The impact of EU Corporate Sustainability Due Diligence Directive and the Carbon Border Adjustment Mechanism on African businesses and opportunities for competitive advantage

Two recent legal developments in the European Union (EU) are likely to have a significant impact on African companies that supply resources to the EU.

The first of these developments is the Carbon Border Adjustment Mechanism (CBAM) which will ultimately impose levies on certain carbon intensive products upon entering the EU. The second development is the EU Corporate Sustainability Due Diligence Directive (CS3D) which imposes obligations on certain companies to assess human rights and environmental impacts arising from its operations and value chain. The CS3D requires that these companies take various measures to address these impacts which will ultimately trickle down to African companies that provide resources and services to companies affected by the CS3D.

Those African companies that adapt their businesses to align with the CBAM and CS3D requirements will be attractive to EU based businesses seeking to minimise their CBAM levies and/or avoid the regulatory penalties contemplated under the CS3D. There are various technical and operational solutions which African companies can implement to achieve these goals. However, companies’ ability to implement these solutions are often stymied by contracts which do not allow for or contemplate sustainability as a key deliverable in providing a resource or service.

This article briefly discusses the CBAM and CS3D before discussing ways that African companies can, through their contractual relationships with business partners, ensure that they can benefit from the first-mover advantage and be a preferred supplier to companies regulated under the CBAM and CS3D.

1. The Carbon Border Adjustment Mechanism

The transitional phase of the CBAM commenced in October 2023. This phase runs until December 2025, during which time importers need only report embedded carbon in respect of aluminium, cement, electricity, fertilizer, steel and hydrogen. It is expected that this list of sectors will increase over time and may include indirect emissions from downstream products such as, in the case of steel, screws, nuts bolts and similar articles. These additional products are only likely to be added at the end of the transitional phase.

During the transitional phase, no levies are payable. With effect from 1 January 2026, the definitive phase will commence, whereupon importers will be required to register, calculate the carbon intensity of the applicable products in accordance with EU methodologies, prepare quarterly reports and purchase CBAM certificates that will be annually surrendered. These quarterly reports will need to cover scope 1, 2 and 3 emissions, although certain scope 3 emissions can be excluded from the calculation.

The price of CBAM certificates will be linked to the price of carbon under the EU Emissions Trading Scheme (EUETS). If a carbon tax was already imposed on the product at its country of origin, the CBAM levy will be calculated based on the differential between the carbon tax imposed and the CBAM levy. The carbon price per ton of CO_2e under the EUETS has varied between €50 and €100 over the past two years.

Considering the above, products manufactured in a more carbon-efficient manner and which will attract a lower CBAM levy are likely to be in demand by EU based companies. Alternatively, manufacturers may seek to relocate operations to jurisdictions outside of the EU which do not attract these levies. However, this may not be a long-term solution if carbon levies are imposed by other jurisdictions and/or on downstream products. Similar levies are also being debated in the USA and Australia.

2. The EU Corporate Sustainability Due Diligence Directive

On 24 May 2024, the Council of the EU passed the CS3D which requires that certain companies undertake human rights and environmental due diligences into their operations and value chains.

The CS3D applies to EU incorporated companies with more than 1000 employees and an annual turnover of more than €450 million and companies with EU franchising or licensing agreements with annual royalties exceeding €22.5 million and an annual net worldwide turnover in excess of €80 million (EU Companies). It also applies to non-EU incorporated companies who have an annual net turnover of €450 million generated in the EU or EU franchising and licensing agreements with annual royalties of more than €22.5 million and an annual turnover of €80 million (Non-EU Companies).

The EU Companies and Non-EU Companies must undertake risk-based human rights and environmental due diligences to identify actual and potential human rights and environmental impacts in their operations and “chain of activities” and implement appropriate measures to:

• prevent or correct impacts.
• invest in infrastructure and production processes.
• support small and medium enterprises.
• obtain contractual guarantees from its contracting partners.
• develop strategies and practices regulating their procurement and distribution practices.

The chain of activities refers to upstream resource suppliers or service providers to the EU Companies and Non-EU Companies as well as downstream customers.

