With 8.3 billion people on the planet, all striving to live a Western-style resource- and energy-heavy lifestyle, there is no doubt that we urgently need to decarbonise the way we do things. Through the UN Millennium Goals, which were succeeded by the organisation’s Sustainable Development Goals (SDGs), came a focus on improving the lives of the poorest people on the planet (through targets such as the provision of better health and education, and clean water).
These two developments are the fundamental drivers for the current debate on environment, social and governance, or ESG. The ESG framework is becoming more and more important for companies, but current hastened legislation by some governments is arguably doing more harm than good.
It therefore helps to take a step back, think about what we want to achieve, and try to chart a way forward based on those objectives rather than on the ideological lines of argument. Given Earth’s finite resources, we need to operate a system that is not overshooting planetary constraints, while still allowing for economic growth. In order to integrate emerging markets and the least-developed countries into global value chains, we need resilient supply chains that keep the flow of goods going. We also want a fairer global economy. It is therefore imperative that we find a workable compromise between these diverging interests.
Non-governmental organisations (NGOs) and the wider development community have begun to see foreign direct investment (FDI) not merely as a corporate capitalist endeavour but as a potential driver for economic development and employment. Without it, the SDGs cannot be achieved.
Looked at from the company`s perspective though, FDI is still a risky business, one that entails many practical difficulties, especially for small and medium-sized enterprises (SMEs), which make up the lion’s share of our economies. Over the past two decades, governments have gone out of their way to facilitate FDI and make it easier for companies to invest in their jurisdiction, although the rise in populist and nationalist politics in many countries has brought with it something of a sea change here. A large volume of environmental, social and supply chain laws are being passed – resulting in additional risks for companies.
It therefore seems hardly surprising that recent UN Conference on Trade and Development figures show a precipitous drop in FDI flows.
In particular, the recently passed national (and currently discussed) European supply chain laws aim to make companies responsible for social and environmental violations, not only of their own subsidiaries but also of their direct suppliers, and even indirect suppliers (the suppliers of their suppliers).
In this article, we first outline the practical problems current supply chain laws (or the wider ESG legislative approaches) are causing, and shed light on the unintended consequences thereof. In the second part we offer potential solutions and policy remedies to reconcile the diverging interests.
Current supply chain laws and their resulting problems
The German Supply Chain Act (Lieferkettensorgfaltspflichtengesetz, or LkSG), which became compulsory for companies of more than 3,000 employees on 1 January 2023, and which will be extended to all companies with more than 1,000 employees on 1 January 2024, requires companies to identify and address “risks of human rights violations within their supply chain”. The LkSG also requires companies to identify and address the risks of forced labour, child labour and discrimination.
The LkSG is by no means unique. There are a range of similar pieces of ESG legislation such as the UK Modern Slavery Act (2015), which requires companies to ensure that there is no slavery or human trafficking in their supply chains, and is very similar to the California Transparency in Supply Chains Act (2010) and the Australian Modern Slavery Act (2018). The US Dodd-Frank Act (2010) requires companies to disclose information about their use of conflict minerals, while the French Duty of Care Law (2017) stipulates due diligence on human rights and environmental risks abuses throughout their entire supply chain. Apart from the EU taxonomy for sustainable activities, there is also the EU’s Corporate Sustainability Reporting Directive, which came into force in January 2023 and applies to all companies of more than 250 employees. Most crucially, however, the EU is currently debating a European-wide supply chain law (the so-called Corporate Sustainability Due Diligence Directive), which is said to go beyond Germany’s LkSG.
That such ESG legislation results in increased costs to companies, owing to demands on compliance, audits and inspections. is largely undisputed by proponents and opponents alike. What is less widely discussed, however, is that these well-meaning pieces of ESG legislation lead to the following five unintended consequences:
- A slowing-down of technological progress and the introduction of new products
- The de-industrialisation of countries adopting ESG legislation
- Preventing the least-developed countries from attracting meaningful volumes of FDI
- The penalisation of SMEs, leading to them being cut out of global value chains (GVCs)
- The legislation puts products and services out of reach of a large section of the population.
