July 13th, 2022
The Challenges of Supply chain Regulation
European efforts to police global supply chains are likely to be limited in their effectiveness while jeopardizing economic development.
The increasing complexity of global supply chains has raised concerns that some companies, taking advantage of opaque interactions with their suppliers, are indirectly abusing human rights or harming the environment. In the area of corporate governance and “soft law,” attempts have already been made to introduce more due diligence into firms’ decision-making. But recent “hard law” initiatives have gone further, especially in European countries and at the level of the European Union. Such efforts, however worthy of their goals, face significant challenges.
Made in the world
Efforts to liberalize trade – such as the multilateral General Agreement on Tariffs and Trade (1947) and the World Trade Organization (1995), as well as bilateral or regional agreements, such as ASEAN, ECOWAS, NAFTA and the European Union – have enabled the rise of international trade since the 1950s and its intensification since the 1990s. The trend has been accompanied by an increase in international investment. Both developments led to the internationalization of production through the globalization of supply chains.
Most products are effectively made all over the world, relying on myriad production stages at different subsidiaries in various countries. Components are produced in one location and assembled in another – and the same goes for the components of the components, and so on. Global supply chains have become an intricate, almost endless network of trade and production, making the economic interactions of our world much more complex.
The economic rationale for both international trade and investment is based on comparative or competitive advantages. Countries can specialize in this or that role in the globalized value chain, leaning on their natural resources, research infrastructure, labor (specialized or inexpensive), or some key location for trade. Firms also decide to invest in various locations depending on those advantages.
There is little doubt that these efforts have contributed immensely to world development. The integration of entire countries into the economic concert of nations has pulled hundreds of millions out of poverty in less than two generations, which is simply staggering at the scale of human history. The economic rise of countries like the Asian Tigers (Hong Kong, Singapore, South Korea, Taiwan) and, more recently, China is a testament to that achievement.
Despite the good results, many resent the process, as it can sometimes lead to human rights abuses (underpaid jobs, excessive overtime, land grabs, child labor, forced or slave labor) and degradation of the environment (pollution, overexploitation of natural resources). Global companies can take advantage, directly or indirectly, of weaker regulatory environments both for labor and environmental standards, thereby reducing their costs or lead times. This enables them to lower their prices for final consumers and/or increase their profits, to the detriment of the environment and the rights of locals.
An example of such cases is the Rana Plaza Building accident in Dhaka, Bangladesh, in April 2013, in which 1,134 died. Although cracks had been detected in the structure, laborers at the garment factory located in the building were ordered to go back to work, with the weight leading to the structure’s collapse. The factory was a supplier to several major brands in the clothing industry.
The fate of Muslim-Chinese Uighur, Kazakh and Kyrgyz ethnic groups in the Xinjiang province of China is another illustration of the problem. The so-called “Xinjiang Aid” policy of the Chinese central government has been suspected by Western organizations and governments as a means of “reeducating” citizens from those minorities in camps, and then forcing them to work in factories. Several top brands in the textile, electronics, and automobile industries may directly or indirectly use such labor.
Another serious concern is the use of forced labor and forced child labor in parts of Africa. Trade in so-called “blood diamonds” is a classic example, while the mining of “conflict minerals” has also emerged in lawless places such as North Kivu, in the Democratic Republic of Congo, where armed groups terrorize populations and force them to work in mines. The minerals that are produced, such as tantalum, tin or tungsten, are found in the semiconductors and circuits of everyday electronic devices, like mobile phones.
Finally, environmental damage can include the overexploitation of resources, such as overfishing, or deforestation in the wood and agricultural industries, leading to a rapid depletion of biodiversity. Deforestation can also come with land grabs, depriving indigenous people who lack formal property titles to ancestral land. Pollution ranges from oil spills and unfiltered smoke to improper waste disposal and CO2 emissions. These can have direct effects on human health, such as silicosis among miners.
From soft to hard law
The complexity of supply chains and corporate structures, coupled with weak or absent rule of law in many countries, can allow global businesses to avoid responsibility for what is happening in those supply chains. However, banning all trade with suppliers from such risky places would prove unpractical, as well as seriously compromise a source of economic development for millions.
The challenge is thus to find some kind of balanced approach. Two options are available, both presenting difficulties: The first is “soft law,” with guidelines, and the second is straightforward regulation with mandatory due diligence mechanisms.
Regarding the soft law approach, in 2011, the United Nations issued its Guiding Principles on Business and Human Rights. The Organisation for Economic Co-operation and Development (OECD) first published what was then called the Guidelines for Multinational Enterprises back in 1976, updating them a fifth time in 2011.
Also illustrative was the Accord on Fire and Building Safety, struck in 2013 after the Rana Plaza tragedy in Bangladesh between some global brands and retailers, and replaced in 2021 by the International Accord for Health and Safety in the Textile and Garment Industry. Both were legally binding, although some major brands have not yet signed.
