Making Global Self-Regulation Effective in Developing Countries

Making Global Self-Regulation Effective in Developing Countries The Global Economic Governance Programme was establis...

Author: Dana L. Brown | Ngaire Woods

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Making Global Self-Regulation Effective in Developing Countries

The Global Economic Governance Programme was established at University College in 2003 to foster research and debate into how global markets and institutions can better serve the needs of people in developing countries. The three core objectives of the programme are:

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to conduct and foster research into international organizations and markets as well as new public–private governance regimes; to create and maintain a network of scholars and policymakers working on these issues; and to influence debate and policy in both the public and the private sector in developed and developing countries.

The Programme is directly linked to Oxford University’s Department of Politics and International Relations and Centre for International Studies. It serves as an interdisciplinary umbrella within Oxford drawing together members of the Departments of Economics, Law, and Development Studies working on these issues and linking them to an international research network. The Programme has been made possible through the generous support of Old Members of University College. Its research projects are principally funded by the MacArthur Foundation (Chicago) and the International Development Research Centre (Ottawa).

Making Global Self-Regulation Effective in Developing Countries Edited by

Dana L. Brown and Ngaire Woods

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Great Clarendon Street, Oxford OX2 6DP Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trademark of Oxford University Press in the UK and in certain other countries Published in the United States by Oxford University Press Inc., New York © The several contributors 2007 The moral rights of the authors have been asserted Database right Oxford University Press (maker) First published 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer British Library Cataloguing in Publication Data Data available Library of Congress Cataloging in Publication Data Data available Typeset by SPI Publisher Services, Pondicherry, India Printed in Great Britain on acid-free paper by Biddles Ltd., King’s Lynn, Norfolk ISBN 978–0–19–923463–9 1 3 5 7 9 10 8 6 4 2

Contents

List of Figures List of Tables List of Contributors

Introduction Dana L. Brown and Ngaire Woods 1. Making Corporate Self-Regulation Effective in Developing Countries David Graham and Ngaire Woods

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2. Do Voluntary Standards Work Among Governments? The Experience of International Financial Standards in East Asia Andrew Walter

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3. Do Voluntary Standards Work Among Corporations? The Experience of the Chemicals Industry Michael Lenox

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4. Making Disclosure Work Better: The Experience of Investor-Driven Environmental Disclosure Robert Repetto

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5. Bringing in Social Actors: Accountability and Regulation in the Global Textiles and Apparel Industry Dara O’Rourke 6. Responsive Regulation and Developing Economies John Braithwaite 7. Using International Institutions to Enhance Self-Regulation: The Case of Labor Rights in Cambodia Sandra Polaski

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Contents

8. Local Politics and the Regulation of Global Water Suppliers in South Africa Bronwen Morgan

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9. Self-Regulation in a World of States Dana L. Brown

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Index

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List of Figures

2.1. Private sector compliance costs and third-party monitoring costs

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4.1. Oil and gas company exposures

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4.2. Three-pollutant cap-and-trade, permits grandfathered

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4.3. Four-pollutant cap-and-trade, announced carbon, permits grandfathered

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4.4. Four-pollutant cap-and-trade, carbon later, permits grandfathered

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6.1. Toward an integration of restorative, deterrent, and incapacitative justice

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6.2. A responsive regulatory pyramid for a developing economy to escalate the networking of regulatory governance

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6.3. Regulatory pyramid for a developing country human rights NGO seeking to escalate networked regulation for human rights

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6.4. A network of governance in which just two nodal actors have a capacity to escalate networked regulation

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7.1. Reinspected factories: response to ILO suggestions

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7.2. Incidence and remediation of wage problems

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8.1. Private sector participation in water: South Africa

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List of Tables

2.1. Key international standards and codes

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2.2. Summary of BCBS core principles for effective banking supervision (September 1997)

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2.3. Compliance with SDDS and adoption of IAS/US GAAP, end 2003

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2.4. SDDS subscription, posting and compliance dates, selected countries and groups

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2.5. Basle CARs in selected Asian countries and the USA, 2003

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3.1. Typology of stakeholder responses to environmental externalities

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3.2. Typology of self-regulatory strategies

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4.1. Probability of a reduction in company shareholder value by more than 10% or 5%

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List of Contributors

John Braithwaite is Professor at the Research School of Social Sciences, Australian National University and Founder of RegNet (the Regulatory Institutions Network) at the Australian National University. He works on business regulation and criminal justice, and particularly on restorative justice. He is the author of Markets in Vice, Markets in Virtue, published by Federation Press. Dana L. Brown is University Lecturer in International Business at the Said Business School, University of Oxford. Her research interests focus on the way that national employment and social policies affect business strategies, particularly in developing and former communist countries. David Graham is a doctoral candidate in International Relations at University College, University of Oxford. He is researching the social and environmental regulation of multinational corporations, focusing on the role of the World Bank as a standard-setter. He has published an article in World Development, coauthored with Ngaire Woods. Michael Lenox is Associate Professor of Strategy at the Fuqua School of Business, Duke University. He holds a secondary appointment as Associate Professor of Environmental Policy at the Nicholas School of Environment, Duke University. He has published numerous articles on corporate selfregulation. Bronwen Morgan is Professor of Socio-Legal Studies in the Faculty of Social Sciences and Law at the University of Bristol, UK. Her research focuses on the political economy of regulatory reform, the intersection between regulation and social and economic human rights, and global governance, especially issues such as citizenship that link social theory and political economy. Sandra Polaski is Senior Associate and Director, Trade, Equity and Development Project at the Carnegie Endowment for International Peace. Until

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List of Contributors

April 2002, she served as the US Secretary of State’s special representative for international labor affairs, the senior State Department official dealing with such matters. She recently published Winners and Losers: Impact of the Doha Round on Developing Countries (Carnegie Endowment Report). Dara O’Rourke is Associate Professor of Environmental and Labor Policy at the University of California at Berkeley. He researches the environmental, social, and equity impacts of global production systems. He is the author of Community-Driven Regulation: Balancing Development and the Environment in Vietnam, published by MIT Press. Robert Repetto is Professor in the Practice of Economics and Sustainable Development at Yale University. He has served on EPA’s Science Advisory Board and National Advisory Council on Environmental Policy and Technology, on the National Research Council’s Board on Sustainable Development and on many NRC committees. As vice president and senior economist at the World Resources Institute in Washington, DC he published numerous books and monographs on environmental policy. Andrew Walter is Senior Lecturer in International Relations and Academic Director of the TRIUM Global EMBA at the London School of Economics. His research interests include the political economy of international money and finance and financial regulation. His forthcoming book is Mock Compliance: The Politics of the International Standards Project in East Asia. Ngaire Woods is Director of the Global Economic Governance Programme and University Lecturer in Politics and International Relations at the University of Oxford. Her most recent book The Globalizers: The IMF, the World Bank, and Their Borrowers was published by Cornell University Press (2006).

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Introduction Dana L. Brown and Ngaire Woods

As companies ‘go global’, they are increasingly using factories and facilities spread across the world. But who regulates their activities in farflung corners of the world economy? In many sectors such as textiles and apparel, chemicals, and forestry, the answer is that companies regulate their own behavior through codes and standards which they agree among themselves. These codes have attracted a lot of attention by scholars who have carefully described and attested to the growth of self-regulation, detailing the number and content of codes of self-regulation and standards which have been promulgated in various sectors. Missing is an analysis of the effectiveness and impact of codes and self-regulation and how it compares to other forms of global regulation. Does corporate self-regulation work and if so under what political and economic conditions is it most likely to be effective? This question is particularly important for developing countries which tend not to be involved in the formulation of sectoral self-regulatory standards and who suffer asymmetrically from their failure—mainly because they lack the domestic regulatory structures which industrialized countries can use to make up for failures in self-regulation. Given that developing countries often have few capacities to regulate global corporations operating within their borders, this book considers some minimal forms of government action that can make global corporate self-regulation more effective. In Chapter 1 of this book, David Graham and Ngaire Woods examine whether voluntary codes of corporate conduct are a promising alternative to regulation in countries where governments have limited capacity to regulate. They review the state of the literature about selfregulation, focusing in particular on market-based pressures which alter

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the incentives on corporations to take greater account of their social and environmental impact. The analysis highlights the critical role information plays in catalyzing such pressures. For this reason, Graham and Woods closely examine voluntary disclosure regimes, highlighting the collective action problem faced by companies in respect of disclosure. The result is a strong argument for mandatory disclosure accompanied by robust enforcement. For developing countries with little capacity to regulate in the first place, this suggests that the prospects for effective self-regulation in developing countries are dim. However, drawing on another approach to understanding voluntary codes enables the authors to propose an alternative way to make corporate self-regulation more effective by leveraging local and global political and legal forums. In Chapter 2 of this book, Andrew Walter highlights the gap between sign-up to and compliance with voluntary codes. It is easy for firms or governments to sign up to voluntary codes or standards, and it is equally easy to track how many of them have done so. But this does not tell us that self-regulation is effective. Crucial is the difference between subscription and compliance. In East Asia, governments have voluntarily agreed to conform to financial codes and standards set by international organizations. However, few have actually complied with the codes and standards. This is partly because the standards were imposed by international organizations and have created unexpected high compliance costs for many domestic actors. This has produced a strong incentive for ‘mock’ compliance. Walter argues that compliance would be improved if there was more involvement of domestic actors in the initial setting of standards. Moreover, he finds that accurately to assess compliance would require engaging actors with local and specific knowledge. The overall lessons about compliance are further explored by Michael Lenox. In Chapter 3, Michael Lenox examines a different form of selfregulation promoted by the international chemicals industry. The Responsible Care Code has often been touted as a success because of its formal standards and the number of participants in the scheme. Contrary to this, Lenox finds that participants in the scheme have improved their standards more slowly than nonparticipants. Like the previous chapters, Lenox’s findings point to the vital input needed from states and local actors. Compliance difficulties in the case of Responsible Care are partly related to the problems of adequate disclosure since the lack of information makes it difficult for activists, industry members, or investors to identify real environmental laggards and hold them to account. The solution, Lenox suggests, is for states to step in to improve industry self-regulation 2

Introduction

by changing the incentives for firms to coordinate, improve disclosure, and deploy punishments and rewards. Disclosure is further examined by Robert Repetto in Chapter 4 who begins by noting the importance of disclosure for achieving compliance with environmental codes and standards. In North America, changes in the financial marketplace have brought about a revolution in disclosure requirements. On the face of it, new regulation has created strong investor-driven incentives to disclose environmental risk. However, Repetto finds that these incentives are not as strong as they seem by examining practices in three sectors. In the pulp and paper industry, there is clear evidence that environmental exposure poses financial risks to companies but that companies have failed to report financially material environmental exposure and risks. Similarly, in the oil and gas producing industry as well as in the electricity-generating industry in spite of high financial risks from environmental exposure, there is under-reporting. The key to ensuring disclosure affects compliance, argues Repetto, is strong enforcement. Companies will only disclose in an adequate and timely way if they know their disclosure requirements will be enforced. To this end, Repetto argues, state agencies need to coordinate among themselves better and to share information with investors and investment analysts. This will enhance their capacity to enforce disclosure requirements which will in turn strengthen the incentive of companies to lower their environmental exposure. In Chapter 5, Dara O’Rourke examines the conditions under which regulatory or private sector self-regulatory schemes are effective in developing countries. He draws on a comprehensive study of efforts to regulate labor conditions in the textile and apparel industry. Joint efforts between multinational firms and wide ranging multistakeholder initiatives (MSIs) have been partly effective in improving conditions in this industry. However, significant weaknesses in monitoring and enforcement exist. Thirdparty monitoring of compliance in far-flung production networks is difficult. However, O’Rourke argues that these efforts could be considerably enhanced by enlisting state and local regulatory authorities as partners, ensuring maximal local involvement in rule-setting and implementation and vastly improving the degree of information about producing factories that is gathered and disclosed. His findings strongly support the idea that coordination across a range of global, national, and local actors is essential for making current regulatory regimes more effective. In Chapter 6, the broader themes raised by O’Rourke are elaborated by John Braithwaite who applies his analytical framework of 3


‘responsive regulation’ to the global economy and to the issue of corporate self-regulation in developing countries. For Braithwaite, responsive regulation is a realistic solution for developing countries because it requires only minimum state capacity and resources. At the core of ‘responsive regulation’ is progressively escalating regulation, with firms self-regulating as an ideal, and states stepping in with sanctions for noncompliance only in the most egregious cases. In the middle, regulation is accomplished through networks of nonstate actors. Braithwaite’s model accords a critical role to the state as the ultimate enforcement agent, but it crucially relies on other actors as well. Local actors must play a role if regulation is to be responsive and comprehensively implemented. But, the power of local actors can be greatly enhanced through networks with transnational and global actors, including nongovernmental organizations (NGOs) and international organizations tasked with upholding human rights. In his chapter here, Braithwaite provides perhaps the most pointed case for focusing on coordinated forms of regulation to overcome challenges arising from global expansion in the developing world. In Chapter 7, Sandra Polaski presents a case study of Cambodia where the involvement of governments and an international organization created a strong framework of social regulation. In Cambodia, bilateral trade relations with the USA put labor rights squarely on the government’s agenda. In that context, local workers were able to negotiate with the government to produce labor codes, with reporting requirements involving the International Labor Organization (ILO). By using its authority to grant export licenses, the Cambodian state considerably bolstered local producers’ participation in the ILO scheme at a minimal cost of resources and expertise. In brief, a particular combination of international agreements, the involvement of multilateral agencies, alongside local and national workers and government agencies made a self-regulatory regime effective. But this is not always the case. In South Africa, global water utilities companies have attempted to forge dialogue with local groups in order to improve their reputation and effectiveness. In Chapter 8, Bronwen Morgan examines this case, asking why global water companies are doing this and what particular incentives they face as they seek to invest in utilities in developing countries. Three of the factors already highlighted in the previous chapters come clearly to the fore. Changes in global rules and opportunities, actions and pressures have reconfigured corporate incentives to behave in particular ways. But equally importantly, national regulation and the emergence of new norms within South African politics have played a key role in shaping the 4

Introduction

environment to which global companies feel they must adapt. Finally, the case study gives a fascinating analysis of local politics, its divisions and dynamics, and the way a range of protest, reactions, and participation by local NGOs, some of whom are supported by transnational movements, can affect corporate behavior. There is generally agreement among the authors in this book that in order for developing countries to realize the benefits of corporate selfregulation, efforts and involvement of the state, local and international actors are required. Only then problems inherent to self-regulation such as compliance and representativeness can be overcome. But how far can self-regulation really go to resolve the complex social, environmental, and developmental problems that developing countries face? In the conclusion to this book, Dana Brown considers the extent to which selfregulatory efforts can supplement for a state role in regulating the global economy. Brown uses historical and recent evidence to argue that even in the globalized economy, states have a vital role to play in fostering economic development and growth; a role that goes beyond that which self-regulatory schemes even intend to accomplish, let alone what they can accomplish. The implication is that ‘weak’ states in the developing world need to become stronger, a fact that cannot be overlooked by international organizations and NGOs whose attention and energy are focused increasingly on bolstering self-regulatory schemes. The increasing attention to corporate self-regulation by global actors makes the contributions in this book timely. For many, self-regulation promises a solution to the key challenges of globalization. By getting corporations to check their own actions, self-regulation can contribute to more equitable growth especially in developing countries where states are often weak. At the same time, for corporations, self-regulation is a more flexible way than the imposition of state rules to address the social, environmental, and ethical issues that have become globally important. The authors of this volume do not necessarily disagree that global selfregulation holds such promise, but they provide important reminders that self-regulation is not a panacea. It is at most just a partial solution, and that only if accompanied by robust disclosure and enforcement backed by social actors and governments. In sum, global self-regulation can be made more effective only if inherent limitations are recognized and if states, local actors, and international organizations work together to overcome these limitations.

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1 Making Corporate Self-Regulation Effective in Developing Countries David Graham and Ngaire Woods

1.1. Introduction Corporate self-regulation has become dizzyingly popular. Most global companies today are signing up to codes of conduct in respect of their social and environmental impact. Many such codes are issued by individual corporations or industry associations, some involving other groups of stakeholders, committing participants to minimum standards of environmental and social conduct (Haufler 2001; Florini 2003). An inventory prepared by the Organization for Economic Cooperation and Development (OECD) analyzes the contents of 246 such codes across most major industry sectors and finds that environmental and labor standards were most prominent among the goals addressed, which also included commitments to protect human rights and refrain from bribery (OECD 2001). The new trend has been encouraged by several international organizations. For example, the United Nations Global Compact and the OECD through its ‘Guidelines for Multinational Enterprises’ invite corporations to uphold principles of human rights, labor rights, and environmental conduct across the whole extent of their global operations (OECD 2000, United Nations Global Compact). For people in developing countries, the rise of self-regulation in global corporations offers a possible way for improving lives and livelihoods. Multinational corporations (MNCs) are playing an ever-larger role in many developing countries. At the same time, governments in these countries often have very weak capacity to regulate or uphold labor or

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Making Corporate Self-Regulation Effective in Developing Countries

environmental standards. Those same governments even when they have capacity are shy of regulating MNCs for fear of losing their investments to other countries. For this reason, the idea that multinationals will themselves accept responsibilities for uptake of corporate social responsibility seems full of promise. The most optimistic view of corporate self-regulation emerges among those who see it as a product of a new global politics which is accompanying economic globalization. On this view, self-regulation reflects a global shift in what is considered appropriate behavior for MNCs in relation to human rights, labor rights, and environmental protection. The new standard has become part of societies’ normative structure, culture, and institutions. The MNCs embedded in these societies cannot escape the new norms which define what is perceived as ‘legitimate’ and appropriate (cf. the argument applied more broadly to international law: Franck 1990). At the core of this view are NGOs and corporations playing ‘increasingly important roles in generating, deepening and implementing transnational norms in such areas as human rights, the environment and anti-corruption’ (Ruggie 2003). Nongovernmental organizations are key to the optimistic view of self-regulation. They act as norm entrepreneurs, enhancing the standing of particular causes and values and persuading others to prioritize them (Finnemore and Sikkink 1998). For example, an activist NGO such as Global Witness is seen to adjust the values of business and society, ‘challenging established thinking on seemingly intractable global issues’ and establishing a central place for the promotion of peaceful and sustainable development in the business of resource extraction (http://www.globalwitness.org/vision.php). When a sufficient number of corporate leaders have been persuaded to adopt a set of emerging norms, they will reach a ‘threshold’ or ‘tipping point’ at which they come to be seen as legitimate and to specify appropriate behavior (Finnemore and Sikkink 1998). Policies and procedures will then be developed to internalize these in corporations’ operational structures. A contrasting approach to explaining the rise of corporate selfregulation is rooted in theories of public choice. This view is skeptical about corporations changing their behavior because of a change in the perceived legitimacy of certain standards. Indeed, one author suggests that managers with altruistic concerns for legitimacy may be removed or else their firms will not last long in a competitive market (Lenox 2003). More fundamentally, public professions of corporate codes of

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David Graham and Ngaire Woods

conduct will not necessarily result in changes in actual behavior. Beyond the sign-up and content of the code, one needs to seek out evidence that corporate behavior changes with the adoption of commitments or responsibilities. Empirical studies show that in practice voluntary codes are often not implemented and that many apparent instances of self-regulation are ineffective (Lenox 2003; Lenox, Walter, and O’Rourke, in this book). These studies do not negate the possibility that self-regulation could work. But they push us to identify why and when self-regulation is effective. The answer lies in the incentives which shape the behavior of companies. To quote an Australian government task force on self-regulation: ‘For industry self-regulation to be effective, there need to be some vested interests or incentives to make it so’ (Commonwealth of Australia Department of the Treasury 2000: 48). Our question then is whether there is any change in incentives underpinning the sign-up by corporations to voluntary codes of conduct. This chapter reviews the changing incentives that give rise to the possibility of effective self-regulation in industrialized countries. To foreshadow the argument, some of these incentives are market-based, these include pressure from consumers and activists, pressures to retain and attract employees, and pressure from investors. Crucial to all of these influences is access to accurate information. However, here voluntary regimes wobble. The evidence suggests that voluntary disclosure regimes do not provide the necessary information to unleash market-based pressures on firms to improve their behavior. One step toward remedying this is to improve auditing or assurance of standards in respect of information. However, we argue (along with other authors in this book) that companies face a serious collective action problem in respect of disclosure. If any one company discloses information about its social and environmental impacts without others doing the same, it risks attracting the adverse attention it seeks to avoid. For this reason, even under the best conditions, mandatory disclosure is required to give rise to a shift in market-based incentives. Mandatory disclosure implies a necessary minimum role for governments if self-regulation is to be effective. Governments need to set standards and also to enforce them. This raises serious problems for developing countries. Many developing countries do not have bureaucratic and judicial capacity to mandate and enforce disclosure of foreign companies. Furthermore, such regulation is perceived as risky since it might discourage investors who will relocate to other countries with 8


less regulation. 1 Recall that these are the same reasons that direct social and environmental regulation is difficult for these countries. Does this mean that there is little promise of effective self-regulation in developing countries? Prospects are dim for effective self-regulation in developing countries if changes in incentives require enforced mandatory disclosure rules. But as we work through the analysis of market-incentives, there is another strand to the argument. In the final section of this chapter, we examine an alternative way to conceive of making corporate self-regulation effective in developing countries, using local and global political and legal forums.

