive is a good compromise in the sense that it achieves improved human rights and environmental outcomes in global production while balancing the trade-offs between these objectives and economic performance and efficiency. The Directive, and its likely uneven transposition   into national supply chain laws – some of which may go well beyond the requirements of the CS3D – and uneven enforcement of national laws provide a “real-world laboratory” for studying the consequences of such regulation for supply chains and the actors and stakeholders involved.

In our view, critical research questions include - but are not limited to - the following:

  • Will the CS3D really create a level playing field within the EU and what will be the regulatory response internationally, particularly in important supplier countries? Given the evidence of uneven enforcement of other EU legislation across Member States, such a level-playing field may be difficult to achieve. It will also be interesting to analyze how the Directive will interact with other existing (sectoral) supply chain regulations. Further, the impacts of the CS3D will also depend on changes in the human rights and environmental situation and regulation outside the EU . These developments within and outside the EU need to be closely watched.

  • How effective is the CS3D in promoting compliance throughout the entire global value chains and will it ultimately benefit workers and the environment in supplier firms? An important empirical question is how the different parameters, especially (a) scope and size thresholds, (b) the (degree of) liability for harm caused by n-tier suppliers, and (c) the capacity of suppliers in the Global South to comply with human rights, influence the Directive’s effectiveness. Another closely related research question will be how best to measure supply chain due diligence.

  • Will companies and value chains be re-organised to circumvent regulatory requirements? If so, how important will trade and investment diversion effects be in economic terms? Recent evidence from trade measures in the US-China trade conflict suggests that these measures can have very significant diversion effects on third countries (Alfaro and Chor, 2023). Potential responses of trade (and investment) flows should hence be monitored, which will require not only the study of company reports, but also systematic empirical inquiry into the structures of value chains and the conditions of production along the value chain, including in distant suppliers (both upstream and downstream). Rigorous empirical research will also be needed to isolate the regulation’s impact from other factors affecting these flows. In addition, such research should also investigate the factors that constrain compliance by suppliers in the Global South, which, in turn, would help to design corresponding and appropriate development and trade facilitation measures.

  • One important risk of HREDD regulation is the potential withdrawal of companies from (trading with) high-risk context where they might be replaced by less HRE-compliant firms that do not export to the EU. Case studies of specific countries and sectors should be able to shed light on the importance of such effects.


Answering these questions can help to identify necessary support measures – for EU-firms, suppliers, worker and other stakeholders – and areas for improved regulation and enforcement.

To explore these issues further, the Research Network Sustainable Global Supply Chains is launching a blog series that will examine the challenges of implementing the CS3D – for example, across sectors and in the Global South – and measuring supply chain due diligence. This article marks the beginning of the series. Over the coming months, we will publish additional articles to inform and enrich the policy discourse on due diligence regulations with scientific research findings.

Table 1

(Click on the table to enlarge)

Source: Own presentation.
Download the table in PDF version

Endnotes

[1]We are researchers from various scientific disciplines and different research institutions working on questions of sustainability issues in global supply chains. In 2020, we established a research network comprising over 120 researchers from around the world to pool and initiate academic research on sustainable global supply chains (www.sustainablesupplychains.org). The project is funded by the German Federal Ministry for Economic Cooperation and Development (BMZ). This text reflects our personal opinions, which do not necessarily reflect the views of all researchers of the network or those of the BMZ.

Contact

Nora Aboushady

German Institute of Development and Sustainability (IDOS)

Tilman Altenburg

German Institute of Development and Sustainability (IDOS)

Inga Carry

German Institute for International and Security Affairs (SWP)

Jann Lay

German Institute for Global and Area Studies (GIGA)

Melanie Müller

German Institute for International and Security Affairs (SWP)

Frauke Steglich

Kiel Institute for the World Economy

Tevin Tafese

German Institute for Global and Area Studies

Rainer Thiele

Kiel Institute for the World Economy

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