The CS3D specifically addresses climate change by requiring EU Companies and Non-EU Companies to develop and annually update a climate transition plan that is compatible with the 1.5 degrees Celsius temperature threshold set in the Paris Agreement. In particular, the plan must address the EU Companies’ and Non-EU Companies’ exposure to fossil-fuel (coal, oil and gas) activities and set emission reduction targets for scope 1, 2 and 3 greenhouse gas emissions.

All the above measures must be published on the EU Companies and Non-EU Companies’ websites and will be enforced by regulatory authorities. Where an EU Company or Non-EU Company is in breach of the CS3D, the regulatory authorities may direct them to take remedial action and may impose fines of not less than 5% of the company’s net worldwide annual turnover.

Like the CBAM, the CS3D is not fully operational with larger companies required to comply with the CS3D within 3 years. The obligation on smaller companies to comply will only arise in the future.

3. What impact does CS3D and CBAM have on African companies that supply the EU?

Companies regulated under the CBAM and CS3D (Affected Companies) will be looking at their existing supply chains to:

• identify ways to reduce any potential CBAM levies.
• evaluate if suppliers comply with international human rights requirements.
• evaluate if suppliers comply with environmental laws.
• evaluate their greenhouse gas emissions exposure due to carbon intensive manufacturing processes employed by suppliers.
• pivot from existing suppliers to new suppliers who reduce their exposure under the CBAM and CS3D.
• re-evaluate existing contractual arrangements with suppliers, imposing more stringent obligations on them to:
  • meet specific environmental, health and safety and human rights targets.
  • comply with emissions targets and implement plans to reduce carbon emissions in their operations and supply chains.
  • report on their compliance with environmental, health and safety, human rights and emissions targets.
  • impose penalties for non-compliance with targets.
  • terminate supplier agreements to move to suppliers that are more closely aligned with the CBAM and CS3D requirements and objectives.

Where African companies’ operations do not align with CBAM and CS3D objectives, Affected Companies may:

• seek to terminate agreements with suppliers.
• refuse to renew supplier agreements unless certain environmental, health and safety and human rights standards are met.
• seek to re-negotiate the terms of the supply agreements to impose additional obligations on suppliers. Suppliers will be obliged to assume these obligations under pain of losing the contract to suppliers that are willing to assume the obligations or who already comply with these requirements.

The above factors may have a financial impact on African companies in that they will be required to:

• invest significant capital into upgrading their operations to comply with environmental and health and safety standards that are more stringent than local law requirements.
• invest in additional resources to comply with the additional monitoring and reporting obligations imposed on the Affected Companies which will be passed on to the Suppliers.
• Investigate weaknesses in their own supply chain and implement measures to improve the robustness of the supply chain in a manner congruent with the CBAM and CS3D requirements. This may require imposing compliance targets, performance requirements, emissions targets etc. on their suppliers.

These additional obligations may prejudice the profitability and even the viability of some suppliers.

4. How do Suppliers need to respond to CS3D and CBAM?

Suppliers should proactively examine:

• their existing agreements with Affected Companies to identify:
  • if or how easily the Affected Companies can terminate the supply agreement.
  • any existing obligations on the Supplier and the Suppliers’ compliance therewith.
  • the term of the agreements and the rights to renew the agreements.
• their own operations and supply chains to identify:
  • non-compliances with environmental laws, health and safety laws and international best practice on human rights laws.
  • opportunities to improve compliance with relevant laws and standards and the capital and operational expenditures required to achieve these requirements.
  • ways in which their supply chain can be improved to comply with the requirements of the CBAM and CS3D.
• their supply chain agreements to ensure that Suppliers can easily fulfil their obligations to the Affected Companies. The nature of the terms and conditions that should be considered or evaluated under these supply chain agreements are explored below.
• ways that the Affected Companies can assist Suppliers to comply with environmental, health and safety and human rights requirements and standards including through capital investment, training and learning and new technologies. However, in doing this, recognizing that the Suppliers also need to invest in implementing these measures.

