Small is big for sustainability

By Jukka Mähonen — 16 June, 2021

Image may contain: Glasses, Property, Dress shirt, Sleeve, Wood.

Jukka Mähönen is Professor at the Department of Private Law, Faculty of Law, University of Oslo.

Small and medium-sized enterprises (SMEs) are the backbone of our economies, both in Europe and globally. They account for 90 per cent of businesses and 50 percent of employment worldwide. The role of SMEs in global value chains have been recognized for a long time. They have a decisive role to play in innovation.

SMEs should be taken seriously

For these reasons SMEs are crucial in the transition to sustainable future. Yet, this is not fully recognized by legislators and regulators. The policy excluding SMEs from sustainability regulation underestimates their role in the economy. Legislators have understandably concentrated on listed companies given the role of financial markets for the world economy and that listed companies often are multinational enterprises (MNEs) controlling global value chains.

However, non-listed SMEs also can be MNEs, with strong impact on global and local value chains. It ignores also the lively variation of business forms on the SME scene, including partnerships and cooperatives. Not all undertakings are companies. Based on the concept of ‘regulatory burden’, SMEs are often exempted from regulation, for instance reporting and disclosure requirements. This undermines their role in the economy and as drivers for sustainable business. We see this reflected in the European Commission’s recent proposal for corporate sustainability reporting directive, excluding all but listed SMEs from the scope of the initiative.

Why is it wrong to exempt SMEs from sustainable finance?

The regulatory decision of excluding SMEs is most clearly seen in finance. The more the financial sector is required to take sustainability into consideration in their investment decisions, the more pressure is created for firms they finance to prove that their business model is sustainable. This is problematic for SMEs because they are not supported with right tools to help them provide reliable information about the impact of their activities and guidelines on due diligence to recognize and mitigate negative impacts.

Due to these limitations, the abilities of SMEs to respond to expectations of their financiers, such as banks and equity investors are also limited, as financiers more and more require integration of sustainability in their investees’ business models and that they report on it. All SMEs, including those in low-income countries  in for example East Asia, the Pacific and the Caribbean and Latin America regions, are less likely to be able to obtain bank loans than large firms. Instead, they rely on internal funds, or cash from friends and family, to launch and initially run their enterprises. This contributes to creating the communitarianism typical to SMEs but also creates a financial deficit.

It also runs against the dominating investing model governing listed companies, with global and local institutional investors. The governance model of listed companies with separation of membership and control is basically unknown to SMEs. Sole entrepreneurs, partners, members and shareholders participate personally in the management of the undertaking, and employees often participate in management.

Need for a regulatory support for SMEs

Accordingly, there is not a sufficient regulatory framework to support SMEs. Regulation for various aspects of sustainability due diligence, covering all environmental, social and governance aspects of the undertaking’s activities, tends to exclude SMEs. We see this with national initiatives, as the French vigilance law and the recent German regulation on supply chains and the now adopted Norwegian law on business transparency. This exclusion is also in contrast to the OECD guidelines, which otherwise have provided much inspiration for such legislative initiatives.

Unfortunately we see this regulatory exclusion playing out at European level also recently with the European Parliament urging the European Commission to issue a legislative proposal in sustainable due diligence, but at the same limiting the scope of its initiative to listed and ‘high-risk’ SMEs only.

However, according to the results of a recent consultation on the European Commission sustainable corporate governance initiative, an overwhelming majority (81 per cent) of respondents expressed support for a broad EU legislative action for a sustainable due diligence duty. Unlike the Commission and the Parliament, many of the respondents recognized the special role of SMEs in due diligence, encouraging the Commission to provide more help and advice in the form of toolboxes, helpdesks and guidelines to support SME due diligence capacity building, instead of SME exemptions.

How to help SMEs become sustainable

In the business law reform proposals from the now concluded SMART project we suggested that SMEs and their boards should enjoy the same benefits of sustainability due diligence requirements as larger undertakings. According to the proposal the boards of all undertakings shall work to ensure that the operations and activities of their business create sustainable value by contributing to global society staying within planetary boundaries. An important tool for the board should include carrying out a sustainability assessment of the undertaking’s activities, including a sustainability due diligence across the operations of its business. To enable SMEs’ sustainable business models, the rules proposed should be proportionate to the scale and complexity of the activities of the undertaking (‘scalability’). In contrast to other proposals, scalability does not mean exemptions from the rules proposed but a general rule of simplified procedures in both due diligence and reporting to be extended to all SMEs.

Albeit SMEs operate often locally the impact of their activities is global through their supply, finance and demand chains. Instead of simply acknowledging this, it is important to truly take seriously the position of SMEs in global value chains. This is not possible without recognizing the role of larger MNEs in controlling value chains. According to the proposal, SMEs in both national and global value chains should have the right to require the information necessary to fulfil the duties set to them from the controlling or lead undertaking of the value chain, whether the lead firm is a company law based parent company or contract based lead undertaking.  With the right for information the SMEs can fulfil their due diligence obligations without excessive burden.

Not only regulation but also true support for SMEs

Further, to ensure resources to fulfil the requirements proposed, it was suggested also an EU level SME Resource, consisting of an Advisory Hub and an Advisory Portal, to provide resources and advice to SMEs fulfilling their due diligence and reporting duties. This resource could be part, for instance, of the InvestEU Programme for the European Green Deal and recovery from the pandemic.

With a combination of scalability in regulation and true support, SMEs can fulfil their due diligence and reporting obligations and thrive in the value chains of which they are part. The European Parliament and the Commission deserve respect for their efforts to secure sustainable due diligence and corporate governance. However, true progress necessitates that we consider all SMEs as important, not only listed ones and those operating in high-risk sectors of economic activity with a significant impact on human rights, the environment and good governance (as proposed by the European Parliament).

SMEs are the backbone of our society and economy. We want to see this continue, with renewed vigour on the path to sustainable future.

Tags: Business and global value chains, Sustainability, Reform proposals
Published June 18, 2021 7:33 AM - Last modified Aug. 24, 2022 6:15 AM