1.2. Market-Based Incentives to Adopt Self-Regulatory Codes The markets in which MNCs operate may supply incentives to selfregulate. Demand for a company’s products, and its supply of labor and capital may all be adversely affected by poor behavior and the adverse publicity it attracts. The behavior of consumers, employees, and investors can prompt companies to undertake self-regulatory activity (Gordon 2000).

1.2.1. Pressure from Consumers and Activists Multinational corporations may be prompted to self-regulate as a direct response to consumer pressure, intensified and assisted by NGO campaigns to encourage boycotts of firms with poor social and environmental standards. Nongovernmental organizations can identify problems associated with corporate behavior and then ‘work strategically to frame these problems in a way that supports consumer understanding and action and that places responsibility on specific corporations’ (O’Rourke, ‘Market Movements’). When activists highlight an issue and encourage consumer action, the resulting damage to corporate reputation can encourage MNCs to undertake effective self-regulation of their operations in developing countries. Even the threat of consumer boycotts can be sufficient to influence corporate conduct (O’Rourke, ‘Market Movements’). 1 The evidence suggests there is less risk than imagined. While regulatory standards for some industries are driven down, in others standards converge upward or remain heterogeneous across countries (Murphy 2004). On issues such as labor standards, national approaches may remain diverse while gradually coming to recognize some minimal norms and rules (Gitterman 2004).

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The latent power of consumers, brought into action by NGO and media publicity, was important in prompting the development of voluntary regulatory standards for footwear and apparel manufacturers in Asia. A combination of activist and consumer pressure against Nike following a 1996 CBS news report revealing sweatshop conditions at a Vietnamese supplier contributed to decreases in the company’s market share and profits (Haufler 2001: 59). The impact of consumer boycotts and activism led the company to attend to the effective implementation of the code of conduct for suppliers’ labor and environmental practices which it had adopted four years earlier. It developed new internal and external monitoring tools and improved management practices and training. Nike’s principal competitors within the sports footwear industry, Reebok and Adidas, then sought to avoid the reputational damage suffered by Nike by establishing effective self-regulatory programs of their own (O’Rourke 2003).

1.2.2. Pressure to Retain and Attract Employees Within large global companies, an oft-cited influence on self-regulation is the desire to recruit and retain the most able employees. Firms with reputations tarnished by poor social and environmental behavior are likely to find it more difficult to recruit and retain employees in their home countries’ labor markets. Corporations which fail to control risks to their reputation will effectively face higher labor costs than those which are perceived as socially and environmentally responsible (Lenox 2003). A 2003 study of employees for Business In The Community found that almost half regarded it as very important that their employer take social and environmental issues seriously (Social Investment Forum 2003: 21). Shell, for instance, argues that its ‘commitment to sustainable development is an important factor in people’s decision to join and stay’ and that ‘alignment between personal values and values of staff and corporate values is a powerful motivator’ (Royal Dutch/Shell Group of Companies 2002: 7). Since the best graduates are particularly averse to working for corporations with poor reputations (World Economic Forum 2003: 17), a further cost may be incurred in the long run if key executive positions are filled with less able candidates.

1.2.3. Pressure from Investors Corporations can face pressure from investors to regulate the social and environmental outcomes of their business activities. For some investors, this pressure is motivated by their own ethical concerns. Others are 10


driven by the fear of potential damage to shareholder value if risks to reputation are not effectively managed. Although it remains a point of contention whether responsible conduct does in fact yield benefits for firms’ share prices (Vogel 2005: 16; Dowell et al. 2000), many institutional investors urge careful management of potential risks to corporate reputation. The Association of British Insurers, for instance, whose members account for 20 percent of investments in the London Stock Exchange (http://www.abi.org.uk) has drawn attention to the financial implications of the ‘social and environmental risks and opportunities for companies . . . in every sector’ (Cowe 2004: 4). Screened funds can be used by normatively committed investors to invest only in companies that meet their ethical standards. There is evidence that this form of investor pressure is being increasingly applied. Investments in professionally managed funds employing major socially responsible investment strategies grew substantially during the 1990s and remained at a high level through the market downturn at the start of this decade. In 2003, the total value of these investments was estimated at $2.16 trillion (Social Investment Forum 2003: 2). In the United Kingdom (UK), such funds account for an increasing proportion of overall funds under management (Davis 2004: 2). Shareholder advocacy—the use of shareholders’ voting rights to improve corporate regulatory policies—is an alternative route through which investors can exert pressure for self-regulation. It can be employed by both normatively committed investors and those who seek to maximize their returns by urging corporate attention to risks that might potentially undermine value. Some 87 percent of UK pension funds responding to a 2002 poll claimed to exercise their voting rights on grounds of social, ethical, and environmental risk (SEE) (Cowe 2004: 16). In the USA, $448 billion of professionally managed funds was used to support shareholder advocacy campaigns. Environmental advocacy has been especially prominent. In the first eight months of 2003, 28 shareholder resolutions were moved in US corporations on issues relating to climate change, 7 of which received support from over 20 percent of shareholders. Shareholder campaigns have been effective in bringing about corporate self-regulation. For instance, pressure organized by union pension funds pushed the California-based energy corporation Unocal to adopt the commitments of the ILO’s ‘Declaration on Fundamental Principles and Rights at Work’, including the rights to freedom of association and collective bargaining. Market pressures are, however, limited in their scope and effectiveness. In particular, they do not always address the issues of most relevance 11


to MNCs’ operations in developing countries and are less effective in changing the behavior of firms without prominent brands. Much ‘ethical’ consumer activity is not targeted at improving conditions in developing countries. Organic produce and free-range eggs are among the most prominent ‘ethical’ purchases (Co-operative Bank 2001: 18). Products, such as energy-efficient appliances, unleaded petrol and renewable electricity which reflect a concern with the global environment, may show little concern about local environmental impacts of companies’ operations in developing countries. Fairly traded coffee, tea and fruit, and sustainable timber can have positive social and environmental conditions in developing countries. But high profile boycotts and campaigns such as those against Shell for human rights abuses in Nigeria and against Nike for poor labor conditions in Asia may be an exception rather than the rule. Similarly, ethically screened funds can incorporate a very wide range of normative concerns, many of which may not be relevant to controlling the potentially damaging effects of corporate activity in developing countries. Labor standards and the environment are among the most significant screens deployed by US mutual funds, being the third and fourth most prevalent respectively. But screens against investment in tobacco and alcohol each account for more than three times as much investment capital as either the labor rights or environmental screens, and human rights concerns are still less prevalent among screened funds (Social Investment Forum 2003: 9–10). Pressure from consumers is likely to be felt strongly only by firms which directly face the mass market and are highly visible, selling products with which they are strongly identified by branding (Haufler 2001: 70). The campaign against Nike relied on the ease with which the brand could be targeted as well as the significance of the brand’s reputation to the company’s value (O’Rourke 2003). Nestlé’s mass-market foodstuff sales could be targeted with relative ease following concerns over the company’s aggressive marketing of breast-milk substitutes in the developing world (Sikkink 1986). In the visibly branded and mass market-facing oil industry, Shell and its principal European rival BP each developed their own self-regulatory systems. In industries which do not face the mass market, however, it may be more difficult for consumers and ethical investors to become accurately aware of a firm’s poor conduct. Even if accurately informed, they may lack information about which brands and products they should boycott in order to sanction the company. Thus, the responsiveness of a small number of corporations with prominent, reputation-sensitive brands ‘may not tell us much about the potential to 12


influence production and consumption that falls outside this top tier of consumption’ (O’Rourke, ‘Market Movements’). Market-based incentives will not, therefore, apply to all MNCs nor to all issues relevant to their conduct in developing countries. Pressures from consumers, investors, and the labor market can all play a role in mitigating damage to the risks to the environment, human rights, and labor rights of some MNC activity in the developing world. But there will not always be a business case for self-regulation (Vogel 2005: 73). The question then—for firms, NGOs, governments, and international organizations—is how to respond to the limitations of market-driven self-regulation.

1.3. Improving Information to Catalyze Market-Based Incentives One set of responses to the problems of market-driven self-regulation attempts to enhance self-regulation by making market-based incentives work better. In particular, firms and governments have sought to address the need for market actors to be extensively informed about corporate activities in order to bring effective pressure for self-regulation to bear. An adequate supply of accurate information about corporate behavior is essential if market-based incentives to self-regulate are to work properly. Without it, the informed decision-making by potential and actual investors, consumers, and employees on which market-based incentives rely is not possible. When information is sporadic and unreliable they cannot assess a company’s performance, comparing it with its own claims and aspirations and with the performance of its competitors. The effect of market-based incentives on MNCs’ conduct in developing countries will therefore depend on securing reliable and comprehensive disclosure of relevant corporate information. This presents a challenge. Legally, companies enjoy an assumption that information they hold is confidential except where its disclosure is specifically mandated. The trend in many developed states toward openness with regard to government information has not extended to corporate information. In the UK, for instance, the Freedom of Information Act 2000 introduced a general right of access to information held by public authorities, limited by various exemptions. No such right exists in relation to information held by companies. Despite the blurring of boundaries between private and public, as the delivery of public services is reformed, corporate information continues to enjoy a privileged 13


status of confidentiality, on the grounds of commercial sensitivity. Even information about companies held by public authorities is liable to be exempted from disclosure under the Freedom of Information Act if it would prejudice commercial interests (FOI Act 2000). This situation may be particularly anomalous with regard to MNCs’ activities in developing countries, where attempts at socially responsible conduct frequently involve private companies undertaking functions—such as the provision of transport, education, and health infrastructure—traditionally associated with governments. Nevertheless, information about these activities enjoys a presumption of confidentiality. If market actors are to be properly informed, information must either be disclosed voluntarily or else specific legal requirements for disclosure must be introduced.

1.3.1. Voluntary Disclosure Pressure from stakeholders for responsible conduct may itself induce companies to release information to demonstrate their good performance (Blacconiere and Patten 1994). For instance, in the late 1990s, Shell responded to the pressure of NGO campaigns and consumer boycotts over its human rights and environmental records by introducing an annual report on its social and environmental performance. The earliest examples of these reports were constructed around an argued defense of the company’s record in implementing its Business Principles. Data supplied in the report was selected to support the case being argued (Royal Dutch/ Shell Group of Companies 1998). The reporting of data that is entirely self-selected and unverified does little to prevent unscrupulous firms creating a misleading impression. Combined with voluntary codes loudly proclaiming lofty aspirations, voluntary reporting can help firms control their reputation without actually changing their behavior. Companies can buy reputational benefits cheaply by adopting voluntary standards or codes but avoiding the costly steps required to implement them. However, they risk a backlash if their duplicity is exposed. As has been noted, many institutional investors have encouraged firms to manage carefully potential risks to their reputation. These investors recognize that the reporting of good news alone does not enable them to form a reliable view of the risks faced by a company. They have exhorted companies to disclose information enabling investors to identify material risks and assess companies’ steps to address them. Disclosure Guidelines issued in October 2001 by the Association of British Insurers recommend that annual reports should ‘include information 14


on SEE related risks and opportunities that may significantly affect the company’s short and long-term value’ (Association of British Insurers 2001). Some firms have responded by moving beyond the reporting of good news stories to publication of data which measures performance through specific indicators. Shell, for instance, worked to develop ‘increasingly verifiable measures of the performance of Shell companies against the [Shell Business] Principles’. Over several years more such measures were introduced to its annual social and environmental reports. While these continued to stress Shell’s aspirations and positive performance, the increasing quantitative content provided readers with data from which to draw their own conclusions, note shortcomings, and monitor changes in performance from year to year.

1.3.2. Improving the Comparability of Voluntary Disclosure Reporting of company performance through specific indicators is an important development in corporate disclosure. Market-based incentives to self-regulate will be most effective when these indicators are standardized across firms. Investors, customers, and employees do not merely judge a company’s performance in isolation. Each set of stakeholders faces choices in their respective markets: consumers a choice of products to buy, a choice of where to invest capital, and a choice of where to supply labor. The reporting of financial data to investors mandated by governments requires each company to provide standard information not only because it is deemed important in judging the merits of a company’s individual performance but because it enables comparison between companies. Similarly, social and environmental performance is best communicated in an easily comparable form, with firms reporting their performance through standard indicators. Standard indicators also help overcome a disincentive to full disclosure of relevant performance information. Any one firm attempting balanced disclosure of information that reveals weaknesses as well as strengths faces the risk that their bad news will be seized upon while more secretive competitors are let off the hook. If standard indicators are available and widely accepted, it becomes more obvious if a firm seeks to hide poor performance by failing to report certain performance indicators. The importance of accurate comparison of disclosures between firms has led to recent attempts to develop standardized voluntary reporting indicators which permit investors to form reliable comparative judgments of different firms’ exposure to risks. Governments and international organizations have supported these efforts. The Global Reporting 15


Initiative (GRI) is a particularly important development in voluntary standardized reporting by companies. Initiated in 1997, it responded to the profusion of inconsistent approaches to social and environmental reporting (GRI 2002: 4). It aims to improve the ‘comparability, consistency, and utility’ of reporting through the development of standard indicators, detailed in its Sustainability Reporting Guidelines (GRI 2002: 9). The indicators specify information to be provided in six categories: direct economic impacts, environmental impacts, labor practices and decent work, human rights, society, and product responsibility (GRI 2002: 36). Environmental reporting includes information on biodiversity and on the levels of emissions, effluent, and waste. Although the labor practices indicators focus on industrial relations between labor and management, they also include health and safety reporting. More fundamental aspects of labor rights, including the use of child labor and forced labor, are covered by the human rights indicators which also include indicators for impacts on indigenous rights. The society indicators include information relating to bribery and corruption and political contributions (GRI 2002: 50–5). The indicators are underpinned by principles of identifying information relevant to sustainability concerns and reporting it fully, accurately, and clearly. Firms are required to report ‘all information that is material to users for assessing the reporting organisation’s economic, environmental, and social performance’ and can then refer to their reporting as being ‘in accordance’ with GRI guidelines (GRI 2002: 26). There is some evidence that the ‘incremental approach’ envisioned in the GRI approach—whereby companies are encouraged to apply at least some of the guidelines and to work incrementally toward fuller compliance—is effective. In its 2002 ‘Environment and Social Report’, BP recognized the value of the GRI indicators but gave reasons for not following the guidelines to structure BP’s reporting. By 2003, the BP ‘Sustainability Report’ provided extensive reporting of the GRI indicators and indexed all the core indicators, pointing to the forms in which each was reported and declaring when an indicator was not reported or covered only in part (BP 2004: 46–7). The GRI indicators, incorporated in reports respecting the GRI principles, offer a strong prospect of escaping the problems of anecdote and incomparability that have dogged reporting of environmental and social impacts. Though much relevant information remains qualitative and cannot easily be expressed quantitatively (as the GRI indicators recognize), standardized reporting facilitates systematic interfirm and intertemporal comparisons. 16


1.3.3. Enhancing the Credibility of Voluntary Disclosure Voluntary disclosure, to be effective, must be credible. Corporate financial reporting is subject to detailed legal requirements for audit and verification, designed to assist stakeholders in judging its accuracy and reliability. But in spite of incentives to provide convincingly audited disclosures to stakeholders to show that risk has been adequately managed, the adoption of independent monitoring of environmental, human rights, and labor rights information remains limited. In 2002, just 36 of the FTSE 250 companies had their environmental and social reports independently audited (Maitland 2002). Environmental and social auditing, when it does take place, faces particular difficulties. When companies report on their finances, their accounts are audited in a highly formalized process aimed at ascertaining whether the reporting conforms ‘in all material aspects’ to ‘an identified reporting framework’ (OECD 2001: 11). Statutory controls and formal standards remove discretion from the auditor and require professional standards of expertise and independence of judgment (OECD 2001: 11). In respect of nonfinancial reporting, there have been few such statutory controls, presenting the risk that nonfinancial auditors or monitors face unbalanced incentives to err toward favorable treatment of their clients. Independence and appropriate expertise are vital qualities of auditing bodies but have been especially difficult to achieve for social and environmental monitoring. Even when monitoring is carried out by bodies external to the reporting corporation, its independence can be undermined if the monitors are paid by the corporation being audited. An examination of labor standards monitoring in China and Korea by Pricewaterhouse Coopers (PwC) found ‘significant and seemingly systematic biases’ in the auditors’ methodologies which ‘call into question the company’s very ability to conduct monitoring that is truly independent’ (O’Rourke 2000). The problems encountered by PwC are likely also to be symptomatic of the difficulties faced by monitors with experience of financial audits adapting to the necessarily very different methods and objectives of environmental and social auditing. Unguided by auditing standards, monitoring will struggle to achieve the credibility that it seeks to provide to the reporting of corporations’ environmental, human rights, and labor rights performance. An OECD report on making corporate codes of conduct work effectively identifies the need for formal auditing standards for social and environmental monitoring which echo the processes used in financial

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auditing. Formal standards remove discretion from the auditor and ‘reinforce its claim to be acting independently of the firm being audited’. Further, auditing standards make it easier for all stakeholders ‘to determine whether the audit has been done competently’ (OECD 2001: 11). A notable attempt to develop such standards has been made by the Institute of Social and Ethical AccountAbility, a membership association of a range of stakeholders including corporations, NGO advocacy groups, business service firms, and researchers. Established in 1996, by March 2004 it comprised over 300 members in 20 countries (see http://www.accountability.org.uk). Noting that the credibility achieved by ‘robust external Assurance’ is ‘a prerequisite for more effective sustainability Reporting’, in March 2003 it introduced the AccountAbility AA1000 Assurance Standard as a ‘non-proprietary, open-source assurance standard’ for nonfinancial audits (Institute of Social and Ethical AccountAbility 2003: 3–4). The AA1000 Assurance Standard is designed to address auditors’ ‘need for a single approach that effectively deals with the qualitative as well as quantitative data that makes up sustainability performance plus the systems that underpin the data and performance’ (see http://www.accountability.org.uk). Three assurance principles form the core of the assurance standard. Reporting should be assessed against requirements of materiality, completeness, and responsiveness. The assurance provider must state whether the reporting firm has included in its report all material information ‘required by its Stakeholders for them to be able to make informed judgements, decisions and actions’. It must assess the degree of completeness to which the reporting company can identify and understand what are the material aspects of its environmental and social performance. Finally, the auditor must ascertain whether the reporting firm has ‘responded to Stakeholder concerns, policies and relevant standards, and adequately communicated these responses’ (Institute of Social and Ethical AccountAbility 2003: 15–18). The principle of materiality points to a particularly helpful advance in the standards of nonfinancial auditing. It notes that firms’ reporting should be assessed for the extent to which it includes information about performance against statutory requirements as well as policies promulgated by the firm or industry association. Attention should also be given, the principle states, to conceptions of materiality held by a firm’s peers as well as to the expressed views and perceptions of stakeholders (Institute of Social and Ethical AccountAbility 2003: 16–17). Attention to supplying material information can serve to sway social and environmental 18


reporting away from ‘good news’ stories and force audited reports to address frankly the risks to which companies remain exposed. Ernst and Young’s assurance report on BP’s sustainability reporting for 2003 was carried out in accordance with the AA1000 Assurance Standard. In its assessment of materiality, the auditor drew attention to the omission of information about legal liabilities faced by the company in connection with its participation in the Baku–Tbilisi–Ceyhan pipeline project. The audit also emphasized the importance of further reporting of BP’s attempts to manage its own reputational risk by encouraging its suppliers to behave consistently with its policies (BP 2004: 42). The AA1000 standard is a potentially significant development in enhancing the quality of nonfinancial auditing corporate reporting on activities in the developing world. Where reporting of MNCs’ environmental, human rights, and labor rights behavior is carried out in accordance with standardized guidelines, and independently audited according to standardized monitoring guidelines, consumers and investors are more likely to have access to sufficient information about companies’ performance to make reliable judgments of their conduct.

