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'Outsourcing' ESG: How mandatory disclosure is affecting supply chains

Firms exploit their suppliers' weak corporate information environment to cope with the reputational costs associated with mandatory ESG disclosure

Published: May 8, 2024 11:56:08 AM IST
Updated: May 8, 2024 11:57:30 AM IST

'Outsourcing' ESG: How mandatory disclosure is affecting supply chainsImage: Shutterstock

Heightened awareness around environmental, social and governance (ESG) issues has led to enhanced demand for ESG-related information from companies and resulted in the passage of mandatory disclosures in numerous countries. Whereas previous research has looked at how mandatory ESG disclosure impacts a firm’s valuation and profitability, we felt that it might also be creating incentives for firms make particular operational decisions with respect to their supply chain.

Put simply, we felt that some firms might be changing suppliers based on the disclosure requirements in their own country and/or the rules in the supplier’s country.

For decades, multinational corporations have adopted global outsourcing strategies to minimize production costs and optimize profit margins—sometimes at the expense of human rights. Nike, for example, was accused of unethical sourcing practices in the 1990s and 2000s when they subcontracted production to Southeast Asian countries with poor working conditions to save on labour costs. Such pressures were fueled by higher production costs in Korean and Taiwanese factories, where Nike’s supplier factories had previously been based.  

Whereas rising prices constituted the main driver for Nike’s supply chain reconfiguration, we posited that reputational costs associated with the passage of mandatory ESG disclosure requirements may result in similar supply chain effects.

Disclosure of ESG-related information consists of published details on corporate strategy and internal business processes that can entail significant compliance costs for firms. Due to heightened awareness about ESG issues by the investment community, mandatory disclosure can induce reputational incentives to ‘compete’ on ESG performance. This is particularly the case in light of the documented positive capital market effects associated with the disclosure of voluntary ESG information.

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Whereas the reputational benefits associated with mandatory disclosure may incentivize firms to make real investments at existing supplier firms (to adhere with ESG standards), the benefits of doing so are only likely to materialize in the long-term. Adjusting the firm’s supply chain configuration comprises a more immediate strategy to meet the higher standards imposed by mandatory disclosure. We set out to test our hypotheses.

Our Research

We analyzed the supply chain data of 22,890 global firms from the FactSet database, spanning from 2003 to 2021. After identifying the year in which mandatory disclosure was introduced in different countries, we examined subsequent changes in firms’ global supply chain composition.
We distinguished between suppliers located in countries with or without mandatory disclosure. The intuition was that focal firms can more likely ‘hide’ their ESG-obligations when suppliers are located in countries without mandatory disclosure.

We felt that a poorer corporate information environment around ESG at supplier firms would allow for a higher likelihood of concealment of customer firms’ adverse ESG activities.

We were looking for two particular supply chain management practices. First, firms concealing their adverse ESG activities by expanding their supplier network and adding new suppliers from countries with weaker ESG-related corporate information environments. Second, firms concealing their adverse ESG activities by switching from existing suppliers to new suppliers from such countries with weaker ESG-related corporate information environments.

Our Findings

As expected, the introduction of mandatory ESG disclosure in jurisdictions where the focal firm was located was indeed associated adjustments in their supply chain composition to benefit from suppliers with more opaque ESG standards.

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After the introduction of mandatory disclosure, firms notably reduced their existing relationship with suppliers in the same country and established new relationships with suppliers from countries without mandatory ESG disclosure.

Collectively, our findings highlight a real effect of mandating ESG reporting in individual jurisdictions. Due to complex global supply chain configurations, firms located in areas with enhanced disclosure requirements are migrating their ESG responsibilities to their suppliers where such activities are more likely to be concealed.

We also explored the role of external governance mechanisms that may mitigate firms’ incentives to adjust their supply chain composition following the introduction of mandatory disclosure. We considered three external factors that have been shown to influence firms’ practices.

Regulatory enforcement. To examine the role of enforcement strength, we used the rule of law index that captures the extent to which agents in a country have confidence in and abide by the rules of society. Prior research suggests that enforcement strength by regulatory bodies can significantly impact corporate governance oversight. Accordingly, we expected that firms’ propensity to evade and/or hide ESG-related obligations to their suppliers would be less pronounced when firms are subject to stronger legal enforcement.

FINDING: Supply chain migration activities are concentrated in firms in countries with a higher degree of law enforcement.

