Recent news headlines have shown companies dealing with challenges related to supply chain due diligence. A notable example includes human rights organisations denouncing IKEA and Amazon. They argue that the companies have not signed the “International Accord on Health and Safety in the Textile Industry” (Bangladesh Accord) and are therefore violating due diligence requirements recently established in German law. This is now being reviewed by the German legal authorities (“Bundesamt für Wirtschaft und Ausfuhrkontrolle”). The companies may face multi-million euro fines if the allegations turn out to be true and they have violated this new law.
Which law are the human rights organisations referring to?
The “Act on Corporate Due Diligence Obligations in Supply Chains” (Ger. “Lieferkettensorgfaltspflichtengesetz”, LkSG) is a piece of German legislation that mandates businesses to uphold human rights standards and environmental guidelines within their supply chains. Implemented at the start of 2023, the introduction of this law, coupled with prospects of even tighter EU regulations, is causing apprehension amongst many businesses. It necessitates a detailed understanding of the law’s implications and strategic methodologies for its efficient enactment.
This article aims to shed light on the LkSG’s significance and the fresh challenges it introduces for businesses, while proposing an incentive-based approach for effective compliance.
LkSG and Game Theory – it’s a match
What is the LkSG and why are we interested in it as game theorists? The new law confronts companies with new challenges. Requirements are sometimes, however, unclear and not entirely concrete given the interpretation of the law can change. Implementation can be very resource intensive and can be difficult to carry out from a commercial perspective.
With so many parties with their own vested interests coming together, this offers an excellent opportunity to look at the implementation of the new law from a game-theoretical point of view.
Introducing LkSG
Let’s begin with an overview. The law currently applies to companies with over 3,000 employees operating in Germany, whether they are German-based or have a branch office within the country. These businesses are required to scrutinize their supply chains for potential breaches against human rights or environmental standards. Discovered violations must be promptly addressed.
The aim of the law is to improve working conditions and environmental standards in global supply chains. It is designed to ensure that companies take responsibility for their entire supply chain and do not tolerate violations against human rights or environmental principles.
Fines will be applied in the case of any violations. The severity of the fines varies depending on the type of violation and the size of the company. However, they can amount to several million euros.
It is expected that the LkSG will be updated in the future. The German Government plans to expand the number of companies involved to ensure even broader protection of human rights and sustainability in global supply chains. An update is also planned within the EU. In addition, fines may be increased, and further penalties introduced.
Due diligence of the LkSG
To understand the game theoretical approach, we first need to understand the requirements of the law. Simply put, the LkSG establishes various due diligence measures for companies to prevent human rights violations and environmental harm along their supply chains.
For example, companies are required to conduct a systematic risk management and risk analysis along their supply chains to identify potential risks for human rights violations and environmental harm. This also includes the evaluation of suppliers and the conditions at their production sites in terms of work and the environment.
Companies should also take preventative measures to avoid human rights violations and environmental harm in their supply chains. These include establishing codes of conduct for suppliers, training for employees, raising awareness of risks in supply chains and fostering sustainable production and supply practices.
In addition, should violations of human rights or environmental principles be identified, companies must take appropriate corrective measures. This may include, for example, supporting affected persons or having workshops with suppliers to help improve working and environmental conditions.
It is also necessary to establish grievance procedures, adopt policy statements, define responsibilities and document/report on this due diligence.
The new law presents companies with extensive challenges
What does this mean for companies? At first glance, these challenges are related primarily to additional expenses and resources that are tied up in companies. However, other risks are also emerging. For instance, there are uncertainties about the exact interpretation of the law. As a result, many companies fear violations due to misunderstanding. This also applies to the planned corresponding law within the EU and an update to the law expected in Germany. In this context, not only will companies with a smaller number of employees be affected, but also indirect suppliers will possibly be assessed. Furthermore, the often unclear data situation regarding individual suppliers leads to difficulties in accurate risk management. Consequently, companies run the risk of drawing inaccurate or even false conclusions from outdated or incorrect data.
Conventional implementation and its risks
To implement the new law, companies use a range of “conventional” measures, but these carry risks. Current implementation recommendations range from comprehensive data analyses to risk management and audits. On the one hand, these conventional methods have the potential to comply with the LkSG. However, one should be cautious when applying them, because although some of the methods certainly carry out implementation in compliance with the law, they are not always the most efficient solution to the challenges posed.
When it comes to risk management, for example, conventional methods often rely on categorising risks into so called ‘risk classes’. Such an indicator-based risk assessment could lead to the exclusion of potentially uncritical suppliers. In practice, risk classification is often based on the supplier’s location and industry. As a result, there is a risk that suppliers with a sufficiently established concept about human rights and environment are excluded as suppliers because they are based in a production country with a high-risk rating, for example. Excluding suppliers based on such screening criteria leads to a smaller range of suppliers and, consequently, possibly leads to commercial disadvantages for the company placing the order.
Data collection and analysis often form the core of the implementation. The use of extensive data sets offers the possibility to support the risk analysis of potential new suppliers, as well as the monitoring of existing suppliers. A risk associated with the strongly data-oriented implementation of due diligence is the quality of the data – misjudgements can occur. An analysis based on historical data from long-term business relationships or inspections does not always lead to a correct assessment of suppliers. Furthermore, changes in the law or in its interpretation may lead to different data needs. Thus, data-driven implementation has the disadvantage of being inflexible.