1.3.4. The Limits of Voluntary Disclosure The development of the GRI and the AA1000 standard both indicate the role of a diverse group of stakeholders, including activist NGOs, in developing standardized reporting to ensure transparency of information about corporate conduct. But although more large corporations are undertaking reporting of environmental and social performance, many remain resistant. Some 750 organizations worldwide used the GRI’s Sustainability Reporting Guidelines in 2005. This number includes a significant number of large MNCs, including BP and Shell, Ford and General Motors, alongside smaller domestic businesses (see http://www.globalreporting.org/guidelines/companies.asp). But, despite pressure from institutional investors to report in accordance with the guidelines (GRI Activities Report 2004), this remains a tiny fraction of the total number of MNCs. Of the firms whose social and environmental reporting is audited in accordance with the AA1000 standard, most are based in the UK. Some, such as BP, British American Tobacco and United Utilities, are large MNCs with extensive operations in developing countries (British American Tobacco 2003; United Utilities 2003); others, though, are primarily domestic companies. In general, the ‘business case’ for voluntary reporting has not yet proved strong enough to persuade 19


many large MNCs to take part. Research in the UK in 2002 showed that although 50 of the FTSE 250 index of the country’s largest companies had reported for the first time in 2001–2, still only 103 companies produced substantial environmental or social reports. Eighty-seven firms supplied short notes in their annual reports while the remainder provided very limited data without detail (Maitland 2002). As a result, many NGOs have focused not on developing voluntary standards but on advocating mandatory disclosure requirements imposed by states.

1.3.5. Mandatory Disclosure A clear prerequisite for corporate self-regulatory codes to be effective is disclosure. But as mentioned above, companies are unlikely to disclose in any meaningful way unless their reporting is mandated by government. There is a collective action problem. If one company were to publish extensive information on their compliance (or inability to comply) but rival companies did not, then the most transparent company would likely suffer as rivals, regulators, and NGOs used the disclosures to their own advantage. Mandatory disclosure requirements set by government regulatory authorities in MNCs’ home countries can oblige firms to disclose standardized information on environmental, labor rights, and human rights performance in a similar way to the requirements for disclosure of financial information in annual reports. This opens up the possibility of legal redress for misstatements—a more robust incentive that exists in self-regulatory reporting (see http://www.foe.org/corporatesunshine/faq. html). Indeed, for this reason recent campaigns by NGOs have sought to expand the scope of mandatory disclosure requirements in both the UK and the USA. In the UK, the ‘CORE’ coalition of forty NGOs, including Amnesty UK, Christian Aid, Friends of the Earth, trade unions and church groups, has pressed for more demanding disclosure requirements (see www.foe.co.uk/ campaigns/corporates/core/news/index.html). CORE worked with sympathetic MPs to develop the ‘Performance of Companies and Government Departments (Reporting) Bill’, which would require the directors of a company to include information in their annual reports on the impact of the company’s operations, policies, products, and procurement practices in relation to employment, the environment, and social and community issues when they consider such information to be material to providing 20


a fair review of the company’s financial performance (Performance of Companies and Government Departments (Reporting) Bill). Although more than 300 MPs signed an Early Day Motion supporting the Bill’s aims, the government blocked further consideration of the Bill on January 30, 2004 (see www.foe.co.uk/campaigns/corporates/core/index.html). Requirements to disclose social and environmental performance were also discussed under the rubric of the Department of Trade and Industry’s 2002 White Paper ‘Modernizing Company Law’ which set out the government’s intention to expand the scope of mandatory disclosure requirements by necessitating preparation of an Operating and Financial Review (OFR) in the Annual Reports of listed companies. In 2004, the Secretary of State for Trade and Industry described this as a measure to ensure that ‘our largest businesses report fairly and transparently on the factors which affect them, including their impact on the environment and society’ (FT March 14, 2004). In the end, however, the reporting is voluntary. Company directors were, from 2006, to have been obliged to consider including information affecting the company’s reputation and details of corporate policies and performance on the environment, employment, and social issues. However, the proposed regulations would have restricted directors’ obligations to considering inclusion, and only when they judged these issues to be material to a company’s financial performance (Cowe 2004: 15). In the USA, the Securities and Exchange Commission (SEC) requires reporting of certain known risks and nonfinancial trends that might affect future financial results. It mandates disclosure ‘where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operations’ (SEC regulations quoted in Repetto 2003). At present risks and trends for which disclosure is mandated are restricted to environmental liabilities, labor relations, and legal proceedings and exclude entirely human rights and workers’ health and safety (see www.foe.org/corporatesunshine/faq.html). Pressure for further change in the USA is being brought to bear by a coalition of NGOs called the ‘Corporate Sunshine Working Group’ (CSWG) which aims to address the perceived inadequacy of information about corporate risks available to institutional investors. The coalition includes Friends of the Earth and the World Resources Institute, institutional investors, and trade unions. They support the voluntary GRI standards but argue that without statutory regulation investors will not receive adequate information. Hence, their proposal for an expansion of 21


the SEC’s mandatory disclosure requirements for social and environmental information focusing on items of particular material significance to financial value (Corporate Sunshine Working Group 2001). Mandatory disclosure requirements are just half the picture. The other half is enforcement. Companies have to know that they will be punished for failing to disclose—and that their competitors will be similarly punished for noncompliance. Yet robust enforcement is difficult even in industrialized governments. This was highlighted by a US government audit of that country’s implementation of a Hazards Analysis and Critical Control Points strategy applied to seafood. The government audit found that the Food and Drug Administration (FDA) simply could not keep up with the necessary level of reviews and monitoring (General Accounting Office 2001). Similar results have been found in other industries (Coglianese and Lazer 2003). Another study shows that in the period 1975–2000 the SEC brought only three administrative proceedings and one civil action for inadequate environmental risk disclosures (Repetto 2003). A study by the US Environmental Protection Agency showed that 74 percent of companies do not meet SEC rules in their disclosure of environmental information (see www.foe.org/corporatesunshine/index.html). In many other countries, the record of disclosure against statutory requirements was even worse (Repetto 2003). A history of low levels of compliance with statutory obligations and of limited efforts by statutory bodies to enforce their requirements argues for caution in identifying the potential achievements of mandatory disclosure in regulating social and environmental outcomes in the global economy. In developing countries the enforcement of mandatory disclosure requirements is likely to be yet more difficult. For a start, many MNCs are registered on stock markets in their home countries. This means that disclosure requirements of securities regulators in developing states will have little effect on them (although they may be able to address the behavior of joint ventures and subsidiary companies). Equally, investors ‘back home’ are unlikely to access or respond to reporting about the operations of individual plants, although clear and standardized reporting will permit investors, consumers, and the like to bring pressure to bear toward compliance. This means that even where there is mandatory disclosure, it will not necessarily provide an incentive for MNCs to comply with self-regulatory codes in their operations in developing countries. For this reason, we need to examine other possible government actions which shift incentives. 22


1.4. Reinforcing Self-Regulation by Nonmarket Means Outside of market-based pressures, there are other ways to create incentives for compliance with self-regulation or with mandatory disclosure requirements. In countries without capacity to regulate, social forces can buttress the role of governments in enforcing disclosure and promoting compliance with voluntary codes. For example, statutory disclosure programs have been effective in reducing environmental damage by companies in developing countries in Southeast Asia and Latin America (World Bank 2000). Notably, such programs have been highly dependent on wellorganized community groups in the immediate vicinity of polluting (or otherwise noncompliant) plants which encourage enforcement of disclosure requirements and use the resulting information to exert pressure on companies for improved performance (World Bank 2000: 59). Put simply, local activists can complement the actions of government as part of making self-regulation work.

1.4.1. Need NGOs—Expectations, Aspirations, and Culture Under what conditions are we most likely to find social action or social enforcement of standards by nonstate groups? Social organizations and NGOs sometimes face barriers created by firms, governments, and resources such as when their organizations or activities are banned, systematically disrupted, or otherwise strongly discouraged. A first condition for NGOs to be effective is for national laws which ensure the freedom to organize and mobilize by upholding rights to associate as workers or consumers and the right to freedom of speech and the capacity to publish (in independent media) criticisms of the actions of companies. More broadly, activism by civil society requires expectations on the part of citizens for better lives or treatment, which can themselves be generated by government policy. Finally, government agencies can provide a crucial focal point and important target for those wishing to uphold standards expressed in government or corporate policy.

1.4.2. Rights/Focal Points of Those Crucial in bolstering the capacity of governments and leveraging transparency is civil society or organized groups which bring together concerned or affected citizens. Such groups have typically played a central 23


role in pressing for information, monitoring the information, and publicizing noncompliance. Yet these groups do not organize or act in a vacuum. Their activities are greatly affected by government policy and institutions. Two examples highlight this. In Vietnam, laws and institutions for environmental protection created a framework within which communities organized and channeled complaints to regulatory agencies. The result has been labeled ‘community-driven regulation’ and highlights the importance of government-created institutional frameworks for mobilizing and channeling social pressures (O’Rourke 2004). A rather different example is afforded by the experience of water privatization in South Africa where government policy created expectations that citizens would have particular kinds of rights to water. That policy combined with local institutions to set up a framework within which local communities have held private companies taking over water systems strongly to account (Morgan 2004). Thus far we have highlighted important ways governments might shift incentives faced by MNCs; in this final section, we examine whether international institutions, actors, and standards might bolster or support such actions. Typically, international law has played a rather weak role. Human rights, environmental standards, and such like are covered by international treaties such as the Universal Declaration of Human Rights, the ILO’s Fundamental Principles on Rights at Work and the Rio Principles on Environment and Development, all of which commit governments to respect standards to which they have jointly agreed. None apply directly to corporations and firms. None are directly enforced by legal actions or sanctions. The proposed adoption by the United Nations Commission on Human Rights of ‘Norms on the Responsibilities of Transnational Corporations and Other Business Enterprises with regard to Human Rights’ (United Nations, Economic and Social Council 2003) has highlighted firms’ fear of an expansion of the coercive regulatory burden (Eaglesham 2004). Though the exact legal status of the document is disputed, business associations have argued that it may impose specific, enforceable legal obligations on MNCs. In their campaign against adoption of the document, the United States Council for International Business has drawn attention to the development of many voluntary codes for the good conduct of business toward human rights (United States Council For International Business 2003b). The UNCIB aims to use evidence of ongoing voluntary regulation to alleviate political pressure for coercive standards and convince governments on the UN Commission on Human Rights not 24


to adopt the ‘Norms’ document (United States Council For International Business 2003a). Though attempts to impose statutory regulation through agreement in the UN remain some way from fruition, they indicate a possible strengthening of international incentives for MNCs to continue and strengthen self-regulatory undertakings. The weaknesses in international law in upholding public goods and social standards look particularly striking when we compare them with the specific and enforceable sets of rights enjoyed by investors against the rights of government to regulate economic activity within their borders. The legitimate regulatory aspirations of governments have long been pitted against the desire of investors to enjoy some guarantee against illegitimate interference or expropriation. This issue was hotly debated in the UN in 1974 when developing countries passed a resolution in the General Assembly entitled a Charter of Rights and Duties of States which strongly reinforced the rights of governments to regulate within their borders. Since that time companies and industries have lobbied successfully for their rights to be protected in an enforceable way. The protection of investors is entrenched in bilateral investment treaties (or Investment Promotion and Protection Agreements), through the 1965 Washington Convention which created the International Center for the Settlement of Investment Disputes, and through the World Trade Organization (WTO) and the specific agreements on TRIPS, TRIMS. In these instruments, we find that states have bound themselves to treat investments fairly and equitably, to give them full security and protection, and to guarantee against unlawful expropriation. Investors have increasingly sought to use these provisions not just against government policies which aim to expropriate them, but equally against any government policies which affect their profitability. As one eminent international lawyer concludes, the ‘fair and equitable’ standard of treatment has taken on a life of its own with ‘an exceptionally wide interpretation . . . greatly favouring investors’ (Lowe 2002: 455). He argues that there must be a category of government actions which are so far removed from deliberate interference with investments that, even though committed by the government and even though they entail losses to investors, they should be beyond the reach of investment-protection treaties. The very fact of this argument highlights the extent to which international law has shifted to endorse investors’ rights. Alongside these muscular and enforceable protections of the rights of companies, the existing multilateral regime of constraints remains weak. 25


Those who have tried to balance investors’ rights with those of local communities have found several difficulties. An illuminating case is proffered by the Convention on Biological Diversity (CBD) 1992 which requires pharmaceutical companies to share some benefit with local communities from whom they seek ‘traditional knowledge’ and remedies as a shortcut toward the research and development of new products (Hayden 2003a; see also Hayden 2003b). A further degree of protection of local know-how has also been attempted in WIPO initiatives on the protection of traditional knowledge. The CBD creates responsibilities on investors (in this case pharmaceutical companies) to direct some benefits to the local communities whose labors and knowledge they are exploiting. On the other side of the coin, the CBD treaty enshrines rights for investors to work without unreasonable restriction. Yet the Convention has had problems on both sides. The USA has steadfastly opposed it on the grounds that it contravenes rights acquired by commercial actors in the WTO and in TRIPS. From the local communities’ side, the treaty regime has provoked problems and tensions at the local level which have made it difficult constructively to channel its benefits (United States Council For International Business 2003a). Softer international conventions and commitments do not create robustly enforceable rights, yet as we noted at the outset of this chapter, there is a strong argument that they have other effects which contribute to the effectiveness of self-regulatory systems. International standards assist in mobilizing civil society within and across countries by creating standards and expectations that such standards might be upheld (Keck and Sikkink 1998). This is captured in the UN Global Compact which seeks to encourage learning and best practice among participating companies who have all committed to existing international standards on human rights, environmental protection, and suchlike. Finally, international cooperation and institutions are being turned to by both governments and international firms who face increasing pressures to provide public goods. As discussed earlier, individual developing country governments fear competition by other countries competitively devaluing their corporate governance requirements so as to attract investment. Here interstate agreements and cooperation can assist in leveling the playing field. Meanwhile international companies—most obviously in oil and gas exploration—are increasingly finding that in many countries and regions they are being required to take on public goods responsibilities. The provision of security, health, education, and other elements crucial for a community to function is falling to multinationals who need 26


to create an environment within which they can work but have little expertise or capacity to take on these public goods functions. For this reason, international firms need effective cooperation between governments, development agencies, international aid arrangements, and other investors. That cooperation can in turn be fine-tuned better to enhance the effectiveness of appropriate government regulation and corporate selfregulation.

1.5. Conclusion This chapter set out to examine the conditions under which corporate self-regulation might be effective in developing countries. Our analysis of market pressures highlights the importance of information, transparency, and disclosure——prerequisites for holding corporations to account for their pledges of self-restraint or voluntary compliance. Yet corporate commitments of transparency and disclosure are not sufficient. Market pressures create too many alternative incentives and collective action problems within industry. Companies may simply find it rational to continue life as before with a little more investment in public relations. If disclosure is to alter the incentives faced by firms, governments need to mandate and enforce it. Furthermore, because of the unevenness of market responses to disclosure, transparency will not always shift incentives better to meet the social goals and public goods to which governments aspire. This is particularly true where firms are operating in developing countries—far from the eyes of their headquarters, regulators, and investors. That being the case, we have nevertheless explored measures which might strengthen the incentives faced by corporations to comply with their own codes of self-regulation. Although developing country governments are weak, there are three factors which together might enhance the effectiveness of self-regulatory codes in developing countries. The first is disclosure—a prerequisite for the market and other social pressures outlined in this chapter. Governments need to mandate standards of disclosure and to work with partner governments in investor home countries to enforce such standards. We have not detailed what forms international or cross-border enforcement of disclosure standards might take. However, we see this as an important question of law and governance at the global level. A second important force toward compliance with self-regulatory codes is social pressure. Local mobilization can draw attention to noncompliance and bolster the 27


position of regulators vis-à-vis investors. This does not mean governments have little role to play. Far from it, social mobilization is likely to be most effective where governments uphold freedoms of association and speech, and create institutions which can respond to social pressures. Finally, international institutions and instruments are important in creating conditions for effective self-regulation. At present, trade and investment treaties create an unbalanced system which robustly protects the rights of foreign investors (who in turn have strong commercial incentives to enforce those rights). The correlate responsibilities of investors toward workers, consumers, and communities are much weaker. That legislation and the interpretation of investor rights need careful re-examination. In the interim, we have noted that even the unenforceable soft law standards play a role in helping to mobilize social pressures within and across states. That pressure, however, depends heavily on governments providing the necessary framework for disclosure and social mobilization.

References Association of British Insurers (2001). ‘Disclosure Guidelines on Socially Responsible Investment’, http://www.ivis.co.uk/pages/framegu.html Blacconiere, W. G. and Patten, D. M. (1994). ‘Environmental Disclosures, Regulatory Costs, and Changes in Firm Value’, Journal of Accounting and Economics, 18(3): 357–77. BP (2004). Defining Our Path: Sustainability Report 2003. British American Tobacco (2003). ‘Social Report 2002/3’. Coglianese, C. and Lazer, D. (2003). ‘Management-Based Regulation: Prescribing Private Management to Achieve Public Goals’, Law and Society Review, 37(4): 691– 730. Commonwealth of Australia Department of the Treasury (2000). ‘Taskforce on Industry Self-Regulation Draft Report’. Co-operative Bank (2001). ‘Who Are the Ethical Consumers?’, http://www.cooperativebank.co.uk/downloads/ethics/ethics_whoconsumers1.pdf Corporate Sunshine Working Group (2001). ‘Proposed Expanded SEC Disclosure Schedule—Draft’, http://www.foe.org/corporatesunshine/proposedisclosure.pdf Cowe, R. (2004). ‘Risk Returns and Responsibility’, Association of British Insurers, February. http://www.abi.org.uk Davis, P. (2004). ‘Marketplace: Ethical Funds Hit High’, Financial Times, March 1. Dowell, G., Hart, S., and Yeung, B. (2000). ‘Do Corporate Global Environmental Standards Create or Destroy Market Value?’, Management Science, 46: 1059–74. Eaglesham, J. (2004). ‘Business Calls for Action on Human Rights Liability Plan’, Financial Times, March 8.

