It got a bit lost in the shuffle, what with the ongoing corona pandemic at the time, but in June 2021, the German Bundestag passed a law that could help redefine the fundamental ethics of the German economy. The Supply Chain Act (Lieferkettensorgfaltspflichtengesetz, or LkSG in German) requires companies in Germany to ensure compliance with certain standards in their supply chains, including basic working conditions, as of January 1, 2023.
This isn’t the first set of regulations like this, but it is the most comprehensive to date. It involves extensive reporting requirements and additional responsibilities, which will now fall to German companies. They will need trained employees, functioning processes and a knowledge of their own supply chains that goes well beyond mere geography. It’s a tight program, but doable within 18 months, right?
In fact, a few company owners have probably been caught off guard by the looming deadline. Many aren’t even aware that the LkSG is relevant to their firms, because they fall below the employee thresholds—3,000 in 2023, and 1,000 in 2024—set out in the law. Only about 600 companies will be affected in 2023, which rises to around 2,900 by 2024.
Yet these guidelines are deceptive. That’s because many smaller firms supply larger ones, which will pass these reporting requirements off onto their suppliers. So, on January 1, if these smaller companies want to provide informed answers about their supply chains to their larger clients, they’ll need to get started on that now.
It’s a process that is generatinginterest not only in Germany. Governments are working on similar regulations worldwide. How Europe’s largest economy manages to implement them could end up being a beacon for other countries.
The LkSG comprises a total of nine due diligence requirements that companies must implement. These include setting up a risk management system, conducting regular risk analyses, establishing complaints procedures and documenting all of these processes. The due diligence obligations don’t just apply to direct suppliers—indirect ones must also be kept in mind if the company has “substantiated knowledge” of possible human rights violations there. The whole thing will be monitored by the German Federal Office for Economic Affairs and Export Control (BAFA in German), which will receive the companies’ reports and will also impose penalties if necessary.
This requires a lot of bureaucratic effort. Larger corporations will be able to handle this more easily. For smaller companies, however, a certain amount of preparation will be necessary. “Many don’t even have sustainable procurement policies, meaning there’s no transparency with regard to their data,” says CEO Yvonne Jamal at the JARO Institute for Sustainability and Digitalization. This will need to change soon. That’s because many smaller and medium-sized enterprises (SMEs) are direct suppliers to larger companies, which will insist that these SMEs also screen their own suppliers, which are also part of the overall supply chain.
Thus the SMEs, which aren’t really directly targeted by the law, will now have to train employees, analyze their own supply chains and establish risk management systems. They will have to make up for shortcomings for which they themselves are partly responsible, as Jamal explains: “The issue was there before, but it just didn’t have any urgency for the companiesbecause the added value wasn’t clear to them.”
“We could begin to see a certain amount of de-globalization.”
For many SMEs, the LkSG is also challenging because they lack the market power of larger corporations to enforce standards all across the globe. In spite of this, companies could work together within industries—if permitted by antitrust laws—and face suppliers with greater combined market power. Still, Jamal recommends communicating with them on an equal footing and offering support.
There are already examples of this. For instance, the supermarket chain Aldi Süd already issued new guidelines regarding working conditions in its own supply chain in early 2021. The discounter, headquartered in western Germany, has its eye on food production in particular. Aldi Süd wants to support its supplier companies in identifying forced labor, preventing it and, if necessary, making amends. In addition, the company also carries out its own so-called social assessments directly at production sites. Cooperation and control are running in tandem.
Overall, many SMEs seem to be worried about what’s ahead. “But we have to allay their fears for the time being, not least because there were many untruths told during the legislative process on the part of some interest groups,” Jamal says. Too few of the positive aspects were communicated. Moreover, the companies would not be left to their own devices in implementing the rules. Many industry associations and the BAFA provide information and recommendations for action. “There are also quite a few NGOs and other organizations that provide assistance,” Jamal says. She recommends using all of these tools. “The companies need clear goals and then they can measure their achievements against meaningful metrics.” A certain urgency is now called for. And as Jamal warns, the run on supporting institutions has already started: “Our institute, for instance, can barely keep up with the slew of inquiries at the moment.”
So companies are making an effort. Not least because it is now part of their due diligence, as Christoph Küffner, a research associate at the Chair for Supply Chain Management at the University of Erlangen Nuremberg (FAU in German) explains: “Misconduct in the supply chain has also entailed risks for companies in the past.” For the company’s own reputation, as an example. According to a study by the EU Commission, investors also expect companies to operate in a correspondingly above-board manner.
Companies should help suppliers uring this changeover, but they are under no obligation to do so.
The Supply Chain Act is intended to provide reliable control systems on the one hand, while not stifling the economy on the other. It’s a delicate balancing act, even if you only consider German enterprises. The challenges are considerably greater in poorer regions. There, suppliers will have to make some significant improvements to continue supplying German companies. Jens Kilimann, a supply chain expert at the management consulting firm Bain & Company, has concerns: “We could see a certain amount of de-globalization.” Companies in the textile industry, for example, might think twice in the future about producing in far-flung countries with supposedly dubious reputations, such as Bangladesh. “Production might then be transferred to Turkey,” he speculates. The problem is that the textile industry in Bangladesh is one of its economy’s main supports and could thereby be severely damaged.
