Regulations are a standard instrument for advancing the development and adoption of more sustainable technologies and business practices. This is especially embraced in the European Union, which has the ambition to be at the forefront of this development. In this post, we give an overview of the most important sustainability-related regulations in the EU.
The benefits of regulation
Regulations are sometimes perceived as purely a compliance burden. In practice, well-designed regulation creates a level playing field and often rewards companies that invest early, turning sustainability into a competitive advantage rather than a cost. Let’s see how that works.
In a market-driven economy, businesses naturally prioritise financial performance. This works well in most cases but breaks down when facing business activities, which have societal costs instead of costs for the business itself. Economists call these externalities. An example of such an activity is poor waste management, like a factory that directs toxic residual chemicals into a nearby river. It’s a cheap solution, but it harms the local environment with negative consequences for society as a whole.
In situations like these, regulations are an effective tool to correct the cost imbalance. They have the power to turn external costs into costs for the businesses and thereby make it more profitable for companies in the market to introduce sustainable practices. Another benefit of regulations is that they can focus on the intended goal, for example the reduction of toxic chemicals in rivers. The way of achieving this goal is up to them, whether it be by collecting and properly disposing the chemicals or by avoiding the residual chemicals by changing the production process. When designing regulations, the challenge is to properly target the intended goal while making the restrictions easy to monitor.
Once a regulation is in place, reversing it again carries real economic risk. Local companies that have already invested in compliant processes would face unfair competition from foreign players who never bore those costs. As a consequence, markets in which regulations are changing frequently are poor destinations for investments. Regulatory stability is therefore not just an environmental concern but also a business one.
Finally, regulation can have a positive impact even when only applied to single regions. For example, companies that produce for many markets might unify their overall business process instead of having different ones specific to each market. Also, new sustainable technologies might be invented that turn out to be competitive even in the absence of regulation, which is the case with PV-based electricity generation.
Implemented and upcoming EU regulations
In the following, we highlight some of the main regulations that exist in the EU to foster sustainable and responsible business practices.
Corporate Sustainability Reporting Directive – CSRD
The CSRD requires all companies with business activities of a specific volume in the European market to report on the company’s policies, targets, and implemented or planned actions with respect to environmental, social, and governance (ESG) topics. The companies themselves are responsible for the selection of issues to report about, but need to justify their decisions. Furthermore, they need to include a “double materiality” analysis, which requires them to incorporate the following two perspectives:
- The inside-out view, which covers the impacts the company has on the environment and society.
- The outside-in view, which lists the risks and effects that (upcoming) sustainability issues have on the company.
This mandatory reporting requirement ensures a certain level of standardised transparency for large businesses operating in the EU. The regulation is in effect for large companies already and is currently being rolled out for smaller businesses.
Corporate Sustainability Due Diligence Directive – CSDDD
The CSDDD is a planned regulation that should start to be binding for the first set of companies in 2029. In contrast to the CSRD, it does not focus on reporting but on concrete actions. Companies need to establish processes to identify potential and actual negative impacts that their own operation or operations within their supply chain have on human rights and the environment. After identification, risks must be prevented, mitigated, or otherwise accounted for as best as possible (with due diligence).
What does this mean in practise? Example activities could be:
- Minimising greenhouse gas emissions within the company’s own logistics operation
- Investing in a wastewater treatment plant for a foreign supplier to prevent harming the environment
- Urging a supplier with exploitive working conditions to improve these, offering expertise and training
As shown in the examples, one of the most important aspects is that companies have a responsibility to also ensure sustainable operations within their supply chain. As a consequence, this regulation will also impact businesses outside the EU.
European Emissions Trading System – EU ETS
The main regulation to combat climate change is the emissions trading system. The general idea is the following:
Each company of a certain size that emits harmful substances (like for example greenhouse gases) into the environment needs to monitor and report on these, as well as acquire a corresponding number of certificates. The certificates are provided by the EU but are limited in number, which caps the overall number of allowed emissions. Having to buy certificates via auctions or trading is expensive, which motivates emission reduction. Furthermore, the total number of allowed emissions is reduced per year, which leads to a decline in total emissions within the EU.
The emission trading system is accompanied by the Carbon Border Adjustment Mechanism (CBAM). It requires companies to also provide certificates for the emissions attributed to goods they import from outside the EU. Thereby, it prevents bypassing the emissions trading system and protects local producers from less sustainable foreign competitors.
Lessons learned
Regulations are an effective and powerful instrument to steer an economy towards more sustainable business practises that benefit society as a whole. The European Union created a set of general core regulations to ensure its leading role in this development.
For the affected companies, this results in a two-fold challenge: The first is data collection, which is already required for accurate reporting according to the CSRD. The second is anticipating the costs and trade-offs of upcoming regulations and incorporating them into strategic business decisions, where again detailed data is the necessary basis. This can be more complex than it seems, as our simplified example of the procurement of apples shows. In this context, the usage of model-based decision making as offered by Doing The Math allows for navigating a world of changing business conditions, in which the costs of emissions are gradually increasing, and sustainable practices become a competitive advantage rather than an additional cost. More details on this topic can be found in our previous blog post, where we explore different ways of combining cost and emission for the sake of decision-making.