ESG Due Diligence in Supply Chains: Is Your Company Ready for the German Supply Chain Act?

Many European countries are adopting new due diligence rules to limit environmental and labor risks in corporate supply chains. While not yet mandatory, regulations are expected to accelerate in the coming decade, so companies need to begin to collect relevant data now.  

One such regulation receiving international attention is Germany’s Act on Corporate Due Diligence in Supply Chains, set to come into effect in January 2023. Other countries have enacted modern slavery laws, but this law is more comprehensive and will soon affect German companies, and the buyers and suppliers who do business in the country. 

Read our overview to learn more about what’s included in the legislation, and how your company needs to prepare.  

The German Supply Chain Act: Who Is Affected and When Does It Come Into Force?

The Lieferkettensorgfaltspflichtengesetz, commonly shortened to LkSG, aims to ensure that companies comply with internationally recognized human rights and environmental policies in their own operations, as well as throughout their global supply chains. 

On January 1, 2023, the act will apply to German-based companies with more than 3,000 employees and foreign-based companies of the same size with offices or branches in Germany. In January 2024, the size threshold will be lowered to 1,000 employees. 

Companies must conduct stringent ESG due diligence concerning human rights and environment-related risks in their supply chains. Some of the issues covered by the LkSG include forced and child labor, unsafe working conditions, harm caused by pollutants, toxic chemical exposure, and unsafe disposal of hazardous waste. 

What Are the Due Diligence Obligations? 

Companies must put the following policies into practice to minimize or prevent human rights violations or environmental-related risks in their supply chains.

• Implement a risk management system and perform regular risk analysis, to avoid potential adverse impacts on human rights and the environment. 
• Issue a human rights strategy policy statement.  
• Create a grievance mechanism to report potential violations that the company must then investigate and follow-up on. 
• Publish a public annual report that documents any risks or violations, and report steps the company has taken to address them.     
  
  

What Are the Consequences of Non-Compliance?

Regulatory offences are punishable with fines of up to 2% of average annual global sales/turnover though they are capped at EUR800,000. More serious are the potential lost sales opportunities; companies that are not compliant can be excluded from winning public contracts in Germany for up to three years. 

Next Steps for Companies Assessing ESG Risks in Their Supply Chains 

1. Map your suppliers. The first and most important step is mapping all your suppliers, including direct and indirect suppliers. Studies have shown that most lower-tier suppliers—those smaller companies providing materials and products to Tier 1 suppliers—fail to mirror the ESG standards expected from the end procurer.¹ Companies can mitigate these risks by analyzing their lower-tier suppliers and addressing potential vulnerabilities. Sustainalytics’ ESG Risk Ratings assess companies’ unmanageable risks across issues such as human rights and resource use. 
2. Begin a risk assessment. Once you have mapped your supply chain, you can conduct a risk assessment by collecting ESG data on all the companies in your supply chain. Gaining total visibility on end-to-end operations can be challenging, with one survey reporting that approximately two-thirds of companies lack crucial information on business continuity arrangements with their lower-tier suppliers.² 
3. Engage with your suppliers. Connecting with every company in your supply chain is a daunting task, but transparency is key. Once you know what the possible risks are in your supply chain, you can work directly with your suppliers to prevent potential human rights or environmental violations.  
4. Show an audit trail. If there are any human rights or environmental-related risks in your supply chain, you will need to show that you have done due diligence on as many companies as possible.  
   
   

Preparing for More Supply Chain Due Diligence Regulations  

The European Union adopted a proposal earlier this year, with the goal to drive corporate sustainability in global value chains, advance the green transition, and protect human rights in Europe and beyond.  

Much like the LkSG, companies will be required to prevent human rights violations and negative environmental impacts in their supply chain, such as pollution and biodiversity loss. The proposed rules will be mandatory only for larger organizations at first (more than 500 employees and more than EUR150 million in net turnover worldwide). However, the rules will inevitably also affect small and medium-size enterprises, as they comprise many of the suppliers for large corporate buyers.  

The coming EU regulations have spurred some member countries, like Germany, to proactively draft their own legislation. The United Kingdom, France, the Netherlands, Norway, and Austria are among the countries that already have modern slavery or human rights due diligence laws in place. Wider scale laws like the EU proposal will affect change more broadly and much faster than country-specific legislation or voluntary action.   

Sources

<sup>1 Villena, V. and Gioia, D. (2020). ‘A More Sustainable Supply Chain,’ Harvard Business Review, accessed (11.01.21) at:  https://hbr.org/2020/03/a-more-sustainable-supply-chain

2 Sneader, K. and Singhal, S (2021). ‘The next normal arrives: Trends that will define 2021—and beyond,’ McKinsey & Co., accessed (18.01.21) at: https://www.mckinsey.com/featured-insights/leadership/the-next-normal-arrives-trends-that-will-define-2021-andbeyond</sup>