The EU Conflict Minerals Regulation: The Uncertain Effects of Supply Chain Due Diligence

On 17 May 2017, a new regulation on supply chain due diligence was published in the European Union’s Official Journal. The regulation, known as the “EU Conflict Minerals Regulation,” imposes obligations on EU importers of tin, tantalum and tungsten, their ores, and gold (“3TG”) originating from conflict-affected and high-risk areas. Armed groups engaged in mining operations in these regions are believed to violate human rights and to use the proceeds from the sale of conflict minerals to finance their militia. The regulation is intended to disrupt the financial flows and, thus, stop the human rights abuses.

The EU Conflict Minerals Regulation is the European counter-part of the US Dodd-Frank conflict minerals legislation (Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Act of 2010) and the implementing regulations issued by the Securities Exchange Commission (SEC). To a large extent, the EU regulation is based on the pre-existing Guidance of the Organisation for Economic Co-operation and Development (OECD), which elaborates the concepts of supply chain responsibility and due diligence in relation to conflict minerals. With this regulation, the EU goes beyond guidance and imposes a form of supply chain liability on EU importers of 3TG.

While the provisions not imposing obligations on companies will enter into force on 9 July 2017, the regulation will become effective for companies on 1 January 2021 and will be directly binding. The standard clause requiring that member states adopt sanctions for violations that ‘effective, dissuasive and proportionate’ has been omitted, however. In response to the question “[w]hat happens if a company doesn’t comply with the regulation,” the Commission has stated that “[i]f a Member State finds an EU importer has not complied with the regulation, it will (i) order the firm to address the problem within a given deadline and (ii) follow up to make sure it does so.” Thus, the focus is on compliance, not sanctioning. Member states are free to impose the sanctions they deem fit, and civil liability law may be applicable to violations that also constitute unlawful acts vis-à-vis third parties. In January 2023, the Commission is to decide whether member states must impose sanctions in the event of persistent failure to comply with the regulation’s obligations.

Global geographical scope of application

The Regulation’s scope of application is uncommon. While the subject matter scope is narrow (only four minerals/metals), the Regulation’s potential geographic scope is the world. As opposed to US law, which applies only to the Democratic Republic of Congo (DRC) and nine adjoining countries, the EU Conflict Minerals Regulation covers 3TG emanating from mining operations in ‘conflict-affected and high-risk areas’ all over the world. Such areas include “areas in a state of armed conflict or fragile post-conflict as well as areas witnessing weak or non-existent governance and security, such as failed states, and widespread and systematic violations of international law, including human rights abuses.”

In other words, all countries that export to the EU, whether they export 3TG raw materials or metals, potentially fall within the scope of the regulation’s due diligence regime. As the European Commission’s Frequently Asked Questions explain, the most affected regions likely include: (i) West Africa, (ii) Central Africa, and some regions in (iii) South America and (iv) East Asia. Of course, the regions concerned may change over time, as old conflicts get settled and new conflicts arise.

The absence of a positive list of covered areas creates a risk of inconsistency as well as compliance risks. Whether a region is conflict-affected or high-risk requires an assessment that may produce more affirmative and negative results. Companies face risks if they are unable to determine with certainty whether a particular region from which they source is high-risk. Two devices, however, are intended to mitigate these risks. First, to “create certainty for and consistency among the practices of economic operators, in particular SMEs,” the Commission has been charged with preparing non-binding guidelines for economic operators. These guidelines should explain “how best to apply the criteria for the identification of conflict-affected and high-risk areas” set out in Article 2(f) of the Regulation. While such guidance may reduce the uncertainty, it probably does not produce the desired certainty, since subjective assessment will continue to be necessary.

