Responsible natural resources trade through supply chain due diligence

14 October 2015

How best to ensure socially-responsible trade in the face of long and complex global value chains?

Supply-chain due diligence is increasingly becoming a business reality and a regulatory requirement. The most recent example for mandatory regulation is a proposal by the European Parliament to translate the Organisation for Economic Co-operation and Development’s Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas into law. The draft rule sheds light on a number of trade regulatory mechanics of supply chain due diligence. This article explores essential elements that assure due diligence’s effectiveness and coherence with existing trade regulation.

Risk-based due diligence has been enshrined in a number of national and regional laws ever since the UN confirmed the corporate obligation to respect human rights in its Guiding Principles on Business and Human Rights endorsed in 2011. Principles 13 and 17 specifically say that the corporate responsibility to protect also extends to adverse human rights impacts “directly linked to their operations, products, or services by their business relationships, even if they have not contributed to those impacts.” To fulfil this objective, the UN Guiding Principles demand the establishment and use of due diligence processes, defined as an “on-going management process that a reasonable and prudent enterprise needs to undertake, in the light of its circumstances to meet its responsibility […].”  Understandings of “reasonable” and “prudent” depend on a company’s sector, operating context, size and position in the supply chain, among other similar factors.

Today the responsibility to systematically track and address human rights risks along the entire supply chain is reflected in a number of national and regional laws. The California Transparency in Supply Chains Act, the UK Modern Slavery Act, the France National Assembly’s Legislative Bill Relating to the Duty and Vigilance of Parent and Subcontracting Companies and section 1502 of the US Dodd-Frank Wall Street Reform and Consumer Protection Act are some examples.

On the one hand, these laws and the principles are based on the understanding that downstream companies, those closest to the consumer, possess the greatest leverage to generate change in the producing upstream industry where most human rights violations occur. On the other hand, they reflect the understanding that human rights assessments must be risk-based, in order to ensure targeted action that addresses the most context-specific and acute risks.  

Upstream, downstream responsibilities

Some adverse human rights implications are understood to be so specific and paramount in a certain sector that the different actors along the supply chain would benefit from further detailed guidance. The OECD has been working towards tools to address specific risks within five selected sectors, namely the extractives and financial sectors, as well as agricultural, textile and garment, and minerals supply chains. The nearly 160-page OECD Due Diligence Guidance is by far the most developed among these. At the heart is a “Five-Step Framework for Risk-Based Supply Chain Due Diligence in the Mineral Supply Chain,” compelling for both its simplicity and comprehensiveness.

According to the framework, downstream and upstream companies are expected to establish strong company management systems; identify and assess risks in the supply chain; design and implement a strategy to respond to the identified risks; and publicly report on their supply chain policies and practices. Companies operating at a point in the supply chain identified as a “point of transformation and traceability,” also need to undertake a middle step by carrying out independent third-party audits and making these available to their business partners.

In the minerals sector smelters and refiners have these characteristics and responsibilities. Each mineral needs to pass through a smelter or refiner along its lifecycle, of which only a limited number operate globally, and these are usually the last point in the supply chain where the origin of a mineral and/or metal can be determined. Risks in the supply chain upstream to the smelters and refiners are thus primarily addressed and managed by these entities whereas companies further downstream can identify and address their risks by ensuring that they buy from smelters and refiners that act responsibly. This approach ensures coherence and coordination in the upstream sector and avoids double auditing. Audited companies are thus the pivotal point that connects the upstream with the downstream, effectively interlocking the downstream sector’s leverage over its supplying smelters and refiners, with the latter implementing power over the upstream sector.

It is important to note that this process is not static but, instead, is envisioned to be evolving. Lack of transparency and traceability and missing audits do not automatically result in a “blacklisting” of upstream companies. Instead, downstream and upstream companies are expected to jointly work towards responsible purchasing, and the audits play an important role. 

Due diligence vs. certification

As a result due diligence fundamentally differs from other approaches. Whereas certificates, labels, and trade bans seek to generate full guarantees for individual products, due diligence is enforced at a company level, and on the basis of minimum standards for mitigation efforts.  The difference is particularly clear when comparing the OECD Due Diligence Guidance with the “blood diamond” Kimberley Process Certification Scheme (KPCS).

The supply chains covered by the two systems are quite similar in some respects. They both relate to extractive industries. Artisanal miners and the informal economy play an important role in each. Crucial points of transformation and traceability can be identified. All covered supply chains have a well-documented history of financing armed conflicts in some of the poorest regions of the world. Breaking the link between trade in the concerned resources and the financing of conflict is the main objective. 

