Jim Little, Savi Thethi & Raghavendra Rengaswamy
Staying ahead of ESG regulations on a global scale can be a challenge but businesses cannot risk falling behind on supply chain policies.
Two Questions to Ask
What are the challenges global organizations face with ESG compliance and how should it shape the policies of businesses that trade globally?
These requirements will have to involve several departments and teams within an organization. How can this be made more efficient while streamlining cost?
Modern supply chains span the globe in an impossibly complex web, yet one stark image is all it takes to sum up the risks they carry. When the 400m-long cargo ship Ever Given wedged across a narrow stretch of the Suez Canal, its bow and stern “docked” on opposite banks in 2021, it blocked the canal for almost a week, freezing close to US$10b of world trade each day. Together with the ongoing disruption caused by the COVID-19 pandemic, the viral image of the mishap showed that, when it comes to globalized supply chains, plain sailing is not guaranteed.
Companies now have even more reason to be concerned about the smooth flow of their goods. These days, environmental, social and governance (ESG) compliance is putting supply chains under pressure too.
Around the world, governments are introducing measures, from local laws to bilateral and multilateral treaties, that set ever more stringent ESG standards for trade in the name of positive causes – to protect the environment, aid the fight against climate change and improve living conditions for their populations. Companies have to show that the global sourcing, production and distribution of their products stand up to that scrutiny.
All of this creates a complex and fast-moving landscape for any company looking to ship goods across borders. They have to ensure their supply chains meet this panoply of new standards, potentially facing penalties and taxation if they don’t. And they have to track and report their efforts correctly too.
“Consumers are demanding the increasing transparency of supply chains,” says Ilona van den Eijnde, Senior Manager in Global Trade and Sustainability Services at Ernst & Young LLP. “They want to know where their clothes are made, where their food is coming from. Meanwhile, countries are looking for new revenue streams, and to tie that to something that benefits the environment and society. With these demands, authorities are putting ever greater pressure on businesses to provide insight on their global supply chains. And that means greater demands on data collection.”
New Demands Take Many Forms
Those new demands take many forms, even under the ”E” of ESG alone. The Paris Agreement of 2016 enjoyed close to universal participation and has since led authorities around the world to introduce environmental programs of their own.
One prominent example is the European Green Deal Industrial Plan, announced by the EU in January 2023. This comprises a range of ambitious measures, such as reducing the impact of plastics, and tracking and trading carbon. It includes both financial obligations, including the taxation of a range of damaging products and processes, and a slew of reporting requirements.
The Green Deal has the potential to be confusing and resource-heavy for businesses. It also provides a fine illustration of the kind of work companies will be required to complete as global ESG compliance develops. “Companies need to understand how these taxes will be calculated,” says J. Michael Heldebrand, EY Americas and US Global Trade Leader. “Second, are there incentives or credits to help offset some of the tax burden? Third, what’s the impact on the end user of the product? Are they happy to absorb the cost of the tax because they see it as a benefit? Or is it an unfair burden that would impact the value the customer sees in the product and delays the purchase?”
These changes present significant upfront costs, especially when there’s no unified method to how they’re applied. The EU takes a largely harmonized approach to certain taxes, such as VAT, where it sets a common minimum rate, and has made further proposals to simplify registration across the trading bloc. But its new sustainability measures mostly lack harmonization. The EU’s member states are creating their own independent regulations. And beyond the EU, a country-by-country reporting burden, and lack of agreed standards, extends for new environmental measures around the world.
As such, many initiatives will lack a clear business case to support the expenditure, as heavy investment doesn’t bring clear rewards.
“Even those that aspire to be carbon-neutral, minimizing and electrifying their fleets because they believe customers and markets will like it, don’t know whether they’re doing the right thing, simply because the terms haven’t been fully defined at a policy level,” says Jeroen Scholten, EY Global Trade Leader – Indirect Tax; Partner, Indirect Tax, Ernst & Young Belastingadviseurs LLP. “And if it is the right thing to do, they still need to know what they get from it and what their customers get from it.”
Meeting New Compliance Obligations
One of the current key business challenges is ESG compliance. Companies are asking whether they know enough about what happens before the taxable event, and what happens after, in order to fully comprehend the potential impact.
“The ESG compliance responsibility may outweigh what can be a simple tax collection and remittance,” says Heldebrand. “Companies struggle with how to make sure they’re doing it correctly. And there may be penalties for not doing so. Those penalties can rack up quickly when companies don’t understand their obligations.”
Having to maintain such a vigilant watch on global compliance can carry severe implications in terms of strategy, planning and commitments. Many organizations will need to overhaul internal processes to make them more streamlined and transparent. The changing ESG picture may also demand improvements to automation and system capabilities to provide the insight to keep pace with evolving regulation.
While many executives have long-term sustainability goals for their supply chains, few have the visibility, technology, or sufficiently comprehensive programs in place to measure their progress.
“It’s absolutely going to stretch companies,” says Scholten. “In many cases, adding or changing data elements requires significant investments from companies with systems that have either been attuned or closely aligned with existing requirements. That is a huge issue. And while they may have a deluge of data at their disposal, many still struggle to make it useful – for figuring out alternative sourcing. The data is powerful, but it’s still manual in the context of using it to make informed decisions.”
In many cases, adding or changing data elements requires significant investments from companies with systems that have either been attuned or closely aligned with existing requirements.
Achieving Transparency in Supply Chains
Another key challenge of ESG compliance lies in the difficulty of making global supply chains transparent; of being able to track and quantify practices in the first place.
