Sustainability was once a buzzword rolled out for corporate social responsibility reports then quickly forgotten. Not anymore.

Shareholders are ratcheting up pressure on management to address social and environmental issues. Climate change and policies aimed at mitigating it are poised to upend major industries, from forestry to garment manufacturing. Research shows that companies make more money when they invest in sustainability. Consumers want to buy products from companies that use socially responsible business practices.

All this helps explain why CEOs increasingly see sustainability as their top priority. A survey found that 91% of CEOs thought it was important to ensure the integrity of supply chains - the networks of businesses providing goods and services that corporations use to make their products.

The push for sustainability is good for workers and for the environment. But it also poses challenges for small businesses that supply big corporations, and which play a vital role in the economies of poor countries. These small and medium enterprises (SMEs) do not have the money needed to adapt to the new business realities.

Costs and benefits of sustainability standards

Global value chains are increasingly governed by sustainability standards. Corporations set some of these standards. National governments establish others. There are also voluntary standards, such as those set by labelling schemes for fair trade and organic products.

Whatever their source, sustainability standards involve costs. To meet environmental standards in textiles manufacturing, SMEs might need to buy new energy-efficient machines, for example, or use expensive non-toxic chemicals in their dyes. Agricultural producers, meanwhile, might be required to increase wages, build more comfortable facilities for workers, or invest in resource-efficient farming practices.

These practices cost money. A study of 16 emerging countries estimated that compliance with standards cost about US$425,000 per firm, largely due to increased spending on labour and capital. Nor are these one-time expenses. SMEs need to spend money over time to maintain and document their compliance. Even voluntary certification standards cost money to achieve and maintain – consider the audits needed to document ongoing compliance.

Importantly, there is evidence that standard-compliant businesses get better access to markets, attract stronger demand for their goods and services, and ultimately make more money. One study found that produce exporters in sub-Saharan Africa earned €2.6 million more than they would have if they didn't meet standards. Workers also benefit from improved conditions. Pesticide-related illnesses and health expenditures plunged in Kenya after small-scale export farmers complied with export standards.

SMEs need financial help to meet sustainability standards and join global value chains

SMEs rarely get help from the corporations to which they sell – or other supply chain partners – to invest in better social and environmental standards. The International Trade Centre studied the costs of achieving sustainability certification and found that producers alone shoulder the vast majority of these expenses.

It is also not a realistic option for SMEs to get a loan from a formal financial institution such as a bank. The IFC estimates that SMEs in emerging countries suffer from a financing shortfall exceeding $2 trillion, with up to 70% of formal SMEs going unserved or underserved by the formal financial sector. Businesses in low-income countries reported that access to finance was the biggest barrier to participating in global value chains, according to a survey.

Lack of financing undermines participation in global value chains.
Image: Source: Reproduced from Cusolito, Safadi, and Taglioni (2016).

This credit crunch doesn’t only hurt businesses. It also generates fallout for countries and their citizens. SMEs account for major shares of employment and GDP in emerging economies. At the same time, global value chains encompass up to 80% of global trade, according to one estimate. The lack of financing for SMEs and their resulting inability to join global value chains weakens economic growth and competitiveness in low-income countries.

Options to help SMEs access financing and join global value chains

There are encouraging signs that SMEs are finding new ways to access the financing they need. But more needs to be done. Here are some policy considerations:

Large businesses and buyers can offer suppliers better terms and bigger orders in exchange for upgrading their sustainability practices. Offering suppliers financial rewards – such as larger orders or higher prices – can provide a strong incentive for these companies to invest in stronger sustainability standards. Using new technologies such as e-invoices can speed up payments to suppliers, and help small businesses build up the creditworthiness they need to access financing from other sources.

Lenders and investors should consider using sustainability performance to assess credit eligibility. Given the evidence that sustainability makes firms more profitable and productive, it stands to reason that sustainable firms should be better able to repay loans. SMEs often need to produce detailed documentation to achieve certification from fair trade or other sustainability schemes. Lenders could draw on that sustainability data to assess creditworthiness.

Governments can establish minimum sustainability guidelines in procurement at the national level. By using their substantial purchasing power, governments could encourage suppliers to comply with labour and environmental standards.

International development finance institutions can use a range of financial products, in association with technical assistance to help SME lenders implement standards assessments and implement environmental and social management systems.

Governments, financial institutions and businesses can work together to support financing models that encourage SMEs to upgrade their production processes to comply with sustainability standards in global value chains. For example, some major global buyers have started offering better supply chain financing terms to their suppliers in exchange for meeting higher environmental, labour, health and safety standards. German footwear and clothing manufacturer Puma recently launched such an arrangement with BNP Paribas bank and the fintech firm GT Nexus. If suppliers get a high score on Puma’s social and environmental audit, they get a higher share of the invoice upfront, which can cut suppliers financing fees.

Encouraging sustainability compliance can help firms become more competitive while making life better for workers and protecting the environment. That’s a win for all.

The new G20 study, conducted by the Global Partnership for Financial Inclusion (GPFI), addresses the issues outlined in this blog. To read the report, click here.