1. ESG legislation is slowing technological progress and new technologies
The most evident illustration of ESG regulations jeopardising new developments is found in the world of electro-mobility. With most countries having legislated the end of internal combustion engines by 2030 or 2035, there is a need to build approximately 40–50 million cars per year based on battery technology (an assumed 50% of the annual global car production of around 90 million units per year). With current technology, this means that we will require an increase of between 160% and 300% (depending on the sources used) of current global lithium production year on year. For cobalt that figure sits between 133% and 250%.
However, 75% of the world’s cobalt production is taking place in the Democratic Republic of Congo (DRC), where only about one-third of the mines are certified to adhere to even the most basic occupational protection standards (and are therefore a far cry from the various ESG wish lists). Add to this that 60% of the world’s rare earth refining is done in China, and it is not difficult to see that very soon we will arrive at the juncture where we will have to decide whether we want to have e-mobility or ESG. The two seem mutually exclusive.
There is no doubt that the water cycle in regions with lithium brines-based mining is heavily under pressure, but to push the problem to corporates and open them up for all sorts of litigation will merely ensure that there is a gaping lack of raw materials for electric vehicle (EV) batteries.
2. ESG will lead to the de-industrialisation of those countries adopting it
There is consensus that compliance with ESG legislation will be costly. Elaborate monitoring and auditing processes, trailing to sub-sub-suppliers in faraway countries, will create an exponential increase in monitoring and auditing efforts. This will have very real consequences.
Additional costs make it more difficult for companies to compete with those that are not subject to similar regulations. If companies suffer such additional burdens in Europe but not outside of Europe, we will see large-scale relocation and offshoring of production (and the consequential loss of employment in ESG signatory countries).
3. ESG legislation will prevent the least-developed countries from attracting FDI
By a similar logic, ESG legislation risks that the least-developed countries will struggle to succeed in attracting meaningful volumes of FDI.
From an investor’s perspective, FDI is a risky business. In the current precarious and protectionist economic climate it already is less attractive to invest in these countries (this is before rising labour costs in such locations are taken into account). Add heavy legal and reputational risks owing to ESG legislation, and companies quite naturally will seek to limit their risk exposure.
Suppliers from, or FDI projects in, Norway and Switzerland will presumably be seen as less risky than those in countries such as Nigeria and Sudan, where the follow-up of individual actors in supply chains and delving into oversight risks is bound to be more complex than in countries that the investor is more familiar with. One can hardly blame the business community – as this is what is asked of them. Many countries in the Middle East and Africa discriminate against homosexuals. Zimbabwe, the country with the biggest lithium deposits in Africa, is ranked 157 out of 180 in the Corruption Perception Index. So, the logical, even necessary step would be to drop them off the list of potential FDI locations. That way, FDI flows going towards the least-developed countries will dry up even further from the already meagre global share of around 2%. One could argue that the ESG laws will lead to a further concentration of FDI in ‘stable’ and developed countries.
4. SMEs will effectively be squeezed out of GVCs
It is said that SMEs are not (yet) affected by ESG legislation, which is only partly true. While turnover and staff thresholds for ESG legislation ensure that such legislation is, for the most part, currently not directly applicable to SMEs, they are nonetheless indirectly affected as participants within GVCs. With this legislation bringing greater complexity to the operations of SMEs, such companies may shorten their supply chains and try to focus on a smaller number of larger suppliers to limit their auditing requirements. Lowering of thresholds over time will only exacerbate this problem.
Indirectly, SMEs will increasingly be affected by these acts. Take a small fashion retailer. How are they supposed to ensure compliance to ESG regulations on every cotton field in China, India or Pakistan that they are connected with, and every dying plant or sowing shop in Bangladesh, not to mention regularly checking the working hours of the lorry driver bringing their T-shirt stocks back to Europe?
5. ESG legislation will put products and services out of reach of a large section of the population
This will result in not only the small fashion retailer disappearing but also the low-cost T-shirts. One might applaud the end of fast fashion, but this is a luxury only afforded to the elites, and increasingly in many Western societies there is a growing share of the population struggling to make ends meet and thus reliant on cheaper products. Artificially increasing the cost of goods under the banner of global justice will result in a larger and larger share of goods being out of reach for the poorest 40–50% of Western populations. When it comes to basic goods, such as the simple T-shirt, this is hard to defend.