In addition, the Commission has been tasked with pulling together a list of conflict-affected and high-risk areas based on expert analysis. This list is to be updated regularly. The list will be (i) indicative, i.e. it will give an indication of countries that are currently or could be affected by conflict, and (ii) non-exhaustive, i.e. it will not necessarily include every area in the world affected by conflict. Companies operating in conflict-affected areas that are not on the list, however, must still comply with the due diligence obligations. Thus, legally, the list helps but will not eliminate the risks. If a region is on the list of conflict-affected and high-risk areas, a company will likely be inclined to treat it as such, even if its assessment suggests otherwise. If a region is not on the list, a company could either avoid the region or conduct its own assessment.

Industries and companies most affected

The EU Conflict Minerals Regulation applies directly only to EU-based importers of 3TG, whether in the form of mineral ores, concentrates or processed metals, whose annual import volumes exceed specified thresholds — the threshold quantities will be laid down in Annex I of the regulation. Smelters and refiners of 3TG, of course, are covered, but there are not that many such operations left in the EU. Importers into the EU of 3TG as minerals or metals, are also covered. Unlike under US law, however, downstream users of these minerals operating beyond the metal stage, including EU importers of products containing 3TG, are not subject to the EU regulation.

Practically speaking, the EU Conflict Minerals Regulation affects mainly EU-based companies in industries that use 3TG to manufacture their products. These industries include the electronics, communication, aerospace and automotive industries. Companies in these sectors use minerals that potentially fall within the scope of the regulation to build products such as laptops, phones, cars, and airplanes. According to Commission estimates, the regulation applies directly to between 600 and 1,000 EU companies.

Given the regulation’s focus on upstream companies, and the broad exemption for downstream entities, there is room for strategic relocation. To escape the due diligence obligations imposed by the regulation, 3TG users that are currently based in the EU could relocate to outside the EU. They could manufacture their products in a non-EU country, and then import into the EU without having to bother with the regulation. Whether this will turn out to be a viable option depends on the costs and benefits of relocation, including import duties and transportation cost – if the EU market demands supply chain due diligence of all producers, this strategy may not work.

Due diligence obligations

Comparable to the French Duty of Vigilance Law, which requires French companies to implement a “vigilance plan” to prevent serious violations of human rights, fundamental freedoms and serious environmental damage, under the EU Conflict Minerals Regulation, EU importers of minerals or metals must establish a supply chain due diligence program and keep documentation demonstrating compliance with the obligations imposed by the regulation, including the results of the independent third-party audits.

According to the Commission’s FAQs, companies that practice due diligence, “first check how risky it is to source raw materials from a certain region afflicted by conflict. They assess the likelihood that those raw materials could be financing conflict or mined using forced labour. By checking the source, they can then make sure that they do not help fund that conflict.” The system required to make these kinds of determinations is worked out in detail.

The EU Conflict Minerals Regulation requires that importers follow the OECD’s Due Diligence Guidance, which sets forth five steps: (i) establish a strong company management system; (ii) identify and assess risk in the supply chain; (iii) design and implement a strategy to respond to identified risks; (iv) carry out an independent third-party audit of supply chain due diligence; and (v) report annually on supply chain due diligence. The management system must include a “grievance mechanism,” which is defined as “an early-warning risk awareness mechanism allowing any interested party, including whistle-blowers, to voice concerns regarding the circumstances of extraction, trade and handling of minerals in and export of minerals from conflict-affected and high-risk areas.”

An EU importer must also operate a “chain of custody or supply chain traceability system.” Such a system requires “a record of the sequence of economic operators which have custody of minerals and metals as they move through a supply chain,” and documents (i) the mineral or metal, including its trade name and type; (ii) name and address of the supplier to the EU importer; (iii) country of origin; (iv) quantities and dates of extraction/production, if available, expressed in volume or weight; (v) where minerals originate from conflict-affected and high-risk areas or, where other supply chain risks as listed in the OECD Due Diligence Guidance have been ascertained by the Union importer, additional information in accordance with the specific recommendations for upstream economic operators, as set out in the OECD Due Diligence Guidance, such as the mine of mineral origin, locations where minerals are consolidated, traded and processed, and taxes, fees and royalties paid.” In short, there is much data to be obtained, verified, and recorded.

