In-House Insights: ESG Compliance in Developing Countries - Challenges and Opportunities for Companies

As the world becomes more aware of the impact of corporate actions on the environment and society, investors and regulators are placing increasing pressure on companies to adhere to Environmental, Social, and Governance (ESG) practices. ESG practices, which include measures such as reducing carbon emissions, promoting diversity and inclusion, and ensuring ethical business practices, have traditionally been viewed as a "nice to have" for companies. However, in recent years, there has been a significant shift in the corporate world as ESG practices are becoming a "must" for companies in order to secure investments and avoid penalties. This article will explore how specific regulatory trends, such as the German Supply Chain Act (Lieferkettengesetz)  which entered into force starting this 2023, are mandating ESG compliance and examine the challenges and opportunities that companies in developing countries face in implementing these practices. We will also look at how the corporate world is adapting to these new requirements and the potential long-term benefits for both the companies and society as a whole.

ESG as a concept has its roots in the socially responsible investing (SRI) movement of the 1960s and 1970s. SRI intended to align financial returns with social and environmental values; whereas the early SRI movement focused primarily on screening out "sin" stocks, such as tobacco and weapons manufacturers, and investing in companies with positive social and environmental impact; the concept broadened to include a wider range of environmental and social issues, such as labor standards, human rights,  diversity and inclusion. ESG grew out of such a concept and recently has gained even more attention as investors and regulators have begun to recognize the financial risks and opportunities associated with these non-financial aspects.

In this regard, the Paris Agreement on climate change, adopted in 2015, raised awareness of the need to address climate risks and opportunities. Additionally, the growing awareness of the impact of corporate actions on society and the environment has led to increased pressure on companies to be more transparent and accountable. This awareness is reshaping the paradigm of investment and financial flows where financial aspects are weighed along with environmental, social, and governance aspects. Initially, ESG was considered a "hot topic" that companies embraced electively to follow the trend; however, today ESG is considered a key aspect of risk management and long-term value creation. Many investors now include ESG considerations in their investment decision-making process, and businesses are increasingly being held accountable for their performance in these areas.

Considering the newly acquired relevance of ESG, firms are focusing their strategies on implementing ESG policies to attain financial and reputational rewards offered by sustainability-aware investors and consumers. Nonetheless, this has brought corporate pretenders that claim to follow ESG principles with the mere purpose of boosting their profitability, but in reality, they are cutting corners to deceive investors and consumers while not truly implementing an ESG strategy, which requires planning and in-depth corporate transformation. This induced illusion has been called "greenwashing" or "color washing," and is one of the main reasons that prompted the regulatory efforts of governments to assess the compliance of ESG in companies accurately and transparently.

The development of ESG-related regulations in the past decade has been abundant, mainly focusing on the European Union. The European Union Non-Financial Reporting Directive (NFRD) (Directive (EU) 2014/95) to be replaced by the Corporate Sustainability Reporting Directive (CSRD) (Directive (EU) 2022/2464) became a hallmark in the regulatory sphere as it enforced the disclosure by certain large corporations of information related to environmental, social and employee-related, human rights, and anti-corruption and bribery matters. This increased corporate accountability that led to increased pressure on companies to improve their performance in these areas and to address any potential risks or negative impacts. Similarly, the Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088) introduces rules for financial market participants and financial advisers to report on how they account for sustainability risks, specifically relevant for the assessment of ESG-related products offered by such financial market participants. The EU Taxonomy Regulation (Regulation (EU) 2020/852) introduced a crucial classification framework to determine if an economic activity is truly sustainable and thus is intended to be observed by existing and future regulations.

These regulations are unquestionably significant in further developing ESG principles and assessing their penetration in the corporate world in Europe. However, how can countries in the developed world transpose these standards to the developing world? This aspect is especially relevant in a globalized economy with supply chains that transcend frontiers. In the past decades, well-known global corporations have suffered from severe reputational damage due to environmental and humanitarian disasters along their supply chain (e.g. the Rana Plaza Factory Collapse).

In this regard, countries such as France with its Duty of Vigilance Law ("Loi sur le devoir de vigilance des sociétés mères et des entreprises donneuses d’ordre") (2017) and the Netherlands with its Child Labor Due Diligence Law ("Wet Zorgplicht Kinderarbeid") (2019) introduced regulatory efforts on a local level to enforce preventive measures throughout their supply chain. Nonetheless, the German Supply Chain Act, which entered into force at the beginning of this year, went above and beyond, threatening firms with a fine of up to 2% of their global turnover if they fail to identify, assess, prevent, and remedy human rights and environmental impacts in their supply chains. This national regulation will certainly have an impact globally, as companies throughout the supply chain of German corporations will need to step up and comply with ESG-related principles in their process as a condition to remain competitive. In the same vein, a European Union Supply Chain Due Diligence Directive is in the pipeline, which would proliferate supply chain compliance by incorporating these constraints into the national laws of all EU Member States. In a similar fashion but in the American continent, Canada is on the verge of enacting the Fighting Against Forced Labour and Child Labour in Supply Chains Act ("Bill S-211"),, which intends to amend Canada’s customs tariffs to prohibit the import of goods mined, manufactured, or produced wholly or in part by forced or child labor.
As evidenced, regulations to enforce ESG should not be considered a temporary trend, but are here to stay. This poses a challenge for countries and companies along the supply chain, as competitiveness will cease to focus solely on cost or quality capabilities and will value robust compliance with environmental and social issues, such as labor standards, human rights, and diversity and inclusion. Therefore, governments and firms might recognize this as an opportunity to improve their legislation or internal processes in order to stand out among their competitors in these new market conditions.

On a business level, companies must establish a strategy that requires a long-term commitment and an integrated approach across the entire organization. An ESG strategy involves (i) assessing the company’s current performance to properly understand the depth of the the action plan, (ii) setting clear targets, (iii) developing clear milestones or goals, (iv) implementing and monitoring progress with the use of KPIs, (v) communicating and reporting information to relevant stakeholders, and (vi) recognizing ESG as a journey, not a destination itself, as the concept (as well as regulatory mandates) are constantly evolving.

Governments may play a significant role in promoting and facilitating the implementation of ESG strategies through regulatory policies and initiatives. Countries with robust legal frameworks and strong enforcement of ESG standards are already in a great position to work with local companies to seize these market opportunities and incentivize the development of ESG initiatives locally.

In conclusion, ESG has evolved from being a trendy and "nice to have" practice to a "must", increasingly becoming enforceable by regulators. The new rules in the developed world intend to have a global reach, and therefore, countries and companies in the developing world will be forced to shift their competitiveness strategy from cost-effective operations to ESG-abiding practices. The implementation of ESG standards requires a long-term commitment and comprehensive approach from companies, where continuous monitoring is essential. Governments may participate as key stakeholders by giving incentives and providing a strong legal framework that allows companies to seize this opportunity granted by new market conditions.