Similar warnings were issued in early 2022 by the Kiel Institute for the World Economy (IfW in German). The authors of an expert report concluded that the LkSG would hit the most productive and fairest companies in developing countries. It is precisely the companies that export to the West that pay higher wages and taxes than those that produce for domestic markets. According to the IfW, if these companies were now forced to close, nothing would be achieved in the struggle against human rights abuses.
This would be a consequence that surely no one wanted to achieve with the LkSG. The law itself states that “enablement should take precedence over withdrawal.” This means that the German companies shouldn’t terminate contracts with suppliers, but instead should support them in getting better and in offering better working conditions. However, this is not a requirement, just a suggestion.
Yet Kilimann does seepossibilities for preventing such collateral damage with minor adjustments to the law. “For instance, you could compile a whitelist of countries where the risks are low,” he suggests. Then again, countries that might seem to be unproblematic at first glance offer no guarantees. “Even in Europe, too, we sometimes see conditions that are reminiscent of modern-day slavery,” says Küffner of the FAU. Working conditions on some vegetable plantations in Spain, for instance, can be terrible.
In the end, SMEs will have to search for solutions together with their suppliers, solutions that benefit both sides. In case of doubt, this usually works better than pressure tactics. The medium-sized company Haas & Co. Magnettechnik, for instance, based in Wiesbaden, Germany, has been working together with its Chinese suppliers to improve working conditions in rare-earth mining, another traditionally riskfilled industry. Implemented measures include emergency switches on the machines and repairs to the workers’ accommodations. The added expense ended up being a worthwhile investment: the improved conditions significantly reduced turnover in the workforce and production quality also increased.
A law on supply chains is always going to be a search for compromise: companies must still be able to function properly, but the law as written must also bring about noticeable changes. As Küffner explains, this will only happen if companies really dig deep into their supply chains. “Of course, a big German corporation—for instance from the automobile industry—already controls its first-tier suppliers,” he says. “And, in turn, these first-tier suppliers certainly control their direct suppliers.” Yet the real problems are often found much deeper in the supply chain. “It starts getting interesting at about tier twelve or tier twenty,” he says. So to truly have a comprehensive effect, control must be exercised in the supply chain all the way down to these levels.
Küffner advises companies to remain calm: “There is no evidence that a supply chain law has had a negative impact on the productivity of a national economy.” Examples come from regulations in Great Britain, France and the Netherlands. Küffner’s FAU colleague Christopher Münch even sees opportunities for a sort of shock therapy. “We also saw it with Covid: all of a sudden, things that had been ruled out for years were possible, like for instance working from home,” he says. The Supply Chain Act could lead to similar breakthroughs for a more socially equitable economy.
“There is no evidence that a supply chain law has had a negative impact on the productivity of a national economy.”
The European Union is also working now on its own supply chain regulations. It’s still just a draft, but it has a lot going for it. Firstly, the group of companies affected will be expanded significantly—companies with at least 500 employees or 150 million euros in annual sales will be subject to the guidelines. Companies in so-called risk industries—including the textile or chemical industries—might even be affected even if they have lower company figures.
The EU proposal also provides for the possibilities of civil liability for companies, an aspect that didn’t make it into the final version of the German law. This means that if a company causes damages due to non-functioning supply chain control procedures, it will have to answer for them. The EU proposal also includes due diligence for environmental obligations. These have hardly played a role in Germany, unless they arise in direct connection to human rights violations.
This aspect is something that the FAU’s Münch views as very important. “My hypothesis is that if a supplier attracts attention because it doesn’t treat its employees well, you can assume that its environmental protection measures are also crap,” he says. “I think it’s a mistake that this hasn’t been included in the current law.”
Management consultant Kilimann has mixed feelings about the planned EU directive. “The EU requirements would mean yet another significant complication for companies,” he warns. Some 13,000 companies in the EU would be affected. “We must be clear: it will lead to decreasing efficiency and less value creation,” he says. And consumers would notice: “In many branches, the textile industry for instance, the margins are extremely tight. There’s barely any cushion.” Higher prices are likely to result. “And then customers will probably decide to shop elsewhere.”
Shouldn’t a new economy be built on fairness? Proponents of the regulations tend to view them as a necessary correction for undesirable developments. FAU expert Küffner sees it as the end of an economic era. “The focus on shareholder value has meant that, over the years, companies have always gone to where production is cheap, with all the consequences that entails,” he says. Stronger protections for the environment and human rights will change this equation. Accordingly, it’s now in acompany’s own best interests to examine their supply chains. “The reason that they are so complex is based on decisions made by businesses to gain competitive advantages in the context of globalization,” JARO’s Jamal says. Those who earn money globally can also take on responsibilities around the globe.