The premise behind the EU Conflict Minerals Regulation

The premise behind the EU Conflict Minerals Regulation is that in conflict-affected or high-risk areas, the revenues of minerals “fuel the outbreak or continuation of violent conflict.” According to the EU legislature, armed groups would often use forced labour to mine minerals; they then sell those minerals to fund their activities and buy weapons. Accordingly, the regulation’s objective is to stop the financing of armed groups in developing countries through the trade of 3TG. Depriving these groups of finance would make it more difficult for them to continue their activities, and mitigate human rights abuses. As one of the recitals states, “breaking the nexus between conflict and illegal exploitation of minerals is a critical element in guaranteeing peace, development and stability.” No further evidence is offered for these propositions.

The EU’s assumptions

Thus, three propositions can be identified on which the EU Conflict Minerals Regulation is based – each of these propositions requires careful review.

The first implicit assumption the EU makes is that conflict is inherently bad, regardless of the cause of conflict or the objectives of the rebels. Peace and stability are the overriding goals. Some conflicts, however, are directed at ending a dictatorial regime or stopping tyranny or human rights abuses by authoritarian regimes. In these cases, conflicts may be necessary to restore freedom and equality, and the regulation’s objective of ending conflict by disarming the opposition, would be unfair. After all, if the regulation’s objective is achieved, the dictatorial regime could continue its abusive practices without opposition under an EU banner of “peace and stability”. If, for instance, rebels conquer a mine from an oppressive dictator, do not use forced labor (which the EU assumes they will do) to mine minerals, and sell those minerals to defend their freedom, should the EU attempt to boycott this group?

Secondly, by limiting the customer base for these minerals, the EU assumes it will deprive rebel groups of income – and cutting the funds of rebel groups will end conflict. However, rebel groups losing mineral income will likely look for other sources of income. These alternative activities may not be any less problematic from an ethical perspective. Think, for example, of revenues from the sale of protected types of timber, protected animals, addictive substances, forced prostitution, and human trafficking. Each of these activities creates greater potential for human rights violations and environmental deterioration than 3TG mining. In addition, the EU appears to assume that cutting the funds of rebel groups – practically, by shutting down their mining activities, which will then be “formalized” as they will come under government control – government revenues will increase, and then, magically, “promote good governance and the rule of law.”

Lastly, the EU assumes that conflict causes human rights abuses. The causal relation may go in the opposite direction, however: human rights abuses cause conflicts. As a related matter, the EU fails to consider that many human rights abuses may be unrelated to conflict – in Saudi Arabia, for instance, there are both peace and stability, and widespread human rights violations. In such cases, conflict may arise to end human rights abuses and restore freedom. Conversely, in some cases, ending a conflict does not mean ending human rights abuses – peace may even facilitate human rights abuses where dictators are able to acquire complete control.

These assumptions show that the EU does not seem to have reflected critically on the criticism directed at the US Dodd-Frank Act. An open letter, published in September 2015, and signed by 70 academics, researchers, journalists, etc., argues that the Dodd-Frank Act “contributes to, rather than alleviates, the very conflicts they set out to address.” The EU has assumed these problems away.

Objectives of the EU Conflict Minerals Regulation

 At an operational level, the EU Conflict Minerals Regulation is aimed at preventing that conflict minerals are exported to the EU and that EU smelters and refiners refrain from using such minerals. To achieve these objectives, the regulation requires that covered minerals are imported into the EU from ‘responsible sources’ only. As Article 1(1) provides, the regulation is “designed to provide transparency and certainty as regards the supply practices of Union importers, and of smelters and refiners sourcing from conflict-affected and high-risk areas.” As “it is difficult for consumers to know if a product they have bought is funding violence, human rights abuses or other crimes overseas,” the regulation is aimed at filling this void.