In recent years, a number of jurisdictions, including Canada and the US, have introduced measures to prevent the importation of goods manufactured using forced or child labour. This has seen major global apparel brands have their products held up at the US border until the companies in question can prove the production process was free of forced labour. US customs has since looped forced labour requirements into its trusted trader program (C-TPAT Validation). It means that for everything from coffee to sneakers, companies are required to have a documented social compliance program in place. At a minimum, that means addressing how their overseas partners ensure that the imported goods aren’t mined, produced or manufactured using any forced, imprisoned or indentured labour. It requires detailed risk-based mapping, and the filing of an annual self-assessment.
“The presumption is that your product is made with forced labour – unless you can prove it doesn’t,” says Lynlee Brown, Partner, Global Trade at Ernst & Young LLP. “And that’s very difficult to do. That’s a big challenge, and companies need to be ever vigilant and mindful of it.”
Given the general direction of travel of socially conscious measures, it’s safe to assume other jurisdictions will introduce similar forced labour regulation of their own. This means establishing greater transparency, further in the supply chain than ever before. It’s a hugely collaborative requirement.
“Someone needs to inform departments across the company what documents they need to keep and decide how they’re going to retain for audit purposes,” says Brown. “That pulls in the sustainability team, trade compliance and legal. What can you ask vs. mandate and require of suppliers versus what can you not. Plus, the operations team, to be able to get those documents. None of that is straightforward. Nor can it be templated. It’s different and bespoke for every situation.”
This sparks a further question of responsibility: Who owns ESG, and how should they approach it?
“Should they tackle it like other initiatives such as tax reform or climate sustainability?” asks van den Eijnde. “And where do those roads converge? Trade professionals are struggling with whether they should own it, as a lot of them don’t have the expertise. So, they’re having to ramp up, or having to use external partners to help put everything into perspective and manage the specific risks. There has to be a collective view, but few know where that collective view happens. That’s a serious challenge.”
Constant Evolution in Trade
The EU Green Deal and US forced labour rules are just two examples of new ESG regulations, taxes and standards. It’s safe to say there will be many more. Supply chains have been globalizing for decades, a trend that can’t be quickly reversed. And global trade is evolving all the time, with smartphones opening up more regions of the world to on-demand deliveries of consumer goods. At the same time, even lovers of convenience are demanding fairer and less impactful processes; and with the governments of the world seeking new revenue streams, many will look to link this to measures that benefit the environment and society.
As most companies still lack the knowledge, capacity or appetite to handle this rapidly escalating tax and compliance picture, an experienced third party may be required to offer cross-functional experience, helping to improve planning and manage risk across the spectrum of supply. External service providers can help structure transactions, collect the requisite data across complex value chains, and help improve communication across disparate departments, ensuring everyone’s talking the same ESG language and aligned on ESG KPIs. They can also handle the ongoing work of continuous improvement, looking downstream at not only emerging technologies and trends, but understanding the factors that are driving the current environment and what is likely to change.
The good news is that companies are getting smarter. They are now more agile, flexible and able to anticipate changes to standards and regulations. Many can be more proactive and predictive about what constitutes a taxable event. And as the global construct becomes more complex and interdependent, the cross-functional collaboration required is serving to elevate the role of tax and trade functions within organizations.
“In the last three years, I’ve seen more VPs of global customs than ever before,” says Brown. “Businesses are now much better equipped to adapt to these measures than they were four years ago. They’re better aligned and make better business decisions. From a policy perspective, they’ve become more able to handle these knee-jerk rules because they’ve done it before. Now it’s a case of ‘let’s do it again’, rather than spinning wheels and losing productivity figuring out how to address it.”
This can-do approach is fitting. After all, while ESG measures require a radical overhaul for many businesses, they are ultimately about making better decisions, and creating better practices, for the good of the whole.
“Nobody wants harmful chemicals in the ground or children making garments in apparel factories,” says Brown. “So while it is a major challenge from a company perspective, figuring out who’s going to do what and how to do it, it’s heading in a direction that’s far better for everyone.”
Three steps businesses should take now.
Here are three key steps to help companies navigate the changing ESG trade landscape:
Establish ownership. As ESG is a complicated and multidisciplinary issue, it’s often passed around within organizations like a hot potato. A common approach is to form a multidisciplinary ESG task force, pulling together different teams to react to specific developments. Yet this is a sticking-plaster measure at best. Determining who’s in charge is an important first step.
Understand your supply chain end-to-end. Companies may take for granted that they know their suppliers. Yet the latest ESG standards require a true understanding of what’s happening right up the chain, everywhere in the world. Gain an appreciation of every step of the value chain, from sourcing raw materials and components to landing at the customer’s door. This may mean updating your technology or partnering with the right third-party expertise. Remember: there are often penalties for getting it wrong and incentives for getting it right.
Set yourself up for continuous improvement. ESG is affected by everything from consumer taste and behaviour to new regulations and revenue streams, all of which are changing all the time. While it can be daunting to jump into such an uncertain picture, companies need to act now to avoid falling foul of evolving expectations. That means establishing a long-term, holistic view of your organization and the operating environment, and this may mean seeking external assistance.
Jim Little is EY Global Microsoft Alliance Lead and EY Americas Technology Strategy Lead
Savi Thethi is EY Americas Consulting Services Technology Transformation Leader
Raghavendra Rengaswamy is EY Global Delivery Services Data & Analytics Leader