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Making Corporate Self-Regulation Effective in Developing Countries Finnemore, M. and Sikkink, K. (1998). ‘International Norm Dynamics and Political Change’, International Organization, 30(4). Florini, A. (2003). ‘Business and Global Governance: The Growing Role of Corporate Codes of Conduct’, Brookings Review, Spring (6). Franck, T. M. (1990). The Power of Legitimacy among Nations. New York: Oxford University Press. Freedom of Information Act (2000). http://www.opsi.gov.uk/Acts/acts2000/ 20000036.htm General Accounting Office (2001). ‘Federal Oversight of Seafood Does Not Sufficiently Protect Consumers’, Report to the Committee on Agriculture, Nutrition, and Forestry, US Senate, GAO-01-204. Gitterman, D. P. (2004). ‘A Race to the Bottom, A Race to the Top, or the March to a Minimum Floor? Economic Integration and Labor Standards in a Comparative Perspective’, in D. Vogel and R. Kagan (eds), Dynamics of Regulatory Change: How Globalization Affects National Regulatory Policies. Berkeley, CA: University of California Press. Global Reporting Initiative (GRI), ‘Sustainability Reporting Guidelines’, http://www.globalreporting.org/ReportingFramework/G3Online/ (2002). ‘Sustainability Reporting Guidelines’, http://www.globalreporting. org/guidelines/2002/GRI_guidelines_print.pdf (2004). ‘Activities Report 2004’, http://www.globalreporting.org/NR/rdonl yres/3D7598C9-2136-4486-BF6A-425712A54353/0/ActivitiesReport2004.pdf Gordon, K. (2000). ‘Rules for the Global Economy: Synergies Between Voluntary and Binding Approaches’, Working Papers on International Investment 1999/3. Paris: OECD, Directorate for Financial, Fiscal and Enterprise Affairs. Haufler, V. (2001). A Public Role for the Private Sector: Industry Self-Regulation in a Global Economy. Washington, DC: Brookings Institution Press. Hayden, C. (2003a). ‘Benefit-Sharing: Experiments in Governance’, Prepared for the SSRC Workshop Intellectual Property, Markets, and Cultural Flows, New York, NY, October 24–5. (2003b). ‘From Market to Market: Bioprospecting’s Idioms of Inclusion’, American Ethnologist, 30(3): 359–71. Institute of Social and Ethical AccountAbility (2003). ‘AA 1000 Assurance Standard’, http://www.accountability.org.uk Keck, M. E. and Sikkink, K. (1998). Activists Beyond Borders: Advocacy Networks in International Politics. Ithaca, NY: Cornell University Press. Lenox, M. J. (2003). ‘The Prospects for Industry Self-Regulation of Environmental Externalities’, Working Paper, October. Lowe, V. (2002). ‘Regulation or Expropriation’, Current Legal Problems, 55: 447– 66. Maitland, A. (2002). ‘Rise in Environmental Reporting’, Financial Times, July 29. Morgan, B. (2004). ‘Global Business, Local Constraints: The Case of Water in South Africa’, Manuscript.

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David Graham and Ngaire Woods Murphy, D. D. (2004). ‘The Business Dynamics of Global Regulatory Competition’, in D. Vogel and R. Kagan (eds), Dynamics of Regulatory Change: How Globalization Affects Nationonal Regulatory Policies. Berkeley, CA: University of California Press. OECD, Working Party on the OECD Guidelines for Multinational Enterprises (2000). ‘The OECD Guidelines for Multinational Enterprises: Review 2000’, DAFFE/IME/WPG, (9), September 11. OECD, Working Party of the Trade Committee (2001). ‘Codes of Corporate Conduct—An Expanded Review of Their Contents’, TD/TC/WP(99)56/FINAL, June 7. O’Rourke, D. (2000). ‘Monitoring the Monitors: A Critique of Pricewaterhouse Coopers (PwC) Labor Monitoring’, Unpublished manuscript.http://web.mit. edu/dorourke/www/PDF/pwc.pdf (2003). ‘Outsourcing Regulation: Analyzing Non-Governmental Systems of Labor Standards and Monitoring’, Policy Studies Journal, 31(1): 1–29. (2004). ‘Motivating a Conflicted Environmental State: Community-driven regulation in Vietnam’, Manuscript. Performance of Companies and Government Departments (Reporting) Bill. http://www.publications.parliament.uk/pa/cm200304/cmbills/027/2004027.pdf Repetto, R. (2003). ‘Protecting Investors and the Environment through Financial Disclosure’, Paper Presented at the Environment Canada Policy Research Seminar Series, November 17. Royal Dutch/Shell Group of Companies (1998). ‘Profits and Principles—Does There Have to be a Choice?: The Shell Report 1998’. (2002). ‘People, Planet and Profits: The Shell Report 2001’, http://www. shell.com/static/royal-en/downloads/shell_report_2001.pdf Ruggie, J. G. (2003). ‘Taking Embedded Liberalism Global: The Corporate Connection’, in D. Held and M. Koenig-Archibugi (eds), Taming Globalization: Frontiers of Governance. Cambridge: Polity Press. Sikkink, K. (1986). ‘Codes of Conduct for Transnational Corporations: The Case of the WHO/UNICEF Code’, International Organization, 40(4): 815–40. Social Investment Forum (2003). ‘2003 Report on Socially Responsible Investing Trends in the United States’, December. http://www.socialinvest.org/areas/ research/trends/sri_trends_report_2003.pdf United Nations, Economic and Social Council (2003). ‘Norms on the Responsibilities of Transnational Corporations and Other Business Enterprises with Regard to Human Rights’, E/CN.4/Sub.2/2003/12/Rev.2, August 26. United States Council for International Business (2003a). ‘Corporate Responsibility Committee: Status Report on the draft Human Rights Code of Conduct’, http://209.238.219.111/USCIB-text-Status-Report.htm (2003b). ‘Talking Points on the Draft: Norms on the Responsibilities of Transnational Corporations and Other Business Enterprises with regard to Human Rights’, http://209.238.219.111/USCIB-text-Talking-Points-htm United Utilities (2003). ‘Corporate Responsibility Report 2003’.

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Making Corporate Self-Regulation Effective in Developing Countries Vogel, D. (2005). The Market for Virtue: The Potential and Limits of Corporate Social Responsibility. Washington, DC: Brookings Institution Press. World Bank (2000). Greening Industry: New Roles for Communities, Markets and Governments. Oxford, UK: Oxford University Press. World Economic Forum (2003). ‘Responding to the Leadership Challenge: Findings of a CEO Survey on Global Corporate Citizenship’, http://www. pwblf.org/csr/csrwebassist.nsf/content/f1d2a3b4c5.html

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2 Do Voluntary Standards Work Among Governments? The Experience of International Financial Standards in East Asia Andrew Walter

Can there be a worldwide ‘race to the top’ in financial regulatory practices? The G7 countries and the international financial institutions (IFIs) would seem to assume so. In recent years, they have actively promoted the adoption of a set of voluntary international standards and codes on the grounds that worldwide convergence on ‘best practice’ in macroeconomic policy and regulation is both possible and desirable. The Financial Stability Forum (FSF), established in the wake of the emerging market crises of the late 1990s, refers to the twelve ‘key standards’ listed on its website as ‘the various economic and financial standards that are internationally accepted as important for sound, stable and well functioning financial systems’. 1 The FSF, along with the International Monetary Fund (IMF) and the World Bank, has been tasked by the G7 countries with the active promotion of international standards and codes so as to encourage better self-regulation in the major emerging market countries. I term this effort the ‘international standards project’. 2 The origin of the international standards project can be found in the major emerging market financial crises of the mid- to late 1990s. 1 Financial Stability Forum, ‘About the Compendium of Standards’, http://www.fsforum. org/compendium/about.html, accessed 15 June 2006. 2 In this chapter I am concerned only with international policy standards, not technical product standards. On the latter, see Mattli and Büthe (2003).

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Do Voluntary Standards Work Among Governments?

Self-regulatory failures in Mexico and especially in East Asia in the 1990s were interpreted by the major developed countries and the IFIs as the prime cause of these crises. Accordingly, since the establishment of a global financial regulatory agency would be unacceptable to the major developed countries, the focus has been on improving selfregulation in those countries where the perceived regulatory weaknesses are both significant and of the greatest consequence for global financial stability. The question that arises is whether this approach to improving selfregulation in the major emerging market countries is likely to succeed. In this chapter, I argue that the East Asian experience since 1997 suggests that the international standards project suffers from some major shortcomings. First, the project makes optimistic assumptions about the strength of the two main international mechanisms promoting compliance: the IFIs and the private financial markets. The weakness of these mechanisms means that compliance remains largely a matter of domestic politics. Second, domestic politics in a number of developing countries often favor what I term ‘mock compliance’ strategies, where governments adopt international standards formally but in ways that limit their impact on the private sector. Third, compliance failures have varying effects on financial stability. Poor compliance can be associated with bad regulatory outcomes, but sometimes noncompliance is the best option. I focus on East Asia for three main reasons. First, East Asian countries were a particular focus of the international standards project because of the dominant view that inadequate financial regulation and supervision was the main cause of the deep crisis in Japan and subsequently in other East Asian economies. Second, after the 1997–8 crisis, most Asian governments pledged to improve self-regulation by adopting international standards. Third, as I argue later, there are considerable differences within East Asia relating to the degree of compliance with international standards. Exploring these differences can help illuminate the causes of failure and success in compliance in general. The rest of this chapter is organized as follows. Section 2.1 describes the origins and nature of the international standards project. Section 2.2 presents a theory of compliance, focusing on the determinants of compliance and compliance failure. Section 2.3 considers compliance with a few key international standards in a few East Asian countries since 1997. Section 2.4 discusses the implications of the argument for financial regulatory reform.

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2.1. International Financial Standards and Codes and the Asian Crisis This section briefly outlines the emergence of international standards in the pre-1997 period before going on to explain the catalytic role of the Asian financial crisis of 1997–8 in the international standards project. Finally, I discuss the presumed roles of the IFIs and private financial markets as international compliance mechanisms.

2.1.1. Origins of the Standards and Codes Exercise The initial steps toward an international regime for financial regulation began in 1974, with the creation of the Basle Committee on Banking Supervision (BCBS) by the G10 central bank governors under the auspices of the Bank for International Settlements (BIS). In response to the globalization of banking, the BCBS subsequently agreed the Basle Concordat on the sharing of supervisory responsibilities in 1983 and the Basle Capital Adequacy Accord of 1988 (Kapstein 1994; Oatley and Nabors 1998). The key objective was to agree some minimum standards of banking sector supervision and to encourage their adoption in the major developed countries. Adoption proceeded via the voluntary agreement of bank regulators in the G10 countries, though in practice most developing countries also adopted the Basle Capital Adequacy Accord in the 1990s (Ho 2002). Even though the Accord was a highly flawed product of political compromise among the major countries, its worldwide adoption entrenched the position of the BCBS at the heart of global financial regulatory standardsetting. It also suggested that there were strong incentives for nonsignatory governments to converge voluntarily on standards set by developed country regulators. Less noticed by commentators and academics was that superficial compliance with the Accord was usually not difficult because it was full of loopholes. 3 The emergence of the ‘Washington Consensus’ on economic policy in the early 1990s also signaled a growing confidence in the appropriateness of Western economic policy models for developing countries. In late 1994 and early 1995, this confidence was reflected in the Western response to the Mexican peso crisis. Although the crisis of this star 3 As I explain in Section 2.3, Oatley and Nabors (1998) and Ho (2002) are among those who overlook the various loopholes that limited the practical impact of the Accord’s adoption in both developed and developing countries.

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pupil of Latin American economic reform prompted a heated debate about the virtues of capital account liberalization, the G7 governments emphasized the failure of the Mexican government to provide timely and reliable macroeconomic data to the markets in the lead-up to the crisis. ‘Transparency’ became the new mantra. 4 If countries like Mexico wished to participate in international financial markets, it was concluded, they needed to adopt Western standards of policy and data transparency. The G7 assigned the IMF to take the lead in establishing benchmarks for the public provision of timely and reliable data. This led to the creation and promulgation of the Specific Data Dissemination Standard (SDDS) and the General Data Dissemination Standard (GDDS) in March 1996 and December 1997, respectively. The SDDS was specifically designed ‘to guide countries seeking access to international capital markets in the dissemination of economic and financial data to the public’. Within little more than two years, however, it became clear that transparency by itself would not solve the problem.

2.1.2. The Impact of the Asian Crisis When much of East Asia succumbed to financial crisis only a few years after Mexico, the international financial reform debate was reignited and ranged more broadly than at any time since the Bretton Woods conference of 1944. Although there were different interpretations of the Asian crisis, the one that most appealed in IFI and G7 circles blamed poor domestic regulation in Asia, exacerbated by cronyism and corruption, for creating moral hazard in the financial and corporate sectors (Corsetti et al. 1998; Krugman 1998). 5 The American, British, and German governments in particular favored this interpretation of the crisis, while Japan, dealing with an intensifying domestic financial crisis at home, was in no position to oppose it. The view that the Asian crisis was primarily due to domestic regulatory failures played an important role in the design of the structural reforms contained in the IMF-led rescue packages (Blustein 2001; IEO 2003). It also 4 See the background paper issued before the Halifax G7 summit of June 1995, which included a section on ‘promoting financial stability in a globalized economy’, available at http://www.library.utoronto.ca/g7/summit/1995halifax/financial/5.html, accessed 4 February 2004. 5 An alternative view gave more weight to poorly regulated and volatile international capital flows (Radelet and Sachs 1998; Wade and Veneroso 1998).

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prompted a renewed effort by the G7 and the IFIs to set and promulgate new international standards and codes that could serve as benchmarks for regulatory upgrading in developing countries. Michel Camdessus, then IMF Managing Director, mapped out the path in a speech in March 1998: ‘[T]here is broad consensus on what needs to be done to strengthen financial systems—improve supervision and prudential standards, ensure that banks meet capital requirements, provide for bad loans, limit connected lending, publish informative financial information, and ensure that insolvent institutions are dealt with promptly.’ 6 With the Basle Accord and SDDS as precedents, the G7 finance ministers argued that the promotion of global financial stability required both sound macroeconomic and sustainable exchange rate policies and ‘the adoption and implementation of internationally-agreed standards and rules in these and other areas’ (G7 Finance Ministers 1999). The twelve ‘key standards for sound financial systems’ are summarized in Table 2.1. They include financial regulatory standards (e.g. banking, securities, and insurance regulation), ‘market infrastructure’ standards (e.g. accounting and corporate governance), and policy and data transparency standards (e.g. fiscal policy, monetary policy, and data transparency). Note that these international standards have no legally binding status and have no formal international compliance mechanism attached to them (Jordan and Majnone 2002: 15). Generally, according to the FSF, standards ‘set out what are widely accepted as good principles, practices, or guidelines in a given [policy] area’. 7 There are a number of things to note about this list. First, it reflects how core aspects of domestic economic regulation and governance have become matters of international concern and negotiation. Second, all of the standards are of relatively recent origin, many postdate the onset of the Asian crisis in July 1997, and upgrading is a continuous process. Third, a wide range of international institutions is responsible for standardsetting, including the major IFIs and other more specialized standardsetting bodies (some of which are private-sector organizations). Fourth, each of the twelve key standards contains further codes and principles, though these often take a fairly general form. By January 2001, in effect, the standards compendium maintained by the FSF comprised 6 Michel Camdessus, remarks at the IMF Seminar on Capital Account Liberalization, Washington, DC, March 9, 1998, available at: http://www.imf.org/external/np/speeches/1998/ 030998.htm, accessed August 14, 2003. 7 FSF, ‘What are Standards?’, http://www.fsforum.org/compendium/what_are_standards. html, accessed April 22, 2003.

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Do Voluntary Standards Work Among Governments? Table 2.1. Key international standards and codes Year of adoption or revision

Standard-setter

Standard or code and official objective

Macroeconomic policy and data transparency standards 1996–7 IMF Special Data Dissemination Standard (SDDS), General Data Dissemination Standard (GDDS): The SDDS serves to guide countries that have, or that might seek, access to international capital markets in the dissemination of comprehensive, timely, accessible and reliable economic, financial and socio-demographic data to the public. The GDDS serves to guide any member countries in the provision to the public of such data. 1998 IMF Code of Good Practices on Fiscal Transparency: contains transparency requirements to provide assurances to the public and to capital markets that a sufficiently complete picture of the structure and finances of government is available so as to allow the soundness of fiscal policy to be reliably assessed. 1999 IMF Code of Good Practices on Transparency in Monetary and Financial Policies: identifies desirable transparency practices for central banks in their conduct of monetary policy and for central banks and other financial agencies in their conduct of financial policies. Institutional and market infrastructure standards 1990/2002 FATF The Forty Recommendations of the Financial Action Task Force on Money Laundering: set out the basic framework for effective anti-money laundering policies. Special Recommendations on Terrorist Financing: set out the basic framework to detect, prevent, and suppress the financing of terrorism and terrorist acts. 1999/2004 OECD Principles of Corporate Governance: aimed at improving the legal, institutional, and regulatory framework for corporate governance in OECD and non-OECD countries. 2001 CPSS/IOSCO Core Principles for Systemically Important Payment Systems (CPSIPS), Recommendations for Securities Settlement Systems (RSSS): CPSIPS sets out core principles for the design and operation of systemically important payment systems. RSSS identifies minimum requirements that securities settlement systems should meet and the best practices that systems should strive for. 2002 IASB International Accounting Standards: set out principles to be observed in the preparation of financial statements. A total of 41 standards have been issued as of July 2003; updating is ongoing. 2002 IFAC International Standards on Auditing: ISAs contain basic principles of auditing and essential procedures together with related guidance in the form of explanatory and other material. 2001 draft, World Bank Principles and Guidelines for Effective Insolvency and not yet Creditor Rights: intended to help countries develop agreed effective insolvency and creditor rights systems. (cont.)

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Andrew Walter Table 2.1. (Continued) Year of adoption or revision

Standard-setter

Financial regulation and supervision 1997/2003 IAIS

1998

IOSCO

1997/2006

BCBS

Standard or code and official objective

Insurance Core Principles: comprise essential principles designed to contribute to effective insurance supervision that promotes financial stability. Objectives and Principles of Securities Regulation: designed to help governments to establish effective systems to regulate securities markets and to promote investor confidence. Core Principles for Effective Banking Supervision: intended to serve as a basic reference for bank supervisory and other public authorities in all countries and internationally. The 25 basic principles are considered essential for any bank supervisory system to be effective.

Sources: IMF and FSF websites.

in total seventy-one specific standards. Finally, many of the standards are interdependent (e.g. accounting, auditing, and corporate governance standards). The Basle Committee’s 25 Core Principles for Effective Banking Supervision (hereafter ‘Core Principles’), issued in September 1997, is one of the most important key standards (Table 2.2). Along with the Corporate Governance Principles (CGP) and International Accounting Standards (IAS), 8 these constitute a central pillar of financial sector regulation and prudential supervision. The first Basle Core Principle, the ‘precondition’ for effective supervision, advocates what is by now G10 conventional wisdom: political independence for financial regulators, a clear set of responsibilities and objectives, the power to enforce compliance, legal protection for supervisors, sufficient financial resources, and so on. The discussion on principles 2 and 3 suggests that ‘clear and objective criteria . . . reduce the potential for political interference in the [bank] licensing approach’ (BCBS 1997: 15–16). Generally, ‘[t]he Principles are minimum requirements . . . intended to serve as a basic reference for supervisory authorities in all countries and internationally’ (BCBS 1997: 2).

8 Strictly speaking, since 2001 the International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS), but existing IAS remain valid until replaced or withdrawn. In what follows, I refer simply to ‘IAS’.

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Do Voluntary Standards Work Among Governments? Table 2.2. Summary of BCBS core principles for effective banking supervision (September 1997) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

Supervisory framework Permissible activities of banks Bank licensing criteria Ownership review powers Investment review powers Minimum capital requirements for banks Bank credit policies Loan evaluation, provisions Large exposure rules Connected lending rules Country risk rules Market risk rules Other material risk rules Internal control systems Preventing fraud Onsite/offsite supervision Contact with management Offsite supervision rules Mechanisms for independent validation of information Consolidated supervision Accounting/disclosure Remedial measures/exit Global consolidation Host country supervision Supervising foreign banks

Sources: BCBS, www.bis.org

Behind this general prescription lay a new ideal type of what may be called ‘regulatory neoliberalism’: the idea that independent regulatory agencies should apply stringent rules in a nondiscretionary fashion in a deregulated financial marketplace. The subtext is fairly clear: excessive state intervention of a discretionary kind, as in many East Asian countries prior to the crisis, creates problems of moral hazard and chronic regulatory failure. Hence, the adoption of Western-style standards would help to eradicate such self-regulatory failures and promote both domestic and international financial stability (Mishkin 2001).

