The burden of ESG compliance on third parties located in developing countries and ultimately the company utilizing them can be great. Supplier businesses that attempt to operate sustainably can be at an economic disadvantage if they can’t produce a product as cheaply as those that don’t. In many areas, they lack governmental regulation or the sociopolitical factors necessary for enforcing ESG compliance. Smaller enterprises may not have an ESG disclosure framework or may not understand how to apply one in their situation.
Now, the impending economic downturn will increase the ESG burden for these companies in at least three ways. Global recession will threaten developing nations, supply chains and corporate ESG efforts, threats that Ethixbase will investigate in future articles:
- Historically, the impact of global recession on emerging economies has been brutal: expensive imports, declining GDP and export revenues, and the lack of foreign direct investment can result in debt crisis. High inflation, interest rates and unemployment are exacerbated by a weakening currency.
- In a recession, supply chains everywhere can anticipate high inventory and decreased demand, which will lower prices and cut into profitability throughout a product pipeline.
- The demand for suppliers to reduce costs and use low-cost resources may collide with a clients’ renewed efforts to develop sustainable practices for mitigating the financial impact of a recession.
Supplier Engagement for Long-Term Benefit
Companies source suppliers in developing countries primarily because the economic opportunities offer them a competitive edge. But retaining the same advantages in a recession may exacerbate practices that violate ESG principles – principles that will continue to be demanded by shareholders, customers, and investors and subjected to increased governmental regulations in developed nations such as Australia, the United Kingdom, and Germany.
or ESG risks?
Workforce and human rights abuses, forced labor, and inhumane working conditions
Natural resources, rare mineral and other raw material availability
Natural resource depletion, conflict materials, mining of rare earth elements including copper, lithium, nickel, cobalt, graphite, and magnesium
Lax environmental regulation
Environmental damage and greenhouse gas emissions
For corporations that help high-risk suppliers meet ESG standards in the current economic environment, there are long-term financial benefits in addition to retaining CSR. Assisting high-risk suppliers fosters sustainability in the local economies and could offer greater economic opportunity as they continue to improve their ESG compliance and attract foreign investor interest. If a recession occurs, emerging markets can offer opportunities for growth when investment is limited in mature economies.
If companies need a roadmap for ESG guidance in developing countries, they can look to one of the pillars of ESG itself. The Paris Agreement of 2015 contends with parallel issues by promoting climate equity and capacity building and stating that developing countries should “address climate change in accordance with their…social and economic conditions.” Since developing countries are more affected by climate change, highly developed countries are encouraged to invest in the sustainability of countries with less resources.
Investment firms and ratings agencies also confront the same issues. These firms adopted ESG standards to guide responsible business investment, requiring public corporations to follow suit. The sector also attempted to apply these standards to foreign direct investment in developing economies, but Moody’s reported that 60% of emerging market credit ratings are negatively affected by ESG factors, such as the production of greenhouse emissions, social unrest and the credibility of governments. If a developing country is less stable, less transparent and weaker in ESG compliance, investors are more reluctant to invest due to perceptions of heightened risks. In particular, the ESG reporting weaknesses that limit investment include vague or unstandardized criteria, lack of client-adjusted criteria, and weak confidence in reporting.
To resolve this dilemma, governments can regulate the financial industry to encourage investors to finance projects in developing countries, such as the UN Sustainable Stock Exchanges Initiative attempts to do. For their part, investors can accept disclosures that meet local best practices instead of the standards of developed countries, and by taking into account the different needs of emerging markets.
Tactical Steps for Cultivating Compliance
Similar measures can be adopted at the corporate level to balance expectations and abilities:
- Accept disclosures that meet local best practices instead of imposing a company’s own standards.
- Evaluate third parties for their specific resilience to environmental and social risks.
- Utilize a customized reporting process that considers existing ESG efforts and specific challenges.
- Recognize that suppliers may not be able to fully mitigate ESG problems immediately but aim for a high level of due diligence in the long term.
- Work with suppliers to develop an incremental program that measures improvement and rate of change.
- Develop a forward-looking analysis and maintain ongoing engagement with suppliers.
In addition to these efforts to enhance supplier compliance, companies can consider paying more for a product while educating all stakeholders about the value of this strategy. Recession or not, consumers may need to accept that complying with ESG principles could result in increased costs for products, just as they accepted the increased cost of organic produce or fair-trade coffee.
The Ethixbase Solution
Ethixbase offers an integrated robust platform that can manages risk in ESG “gray areas.” Less mature companies in high-risk countries require enhanced due diligence and a program tailored for their risk exposure. With Ethixbase’s configurable and scalable architecture, ESG risk exposure is customized by region and specific ESG concerns.
Working with a multilingual team, NGOs, and partners across the globe, Ethixbase identifies the human rights, environment, and social issues affecting third parties in developing countries. The platform enables companies to engage with suppliers to improve compliance training and reporting capabilities while monitoring and tracking progress over time.