Also read: Investing responsibly: ESG and the well-intentioned investor

Analysts. Research suggests that analyst following can serve as effective external ‘monitor’, mitigating agency problems between firm insiders and outsiders. For example, higher analyst coverage is associated with fewer earnings-management activities and stock crash risks. We expected to find that firms’ propensity to evade and/or outsource ESG-related obligations to their suppliers following mandatory disclosure would be less pronounced in firms with greater analyst coverage.

FINDING: In response to the introduction of mandatory ESG disclosure in a country, firms with higher analyst coverage were indeed less likely to choose new suppliers from countries without mandatory ESG disclosure.

Presence of institutional investors. Institutional ownership is positively associated with management conservatism, corporate governance and innovation. Recent years have seen an increasing demand for sustainability principles in asset management by institutional investors. For example, in 2020, the US Forum for Sustainable and Responsible Investment (USSIF) reported US$16.6 trillion of assets under management according to sustainable and responsible investment principles with significant representation by institutional investors. This constitutes an increase of more than 8x since 2003, the beginning of our sample period.

Accordingly, we expected that the likelihood for firms to engage in unethical supply chain activities in response to mandatory disclosure would be less pronounced for firms with higher institutional ownership.

FINDING: Compared to firms with lower institutional ownership, firms with higher institutional ownership were indeed less likely to reduce the number of new suppliers from home countries in response to mandatory disclosure.  Collectively, our results corroborate the role of financial intermediaries as ‘external monitors.’

Finally, we examined other possible effects following the introduction of mandatory ESG disclosure. First, we explored whether and how such disclosure is associated with reported ESG performance. Specifically, we looked at the number of reported ESG incidents and found that the introduction of mandatory disclosure is associated with an overall decline in the number of reported ESG incidents—that is, an improved ESG profile.

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Moreover, we found that the effect of an improved ESG profile following the introduction of mandatory disclosure was primarily driven by firms that engaged in supply chain migration activities in the three years following the introduction of the mandate. This suggests that firms’ supply chain management strategies were successful in attaining an improved ESG profile.

Second, we explored whether and how mandatory disclosure is associated with changes in firms’ cost structure. A potential explanation for observing changes in the global supply chain composition may be that it is simply driven by rising production costs such that firms have incentives to relocate to relatively underdeveloped countries.

Whereas we found an overall increase in production costs following the introduction of mandatory disclosure, we did not find evidence that these increases led to significant differences between firms with and without engagement in supply chain migration activities in the three years following the introduction of mandated disclosure. This finding corroborates that the changes in supply chain composition in response to mandatory disclosure may not be entirely driven by cost-based motives, but based on reputational incentives to conceal adverse ESG-related activities.

Key Takeaways

Following the introduction of mandatory ESG disclosure, a portion of firms ‘evaded’ their ESG-related supply chain activities by switching to suppliers where the ESG-related corporate information environment was weaker. In contrast, we did not find any evidence of a change to suppliers with stronger corporate information environments. These findings confirm that stronger standards at supplier firms may comprise a burden in light of elevated disclosure standards. Specifically, firms selected a higher number of new suppliers from countries without mandatory ESG disclosure. Overall, our findings suggest that firms exploit their suppliers’ weak corporate information environment to cope with the reputational costs associated with mandatory ESG disclosure.

Also read: ESG Strategies: Development and implementation guide

In closing

Our findings are consistent with mandatory ESG disclosures generating reputational costs for firms wanting to manage their ESG profile. That is, in order to evade and/or hide their ESG-related obligations following the implementation of mandatory disclosures, they decide to engage in supply-chain migration strategies that transfer ESG-related risks to supplier firms located in countries with weaker corporate information environments. However, such supply chain migration strategies are mitigated by financial intermediaries such as analysts and institutional investors acting as external monitors.

Our evidence also indicates that the migration strategy of supply chains partially explains the reduction of reported ESG incidents following the introduction of mandatory disclosure. Overall, our findings suggest that mandatory disclosure policies can have long-lasting real effects in changing firms’ global outsourcing practices.

Hai Lu is the McCutcheon Professor in International Business and Professor of Accounting at the Rotman School of Management and Director of the School’s Guanghua-Rotman Centre for Information and Capital Market Research. Jee-Eun Shin is an Assistant Professor of Accounting at the Rotman School. This article summarizes their working paper, “Migration of Global Supply Chains: A Real Effect of Mandatory ESG Disclosure”, which is available online.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]