2.1.3. External Compliance Mechanisms All of the international institutions involved in the international standards project recognize that promulgation is one thing and compliance is another. There is an explicit emphasis in the official literature on two interdependent, external compliance mechanisms: market and official incentives. Market incentives would be promoted by educating market 39

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actors about the various international standards and encouraging them to take them into account in assessing international portfolio risk (FSF 2000: 4). Essentially, markets would encourage compliance by raising the cost of finance for sovereign or private sector borrowers in noncompliant countries. The operation of market pressure was also seen as dependent on the provision of credible and timely information about the level of country observance of various standards. Here, the IFIs were to play a key role by assessing compliance in an objective manner and making this information available to market actors. The assessment of country compliance with standards and codes has been part of the IMF’s Article IV policy surveillance role since May 1999. The IMF executive board also included observance of standards among factors taken into consideration in committing financing to a country under the Contingent Credit Line (CCL) facility. 9 As noted earlier, the upgrading of financial regulatory, accounting, and corporate governance standards were also prominent aspects of the IFIs’ conditionality packages in Asia and elsewhere in the late 1990s. Most importantly, the joint IMF– World Bank Financial Sector Assessment Programme (FSAP) is designed to assess country compliance with international standards, though on a voluntary basis. 10 Reports on standards observance are prepared for the executive boards of the IFIs and may be published in the form of Reports on the Observance of Standards and Codes (ROSCs). Despite their voluntary nature, as of the end of April 2005, 592 initial assessments of standards observance and 131 updates had been completed in 122 countries, constituting two-thirds of the IMF membership (IMF and World Bank 2005: 14). The rate of ROSC publication is about 75 percent to date. Official incentives for standards compliance would work through two main mechanisms. The first was by promoting a dialogue between the IFIs, their executive boards, and member countries. There have been considerable efforts by the IFIs to raise awareness of the importance of better self-regulation in member states, and the IMF in particular has invested significant new resources in this area. Second, by encouraging the publication of ROSC modules, IFI assessments could be expected to bolster market pressure on governments to comply by raising the financial costs of nonobservance.

9 Particularly SDDS, the Codes on Fiscal Transparency, on Transparency in Monetary and Financial Policies and the Basle Core Principles (Clark 2000: 168, fn. 20). 10 The US Treasury has argued for mandatory participation (US GAO 2003: 65), though the USA itself has published only one ROSC, on fiscal transparency.

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2.2. Compliance in Theory Should we expect the market and official compliance mechanisms outlined above to operate effectively? In Section 2.2.1, I outline how we should understand compliance, the effect of compliance costs and ease of third-party monitoring on compliance outcomes.

2.2.1. What Is Compliance? Some authors assume that once international standards are promulgated, the external market and official pressures for compliance outlined above will be sufficiently powerful to ensure compliance (e.g. Soederberg 2003). I argue below that this view is mistaken and that a significant gap between ‘implementation’ and ‘compliance’ is likely to arise in particular cases. Compliance is a more comprehensive concept than ‘implementation’. Implementation occurs when state legislatures and agencies take the necessary steps to ensure that official policies and regulations are consistent with international standards. Compliance occurs when countries’ actual behavior conforms to the prescriptions of a specific rule or standard. 11 Thus, a gap may arise between implementation and compliance if individual actors in the public and/or private sector behave in ways inconsistent with implemented regulations and if domestic enforcement is weak. Compliance could also conceivably occur in the absence of formal implementation, though often a failure by a government to adopt or implement international standards in the first place will derive from domestic resistance to compliance. Note in this regard that although the burden of implementation falls primarily on the state and its agencies, the burden of compliance often falls on both the public and the private sector. Although some international standards only constrain aspects of public sector behavior (e.g. SDDS), other international standards can imply considerable costs for private sector actors. This applies to most standards relevant to financial regulation, including IAS, corporate governance, and banking supervision standards. Thus, for example, if a country adopts IAS for domestic financial reporting by listed companies, the level of country compliance is likely to be affected by the expected costs incurred 11 Compliance is a ‘state of conformity between an actor’s behavior and a specified rule’ (Raustiala and Slaughter 2002: 539). This definition owes much to Young (1979: 3). See also Shelton (2003: 5).

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by companies who must change their methods and degree of financial disclosure and the costs they can expect to incur in the event of noncompliance. There is no reason to believe that compliance failures will only occur when private sector actors fail to conform to (implemented) international standards. ‘Regulatory forbearance’ also occurs when the government or its agencies intentionally refrain from strictly enforcing adopted regulations, systematically or on an ad hoc basis. As in the classic ‘timeinconsistency’ problem in monetary policy, it may be optimal for the government to commit itself to the adoption of international standards and subsequently to engage in regulatory forbearance (e.g. because the strict application of new prudential rules could lead to a contraction of private sector credit). Regulatory forbearance includes allowing technically insolvent banks to continue operating, temporary relaxations or nonapplication of rules relating to bad loan accounting or provisioning, turning a blind eye to violations of exposure rules, rapid deregulation of new lines of business to allow banks to build profits, and so on (Honohan and Klingebiel 2000: 7). In addition, compliance failure may occur because of low bureaucratic capacity or corruption, both of which limit the effectiveness of oversight and enforcement. Highly independent and powerful agencies may also obstruct compliance. By strictly applying regulations that force bank failures, for example, regulators may leave themselves open to accusations of past negligence or incompetence. 12

2.2.2. Compliance Costs and Benefits Although the benefits of observance of international standards are often made to sound self-evident, they can raise fundamental economic and political issues for developing countries in particular. In the first place, there is little doubt that representatives from the major Western economies have dominated the standard-setting process in most cases. The perception that they are not just Western but Anglo-Saxon in origin is strong in developing countries, potentially creating what the IMF likes 12 Such considerations may have played a part in the 1980s decision of the US regulator of savings and loan (S&L) institutions, the Federal Savings and Loans Insurance Corporation (FLSIC), to engage in regulatory forbearance (Jackson and Lodge 2000: 109).

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to refer to as ‘ownership problems’. 13 This perception of limited legitimacy and the consequent politicization of international standard-setting significantly lessen the likelihood of ‘norm-driven’ compliance, as does the often substantial gap between international and existing domestic standards. 14 Rather than focus on this legitimacy question here, I consider compliance from a simple cost–benefit perspective. Considering compliance costs first, there are potentially significant distributional asymmetries at both the international and domestic levels. In the case where international standards are more stringent than existing domestic standards, this implies potentially significant compliance costs for public and private sector actors. Compliance costs are therefore generally higher for developing countries than for the developed countries who dominate international standard-setting. As for domestic compliance costs, these tend to be concentrated on particular sectors or societal groups (e.g. banking regulatory standards raise costs for the banking sector, IAS raise costs for the business sector generally, etc.). They also tend to be higher in the short run: the one-off costs of adjusting to higher standards tend to be greater than the ongoing costs of compliance. 15 Compliance benefits may be potentially high for countries whose domestic standards are lax compared to international standards (the key benefit, presumably, is greater financial stability). However, compared to compliance costs, benefits of these kinds tend to be both uncertain and long term in nature. Moreover, while compliance costs tend to be concentrated on businesses or particular business sectors, compliance benefits tend to be much more widely spread across society. Indeed, the main supposed benefit of adopting international standards, greater financial and economic stability, has public good characteristics. The nature of compliance costs and benefits and their distribution makes standards compliance rather like trade liberalization, and quite different from technical standards. Technical standards often exhibit strong market incentives for compliance because of high network externalities 13 Arguments of this kind were made by Asian representatives at the first Asia-Pacific meeting of the FSF in October 2001 (FSF Press Release, ‘First Asia-Pacific Regional Meeting of the FSF’, Ref. No. 32/2001E, October 19, 2001). 14 For a discussion of these and other factors that hinder norm-driven compliance, see Checkel (2001) and Underdal (1999). 15 Think, for example, of the initial costs incurred by European firms in adjusting to the recent adoption of IAS in Europe, or to the new listing and corporate governance requirements in the USA.

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(i.e. the benefits of compliance increase as more actors adhere to the standard). By contrast, those sectors that bear most of the immediate costs of compliance with policy standards are likely to oppose compliance, whereas the potential beneficiaries will have comparatively little incentive to lobby strongly for their adoption. As a result, when existing domestic standards are inferior to international standards and compliance costs for the private sector are substantial, governments are not likely to favor compliance. As an empirical matter, private sector compliance costs in East Asia varied substantially across international standards. They were especially high for IAS, corporate governance standards and financial sector regulation standards, since existing domestic standards in these areas were poor in most Asian countries in 1997. Adopting international standards in these areas was especially costly for the family- and state-owned banks and companies which predominate in Asia (Claessens et al. 1999; Capulong et al. 2000: vol. 1, 23–8). Low levels of bank capitalization, poor corporate profitability, and the predominance of relationship lending meant that higher prudential and disclosure standards would be especially costly for banks and for their customers. This was especially true after the crisis, when the private sector in the crisis-hit Asian countries was in a highly distressed situation. By contrast, private sector compliance costs were low for other standards such as SDDS and the other macroeconomic transparency standards, though adherence to these international standards could potentially reduce both public and private borrowing costs. 16 We would therefore expect levels of Asian compliance to be greater for these standards than for prudential, corporate governance, and financial disclosure standards.

2.2.3. Monitoring, International Pressure, and Compliance This conclusion might be questioned for the following reason. Even if the private sector is largely opposed to compliance with certain international standards, international actors may still place considerable pressure on both governments and the private sector to comply. As we have seen, the international standards project has explicitly cited both the IFIs and international financial markets as important external compliance mechanisms. However, I wish to argue that these two mechanisms are likely 16 For example, if SDDS adherence reduces the sovereign borrowing rate, this could reduce the average private sector borrowing rate, since the former is usually a floor for the latter.

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to be weak in precisely those areas where the domestic-level compliance incentives discussed above are also weak. Let us assume that the external pressure on countries to adopt international standards is indeed strong, but that governments and the domestic private sector believe that it will be difficult for third parties to monitor the true level of compliance and/or to punish noncompliance. In this situation, the government may decide that its best option is to adopt international standards but to engage in ‘mock compliance’, or formal adoption or implementation without substantive compliance. The government may believe that by doing so it will obtain at least some of the benefits of compliance (or at a minimum, avoid the costs of explicit noncompliance), 17 while the domestic private sector may be reassured that they will not bear large real compliance costs in practice. Although well-capitalized and strongly managed banks and companies may prefer the gap between formal and substantive compliance to be relatively small, weak banks and firms threatened with their very survival have stronger incentives to lobby for mock compliance. The government also has stronger short-term incentives to be concerned about business failures. The difficulty of third-party monitoring of compliance, and hence the applicability of this argument, will vary by international standard. In the case of the SDDS, for example, monitoring is relatively straightforward. Whether countries meet the SDDS requirements is publicly disclosed in a simple yes–no manner on the IMF’s Dissemination Standards Bulletin Board (DSBB). Although the IMF does not monitor in depth the quality of the data placed by the country authorities on the DSBB, cross-checks embedded in the format and considerations of reputation both pose constraints on fraudulent postings. By comparison, monitoring the quality of compliance with the Basle Core Principles, CGP, or IAS is very difficult and costly for third parties, requiring considerable research and qualitative judgment. To take one obvious but typical example, a government may say that its domestic accounting standards ‘approximate’ IAS. Estimating the importance of any divergences between domestic and international standards in such cases is difficult enough. Even when governments claim that all listed companies must report using IAS (which is the case today 17 The costs of explicit noncompliance by one country are likely to increase if most of its peers adopt international standards. Of course, if third parties have imperfect information concerning governments’ true compliance intentions, the credibility of any government’s commitment to compliance will be low (Rodrik 1989: 757). As a result, some potential benefits such as lower borrowing costs may not be forthcoming. However, governments with weak compliance intentions may calculate that they have little to lose from formal compliance and the potential to achieve other benefits, such as cooperation with the IMF.

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for about half of all countries), 18 assessment of the quality of compliance requires in-depth analysis of auditing processes, stock market organization, and the strength of legal enforcement among other things. Some might argue that the IFIs themselves perform this task through the FSAP process. However, this process has major shortcomings from the point of view of market participants. As noted earlier, country participation in the FSAP is voluntary, as is publication of ROSCs. Even when published, sensitive information is removed, usually including any quantitative assessments that might be more easily digested by market actors. Furthermore, given the resource-intensive nature of the FSAP process, updates are infrequent. Unsurprisingly, private sector analysts routinely respond that ROSCs are ‘untimely, outdated, and too dense to be useful’ (US GAO 2003: 22). The considerable difficulties encountered in assessing compliance are one reason why the IFIs and market actors tend to be weak at enforcing compliance, but there are other reasons. Even if the IFIs have explicit knowledge of poor quality compliance in a particular case, they may be reluctant to make this known so as to avoid precipitating a market reaction or to maintain a good working relationship with the government. In practice, market participants have little faith in the willingness of the IFIs to ‘blow the whistle’ on countries that fail to observe core standards (FSF 2000: 20–31). There are also reasons to believe that markets will not consistently punish poor compliers. If we assume investors will be concerned primarily with financial returns, a particular company’s compliance with international standards will only be relevant to the investment decision if such compliance affects risk-adjusted profitability. Although better financial disclosure and higher corporate governance standards might sometimes be important to investors, strong market positions, and political connections might be more important in emerging markets. 19 In practice, such ‘pull’ factors that apply to particular companies and markets tend to be swamped by aggregate ‘push’ factors like the level of liquidity in developed country financial markets. Push factors are the dominant determinants of equity inflows into emerging market countries (Maxfield 1998; IMF 2001: 40–1). Indeed, emerging market countries and firms with 18 Deloitte provides information on national accounting requirements for 143 countries, of which 72 required IAS reporting for all listed companies as of March 26, 2006 (http://www.iasplus.com/country/useias.htm, accessed June 19, 2006). 19 One bank respondent to an FSF survey said that if it were to require strict observance of IAS in its business in developing countries, up to 25 percent of this business would be lost (FSF 2000: 23–4).

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better quality corporate governance have tended to under-perform those with poorer quality corporate governance when international liquidity is flowing into these countries, as in recent years (CLSA Emerging Markets 2005: 4). Unsurprisingly, few companies have felt a need to undertake independent and transparent assessments of the quality of their corporate governance. 20 It may be said that banks, which are especially dependent on reputation for their viability, should be subject to considerable market compliance pressure. Again, however, formal compliance with international standards such as the Basle capital adequacy minima may be all that is necessary. Although sophisticated creditors understand that banks’ capital adequacy ratios (CARs) are easily manipulated and are a poor measure of true financial strength, formal compliance by banks seems to be all that is necessary. This is because such creditors take into account that national authorities usually effectively guarantee the liabilities of formally compliant banks (Moody’s Investor Services 1999; Fitch Ratings 2003a). In other words, too-big-to-fail assumptions can short-circuit market pressure for substantive compliance with international standards. To summarize, the argument suggests that compliance strategies are driven by domestic political factors instead of by external compliance pressures, which we suggest will often be weak. In particular, we expect that mock compliance strategies will be more likely when private sector compliance costs and third-party compliance monitoring costs are both relatively high. This is illustrated by quadrant 4 in Figure 2.1. The following section considers whether this prediction is consistent with the evidence.

2.3. Compliance in Practice In what follows I briefly assess the prediction of Section 2.2 in two ways. First, I compare compliance with SDDS (where private sector compliance costs and monitoring costs are low) and IAS (where both costs are high) globally and in East Asia. Second, I assess compliance across East Asian countries in one key standard of the Basle Core Principles for which 20 Standard & Poor’s, the credit ratings agency, announced in 2002 that it would offer corporate governance ratings based on the OECD Principles for companies to complement their credit ratings (Standard & Poor’s 2002). However, as of February 6, 2005, only twentyfive companies had been rated, fourteen of which were from Russia.

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Andrew Walter Compliance costs Low 1

Monitoring costs

Low

2

SDDS, GDDS

3

High

High

Macroeconomic transparency standards

4 Prudential regulation, corporate governance standards, IAS, money laundering standards

Figure 2.1. Private sector compliance costs and third-party monitoring costs

private (and public) sector compliance costs and third-party monitoring costs are relatively high: the Basle capital adequacy regime.

2.3.1. SDDS vs. IAS Table 2.3 compares rates of compliance with SDDS to rates of adoption of IAS or US Generally Accepted Accounting Principles (GAAP) across different country categories. 21 It shows that on average, at the end of 2003 SDDS compliance among IMF members was 29 percent. This was similar to the percentage of countries that had adopted IAS or US GAAP in full, though lower than the 59 percent of countries that at that time required or allowed at least some firms to report using these international standards. Compliance with SDDS, as one would expect, is much higher for the major emerging market countries on JP Morgan’s EMBIG database, but the adoption of IAS is much lower for this group (58% vs. 29%). It is even higher for those countries hit by systemic banking crises in recent years. Of eighteen major banking crisis countries over 21 For sources and definitions, see Table 2.3. The IAS/US GAAP calculations are made using data for those countries for which information is available, which probably biases the estimates upward. I use US GAAP and IAS as joint benchmarks for international accounting standards because of the unresolved competition between them for international standards status.

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Do Voluntary Standards Work Among Governments? Table 2.3. Compliance with SDDS and adoption of IAS/US GAAP, end 2003

% of IMF members/known countries: IFRS % of emerging market countries (EMBIG) % of countries with banking crises within past 5 yrs % of 58 crisis-hit countries (past 10 yrs) % of 18 major crisis-hit countries (past 10 yrs) % of 10 major East Asian economies

SDDS

IFRS/US GAAP (full adoption)

IFRS/US GAAP (including partial definition)

29 58 47 50 78 80

30 29 22 29 6 0

59 50 47 53 22 20

Notes: SDDS compliance is measured by whether a country is deemed by the IMF to have met SDDS specifications. Banking crises are defined as ‘systemic’ (Caprio and Klingebiel 2003). The 18 major banking crisis countries are Argentina, Brazil, China, the Czech Republic, Egypt, Hungary, India, Indonesia, Japan, Korea, Malaysia, Mexico, the Philippines, Poland, Russia, Thailand, Turkey, and Venezuela. Emerging market countries are those on the JP Morgan Emerging Market Bond Index Global (EMBIG). The 10 major East Asian economies are China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. Sources: Street (2002); IAS Plus website (http://www.iasplus.com/country/country.htm), SDDS website (http:// dsbb.imf.org/Applications/web/sddshome), and Caprio and Klingebiel (2003).

the past decade, 78 percent are SDDS subscribers. Levels of SDDS compliance by major East Asian countries are higher: eight of the possible nine are subscribers (Taiwan is not an IMF member; China was the only nonsubscriber). Table 2.4 shows that the major crisis-hit East Asian countries were relatively early subscribers to SDDS, only slightly behind the G7 average, though they took longer than most countries to meet in full the various SDDS specifications. Note, however, that Korea complied with SDDS much more quickly than the G7 average and that the average time to compliance for all countries is low because since 2001, new SDDS subscribers have tended to collapse all three stages of SDDS compliance into one. By contrast, few major crisis-hit countries adopted IAS/US GAAP (only one of eighteen did so in full); none of the major East Asian economies did so. Table 2.3 gives a misleading picture of the extent of compliance with IAS in two ways. First, it ignores the fact that most countries in East Asia have revised domestic accounting standards in recent years and brought them closer to international standards. Second, it only shows formal adoption rates, not true compliance. Estimating the latter is very difficult. It was clear in 2002–3 that important areas of divergence between national and IAS remained in most cases in East Asia, though this is difficult even for experts to assess. 22 Moreover, few believe the quality of financial reporting 22

For example: see the country assessments in Nobes (2001).