The instruments the regulation employs to achieve its objectives include due diligence, record keeping, traceability, and disclosure requirements. All of these impose costs on regulated companies. In competitively dynamic markets, however, these additional compliance costs might force companies to reduce costs elsewhere in their operations, such as laborer’s wages – or might result in higher prices. Consequently, the question rises what the regulation’s effects will be on sourcing of minerals. After all, the EU legislature wants to protect responsible smelters, refiners, and mineral users.

Effects on responsible companies

The regulation wants to avoid putting a responsible miner, smelter, or refiner from a conflict-affected or high-risk area in a competitively disadvantaged position. As a practical matter, however, responsible operators in such areas will face higher costs, because they will be required to conduct the necessary due diligence and provide the necessary evidence to be able to demonstrate that they are “responsible” and should be allowed to export to the EU. These extra costs will force these good operators to (i) increase their prices, which is not an option in competitive markets; or, more likely, (ii) cut other costs, such as the laborers’ wages. Claims by NGO’s that higher prices represent more profit for the miners and thus higher wages for the laborers, are not well-grounded – higher prices may simply reflect higher cost of production. Smaller mines might even have to close as they become unprofitable due to increased costs, resulting in unemployment and loss of economic opportunities.

As responsible mines face increased operational cost and thus may become unprofitable, they become vulnerable to take-over by networks involved in fraudulent and sometimes violent exploitation. These network are operated by both rebel groups as well as other factions looking to sell minerals in the informal economy, often by smuggling. Thus, while only a small number of mining sites are de facto controlled by militia, many mines may be at risk of “informalization”.

The trouble associated with sourcing from conflict-affected or high-risk area might even lead to avoidance of these areas altogether. While some companies will face relatively (e.g., on a per unit of production basis) low compliance cost, others may incur relatively high cost. Rather than going through the trouble of establishing that sources in such areas are responsible and incurring the related costs, buyers might demand lower prices to compensate for their compliance costs, or they may decide to stay away from such areas. The latter would seem to be an entirely rational strategy, in particular for companies that face relatively high compliance costs.

Echoing this concern, at a public hearing in 2013, Karel De Gucht, then European Trade Commissioner, stated that “the EU hopes to avoid some of the unintended consequences of the conflict minerals effort, like the creation of de facto embargoes of certain conflict regions”. This hope may not be realistic, however – to reduce risk and costs, at least some companies will conveniently avoid trading with these regions. If companies indeed refrain from sourcing minerals from conflict-affected and high risk areas, their populations may be hit twice.

Despite the numerous reports addressed to the US government on the unintended negative effects of the Dodd-Frank Act on the Congolese people and many recommendations for a better approach, the European Commission did not consider these effects and recommendations in the impact assessment of the proposed regulation. This assessment emphasizes due diligence costs and employment effects on EU companies. It also recommended a voluntary approach, instead of the mandatory regulation that the EU legislature chose to adopt.

Conclusions

The EU Conflict Minerals Regulation imposes a form of supply chain liability on EU importers of 3TG from conflict-affected or high risk areas. The regulation’s intention is to deprive rebels of funding by stopping the sale of their minerals to the EU, and consequently to put an end to such conflicts. EU-based importers of 3TG will have onerous due diligence obligations under the regulation. They will face increased cost and compliance risks, which the regulation only partly mitigates.

Further, the regulation may have a series of secondary order effects, which could counter any favorable effect it may have on the funding of conflicts. The preliminary question whether conflicts should always be stopped, is not adequately addressed. Where the regulation does have effect, militia will sell their minerals to buyers outside the EU or search for different sources of revenue to fund their activities, which may well pose more serious ethical challenges. In addition, the regulation indirectly may have negative effects on responsible miners in conflict areas, including unemployment and loss of economic opportunities.

By January 2023, the Commission will have to evaluate “the functioning and effectiveness” of the EU Conflicts Mineral Regulation, including its “impact on the ground” and the cost of responsible sourcing. At that time, we might get a better picture of its effects in the real world. To obtain a realistic picture, however, the Commission should cover the secondary order effects in its evaluation.

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