Consumer sentiments are shifting towards favoring more responsible business practices. Simultaneously, concerns about human rights and the environmental impacts of such practices are also on the rise. These concerns contribute to the increasing urgency to transform supply chains towards more environmentally and socially sustainable models. the environmental, social, and corporate governance (ESG) has emerged as one of the most prominent sustainability frameworks to benchmark corporate practices, including companies’ supply chains.
In this article, we explore the importance of ESG compliance in China, an indispensable sourcing market for European companies, in ensuring sustainable supply chains for European firms. We also dive into the development of China’s ESG reporting framework, and the best practices to enable more sustainable sourcing in the country.
Importance of Sustainable Supply Chain in China for European Companies
For European companies, ESG has become more and more consequential due to a combination of three factors: regulatory changes in Europe, recent global supply chain disruptions, and changing sentiments among consumers. As a result of these developments, ESG compliance in China has become a focal point for European firms.
Importance of Sustainable Supply Chain for European Companies
In February 2022, European Union (EU) Commission issued a directive on corporate sustainable sourcing and due diligence that requires EU member states to create new laws to inspect ESG matters in their supply chains. Failure to comply with this directive can entail civil liabilities that lead to significant losses of revenue for the companies in question.
In addition to new regulations, there is also increasing consumer attention toward ESG matters. According to a 2021 study by PwC, about 80% of respondents said they were likelier to buy from companies that maintain a satisfactory ESG record. As a result, companies have been compelled to put more emphasis on ESG matters so as not to alienate a large portion of their customer base.
Importance of Sustainable Supply Chain in China
In 2022, China was the EU’s largest provider of goods to the bloc with about 20.8% of the total imports, a staggering value of US$676 billion. This represents a 150% rise compared to 2012. These numbers demonstrate the vital role of China as European companies’ most important manufacturing hub.
As a result, China’s continued importance as a sourcing destination, and the increasing preoccupation in Europe with sustainable sourcing, have made ESG compliance in the country a major concern for European companies.
Understanding the ESG Landscape in China
Though a standardized national ESG framework in China is a relatively recent development, the country’s framework has developed rapidly to evolve from a fragmented collection of standards created by governmental departments and local authorities to a nationwide framework, all within seven years.
Development of ESG Framework
The foundation of China’s ESG framework was laid in 2016 when seven top financial ministries and agencies, including the People’s Bank of China (PBOC) and the Ministry of Finance, issued a guideline that established a system of environmental information disclosure system for listed companies to encourage more investment in environmentally-friendly projects. In the same year, the Ministry of Industry and Information Technology issued the “Guidelines for the Implementation of Green Manufacturing Projects (2016–2020)” and the “Notice on Developing Green Manufacturing System” to boost green manufacturing and green supply chain. The latter document also drafted standards and evaluation systems for the green supply chain.
Similar to the national efforts, regions such as Shanghai, Beijing, and Guangdong formulated the “Implementation Plan of Green Manufacturing System (2018–2020)” to boost green manufacturing and green supply chain in their jurisdictions.
In addition to the government’s initiatives, China’s largest enterprises on the Shanghai and Shenzen Stock Exchanges also started to voluntarily report ESG information. In 2020, 1450 companies published annual ESG reports, a 291% increase compared with 2009.
All of these disparate efforts culminated in the creation of the nationwide guideline for corporate disclosure standards for ESG in June 2022 by the Assets Supervision and Administration Commission. This guideline was meant to provide China-listed enterprises with a unified and China-focused ESG framework instead of relying on USA, UK, and EU frameworks. The framework has been voluntary since its creation but China is currently working on The new version will focus on environmental matters, poverty reduction, and rural revitalization. There are indicators that this version will be implemented in state enterprises first as soon as the end of 2024.
Overall, however, Chinese companies have been slow on adapting ESG measures and are still lagging behind Western firms. In a 2022 research by JP Morgan Asset Management, Chinese companies had a much lower median ESG score than those from the US and France. However, companies in China are catching on and there have been more and more requirements for ESG analyses to help these companies improve their performance.
Key ESG Factors in China
The 2022 ESG framework includes 100 metrics divided into three primary areas of ESG: environmental, social, and corporate governance. However, the framework primarily focuses on environmental factors to help realize the country’s ambitious goal of reaching peak carbon emissions by 2030 and achieving carbon neutrality by 2060. As a result, the framework has a more substantial number of metrics reserved for environmental matters such as greenhouse gas and other pollutants emission, water consumption, energy consumption, and waste generation.
The framework also incorporates requirements regarding labor rights such as labor safety, wages, working hours, and gender composition of the workforce. In terms of corporate governance, the framework focuses on the gender composition of the boards of directors, executive compensation, and corporate authority structure.
China’s Current Environmental, Social, and Corporate Governance Requirements
Due to the country’s ambitious climate ambitions, China is particularly focused on environmental issues among the three elements. However, this does not mean that the country neglects the social and corporate governance aspects.