Conventional wisdom increasingly holds that voluntary due diligence is not enough, and that hard law is required. Various initiatives with different scopes have emerged; the United Kingdom, for instance, passed the Modern Slavery Act in 2015 to ban all types of slavery. The United States’ Uyghur Forced Labor Prevention Act, passed in December 2021, bans imports from China’s Xinjiang region unless companies can prove with “clear and convincing evidence” that components were not produced with forced labor. Less specific, more comprehensive due diligence regulations have been passed in France, with the 2017 “Loi de vigilance,” and in Germany with 2021’s “Initiative Lieferkettengesetz” (to be enforced in 2023).
The EU is following suit, with a proposed Corporate Sustainability Due Diligence Directive presented by the European Commission in February 2022. The core idea is that “companies identify, assess and prioritize human rights and environmental risks” in their supply chain, in order to “prevent and mitigate” those risks.
An EU law would supposedly avoid fragmentation and “[level] the playing field” in the single market, thus reducing legal uncertainty, clarifying duties and reinforcing accountability. To some extent, the EU proposal draws its influence from the aforementioned French and, especially, German laws, also sharing some of their limitations. The proposed EU legislation could ultimately be too lax to be effective (from the point of view of human rights organizations) or too costly to be realistic (as the business community sees it).
One criticism from human rights activists is that according to the EU proposal, due diligence duties (as well as civil liability) are limited in scope to established supply chain relationships. This means, for instance, that human rights violations could continue for nonestablished, more informal, short-term relationships. Worse, this could give global companies the incentive to rely mostly on such nonestablished relationships in their supply chain. This would mean the project focuses on those risks companies can easily identify, rather than the effective severity of risks taken by workers (or harm to the environment) in total supply chains.
Secondly, businesses covered by the regulation will be limited to entities in textile, agriculture and mineral extraction. SMEs would be exempt: it will only reach those considered very large (more than 500 employees and a net worldwide turnover of 150 million euros for EU companies, or of 150 million euros in the EU for non-European companies active there); or large (at least 250 employees and a worldwide turnover of 40 million euros for EU companies, or 40 million euros in the EU for non-European companies). Some estimate those covered to represent only 1 percent of all European firms.
Activists’ third criticism is that the draft seems to largely open the door to contractual assurances and external audits, which could make it easier for companies to shift their responsibilities, while increasing their costs. Fourth, human rights organizations fear that affected or potentially affected stakeholders will not be given the proper role in the process of evaluating risks or harm. Some insist, for example, that workers’ councils in the manner of the German model should be introduced.
Finally, the directive’s civil liability portion would excessively place the burden of proof (to show a breach of duties and a causal link with harm) on affected parties, usually poor workers. Human rights advocates think companies should still face possible liability even when due diligence has been respected.
The second group of observers is skeptical about the proposed EU regulation from a different perspective. To be sure, they recognize the stakes at hand involving human rights and environmental protections; and they understand the limitations of concurrent national due diligence policies, which end up creating trade barrier asymmetries and competition distortion in the Single European Market. But they insist that the legislation also has costs, as is too often forgotten when trying to do good through regulation.
They emphasize the degree of complexity in even an apparently basic supply chain. Just three levels of suppliers for a company, and a hypothetical 10 suppliers at each stage, means more than a thousand companies to oversee. Even if only 1 percent of companies are the regulation’s primary target, in reality, all of their suppliers – both within the EU and beyond – must be included as secondary targets for due diligence. No wonder the process imposes compliance costs to businesses so high that they are incentivized to stop contracting in problematic places.
Further, the EU is an important source of exports and investment for a lot of emerging economies. The corresponding cost for developing countries would be the effects of the deglobalization process initiated by the legislation. Those emerging economies would see jobs flee, increasing poverty rates.
According to a survey by the Institute of German Economy (IDW), the German supply chain law has seen nearly one-fifth of German companies now planning to contract only with suppliers in countries with greater human rights, labor and environmental standards. In another IDW study, on the French case, researchers found that the regulation is associated with lower levels of trade, especially in developing countries and former French colonies.
While some governments will strive to improve their policies to retain foreign economic ties, others simply will not, and will lose investments. Global companies, while undeniably taking advantage of the local regulatory environment, are in fact mostly contributing to its improvement: they offer higher wages and increase work and safety standards. And, because by raising per capita incomes they directly impact development, they indirectly stimulate the “social demands” that go with it, like reducing corruption. Seeing the exit of global investment because of costly due diligence regulations would deliver a slowdown of the “catch-up” process.
While law (or regulation) is supposed to clarify rights, duties and responsibilities in human interactions, some legal experts believe a major limitation of the proposed EU text lies in its legal ambiguity. Part of the ambiguity is supposedly set aside to be dealt with when national legislatures adapt the European directive. But this then defeats the purpose of harmonizing European regulation and “leveling the playing field,” which might create distortions in competition.
Moreover, the outcome of due diligence assumes an “obligation of results.” However, the text focuses on “obligations of means” (with compliance processes, risk management, and so on) – representing another dose of uncertainty, which is bad for businesses’ legal planning.
While the regulation initially only applies to “big” companies, it de facto affects the SMEs in their supply chain, within and outside the EU. Some worry that it would be too complex and costly for businesses, ultimately leading to adverse effects on development.
The views expressed on austriancenter.com are not necessarily those of the Austrian Economics Center.
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