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Table 2.4. SDDS subscription, posting and compliance dates, selected countries, and groups

Average all countries G7 average Indonesia Korea Malaysia Singapore Thailand

Date of subscription (1)

Date metadata were posted on the DSBB (2)

Date when subscriber met SDDS specifications (3)

3−1 (days)

3−2 (days)

April 20, 1998 July 5, 1996 September 24, 1996 September 20, 1996 August 21, 1996 August 1, 1996 August 9, 1996

October 2, 1998 November 19, 1996 May 21, 1997 March 30, 1998 September 19, 1996 September 19, 1996 September 19, 1996

March 30, 2001 January 3, 2000 June 2, 2000 November 1, 1999 September 1, 2000 January 30, 2001 May 16, 2000

1,060 1,258 1,328 1,121 1,450 1,619 1,357

897 1,124 1,091 571 1,422 1,571 1,317

Note: The average figure is for all 61 SDDS subscribers as of June 22, 2005. Sources: IMF, DSBB: http://dsbb.imf.org/Applications/web/sddssubscriptiondates/, accessed June 22, 2005.


in most of East Asia to be on a par with that, say, in the USA and UK. Comparable measures of the quality of accounting and auditing are hard to find, but survey measures of the quality of national accounting regimes generally show that East Asian countries except Singapore and Hong Kong substantially lag the G7 average. 23 Most Asian countries adopted a strategy of moving only toward allowing IAS reporting for some companies (usually those that are foreign-listed and for whom compliance costs are low), while more incrementally modifying national accounting standards for the rest. On balance, then, it is reasonable to conclude that the quality of compliance with SDDS is probably considerably greater in East Asia than is compliance with IAS. This is consistent with the prediction made in Section 2.2.

2.3.2. Basle CARs By comparison with SDDS and even IAS, assessing the degree of country compliance with the Basle Core Principles is very difficult. Published FSSAs and ROSCs, as already noted, are in very short supply: only Hong Kong, Korea, Japan, and Singapore have undertaken FSAPs and published banking ROSCs, despite considerable international pressure on the others to do so (US GAO 2003: 19). These reports are also qualitative, difficult to compare across countries, and often pull punches, though the Japanese assessment is, unusually, sharply critical in places. For this reason and because of space considerations, I simplify the task in this section by considering only East Asian convergence on the Basle capital adequacy provisions. Is there evidence that the quality of compliance is poor in this area, as predicted above? In terms of formal adoption, fully 90 percent of all countries surveyed by the World Bank have signaled that they had adopted the Basle capital adequacy regime by 2001, which requires internationally active banks to have a minimum 8 percent risk weighted capital ratio (Barth, Caprio, and Levine 2002). This is a much higher formal adoption figure than for any other international standard discussed here. Furthermore, as Table 2.5 shows, official Basle CARs in the major Asian crisis-hit developing countries were considerably in excess of the 8 percent Basle minimum. In many cases, average Asian bank CARs were above those in the USA by early 2003. 23

See, for example, the World Economic Forum survey (2003: 610).

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Andrew Walter Table 2.5. Basle CARs in selected Asian countries and the USA, 2003 Country

Hong Kong Indonesia Japan Korea Malaysia Singapore Thailand USA

Official average capital adequacy ratios, mid-2003 (%)

Moody’s Bank Financial Strength Ratings, March 2003

15.6 21.4 10.8 10.4 13.4 17.8 13.6 12.7

C+ E D− D− D+ B D− B

Notes: CARs are unweighted averages, whereas Moody’s BSRF ratings are weighted averages. Moody’s BFSR ratings explicitly do not take into account the probability of public sector assistance in the event of potential default. Ratings are from A (the strongest) to E (the weakest). Sources: IMF, Global Financial Stability Report, April 2004; Moody’s, Bank Risk Monitor, March 2003.

To conclude that this reveals over- rather than under-compliance would be wrong, however. There is little doubt that most Asian banks in 2003 had real capitalization levels that were much lower than those of US banks, contrary to the official CARs. The final column of Table 2.5 shows Moody’s bank credit risk department’s average Bank Financial Strength Rating (BFSR). Moody’s BFSRs, in contrast to their standard deposit ratings, are intended as an indication of the ‘stand-alone’ financial strength of banks. As such, BFSRs explicitly do not take into account the probability that the government would rescue a financially distressed bank. It is clear that there is, if anything, an inverse relationship between official CARs and Moody’s estimates of the true financial strength of banks. 24 Only Singapore’s banks have comparable financial strength ratings to the USA, but most of the banks elsewhere in Asia were rated in the two lowest categories of E or D−. There are many reasons why official CARs are not comparable across countries and why they can be wholly misleading as indicators of bank financial strength. The 1988 Basle regime is notoriously weak as regards to rules on loan loss provisions and the components of bank capital, with the result that official ratios often hide a multitude of sins. 25 Below, I provide some illustrations of the often poor quality of compliance with 24 Fitch Ratings (2003b) finds this inverse relationship holds generally using its own estimates of banks’ stand-alone financial strength. 25 For the calculation of Basle CARs, see http://www.bis.org/publ/bcbs04.htm, accessed April 11, 2004.

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these standards in postcrisis Asia in three main areas, though these do not exhaust the problems with official CARs. First, loan accounting standards and practices remained opaque in postcrisis Asia, particularly for ‘restructured’ nonperforming loans (NPLs), which made up large proportions of bank assets in countries like Indonesia and Thailand. Lax loan accounting has the result of reducing required loan loss provisions, increasing reported profits and inflating official capital. After the crisis, with the encouragement of the IFIs, most countries in the region converged on the standard three-month past due rule for calculating NPLs. 26 In Thailand after the crisis, debt classified as ‘doubtful’ or ‘loss’ could be reclassified as ‘substandard’ when a debt restructuring agreement was signed. Substandard or ‘special mention’ debt would remain within those categories until three months of repayments (or three installments) were fulfilled, after which they could be upgraded to the pass (i.e. accrual) category. This less conservative standard (compared to the USA, which requires six months of repayments) was further relaxed on April 10, 2000, allowing the immediate reclassification of restructured loans to accrual status that satisfied certain criteria. Nor were Thai banks required to report the total amount of such restructured debt in accrual status, though the high levels of ‘re-entry NPLs’ reported by the Bank of Thailand (BOT) suggested that many restructured loans had turned bad again. Direct evidence of lax loan accounting in Thailand is given by DBS (Singapore) Group’s consolidated accounts for 2001 and 2002. This group has a Thai subsidiary, DBS-Thai Danu Bank (TDB). DBS Group is required by Singapore’s conservative Monetary Authority to note in these accounts that Thailand’s loan classification standards are much laxer than Singapore’s, and that if the latter’s classification standards were used instead, TDB’s NPLs would be about five times higher. Indeed, DBS explicitly noted that according to Thai GAAP, TDB had positive net assets, but that according to Singapore accounting standards it was technically insolvent. 27 If this difference is representative of Thai classification standards, 26 The exceptions are Korea, which from 1999 partially instituted a US-style ‘forwardlooking criteria’ (FLC) approach to NPL estimation, and Malaysia, which retains a dual three and six-month standard. 27 DBS Group, Annual Report (2001), p. 126 and Annual Report (2002), p. 80 (Notes to the Consolidated Financial Statements). According to Singapore standards, TDB’s NPLs at the end of 2001 were 27.7 percent of total loans, whereas by Thai standards they were merely 5.8 percent (the figures for 2002 were 25.4% and 5.1%, with substandard loans increasing slightly from 2001–2). Furthermore, TDB’s level of NPLs increased to 28.8 percent of total loans in December 2003 (available at: http://www.dbs.com/investor/2003/ fy/PerfSummaryFY2003.pdf, accessed February 25, 2004).

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it implies substantial regulatory forbearance by the BOT and continuing severe weakness in the banking sector. 28 A second illustration of poor quality compliance can be found in the regulatory treatment of collateral. Asian banks usually require collateral when lending, particularly property collateral. A large percentage of the value of the collateral attached to NPLs can usually be offset against required provisions. As a result, lax collateral valuation practices can also inflate official CARs. For example, in Thailand, the BOT defined the market value of collateral as ‘the probable price on the date of the collateral asset valuation or appraisal under normal market conditions with no transaction costs (nor taxes)’. 29 According to many analysts, the ‘normal market conditions’ clause, and the poor quality of valuation firms in Thailand, meant that collateral was often overvalued. Furthermore, in countries like Thailand and Indonesia, where most collateral is in the form of illiquid real estate and where the legal foreclosure regimes were dysfunctional, a best practice (conservative) approach would not allow such netting practices regarding required provisions (Song 2002: 21). A third area of weakness can be found in the definitions of the allowable components of capital, which vary considerably by country. In Thailand, regulators allowed banks to issue expensive hybrid debt instruments (socalled CAPs and SLIPS) and to include these in Tier I capital, contrary to practice in the USA and elsewhere. 30 In Japan, meanwhile, by early 2003 more than half the Tier 1 capital of major banks consisted of deferred tax assets (DTAs), most of which are past tax losses carried forward. 31 For two of the top seven banks, DTAs made up all of Tier 1 capital (Fitch Ratings 2003c: 17). The Japanese rules on DTAs were lax by almost any standard. In Japan, DTAs could be carried forward for up to five years, as opposed to only one year (or a maximum of 10% of Tier 1 capital) in the USA, the only other major country in which DTAs are important. Since the value of DTAs was often in doubt due to very poor bank profitability, and since 28 Further evidence from another Singapore-owned Thai bank, UOB-Radhanasin Bank, gives a very similar picture to the TDB case (UOB Group, Annual Report (2001), and UOBRadhanasin Bank monthly reports to BOT, available at: http://www.bot.or.th/bothomepage/ databank/financial_institutions/npl_fi/254412/ecb.htm). 29 BOT, ‘Regulations for Collateral Valuation and Appraisal’, http://www.bot.or.th/ bothomepage/notification/fsupv/2541/thtm/RCVA.DOC, accessed April 1, 2002. Italics added. 30 Confidential author interviews, regulatory officials, Hong Kong, April 2002, and Thailand, March 2002. In the USA, approved subordinated debt instruments are only allowable as Tier II capital: Comptroller of the Currency (2001: 40). 31 DTAs arise due to differences between financial reporting for accounting disclosure and for tax purposes.

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in particular they are not generally available to cushion large losses, there is a strong case for their use as core capital to be sharply constrained (IMF 2003: 8, 18). Their heavy use by Japanese banks cast considerable doubt on the quality of their compliance with the Basle regime. The weakness of internal and external auditors is another factor that allows banks and regulators to collude in regulatory forbearance. 32 Evidence of strong postcrisis pressure on crisis-hit Asian countries to adopt a mock compliance strategy regarding bank capitalization standards is consistent with the theory offered in Section 2.2. The higher quality of compliance witnessed in Hong Kong and Singapore is also supportive. This is not because these countries are rich (cf. Japan) or because they have independent regulatory authorities (neither Singapore nor Hong Kong has). Rather, higher compliance with Basle has been possible for Singapore’s and Hong Kong’s banks because their economies were much less affected by the crisis, so that the private sector costs of compliance were much lower than in their crisis-hit neighbors. Their banks and other companies are also relatively internationalized and the authorities in both have seen overcompliance as a means of distinguishing themselves from their less compliant neighbors. In general, then, we can conclude that where the private sector costs of compliance with international standards and third-party monitoring costs are both relatively low, as is the case for SDDS, levels of compliance in East Asia are high. However, where private sector compliance costs and monitoring costs are both high, as is the case with IAS and Basle capitalization standards, the quality of compliance is relatively poor. That the Asian countries wished to signal their intentions to converge on international standards of this kind despite the difficulty of achieving compliance after 1997 suggests that they were under considerable pressure to do so. The crises that hit Asia demolished the credibility of their previous regulatory frameworks, to the extent they existed, and entrenched the idea that the only viable path to reform was to adopt Western-style financial regulatory standards. At the same time, the economic distress the crises produced made it more difficult to comply in practice with the international standards that received most attention by the IFIs (financial supervision standards, corporate governance standards, and accounting 32 However, the external auditors of Resona, a major Japanese bank, refused in March 2003 to accept the bank’s stated value of DTAs, resulting in an overnight collapse of the bank’s CAR and a further costly government bailout. Two other major banks also wrote down DTAs in FY2003, though bank analysts believed others should have done the same (Fitch Ratings 2003c: 3).

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standards). The evident reluctance of a number of important East Asian countries (notably China, Indonesia, Malaysia, and Thailand) to submit to the FSAP review process is another indication of this dilemma.

2.4. Implications for Self-Regulatory Reform What are the implications of the preceding analysis for the reform of self-regulation? We have seen that external compliance mechanisms (IFIs and markets) can promote the reform of domestic regulation after crises. However, governments in crisis-hit countries are also usually subject to stronger domestic pressures to resist substantive compliance with international regulatory standards, leading them to square this circle via mock compliance strategies. The question this raises is whether this outcome is suboptimal and, if so, what should be done about it. The answer, I suggest, is a mixed one. That there is often considerable domestic flexibility in adopting and adapting international standards is not, on the face of it, a bad thing for two reasons. First, given the legitimacy problems of international standards, retaining some flexibility might be politically important. Second, contrary to the prescriptions of the new ideal type of regulatory neoliberalism, there are occasions on which governments should engage in discretionary regulatory forbearance. Though Asian regulators strenuously denied that they were engaged in forbearance in the postcrisis years, there is little doubt that many were. Thailand’s relatively lax loan accounting and Tier I capital definitions, Japan’s lax loan accounting and regulatory treatment of DTAs, Malaysia’s relaxation of bad loan definitions, Indonesia’s extraordinarily expensive purchase of bad private sector assets, Korea’s encouragement of state-owned banks to lend to a few large firms—all are examples of discretionary interventions aimed at giving breathing space to a highly distressed private sector. 33 Although many Western critics tended to see this as evidence of continuing collusive, ‘cronyistic’ relationships between East Asian states and their private sectors, such examples might also be seen as pragmatism. This was a pragmatism that, in the new intellectual climate of regulatory neoliberalism, did not dare speak its name. 34 33

For further details, see Walter (forthcoming 2007). The exception is Malaysia, where Prime Minister Mahathir was openly critical of the assumption that it made sense to import more stringent Western financial regulations in the midst of the crisis. 34

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No doubt in some cases the Western critics of discretionary interventionism in Asian financial regulation are right. However, we should not overlook that the major Western countries, the IFIs and international banks saw the crisis as a once-in-a-lifetime opportunity to fundamentally remodel the relationship between state and market in East Asia. The international standards project was at least as much a deployment of power as the bringing of regulatory ‘best practice’ to an important part of the developing world. Is it obvious that Japan should have strictly enforced US-style rules in 2002–3, thereby forcing its government to recapitalize, nationalize, or close most of its big banks? (cf. Fitch Ratings 2003c: 2). Western critics of Japan’s approach worked themselves up into a frenzy of indignation, but it may be doubted that forbearance is as great a sin as they claimed. Since early 2003, the Japanese banking system has greatly reduced its NPL problem and profits have recovered rapidly, thanks in part to the extraordinary use of DTAs and other time-buying measures. In retrospect, it might have been simpler and more straightforward for the Asian governments simply to argue that Western standards were inappropriate to the circumstances of the postcrisis period. That they felt unable to do so underlines the effect of the crisis on self-confidence in the region. However, denial of the obvious drained the credibility of governments and regulatory agencies, with serious negative consequences (most notably, perhaps, in Japan). If the strict application of international standards did not always make sense in the immediate postcrisis period, the question remains whether such standards are appropriate benchmarks for long-term regulatory convergence in Asia and elsewhere. Clearly, the pre-1998 financial regulatory regimes in Indonesia, Korea, Japan, and Thailand all had major failings that contributed to the depth of the crisis these countries suffered in the late 1990s. However, it would be wrong to see international standards as a panacea in all areas. Not only is the international standard-setting process dominated by the major Western countries, but they are the products of domestic politics within these countries. No doubt American bank regulatory, corporate governance, and accounting standards are generally more stringent than those in most developing countries, but as recent scandals have amply demonstrated, US rules are sometimes far from ‘best practice’. Nor is it clear that one size should fit all. In the case of corporate governance standards, the importation of Western rules on board independence has failed to place significant constraints on family ownermanagers (Nam and Nam 2004). There is also a difficulty in asking countries to accept a rules-based model of financial regulation and 57

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supervision when (as in Asia) personal relationships continue to predominate. Institutionally, personal relationships compensated successfully in the past for weaknesses in the institutions that are necessary for arm’slength finance: secure property rights, third-party legal enforcement of contracts, etc. (Yoshitomi et al. 2003: 78). The interdependence of the reforms required by the various standards and codes arguably poses an enormously difficult, complex, and costly transition task for many developing countries. Even in the case of IAS, where the case for a single set of international standards is strong, we need to ask whether the costs of compliance exceed the potential benefit. The sophisticated treatment of financial instruments required by IAS 39, for example, is much less relevant to most firms in developing countries. In general, the appropriate sequencing of institutional reforms remains an open question. Moreover, as we have seen, regulatory outcomes remain dominated by domestic, economic, and political factors. Setting the standards bar at a fairly high level for developing countries may be the best way of encouraging serious long-term reform, but in the meantime, this approach more or less condemns most countries to a degree of failure. It may also promote a confrontational approach to regulation and supervision that alienates the private sector rather than encouraging them to see better regulation as in their interest.

References BCBS (Basle Committee on Banking Supervision) (September, 1997). Core Principles for Banking Supervision. Basle: BCBS. Barth, James R., Gerard Caprio, and Ross Levine (2002). ‘Bank Regulation and Supervision Database’, World Bank. Available at http://econ.worldbank.org/ view.php?type=18&id=12171 Blustein, Paul (2001). The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF. New York: Public Affairs. Caprio, Gerard and Daniela Klingebiel (2003). ‘Episodes of Systemic and Borderline Financial Crises’, World Bank, January. Available at http://econ.worldbank.org/ view.php?type=18&id=23456 Capulong, Ma. Virginita, David Edwards, David Webb, and Juzhong Zhuang (eds) (2000). Corporate Governance and Finance in East Asia: A Study of Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand, 2 vols. Manila: Asian Development Bank.

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Do Voluntary Standards Work Among Governments? Checkel, Jeffrey (Summer 2001). ‘Why Comply?’, International Organization, 55(3): 553–88. Claessens, Stijn, Simeon Djankov, and Larry Lang (1999). ‘The Separation of Ownership and Control in East Asian Corporations’, World Bank Working Paper, November. Clark, Alastair (2000). ‘International Standards and Codes’, Financial Stability Review, December: 162–8. CLSA Emerging Markets (April 2005). CG Watch 2005: Corporate Governance in Asia. CLSA Emerging Markets and Asian Corporate Governance Association. Comptroller of the Currency (US), Administrator of National Banks (January 2001). An Examiner’s Guide to Problem Bank Identification, Rehabilitation, and Resolution. Washington, DC: OCC. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini (1998). ‘Paper Tigers? A Model of the Asian Crisis’, Working Paper, December. Fitch Ratings (2003a). ‘Bank Rating Methodology’, March 20. (2003b). ‘Are Credit Ratings Correlated with Regulatory Capital?’, November 26. (2003c). ‘Japanese Banks: Results for 2002/2003—Where’s the Way Out?’, Special Report Japan, June 25. FSF (Financial Stability Forum) (2000). ‘Report of the Follow-Up Group on Incentives to Foster Implementation of Standards’, Basle, August 31. G7 Finance Ministers (1999). ‘Strengthening the International Financial Architecture’, Report of G7 Finance Ministers to the Cologne Economic Summit, June. Ho, Daniel E. (2002). ‘Compliance and International Soft Law: Why do Countries Implement the Basle Accord?’, Journal of International Economic Law, 5(3): 647– 88. Honohan, Patrick and Daniela Klingebiel (2000). ‘Controlling Fiscal Costs of Banking Crises’, World Bank. IEO (Independent Evaluation Office, IMF) (July 2003). The IMF and Recent Capital Account Crises: Indonesia, Korea, Brazil. Washington, DC: IMF. IMF (2001). Emerging Market Financing. Washington, DC: IMF. (September 2003). Japan: Financial System Stability Assessment and Supplementary Information. Washington, DC: IMF Country Report No. 03/287. and World Bank (July 2005). The Standards and Codes Initiative—Is it Effective? and How Can it be Improved? Washington, DC: IMF and World Bank. Jackson, Patricia and David Lodge (June 2000). ‘Fair Value Accounting, Capital Standards, Expected Loss Provisioning, and Financial Stability’, Financial Stability Review. Jordan, Cally and Giovanni Majnone (2002). ‘Financial Regulatory Harmonization and the Globalization of Finance’, World Bank Policy Research Working Paper, No. 2919, October.