5. When should African businesses evaluate their supply agreements?

The CBAM and CS3D may only be in their infancy but Affected Companies have already begun to de-risk their liability under these laws. Companies that align their operations and supply chains with CBAM and CS3D requirements will be attractive to Affected Companies and may win significant market share over competitors that fail to act. There are also opportunities for Affected Companies to work with their suppliers to assist them in strengthening their supply chain and implement policies, procedures and technology to assist suppliers in meeting the Affected Companies targets and objectives and reporting obligations.

6. Why should African Companies review their operations and supply agreements?

Often ESG considerations (such as those contemplated in the CBAM and CS3D) are not key components driving procurement practices, with price and quality being the primary considerations. As a result, companies may be locked into supply agreements with parties that may not subscribe to the requirements of CBAM and CS3D or international best practice which, in turn, will make African Companies’ supplying Affected Companies less attractive suppliers. Assessing existing contractual arrangements and drafting and negotiating new supplier contracts taking into consideration ESG requirements (like those set out above in CBAM and CS3D) is something that Affected Companies and African Companies supplying the EU should focus on during the initial phases of the CBAM and CS3D to ensure that when these legal regimes are fully effective, they are able to comply and/or reduce the risk of significant financial penalties.

We consider the following principles as important in evaluating existing contractual arrangements and negotiating new contractual regimes affected by CBAM and CS3D:

• Term Sheets: Ensure that ESG issues are set out in terms sheets negotiated with suppliers / contractors. The term sheet should set out the standards that the supplier or contractor must meet, the time frame within which the standards must be met and the consequences if the specified targets and objectives are not met.
• Objective and auditable targets: Any targets that are selected with which the supplier or contractor must comply must be possible and measurable. That is, the parties must be able to objectively assess the supplier / contractor’s compliance with agreed targets.
• Reviewing and Reporting: Agreements should include obligations on the supplier / contractors to report on their compliance with the agreed targets at specified intervals. The reports need to include sufficient information so that compliance can be assessed.
• Termination Rights: Agreements should include termination rights that are linked to (i) a failure by the supplier / contractor to comply with the ESG targets; (ii) circumstances where a competitor can provide similar products or services with a better ESG pedigree (and the supplier / contractor cannot match the competitor’s ESG performance); and/or (iii) circumstances where the supplier or contractor is found to be “ESG-washing”.
• Termination penalties: Some agreements contain break fees if the agreement is terminated. These clauses may lock companies into long-term agreements with suppliers or contractors that do not adopt ESG best practices or fail to innovate to improve the ESG pedigree of their goods or services. Break fees should not apply in respect of ESG-performance related agreement termination.
• Liquidated damages: Innovative alternative remedies can be adopted rather than terminating the agreement where a supplier or contractor fails to meet the ESG targets. These may include monetary payments or could even include purchasing carbon credits, contributing to ESG-related charities or planting trees. However, offsetting should be approached with caution as it may result in the risk of greenwashing.
• Legacy clauses: Where the company has significant bargaining power, it may consider imposing legacy ESG clauses into its agreements with suppliers and contractors. These clauses require that the supplier and contractors impose similar ESG obligations imposed on its suppliers and contractors.
• Preferential trading terms: Not all conditions in the agreement need to be sanctioned. It is possible for companies to offer preferential trading terms (such as better interest rates, increased use of their goods or services or better payment terms) to those suppliers / contractors that meet and exceed the ESG standards.
• Risk-sharing options: Consider ways in which the parties can assist each other to achieve the objectives and targets required under the agreement with investment opportunities, training and skills development and sharing of technologies.
• Warranties and indemnities: In some instances, it may be appropriate for suppliers or contractors to warrant a particular situation when it comes to its ESG performance. Failing to comply with the warranty would allow the company to claim damages under the agreement.

Burnell Attorneys Inc. is a specialist ESG law firm based in Johannesburg, South Africa. We assist clients across the African continent in incorporating and implementing ESG practices in their businesses, including drafting and reviewing supply agreements that meet the requirements of CS3D / CBAM and allow companies to nimbly achieve their decarbonization goals. To discuss ways that we can assist your business, please contact Matthew Burnell on matt@burnellattorneys.com.