But, on the other hand, these two systems designed to address risk derived from a natural resource trade could not be more different. Unlike the OECD Due Diligence Guidance and the national laws based on it, the Kimberley Process is essentially a state-to-state system, whereby states guarantee by means of a certificate that their rough diamonds were not financing rebel movements and agree to trade only with other participating countries that meet the same minimum requirements. In addition, the Kimberley Process is limited to trade in “rough diamonds used by rebel movements to finance wars against legitimate governments,” whereas the OECD Due Diligence Guidance concerns trade in minerals “associated with serious human rights abuses, direct or indirect support to non-state armed groups or public and private security forces, bribery and fraud, money laundering, [and irregularities in] payment of tax fees and royalties due to governments.”

This state-centred focus has not only kept the 81 participating countries representing approximately 99.8 percent of the global rough diamond production from updating the Kimberley Process (KP) mandate – for example, to also include situations of armed conflict and serious human rights violations – but has also often paralysed the organisation in cases of non-compliance. For instance, due to its limited focus on the financing of rebel movements the Kimberley Process allows for trade in diamonds from the Zimbabwean Marange diamond fields, despite the meticulous documentation of serious human rights violations by government forces in the region. [Ref 1]

Events in the Central African Republic (CAR) offer another recent example of the Kimberley Process’ inability to properly address the problem of blood diamonds.  In May 2014, a shipment of 6634 carats of falsely certified diamonds was seized in Antwerp, Belgium with the Kimberley Process Working Group of Diamond Experts noting that it was highly probable that the diamonds had originated in CAR. Since its suspension from the process in May 2013, 140,000 diamond carats, worth around US$24 million US, are estimated to have been smuggled out of CAR. [Ref 2] The incident is by no means an isolated case and the industry is conscious of the risks associated with KP certificates. At the same time, the continuous high regard for the system in the international community has resulted in a situation where the downstream industry is largely discharged of its responsibility, with certificates cleaning a diamond’s status rather than certifying its clean status.

In contrast, supply chain due diligence places the responsibility to identify and mitigate risk on individual companies, demanding corporate action not only but especially where inter-state systems fail. In the case of conflict minerals, this effectively means that downstream companies are under an obligation to identify the risk of buying minerals or metals produced by smelters and refiners who do not conduct due diligence and who source irresponsibly, in particular from conflict-affected and high-risk areas. Smelters and refiners, on the other hand, may be operating with existing certificates, including those from inter-state systems and industry schemes, but are nonetheless under an obligation to conduct their own due diligence investigations into local realities.

Translating due diligence requirements into trade regulation

Translating the Kimberley Process Certification Scheme into a trade regulation was fairly straightforward as it prohibits trade in non-certified rough diamonds. The WTO granted a multi-year waiver for the scheme in February 2003 and this has been renewed numerous times since.

A first, though only partial, example of translating the OECD Due Diligence Guidance into law is section 1502 of the US Dodd Frank Act. Under the Act and subsequent rulings by the Securities and Exchange Commission (SEC), US listed companies are under an obligation to report on their mineral due diligence processes and to disclose the status of their products as ”DRC conflict-free” or “Not DRC conflict-free,” although the origin-disclosure requirement is currently postponed and subject to a pending legal challenge.

If upheld, the law goes beyond international standards, as it would require companies to trace the origin of the minerals used in individual product lines and to label the latter accordingly. As a consequence of this feature companies interpreting the law often ignore one of the most important features of risk-based due diligence, namely, the recognition that risk mitigation should be evolving and gradual. For other issues the law stays behind international standards. For example, with its exclusive focus on the African Great Lakes Region, the law assumes that risks are static. It places greater obligations on companies that are active in that region, despite the fact that similar risks already exist, and could emerge in other regions.

The EU has over the last year been engaged in a similar process of translating a risk-based due diligence standard for mineral supply chains into law. In March 2014 the EU Commission’s Directorate General for Trade proposed a first draft outlining a voluntary opt-in scheme under which approximately 21 European smelters and refiners could have chosen to voluntarily self-certify to be complying with the OECD Due Diligence Guidance. There was no provision for downstream companies. Instead the aim was to exclusively build on the notion of ‘crucial points of transformation and traceability’. After a lengthy process in the European Parliament, which culminated in a strong proposal by the plenary calling for a mandatory approach applying to the entire supply chain in accordance with the OECD Due Diligence Guidance, the draft law will soon be subject to final trialogue negotiations between the Commission, the Parliament, and the European Council.