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Andrew Walter Kapstein, Ethan B. (1994). Governing the Global Economy. Cambridge, MA: Harvard University Press. Krugman, Paul (January 1998). ‘What Happened to Asia?’, Unpublished Paper, MIT. Mattli, Walter and Tim Büthe (2003). ‘Setting International Standards: Technological Rationality or Primacy of Power?’, World Politics, 56(1): 1–42. Maxfield, Sylvia (1998). ‘Understanding the Political Implications of Financial Internationalization in Emerging Market Countries’, World Development, 26(7): 1201–19. Mishkin, Frederic S. (January 2001). ‘Financial Policies and the Prevention of Financial Crises in Emerging Market Countries’, NBER Working Paper, No. 8087. Moody’s Investor Services (1999). ‘Rating Methodology: Bank Credit Risk—An Analytical Framework for Banks in Developed Markets’, April. Nam, Sang-Woo and Il Chong Nam (October 2004). Corporate Governance in Asia: Recent Evidence from Indonesia, Republic of Korea, Malaysia and Thailand. Tokyo: Asian Development Bank Institute. Nobes, Christopher (ed.) (2001). GAAP 2001: A Survey of National Accounting Standards Benchmarked Against International Accounting Standards (Anderson, BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant Thornton, KPMG, PricewaterhouseCoopers). Oatley, Thomas and R. Nabors (1998). ‘Redistributive Cooperation, Market Failure, Wealth Transfers and the Basle Accord’, International Organization, 52(1): 35–54. Radelet, Steven and Jeffrey Sachs (1998). ‘The Onset of the East Asian Currency Crisis’, NBER Working Paper No. 6680 (April). Raustiala, Kal and Anne-Marie Slaughter (2002). ‘International Law, International Relations and Compliance’, in Walter Carlsnaes, Thomas Risse, and Beth A. Simmons (eds), The Handbook of International Relations. Thousand Oaks, CA: Sage, 538–58. Rodrik, Dani (1989). ‘Promises, Promises: Credible Policy Reform via Signalling’, Economic Journal, 99(September): 756–72. Shelton, Dinah (ed.) (2003). Commitment and Compliance: The Role of Non-Binding Norms in the International Legal System. New York: Oxford University Press. Soederberg, Susanne (2003). ‘The Promotion of “Anglo-American” Corporate Governance in the South: Who Benefits from the New International Standard?’, Third World Quarterly, 24(1): 7–27. Song, Inwon (2002). ‘Collateral in Loan Classification and Provisioning’, IMF Working Paper, WP/02/122, July. Standard and Poor’s (2002). ‘Corporate Governance Scores: Criteria, Methodology and Definitions’. Available at http://www.standardandpoors.com Street, Donna L. (2002). GAAP Convergence 2002: A Survey of National Methods to Promote and Achieve Convergence with International Financial Reporting Standards (BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant Thornton, KPMG, PricewaterhouseCoopers).

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Do Voluntary Standards Work Among Governments? Underdal, Arild (1998). ‘Explaining Compliance and Defection: Three Models’, European Journal of International Relations, 4(1): 5–30. US GAO [General Accounting Office] (2003). ‘International Financial Crises: Challenges Remain in IMF’s Ability to Anticipate, Prevent, and Resolve Financial Crises’, report to the Chairman, Committee on Financial Services, and to the Vice Chairman, Joint Economic Committee, House of Representatives, Washington, DC, GAO-03-734, June 16. Wade, Robert and Frank Veneroso (1998). ‘The Asian Crisis: The High Debt Model Versus the Wall Street—Treasury—IMF Complex’, New Left Review, No. 288, March/April, 3–23. Walter, Andrew (forthcoming 2007). Toward Compliance: The Political Economy of International Standards in East Asia. Ithaca, NY: Cornell University Press. World Economic Forum (2003). The Global Competitiveness Report 2002–2003. New York: Oxford University Press. Yoshitomi, Masuru et al. (2003). Post-Crisis Development Paradigms in Asia. Tokyo: Asian Development Bank Institute. Young, Oran R. (1979). Compliance and Public Authority: A Theory with International Applications. Baltimore, MD: Johns Hopkins University Press.

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3 Do Voluntary Standards Work Among Corporations? The Experience of the Chemicals Industry Michael Lenox

In an attempt to avoid costly government regulation and other liabilities as a result of environmental externalities, a growing number of firms have promoted industry self-regulation—the association of firms to voluntarily control their collective behavior. In the past twenty years, environmental self-regulatory programs have proliferated in both the USA and abroad (Nash and Ehrenfeld 1996). Growing environmental regulations in industrialized nations and increasing environmental activism of consumers and the public in general have driven many industries to look for alternative strategies to deal with stakeholders. Industries have attempted to avoid costly government regulation and to placate concerned stakeholders by promising to voluntarily reduce their environmental impacts. In this chapter, we explore the conditions under which effective industry self-regulation is likely to emerge. Formally, we define ‘self-regulation’ as the provision of public goods beyond that required by law. As opposed to unilateral self-regulation by a single firm, industry self-regulation entails collective action by member firms to improve the reputation of the industry as a whole. To facilitate collective investment, many industries have relied on trade associations to initiate and coordinate programs. These programs typically entail the adoption of codes of environmental management practice by member firms. Codes of environmental management practice stipulate environmental goals for firms beyond those that are codified into government regulation. They include guidance as to how participating firms are to meet these goals. Trade associations utilize

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a mix of mechanisms, including trade association oversight, external verification, and peer pressure, to ensure compliance with program goals. In the sections to follow, we discuss the incentives for firms to selfregulate and how the costs of failure to self-regulate are often borne by the collective, for example the industry, rather than narrowly by individual firms. Given this collective nature, we discuss a number of challenges to industry self-regulation, in particular, adverse selection, moral hazard, and freeriding. In the latter half of this chapter, we discuss the various strategies firms adopt with regards to self-regulatory efforts and identify potential public policies that may help facilitate industry self-regulation. Throughout this chapter, we reference previous empirical work conducted by the authors. In particular, we pull from a series of studies examining the American Chemistry Council’s (ACC) 1 Responsible Care™ program (King and Lenox 2000; Lenox and Nash 2003; Lenox 2006). The ACC is the primary trade association of the US chemical industry and consists of many of the largest US chemical producers. Responsible Care was initiated by the ACC in 1989 in response to negative public perception surrounding the chemical industry in the USA. Participation was required as a condition of membership in the ACC. Members pledged to uphold a set of ten principles and to adopt six codes of management practice. The codes required that firms adopt certain practices, dedicate staff to specific activities, and employ particular techniques. They did not, however, set specific environmental performance criteria. Initially, compliance to program requirements was self-reported by member firms. Failure to comply with program requirements could result in expulsion from the ACC, though in the first few years of the program no firms were expelled. The hope of the chemical firms who made up the ACC was that by voluntarily reducing the harmful environmental impacts of chemical manufacturing operations they could improve the chemical industry’s reputation and subsequently forestall further government regulation and ease community relations and the citing of new manufacturing facilities.

3.1. Incentives for Industry Self-Regulation Traditionally, the environmental impact of industrial processes has been assumed to be a pure externality. In other words, in the absence of 1 Prior to 2000, The American Chemistry Council was known as the Chemical Manufacturers Association.

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government regulation, the harm caused by environmental degradation as a result of economic activity is borne by others than those who generate the environmental impacts. For example, a factory polluting a river does not bear the cost of the damages to fisheries downstream. Since there is not a market for water pollution, damaged parties have no recourse against the factory. While the factory may utilize more of a resource (in this case clean water) than is socially optimal, the factory has no incentive to reduce its environmental impact. In such a world, profit-seeking firms are unlikely to self-regulate. Industry self-regulation may be viewed as corporate philanthropy at best and foolhardy and welfare decreasing at worst (see Friedman 1970). While purely altruistic-driven self-regulation may be possible, we suspect that it will be rare, idiosyncratic, and ultimately limited due to the disciplinary forces of capital markets. 2 Altruistic managers are likely either to be removed by shareholders or to lead their enterprises to competitive failure and exit. 3 While managers may have some discretion to be altruistic in the presence of weak corporate governance, recent history has shown that managers rarely act on behalf of the public but rather in their own narrow self-interest when discretion is available. More likely, industry self-regulation arises as a result of some financial benefit that it provides to firms. In the absence of market imperfections, firms that self-regulate will incur costs with no offsetting financial benefit (Reinhardt 1999). Such firms will eventually be driven out of the market, as lower cost rivals are able to drive market prices to the self-regulating firm’s average unit cost. However, there often exist external pressures that, when brought to bear, ‘internalize’ externalities. Costs may be imposed on polluting firms such that they have an incentive to reduce their environmental impacts even in the absence of government regulation. The most obvious pressure is the threat of future government regulation. Industry self-regulation may be a potent strategy by industries to forestall government regulation. By demonstrating to legislators that they can police their own, industries may be able to avoid costly government intervention. This is one of the reasons given by the ACC for the creation of the Responsible Care program. According to the trade association, pollution reductions may be achieved at lower cost (both to firms and 2 We define altruistic behavior as strategic choices that benefit external stakeholders such as the general public at the expense of the firm’s profit objective. 3 It is possible that under some circumstances that altruistic-driven self-regulation may be sustainable. In particular, tightly held private firms may have owners who are willing to sacrifice returns for the greater welfare.

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to society) through industry self-regulation than by governmental regulation (Chemical Manufacturers Association 1991). The implicit assumption being that industry members have better information than regulators about technological opportunities and the efficiency of various solutions. Especially derided by the for-profit sector are command and control regulations that specify specific technological solutions that may not be efficient for every producer in the industry. In addition, self-regulation potentially could reduce the political costs of crafting legislation and regulatory rules and the regulatory cost of monitoring and enforcing rules. Beyond pressure from the state, nongovernmental stakeholders such as consumers, community advocacy groups, and environmental organizations may place substantial pressure to self-regulate directly on firms. Boycotts, lawsuits, and protests by activist stakeholders may be extremely costly to firms. Effective boycotts can have a significant impact on firm revenues. Successful lawsuits can cost firms millions of dollars. Protests may raise operational expenses by making it difficult to get permits or to site new facilities. Each of these stakeholder actions may embolden public sentiment and lead to future government regulation, depress consumer demand, and raise labor costs by making it more difficult to hire and retain quality employees. Furthermore, protests, boycotts, and lawsuits may siphon scarce managerial attention away from other pressing firm endeavors. The Responsible Care program was started in large part to deal with negative public perceptions of the chemical industry that manifested themselves in the actions of activist stakeholders. However, if stakeholders have good information about the environmental performance of firms, pressure to self-regulate by activists should inspire firms to unilaterally reduce their environmental footprint (see Table 3.1). In other words, firms would not need to coordinate their pollution reduction efforts as in the Responsible Care case. Activists could target polluting firms while ignoring or even rewarding higher quality (i.e. less polluting) firms. In essence, a market for environment-friendly products and practices would Table 3.1. Typology of stakeholder responses to environmental externalities High

Low

Stakeholder ability to differentiate competitors

Simplistic but targeted Informed & precise

Arbitrary & capricious Ambivalent (or worse)

Stakeholder ability to assess firm’s performance

Ambivalent (or worse) Informed & precise

Arbitrary & capricious Simplistic but targeted

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be created. These markets could be further enhanced by general consumer demand for environment-friendly goods. 4 If such a market exists, selfregulating firms would be able to differentiate their products and services from competitors and command price premiums. However, the assessment of firm environmental performance by stakeholders is rife with information asymmetries. The environmental behavior and performance of firms are often unobservable. Reliable metrics are few and the ones that do exist are often ambiguous and noncommensurate with other metrics. As a result, firms find themselves in a world where stakeholders have little information on the environmental performance of themselves and their competitors. In such a world, stakeholder actions tend to be arbitrary and capricious. Activists may lash out at a firm, not because it is a relatively poor performer within its industry, but because it is large and visible. The whole industry may be held responsible for the actions of a handful of laggards. In the absence of credible information, even environmental leaders may find themselves under scrutiny. In such a situation, leading firms may try to reduce information asymmetries by providing detailed information on their own performance. However, it is exceedingly difficult for high-quality firms to make credible claims about their environmental performance (and thus appease environment-friendly consumers and avoid the ire of activist stakeholders). Absent additional information from competitors, stakeholders will have difficulty making use of detailed performance data released by high-quality firms. At best, activist stakeholders may be ambivalent to corporate-provided information. At worst, activists may target firms who release information given their ability to scrutinize their performance. As a result, efforts to unilaterally self-regulate are often insufficient. Ultimately, individual environmental reputations are tied with other firms within the industry. Fatal accidents, damaging spills, and the emission of toxic pollutants have consequences not only for the offending firm but for all firms within an industry. Environmental leaders may find themselves facing the same regulations, activist pressures, and consumer demands as environmental laggards. Anecdotal evidence suggests that this was the case in the US chemical industry. The ACC lamented that chemical firms were often all ‘tarred by the same brush’. An accident at one chemical plant had repercussions not only for the owner but for all firms within the industry. A prime 4 Surveys of US consumers suggest that demand is relatively elastic with regards to environmental impacts. Nonetheless environment impacts have been found to be important purchase criteria in at least some segments of the US economy.

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example was the accident at a Union Carbide plant in Bhopal, India in 1984 in which thousands died. Analysts observed that not only did Union Carbide suffer financially from the accident, but that other chemical firms also saw their stock devalued in the wake of the accident. Investments by some firms to reduce accidents were insufficient to avoid the negative repercussions of others’ actions.

3.2. Challenges to Industry Self-Regulation The collective nature of government regulation, activist pressure, and consumer demand forces firms to band together if they wish to minimize the threat posed by these various stakeholders. Hence, for self-regulation to be beneficial, investments are needed by self-interested firms in the collective reputation of the industry. This creates a ‘reputation commons’ problem (King, Lenox, and Barnett 2001). Like all commons problems, the nonexcludability of contributions to industry reputation creates a collective good. When a collective good is provided, all members of the relevant group benefit regardless of whether they contribute to providing the good or not. Consequently, such goods are subject to freeriding, that is, firms will do nothing while benefiting from the efforts of others. Common examples of collective goods include maintaining public fisheries, rangelands, and aquifers and the provision of basic scientific research and education. In all these cases, the possibility of freeriding often leads to under investment in the collective good. Traditionally, scholars have proposed that the collective good problem can only be solved by an independent governing body (e.g. the state). A sovereign authority is needed to either directly provide the collective good (Pigou 1912) or to privatize the good so that each user bears the full costs and benefits of his actions and thus will not tend to overuse the resource (Coase 1960). According to the traditional view, without such a ‘leviathan’, collective goods fall victim to the ‘remorseless workings of things’ (Hobbes 1960; Hardin 1968). In contrast, recent research suggests that firms may, under certain circumstances, collectively self-regulate their behavior. Examples of successful self-regulation are numerous and diverse. For centuries, certain communities have successfully managed common resources such as water, fish, and land (King 1995). Examples of successful self-regulation within business include the management of a commodity futures exchange (Abolafia 1985), safety regulation in the nuclear power industry 67

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(Rees 1997), and shipping rules in the international maritime industry (Furgur 1997). Economists have focused on a number of factors that may facilitate self-regulation. Game theoretic treatments propose that credible threats of punishment for noncompliance are necessary for collective self-regulation (Radner 1981; Kreps and Wilson 1982; Axelrod 1986). Central for such outcomes is the notion of reciprocity acting as a mutual deterrent to deviant behavior. When one firm violates agreed-upon rules, mechanisms must be put in place to sanction that firm. In essence, firms must agree to punish one another if one of them deviates. Scholars have provided a number of specific examples in which reciprocal actions enforced self-regulation. In some New England lobstering communities, lobstermen who overfish have the buoys on their traps cut (Ostrom 1990). In the Champagne fairs of medieval England, traders who reneged on agreed-upon exchanges were forcibly removed from the fair grounds by a collectively appointed judiciary (Milgrom, North, and Weingast 1990). The Maghribi traders from the eleventh-century Mediterranean enforced a commercial code by ostracizing and retaliating against members found in violation (Greif 1993). In the case of modern industry self-regulation, the potential punishments are limited. Civil law prohibits any number of draconian retaliatory responses (such as destroying property). Antitrust law does not allow firms to collectively boycott or to raise prices for competitors. Subsequently, any punishments administered for failure to comply with a self-regulatory program must be accepted by firms who participate voluntarily. Since firms may not force industry members to join into such programs, a firm may avoid punishment by simply exiting the program. Given that participation in industry self-regulation is voluntary, we would expect such initiatives to be subject to free riding. Unable to force industry members to participate, firms would elect not to participate, enjoying the fruits of the labor of self-regulatory participants while avoiding the costs. For moderate size industries and absent heterogeneity among firms, we might expect that self-regulatory programs would fall apart (Olson 1965). Segerson and Dawson (2001) demonstrate, however, that fear of such failure might cause some firms to participate so long as the cost of membership is less than the cost of government regulation or stakeholder sanctions in the absence of industry self-regulation. Presumably these firms disproportionately bear the cost of failure and thus are willing to provide for the collective good. In our studies of Responsible Care, we provide empirical evidence that a critical number of firms may 68


band together to continue the collective effort even though each firm would benefit from freeriding off the program (Lenox 2006). Hence, we may observe two sets of firms within an industry—those who self-regulate and those who freeride. Interestingly, whether a firm self-regulates or freerides may provide valuable information to stakeholders. Participation in self-regulatory programs may provide a signal to stakeholders about a firm’s quality. Stakeholders may subsequently reward firms for participation. For example, adherence to a standard set of practices may provide evidence of due diligence in legal battles. Even if a firm’s environmental performance is below the norm, its adherence to management practices adopted by other firms may demonstrate that it has not been willfully negligent (King and Baerwald 1998). To the extent participation in a self-regulatory program provides insurance, some firms who might otherwise not participate will have incentives to participate despite the costs. Troubling, though, is that if there is no mechanism for screening members, these programs may be subject to adverse selection—bad firms will join to receive the insurance and signaling benefits. While some firms will join to improve the collective reputation others may join to mask their poor performance. This is exactly our finding with respect to Responsible Care (King and Lenox 2000). In a study of over 3,500 US chemical facilities over the period 1987–96, we present evidence that a few larger, less polluting firms join Responsible Care but that, in general, dirtier firms tended to join Responsible Care. This is perhaps not surprising given that over the first decade of its existence, the Responsible Care program allowed self-monitoring by firms and had no history of expelling noncompliant members. Even if all members join with the intention to improve the industry’s reputation, the absence of mechanisms to monitor and sanction firms who fail to comply with program objectives may lead to moral hazard. In other words, once in receipt of the insurance benefits conferred to program participants, members have an incentive to be more risk seeking and consequently underinvest in environmental improvements. The duediligence benefits discussed above may lead to a race to the bottom as ‘best practice’ degrades as firms reduce investments. Our research on Responsible Care provides collaborating evidence (King and Lenox 2000). We found no evidence that Responsible Care firms reduced their toxic emissions any faster than nonparticipants and, in fact, found weak evidence that they reduced emissions less quickly than comparable nonparticipants. 69

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On the basis of our findings, we argue that absent explicit mechanisms for penalizing malfeasance, self-regulatory programs are likely subject to adverse selection and moral hazard. As pointed out earlier, however, selfregulatory programs are limited in the punishments they may administer. Monetary penalties such as fines are likely to raise antitrust concerns among government regulators. Neoinstitutional theorists have claimed that compliance may be achieved through informal mechanisms such as shaming and public exposure (Braithwaite 1989) and the emergence of new norms and values that change members’ preferences for collectively valued actions (Gunningham 1995; Furger 1997; Hoffman 1997; Rees 1997). According to this perspective increases in interpersonal communication can serve as a ‘basic ingredient of sustained individual accountability’ (Furger 1997: 449). While sociologists have argued that subtler coercive, normative, and mimetic means may be evoked, our previous empirical research casts doubt on the power of informal sanctions to prevent adverse selection into industry self-regulatory programs at least in the case of the US chemical industry during the early 1990s (King and Lenox 2000). Trade associations are nonprofit organizations that rely on the support of voluntary members in order to remain viable. For many trade associations, lobbying government on behalf of members’ interest to minimize the costs of regulatory compliance is their major activity. Facilitating industry self-regulatory programs, however, is substantively different from these activities. It is perhaps not surprising that trade association-managed selfregulatory programs are only as effective as the explicit sanctions brought to bear to ensure compliance.