The repercussions here are massive. ESG will hit many, if not most, product groups; chocolate is way too problematic due to the sourcing of cocoa butter; EVs, as mentioned above, are out of reach due to the way in which lithium and cobalt are mined.
In the medium term, producers will re-orientate themselves towards customers who are less picky and morally driven than Westerners, eventually depriving the West of many product categories.
So how to pursue ESG goals?
In spite of the identified issues listed above, the underlying aims of the pieces of legislation related to ESG are laudable and well worth pursuing. So the focus must be on inserting more fairness into international dealings in a more practical way for companies.
Solutions stem in part from technical measures and already available databases, but also from adjusting current ESG legislation to accommodate corporate needs. This can be done in the following five ways.
- Current supply chain laws are nebulous and need more specific interpretations of applicable rules
- ESG signatory countries will need a supply chain law/ESG border adjustment tax
- There must be exceptions or transition periods for a small number of critical raw materials
- Tools must be made available to facilitate supply chain monitoring
- Legal proceedings must be limited to serious cases to avoid exorbitant claims.
1. Current supply chain laws are nebulous and need more specific interpretation of applicable rules
National supply chain laws such as the German LkSG are highly ambiguous. To make it workable, regulators need to clarify the law’s requirements; for instance, by issuing guidance materials to help companies understand how to comply with the law.
2. ESG signatory countries will need a supply chain law/ESG border adjustment tax
The principle of a carbon border adjustment tax (CBAM) could be applied to protect European and North American companies from a loss of their competitive position resulting from these ESG and supply chain laws.
Companies in countries that are not subject to the supply chain laws (and consequently the additional costs resulting thereof) can produce at lower costs, out-competing European and US companies in the global market. This uneven playing field for companies would then invariably lead to them shifting production out of jurisdictions that impose onerous supply chain laws.
One potential solution to this issue could be a mechanism similar to the CBAM, ensuring that imported products meet the same human rights and environmental standards as domestically produced products, or charging a surcharge equivalent to the monetary value of operating beyond these rules (which could then be used to support developmental projects).
However, devising a CBAM-like mechanism to balance the effects of the ESG and supply chain law would be even more complex than for carbon emissions, and would potentially lead to legal and political challenges, as well as accusations of protectionism. To not apply such a mechanism, however, risks deindustrialising Europe.
3. There must be exceptions or transition periods for a small number of critical raw materials
The DRC is one of the largest producers of cobalt in the world (producing more than three-times as much cobalt as the next ten biggest supply countries combined). However, cobalt mining in the DRC has been associated with serious human rights violations, child labour, forced labour and dangerous working conditions. The way in which supply chain laws stand at the moment means that companies can’t import cobalt from the DRC without the risk of being sued.
However, with demand rising by an order of magnitude over the next few years, this will leave the world, and in particular Europe, unable to produce batteries for electro-mobility. Potential solutions, even if entirely inadequate to produce even a fraction of the needed raw materials, could be boiled down to the following.
- An attempt to diversify sources of cobalt to other countries. While Australia and Canada are potential alternatives, their respective 5,900 metric tonnes (t) and 3,900t are negligible compared with the DRC’s 130,000t and are far from being a realistic replacement.
- Attempting to improve working conditions in the DRC. However, to really address human rights violations and eliminate child labour, ownership stakes might be necessary to ensure relevant actions. Not least on account of ESG regulations and the focus on the mining industry, Western investment in the DRC is at a historic low.
- Investing heavily in research and development to develop alternative technologies such as batteries using less cobalt (for example, the European-favoured nickel-based battery chemistry). However, this will only lead to a different set of countries having the same conundrum.
- Attempting to solve the problem by increased recycling of cobalt won’t be a realistic option given the exponential growth, as well as the lifetime, of batteries.
If we intend to continue with the shift from internal combustion engines to EVs, it is hard to see a solution short of exceptions for raw materials or longer lead-in periods for the legislation to become binding.