During discussions in Parliament a number of alternative options were tabled with some aimed at finding a middle ground. These included one proposal to adopt the Commission’s approach on a mandatory basis and to complement it with a voluntary labelling component for manufacturing companies. Under that hybrid system, all raw materials entering the EU would have been captured by the due diligence obligations except those produced within the 28-nation bloc, while minerals entering as components of part or final products would have flown under the radar. Besides these potentially discriminatory and inefficiency aspects, there were great concerns that the system would create the opposite of a level playing field by singling out the 21 European smelters and refiners importing raw materials out of 450 globally, creating further incentives for European manufacturers to source from the non-European metals industry and to outsource their practices to import part-products instead. There was also a concern of subjecting human rights abuses as grave as those associated with armed conflict to a consumer-choice label.

By turning this the other way around and imposing obligations on all supply chain actors, the current Parliamentary proposal is expected to create a multiplier effect, whereby the non-European parts of the supply chain will be affected due to market pressure within the EU, giving security to both producers and consumers. The final Parliament outcome, however, is not particularly detailed regarding the obligations for downstream companies. Yet the text suggests that it is meant to apply to all European and non-European companies that first place products containing the covered minerals –for the moment tin, tantalum, tungsten, and gold – on the market, irrespective of their form. The draft law expects that these downstream companies would conduct due diligence by establishing an internal management system, identifying and mitigating the risk to be sourcing metals from a non-responsible smelter or refiner– based on a list of responsible smelters and refiners, audits, and other information – which may be done collectively through industry schemes. Finally, the Parliament’s proposal includes an obligation for public disclosure on company websites and in management reports, where available. All of these obligations would come in different degrees of strength to be “appropriate for a company’s individual circumstance, including its size, role and position in the supply chain.”

The system does not, however, foresee product tracking, labelling, or a certification mechanism for downstream companies under which companies are shown to be compliant. Enforcement relies instead on public disclosure and on ordinary non-compliance sanctions available under national civil and criminal law. This includes, in particular, sanctions for cases of fraudulent reporting or omissions and negligence in due diligence as they apply to other due diligence systems such as those on anti-money laundering in the finance sector.

In accordance with practice under other EU regulations, for instance in the areas of food and health standards, EU member states would be free to request domestic companies to register with local chambers of commerce or local authorities for the purpose of being included in a general register of qualifying entities. This would also aid random checks by authorities. On the other hand, foreign importers who fall within the scope of such regulation could register with the customs authorities, thereby declaring that they fall within the scope and will comply with the due diligence and public reporting requirements. No further action by the customs authority, however, would be expected as there is no product and hence import-component in the law.

Lessons for other sectors

Public discussions in Parliament indicate that two main convictions informed the outcome. First, the notion that each economic actor should not only be required, but should be able to participate and that such holistic action requires common but differentiated responsibilities tailored to a company’s size. There was a clear fear that a voluntary system would create inefficiencies working in favour of large companies subject to stronger market pressure, while small-and-medium sized enterprises would be excluded for cost reasons. The key word is now “burden sharing.”

Second, the concept that a system must be about addressing risks and generating change, but should not be blacklisting certain regions or industries or expecting full guarantees. The aim is to incentivise more responsible trade and not to ban trade that risks being irresponsible. Especially in the context of trade from conflict-affected and high-risk areas and in industries relying on artisanal miners, this is crucial, as international regulation should incentivise responsible purchasing that helps rebuild local economies. The aim should not be to “de-risk,” and have industries pull out from the region to purchase elsewhere, thereby destroying legitimate income opportunities. Risk-based due diligence can generate such change in supply chains by making a more responsible standard the norm, while avoiding shock situations that are usually created by trade bans. In order to achieve this, it is crucial that the gradual and evolving nature of due diligence is fully understood, and that it is not turned into a black-and-white labelling or certification system inserted.

Similar, if not identical, convictions should drive efforts in other areas and for other risks. Risk-based due diligence has the potential to properly address labour rights, environmental protection, carbon footprints, and many other challenges as it is based on the idea of addressing the most frequent risks and doing so in a joint, harmonised way while keeping the responsibility within individual companies. This holds true for the ongoing process of developing guidance for the apparel industry on the basis of the five-step due diligence framework, as well as for ongoing discussions to develop a specific supplement to the OECD Due Diligence Guidance regarding precious stones.

The views expressed in this article are the views of the author alone.

Marie Wilke, Associate Lawyer, WTI Advisors; Advising a multi-stakeholder client on EU conflict minerals regulation

[Ref 1] See the Zimbabwe Campaign of Global Witness. In response to the KPCS’ reaction to the Marange human rights violations, Global Witness resigned as one of the two formal Civil Society Observers to the KPSC in 2011.

[Ref2] Bloomberg, “Smugglers Defy Conflict-Diamonds Ban in Central African Republic”, March 23 2015.

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