The three Laws on the Prevention and Control of Air, Water, and Soil Pollution govern airborne, air, and water pollution in China. These laws grant the government the right to list out heavily polluting production processes that can negatively impact China’s air, soil, and water. Companies must then discard these processes and adopt new and cleaner ones. Moreover, any enterprises that surpass the local and national pollution thresholds will be subjected to a fine and inspection. These environmental protection laws are currently applied to specific industries that have high rates of emissions such as iron and steel as well as thermal power. Enforcement is also focused on certain industrial regions such as Beijing and Shanghai.
In addition to laws against pollution, China also requires companies to adopt measures to ensure the economical use of energy. According to the Law on Energy Conservation, companies are encouraged to apply the latest technologies to conserve and reuse energy. The law also encourages companies to set conservation targets more ambitious than those of the local and national governments.
In terms of labor rights, China requires firms to sign written contracts with employees within one month of working. In addition, the country also requires employers to pay employees for overtime work 150% on extra hours on work days, 200% on weekends, and 300% on public holidays. In addition, employers will also have to contribute to employees’ social security and ensure employees receive the minimum wage of US$370 per month.
Beyond working conditions, employers are also required by the Labor Law to scrap gender discrimination measures such as stating gender preference in recruitment, restricting employment due to marriage or childbirth, and imposing discriminatory promotion policies against women. In addition, employers are required to formulate policies combating workplace gender-based harassment.
Corporate Governance Considerations
In China, the domain of corporate governance is controlled by the Code of Corporate Governance for Listed Companies. The Code seeks to establish a system of rights and obligations between shareholders and the management teams of listed companies.
The Code stipulates that listed companies establish transparent procedures to elect directors to ensure fairness in the election process. In addition, the code requires companies to give minority shareholders the chance to influence the election of directors. The Code also compels companies to disclose information regarding the companies’ structures, the performance of the management teams and directors, explanations as to why companies do not follow the standards set out by the code, and the specific work of the management teams.
Best Practices for Sustainable Supply Chain in China
There are several approaches that European companies can adopt to successfully ensure their supply chain’s ESG compliance in China.
Establish Alliances with other Companies
One important way to ensure the supply chain’s ESG compliance is to create standards that suppliers must follow. However, as one single enterprise may not be influential enough to create changes in the behavior of suppliers, companies should band together to create alliances that can amplify the call for more sustainable sourcing practices from suppliers. An alliance will first set ESG standards for suppliers and only those that meet the standards are allowed to work with the alliance members.
In real life, this practice is exemplified by the Responsible Business Alliance (RBA), which includes Apple, Intel, Dell, IBM, and many more. RBA sets sustainable standards and hires third-party parties to perform audits of suppliers. Suppliers are then ranked according to their ESG performance in RBA’s audits. The final results will then be made accessible within RBA, thus ensuring that suppliers must comply with the alliance’s standards to be able to do business with one of its members.
Collaborate with Suppliers
Companies can also seek to establish more collaborative and less top-down relationships with suppliers to ensure that their supply chains comply with ESG standards. This type of practice is characterized by lighter monitoring than the alliance approach but is more focused on establishing shared goals through training, goal setting, and information sharing.
One notable example of this approach is Walmart in 2008, which wanted to reduce the carbon footprint of its supply chain in China. The company thus formed an association with its 200 Chinese factories. In addition to auditing members as usual, the association also conducted training, information sharing, and drafting action plans to ensure that these factories share Walmart’s vision for carbon reduction.
In another development, companies can also use artificial intelligence (AI) to track suppliers’ ESG performance. For example, the Boston Consulting Group’s AI platform called CO2-AI helps companies such as Dell and Coca-Cola rapidly gather and track hundreds or even thousands of their suppliers’ carbon footprint at the same time. The use of AI will help companies to monitor suppliers’ ESG performance on a large scale simultaneously, saving time and resources in the process.
A combination of regulatory changes, recent disruptions in the global supply chain, and changing consumer sentiments have made ESG factors in the supply chain more important than ever for European companies. ESG in China, with its position as Europe’s most important manufacturing hub, is emerging as a major concern for European companies.
China’s ESG standard is still a recent development that started with a disparate series of departmental and local frameworks. In 2022, China began to unify all of these standards to create a nationwide, though still voluntary, one. However, China is developing this standard into a compulsory version for all China-listed companies.
China’s ESG standard, though compatible with international ones, is meant to address China’s domestic concerns. As such, the standard is more focused on environmental matters, reflecting the country’s long-term environmental ambitions. Though environmental issues feature prominently, the standard does not neglect social and corporate governance matters.
Overall, the pursuit of sustainable sourcing in China is worthwhile for European companies. In the short and medium term, attaining supply chain sustainability can help these companies build solid brand reputations that attract both consumers and potential employees. In the long term, however, supply chain sustainability will help companies achieve supply chain optimization to navigate future uncertainties in global trade due to climate change.
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