4. Tools must be made available to facilitate supply chain monitoring
There are a number of data tools that can help with the practical implementation of supply chain laws, such as Moody’s ESG ratings and Altana‘s supplier tracking. Both tools can help improve practical implementation for companies with the data and insights needed to complete the required risk assessments.
Apart from Altana’s supplier tracking tool, there are other solutions such as Sourcemap, a similar supply chain mapping platform. Combined with platforms for ESG ratings, companies can identify high-risk suppliers. Moody’s ESG ratings show a supplier’s risk of child labour or environmental violations. Similar solutions are offered by Sustainalytics or EcoVadis. With this information, companies can take steps to mitigate ESG-related risks. Given that nation states are simply shedding the responsibility for ESG compliance to companies, it might not be unreasonable to suggest the provision of some basic version of these tools, as they can help companies comply with supply chain laws and promote ethical and sustainable supply chain management, as a free-of-charge base version.
5. Legal proceedings must be limited to serious cases to avoid exorbitant claims
Some supply chain laws have (and in some countries discussions lean towards) a reverse burden of proof. This cancels the legal principle of innocent until proven guilty, as the burden of proof is shifted from the plaintiff to the defendant. However, with companies having to prove their innocence, rather than NGOs or individuals having to prove the defendant’s guilt, this opens the door to excessive and frivolous litigation by NGOs.
This leads to unfair outcomes, as companies might end up having to prove a negative, which often is difficult or impossible to do. In that case, ‘innocent’ companies can be hounded out of countries by anti-capitalist agitators based on nothing more than accusations, which will lead to a tidal wave of litigation. It is of course a question of perspective who is ‘innocent’ and who isn’t, but the Dutch ruling against Shell on 26 May 2021 is a watershed in that regard. This led to another 30 multinational companies being targeted. However, with courts decreeing what the right level of carbon reduction is, and some NGOs creating a business model out of suing companies, having one’s headquarters (and principal economic activities) in such a jurisdiction might not make a great deal of business sense anymore.
If governments want to ensure that NGOs or individuals can take large corporations to court, they can, under certain conditions, provide funding for legal aid under the traditional legal procedures (where the accusers have to bring proof for their accusations). Governments should also improve and clarify the frameworks and rules under which NGOs can bring legal action.
To avoid the creation of a litigious climate, the easiest and maybe most straightforward approach for a government might be the creation of a negative list – outlining all those actors that have been proven wrong on ESG matters (or the opposite, ‘white lists’, naming all companies that are safe to trade with). By using a system of “actors that are good to trade”, the business community would gain operational safety while the spirit of the ESG principles is being adhered to.
In conclusion, and linked to this last point, it is hard not to detect a degree of disingenuousness by governments in simply shifting the burden of enforcing ESG rules and obligations to the business community, having failed to succeed in this field themselves, especially given that enforcing agreements on human rights is the prerogative of nation states rather than private actors. There is disingenuousness in bewailing the rise of restrictive investment measures and protectionism, while at the same time passing laws that result in uncontrollable legal consequences for companies.
Most important, however, is the way in which such pieces of legislation are forced through the system. In the case of the LkSG in Germany, the ministerial draft was open to public scrutiny and civic engagement for a full six-and-a-half hours. While lobby groups had (quite naturally) vastly differing perspectives on the text, virtually all – from Transparency International, to Friends of the Earth, to the Association of German Industry – commented on it, making engagement with the legislative process a farce.
Similarly European public affairs veteran Daniel Guéguen wrote: “The European Commission’s sustainable finance taxonomy bears all the hallmarks of failed governance: opacity, imprecision and subjectivity with a punitive approach.” This is without taking into account the practical impossibilities of ensuring ‘fair payment’ (a demand far exceeding the claim that supply chain laws merely seek to ensure human rights) of sub-sub-suppliers, given the European data protection legislation.
If we want ESG objectives that are worthy to be pursued and implemented, we need to work together. We need to find a workable compromise that is acceptable for all. And we should stop pushing legislation through at the 11th hour, leading governments to wash their hands of it and be done, simply pushing the responsibility to the corporate sector. The price we will all pay for that will be impossibly high.