This type of risk management can incentivise suppliers to hide potential risks. This is especially a risk that exists with the regular use of local inspections as a method of supplier verification. In the worst case, it even leads to suppliers simply becoming better at hiding violations.
While a game-theoretical approach still utilises data, its primary strength lies in reshaping strategy with a shifted emphasis. It can harness data efficiently without being entirely dependent on it.
Overall, the analysis shows the importance of presenting suppliers with an incentive-based mechanism. This avoids relying on backward-looking data for risk assessment but enables companies to set concrete incentives for suppliers’ future behaviour and thus steer them. Furthermore, this leads to alleviated challenges by motivating suppliers themselves to implement improvements and allows companies to conduct a more accurate risk assessment.
A game theoretical perspective – three examples
But how exactly can an incentive-based implementation of the LkSG be achieved? There are several solutions and mechanisms for this, which we present below as examples. The solutions are each based on one of the due diligence requirements defined by the law. The focus is on the due diligence requirements of risk management and risk analysis, preventive measures and corrective measures, as this is where incentive-based implementation can achieve the greatest benefit.
1. Risk Management and Truth-Telling Mechanisms
To illustrate the incentive-based mechanisms to comply with the LkSG, we consider a company affected by the LkSG. According to the law, this company is obliged to conduct an annual risk assessment of all direct suppliers regarding violations of human rights and environmental protection. How would the company implement the directives of the law applying standard practice?
To establish risk management based on standard procedure – which is mostly data-driven – the company would first collect the data needed for the analysis. Afterwards the company must build a risk indicator out of the separate thresholds in an extensive data analysis to finally evaluate the suppliers as part of the risk analysis.
A solution based on insights from Game Theory, such as a Truth-Telling-Mechanism, can save time and costs. Suppliers are encouraged to provide truthful self-disclosure about their risks and hazards. This is how the Truth-Telling-Mechanism could work:The company asks its suppliers to fill out a questionnaire according to their level of information.
The company then carries out checks on the statements made by the supplier in the form of audits. Not all suppliers and criteria are checked, but random samples are taken. By comparing the checks with the information provided in the questionnaire, a so called “deviation indicator” is created, which categorises the “truthfulness” of the supplier’s self-disclosure. If the indicator is poor, penalties are imposed, for example in the form of monetary payments or further requirements. If the indicator is good, on the other hand, the supplier receives bonuses, discounts or other benefits.
The balance between regular reviews and appropriate penalties or bonuses thus allows truthful reporting to be a preferred strategy by the supplier. This reduces the cost and effort of the company in carrying out the risk assessment.
2. Preventive Measures and Bonus/Penalty
The LkSG demands that companies take preventive measures in the company’s own business area, as well as for direct suppliers. These measures are to be taken as soon as a risk has been identified. This includes submitting a statement of principles on human rights. Preventive measures in the own business unit can be, for example, training or monitoring measures.
When a company wants to take preventive measures regarding direct suppliers, it can rely on various conventional methods already in use. Such measures include for example the selection of suppliers via verification through control mechanisms. Furthermore, some approaches entail that suppliers are given best-practice examples.
A smarter way to implement preventive measures using a game-theoretical approach is the integration of a bonus/penalty mechanism. With this tool the company can incentivise suppliers to comply with the law in the best possible way. The company has the possibility to define and adjust risk criteria if necessary and subsequently evaluates suppliers according to these criteria. By implementing these measures, suppliers can influence their rating. For example, suppliers can agree to audits, conduct training, or invest in measures to obtain a bonus which will give them an advantage with existing business or in securing future awards.
Through this approach, suppliers increase their competitiveness by complying with the regulations by their own choice. This behaviour directly helps the company to comply with the LkSG.
3. Corrective Measures and Contract Theory
The LkSG states that violations which have occurred or are about to occur must be prevented, terminated, or mitigated by corrective action. If termination is not possible in the near future for direct suppliers, a concept for termination or mitigation must be implemented.
Apart from the usual measures, the company can use contract theory, as part of Game Theory to fulfill this specific due diligence requirement. It proposes to contractually embed economic incentives to encourage desired actions and outcomes by suppliers.
To implement corrective measures, on the one hand, the company determines necessary actions before a violation of duties occurs. On the other hand, it creates incentives for taking corrective measures as quickly as possible if a violation has already occurred. Incentives can, for example, consist of extensive reporting requirements, bonuses/penalties or better/worse contract conditions.
If all relevant aspects are considered during contract creation, the company ensures a faster and more effective implementation throughout the supply chain. Suppliers have a significant advantage to proactively participate and comply with the law.
Summary
This article aims to shed light on the LkSG’s significance and the fresh challenges it brings for businesses.
Conventional implementation as a way to fulfil the requirements of the law has a strong focus on extensive data management, which potentially leads to risks such as excluding non-critical suppliers and dealing with outdated data or even, in the worst case, incentivising suppliers to hide violations instead of fixing them.
As an alternative, a game-theoretical view helps to shape an incentive-based future in which the LkSG can be implemented in a more efficient and more flexible way. By creating incentives, suppliers will be motivated to take measures proactively. Moreover, by using the necessary data in a smart way, not only are risks mitigated, but opportunities are also generated. In a world increasingly demanding corporate responsibility, adopting flexible, incentive-based strategies not only ensures legal compliance but fosters a more ethical and transparent business environment.