3.3. Strategic Implications An interesting picture begins to emerge when we consider the challenges to industry self-regulation. We identify four generic strategic positions that firms may take with respect to self-regulatory efforts within their industries (see Table 3.2). We suspect that in many cases some firms will freeride off the efforts of others (Table 3.2: lower-left quadrant). These firms choose not to participate in industry-led efforts and do not selfregulate unilaterally. They gain the benefits of industry self-regulation without incurring the costs of participating and self-regulating themselves. In the case of Responsible Care, over 70 percent of US chemical firms choose not to participate (Lenox 2006). These firms tended to be 70

Do Voluntary Standards Work Among Corporations? Table 3.2. Typology of self-regulatory strategies

Self-regulate

Do not self-regulate

Do not participate Participate in program

smaller firms or firms with little production in the chemical industry. We may speculate that their absence from a self-regulatory program would likely not be of major concern to external stakeholders and thus not lead to the collapse of the self-regulatory effort. We propose that a second group of firms (Table 3.2: lower-right quadrant) may join self-regulatory efforts to gain the legitimacy and learning benefits of membership without putting forth the effort to meet the standards specified in the program. In other words, these firms fail to truly self-regulate. (We refer to them as laggards for lack of a better term.) In the case of Responsible Care, these firms tended to be dirtier firms from dirtier industry segments. Conservatively, roughly 10 percent of ACC members fell into this category. One inference is that companies with high risk for future liability (those in the most polluting sectors) joined for the liability protection that membership provided. These firms were able to avoid meeting the standards because Responsible Care lacked explicit monitoring and sanctioning mechanisms. Absent these mechanisms, firms could join the self-regulatory program without putting forth any real effort, for example, making changes to their production and management processes. We may surmise that the liability benefits that laggard firms seek is available despite their lack of effort due to the actions of a set of leading firms (Table 3.2: upper-right quadrant). In the case of Responsible Care, these leading firms tended to be larger firms, heavily focused in the chemical industry (e.g. Dow and Dupont). Their exit would likely lead to the collapse of the Responsible Care program. Furthermore, their active participation was necessary to placate concerned stakeholders. These firms likely continued to participate despite the various forms of freeriding 71

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taking place because they internalize the benefits from industry selfregulation more than others. Finally, there may exist a small set of loner firms (Table 3.2: upperleft quadrant) who choose not to participate in industry self-regulatory efforts but that unilaterally self-regulate nonetheless. These firms have private incentives to improve environmental performance regardless of the actions of others. These may be highly visible firms or foreign firms who find themselves under greater stakeholder pressures (King and Shaver 2001). These firms may elect not to participate in industry self-regulatory efforts because these nonmembers use alternative management programs that would be disrupted by participation. For some firms, participation may even damage their reputation. Due to adverse selection, Responsible Care members tended to be more polluting and more slowly improving than nonmembers on average (King and Lenox 2000). Responsible Care members also have a reputation for overly conservative management among some Wall Street analysts (Anonymous 1999). Thus small, clean, and aggressive firms may have harmed their reputation if they chose to participate in Responsible Care. The presence of loners suggests that the value created by the selfregulatory efforts of leading firms is degraded by the presence of laggards and, to a lesser extent, freeriders. The marginal improvement in industry reputation due to self-regulation by leading firms is less, given laggards and freeriders. In addition, the ability of leading firms to differentiate themselves from others in the industry is undermined by the presence of laggards. From the leading firms’ perspective, the existence of laggards and freeriders may be tolerated but is obviously not desirable. Thus, leading firms may pursue a number of actions to narrow the scope of these two groups. We will consider each in turn. We propose that the most viable way to eliminate laggards is to simply expel noncompliant firms from the program. This means that self-regulatory organizations must (a) establish structures to monitor individual firm compliance with program objectives and (b) establish procedures for removal of firms from the program. Otherwise, industry self-regulatory programs will attract poor performers who may benefit from participation without putting forth any real effort. Only when rigid monitoring and sanctioning mechanisms are in place, may poor performers be dissuaded from joining the self-regulatory program in the first place. Empirical work of ours comparing across four trade association sponsored programs in different industries provides evidence consistent with 72


this proposition (Lenox and Nash 2003). Using a sample of over 4,000 US firms in the chemical, textile, and pulp and paper industries, we find evidence that, in at least one program, more polluting firms tended to join, while in another, cleaner firms were more likely to join. We speculate that differences in the structure of the programs drive these findings. In particular, the self-regulatory programs that were able to avoid adverse selection had a history of expelling noncompliant members while the less successful programs had not. The elimination of freeriders is more difficult. As mentioned earlier, antitrust law prohibits firms from forcing compliance with standards on nonparticipant firms through various retaliatory measures. Since firms can only voluntarily participate in industry self-regulatory efforts, their only recourse to leading firms is to expel noncompliant members. One potential solution for leading firms is to lobby government to impose the standard on the industry. Of course, this ceases to be ‘self’ regulation and simply reflects lobbying by firms to impose government regulations that create favorable barriers to entry in the industry. In fact, some antitrust experts have expressed concern that industry self-regulation is really an attempt by leading firms to force out lower cost rivals. Another potential solution to the freerider problem is for leading firms to differentiate program participants from nonparticipants in such a way that the value created by the self-regulatory effort is appropriated solely by participants. To the extent that participation in self-regulation may serve as a signal of superior environmental performance, external stakeholders may differentiate between firms and direct their environmental externality ‘internalization’ efforts to poor performers. Referring back to Table 3.1, participation in industry self-regulatory efforts may be a way to move from the ‘arbitrary and capricious’ world due to rampant information asymmetries to the ‘informed and precise’ world where environmental laggards are punished and environmental leaders are rewarded. In other words, leading firms may be able to privatize the reputation commons.

3.4. Policy Implications To the extent that industry self-regulation is socially desirable, the state may wish to aid industry efforts to self-regulate. There are a number of actions that the state may feasibly take to help promote industry selfregulation and mitigate some of the challenges to self-regulation. For one, the state could use the threat of future regulation to coerce industry 73

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self-regulation. Yet, as discussed above, the mere presence of collective incentives may not be sufficient to establish industry self-regulation given the organizational challenges to success. An alternative approach is for the state to require firms to abide by industry standards using the government regulatory apparatus. While this would solve the freerider problem, such compliance requirements resemble traditional government regulation and likely provide few of the efficiency benefits of ‘self’-regulation. A third possibility is for the state to allow various forms of collusion that otherwise may be prevented by antitrust law. For example, leading firms may be given permission to punish those firms who fail to comply with industry self-regulatory efforts. In the chemical industry, it has been suggested that self-regulating firms could raise the factor prices of nonparticipating firms because of the dense vertical exchanges that occur within the industry. This is a potentially powerful way to address the freerider problem. However, the state would need to balance the welfare gains from reducing environmental externalities with the threats of potential price collusion and exercise of market power to limit entry as a result of allowing such coordination. Another possibility is for the state to reward firms who participate in industry self-regulatory efforts. This would help address the freerider problem by providing incentives directly to those who self-regulate. Potential rewards include favorable treatment in permit and review processes, preference in government procurement contracts, and reduced fines in light of regulatory violations. Of course, from the state’s perspective, any attempt to reward self-regulation participants is contingent that they are able to achieve their self-regulatory goals, that is that they have adopted structures which avoid the adverse selection and moral hazard problems. Finally, the state may take actions to help solve the information asymmetry problem between stakeholders and firms. In other words, the state could help eliminate the reputation commons problem. In doing so, stakeholders could directly punish polluting firms and provide incentives for unilateral self-regulation—thus avoiding the freeriding, adverse selection, and moral hazard problems associated with industry self-regulation. Potential actions by the state include various forms of standard setting and reporting requirements. For example, the US Environmental Protection Agency’s Toxic Release Inventory (TRI)—a database of annual toxic emissions of US manufacturing facilities—is one such attempt to provide accurate, unbiased environmental performance data for use by nongovernmental stakeholders. 74


3.5. Conclusions Industry self-regulation has the potential to offer an efficient and effective complement to traditional government regulation. Industry-led efforts to self-regulate may reduce the costs of achieving environmental impact reductions and avoid the political and regulatory costs associated with regulation by the state. Increasingly, society is dealing with environmental issues on a global scale—atmospheric warming, the creation of the ozone hole, the loss of biodiversity. As the scale of these problems has increased, so has the scale of the necessary political coordination needed to address these concerns. Given the absence of a single state to enforce regulation in the global context, we suspect that industry selfregulation will become increasingly important in efforts to address global environmental impacts. Given industry self-regulation’s growing importance, it is critical to consider the incentives motivating firms to self-regulate and the challenges to collective action that industry self-regulatory efforts face. We propose that industry self-regulation arises in response to threats of future government regulation and to pressure from external stakeholders such as consumers and activists. Response to such pressures often requires collective action on the part of industry members since information asymmetries prevent the accurate assignment of individual firm performance. In other words, industry reputation is a collective good in which the poor behavior of some firms has negative repercussions for all within the industry. As a result of the collective nature of industry self-regulation, industry efforts are subject to freeriding, that is some firms will fail to selfregulate while gaining benefits from those who do. When participants in self-regulatory efforts fail to install viable monitoring and sanctioning mechanisms, industry self-regulatory programs will be subject to adverse selection and moral hazard in addition. Polluting firms will join to receive the insurance benefits of membership while failing to put forth the effort required. There are a number of strategies that may help mitigate these problems. Adverse selection and moral hazard may be avoided by installing explicit procedures for reviewing firm compliance with program goals and for removing those firms who fail to comply thus ensuring that participants in self-regulatory initiatives truly self-regulate. While freeriders are difficult to eliminate completely, leading firms may reduce the benefits to freeriding by attempting to differentiate themselves through 75

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their participation in the self-regulatory program. The state may play an active role by helping to reduce information asymmetries between firms and their stakeholders and by rewarding self-regulating firms. In the end, while our research suggests that industry self-regulation faces a number of important challenges, our conclusion is that when structured properly industry self-regulation holds promise as a valuable approach to address global environmental concerns.

References Abolafia, M. Y. (1985). ‘Self-regulation as Market Maintenance: An Organizational Perspective’, in R. G. Noll (ed.), Regulatory Policy and the Social Sciences. Berkeley, CA: University of Califonia Press, pp. 312–43. Anonymous (1999). Personal conversation with a manager of a large screened mutual fund. (Name withheld at respondent’s request.) Axelrod, R. (1986). ‘An Evolutionary Approach to Norms’, American Political Science Review, 80(4): 1095–111. Braithwaite, J. (1989). Crime, Shame, and Reintegration. Cambridge, UK: Cambridge University Press. Chemical Manufacturers Association (1991). Responsible Care: A Public Commitment. Washington, DC. Coase, R. H. (1960). ‘The Problem of Social Cost’, The Journal of Law & Economics, 3: 1–44. Friedman, M. (1970). ‘The Social Responsibility of Business is to Increase its Profits’, New York Times Magazine, September 13: 32+. Furger, F. (1997). ‘Accountability and Systems of Self-Governance: The Case of the Maritime Industry’, Law & Policy, 19(4): 445. Greif, A. (1993). ‘Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders’ Coalition’, The American Economic Review, 83(3): 525– 48. Gunningham, N. (1995). ‘Environment, Self-Regulation, and the Chemical Industry: Assessing Responsible Care’, Law & Policy, 17(1): 57–108. Hardin, G. (1968). ‘The Tragedy of the Commons’, Science, 162: 1243–8. Hobbes, T. (1960). Leviathan. Oxford, UK: Basil Blackwell. Hoffman, A. (1997). From Heresy to Dogma: An Institutional History of Corporate Environmentalism. San Francisco, CA: New Lexington Press. King, A. (1995). ‘Avoiding Ecological Surprise: Lessons from Long-Standing Communities’, Academy of Management Review, 20(4). and Baerwald, S. (1998). ‘Greening Arguments: Opportunities for the Strategic Management of Public Opinion’, in K. Sexton et al. (eds), Better Environmental Decisions: Strategies for Governments, Businesses and Communities. Washington, DC: Island Press.

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Do Voluntary Standards Work Among Corporations? and Lenox, M. (2000). ‘Industry Self-Regulation Without Sanctions: The Chemical Industry’s Responsible Care Program’, Academy of Management Journal, 43(4): 698–716. and Shaver, J. M. (2001). ‘Are Aliens Green? Assessing Foreign Establishments’ Environmental Conduct in the United States’, Strategic Management Journal, 22: 1069–85. Lenox, M., and Barnett, M. (2001). ‘Strategic Responses to the Reputation Commons Problem’, in Hoffman and Ventresca (eds), Organizations, Policy and the Natural Environment: Institutional and Strategic Perspectives. Stanford, CA: Stanford University Press. Kreps, D. M. and Wilson, R. (1982). ‘Sequential Equilibria’, Econometrica, 50(4): 863–94. Lenox, M. (2006). ‘The Role of Private Decentralized Institutions in Sustaining Industry Self-Regulation’, Working Paper. and Nash, J. (2003). ‘Industry Self-Regulation and Adverse Selection: A Comparison Across Four Trade Association Programs’, Business Strategy and Environment, 12(6): 343–56. Milgrom, P. R., North, D. C., and Weingast, B. R. (1990). ‘The Role of Institutions in the Revival of Trade: The Medieval Law Merchant, Private Judges, and the Champagne Fairs’, Economics and Politics, 2: 1–23. Nash, J. and Ehrenfeld, J. (1996). ‘Code Green’, Environment, 38(1): 16. Olson, M. (1965). The Logic of Collective Action. Cambridge, MA: Harvard University Press. Ostrom, E. (1990). Governing the Commons: The Evolution of Institutions for Collective Action. New York: Cambridge University Press. Pigou, A. C. (1912). Wealth and Welfare. Cambridge, UK: Cambridge University Press. Radner, R. (1981). ‘Monitoring Cooperative Agreements in a Repeated Principal– Agent Relationship’, Econometrica, 49(5): 1127–48. Rees, J. (1997). ‘The Development of Communitarian Regulation in the Chemical Industry’, Law and Policy, 19(4): 477. Reinhardt, F. (1999). ‘Market Failure and the Environmental Policies of Firms’, Journal of Industrial Ecology, 3(1). Segerson, K. and Dawson, N. L. (2001). ‘Environmental Voluntary Agreements: Participation and Free Riding’, in K. Deketelaere and E. Orts (eds), Environmental Contracts: Comparative Approaches to Regulatory Innovation in the United States and Europe. Philadelphia, PA: Kluwer, pp. 369–88.

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4 Making Disclosure Work Better: The Experience of Investor-Driven Environmental Disclosure Robert Repetto 1

4.1. Introduction Experience in the world’s financial markets during the past decade underscores the importance of transparency and disclosure for the protection of investors and the efficient functioning of capital markets. Disclosure of financially material environmental information serves not only these ends but also that of environmental protection. It allows investors and insurers to judge more accurately the environmental risks being incurred by companies and industries, which might affect their financial results and conditions, and to price those risks more accurately. Pricing environmental risks accurately reduces principal–agent problems between management and outside investors that tempts the former to pursue environmentally risky strategies in pursuit of increased short-term profitability. Environmental disclosure is a particular case, with the same underlying rationale, of the principle underlying most securities regulation that all material information should be promptly disclosed. Environmental and sustainability reporting has increased substantially over recent decades, but most of it is divorced from company’s financial statements and does not serve the interests of investors adequately. Such reporting serves companies’ interest in informing and mollifying environmentally concerned stakeholders and may also reflect stronger 1 Robert Repetto is Professor in the Practice of Economics and Sustainable Development, Yale School of Forestry and Environmental Studies.

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internal management information systems but rarely enlightens investors on the financial implications of companies’ environmental exposures. Some companies—those with exposures significantly more favorable than their competitors’—would seem to have an interest in informing investors of their superior position and in raising disclosure standards, but in reality there is little systematic differentiation among companies in environmental transparency, even with respect to compliance with existing legal disclosure requirements. Stronger enforcement of these existing disclosure requirements is needed to induce more widespread compliance. Stronger enforcement is needed, but new regulation generally is not needed. The Sarbanes–Oxley Law in the USA and a variety of other recent regulatory enhancements in other financial centers have already elaborated on the underlying principle that all material environmental information must be disclosed. In the world of corporate counsels and boardrooms, news of a few well-publicized enforcement cases brings about widespread self-examination and self-correction to avoid similar difficulties. Thus, without much additional regulation or bureaucracy, the power of financial markets can be brought to bear to reduce environmental risks, while simultaneously making capital markets more efficient. This could be quite useful in middle-income countries with growing domestic capital markets and significant environmental problems, but with environmental regulatory systems that are still being developed. Financial markets evidently will reward companies with better disclosure policies and practices. In the USA, companies that reported no significant weaknesses for the years 2004 and 2005 in their internal systems to capture and disclose material information substantially outperformed the overall stock market. Those companies that reported such weaknesses in 2004 but not in 2005 also outperformed the market, but to a lesser degree. By contrast, companies that reported weaknesses in their internal controls in both 2004 and 2005 markedly underperformed the market (Reilly 2006).

4.2. Increasing Capital Market Attention to Environmental Issues In virtually all segments of the financial marketplace, the attention to environmental issues has increased rapidly over the past two decades (Labatt and White 2002). To some observers, this trend merely reflects underlying fundamentals. Expanding economic output and population 79

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have put more stress on environmental quality while rising incomes have strengthened public demands for environmental amenities (Hawken, Lovins, and Lovins 1999). As an inevitable result of this conflict, environmental issues have gained prominence in the business world and will continue to do so. Leaders in many industries already cite them as important management concerns (Schmidheiny and Zorraquin 1996).

4.2.1. Asset Managers Among institutional asset managers, these trends are reflected in the rapid growth of environmentally screened or ‘socially responsible’ mutual funds and other portfolios. Such portfolios now hold at least $2 trillion in assets (Social Investment Forum 2001). Their growth has been stimulated by two factors, in addition to the growing investor interest in ‘ethical’ investing. First, the replacement of defined-benefit pension plans by definedcontribution plans in which beneficiaries have greater control over asset allocation has led money management firms to create and offer screened funds as an investment choice. For this reason, among others, almost all major investment houses now have staff responsible for environmental evaluation and research. Second, the demonstration in recent years that screened portfolios often provide risk-adjusted returns superior or equal to unscreened benchmarks has encouraged investors to allocate at least a portion of their assets to the environmentally screened portfolios (Labatt and White 2002: 151–4). Many managers of pension funds and other endowments, which together command trillions of dollars in assets, have evolved a heightened interest in the long-term sustainability of entire communities and economies because of their long-term obligations to beneficiaries and the size and breadth of their asset holdings. They have become universal investors, internalizing the externality costs generated by individual firms within their portfolios. Broader concerns about sustainability have led managers of large US pension funds, such as CalPERS and TIAA-CREF, to take an active interest in corporate governance, including environmental governance. The Investor Network on Climate Risk, including institutional investors with more than a trillion dollars in assets, have submitted many shareholders’ resolutions calling on companies to reveal and address the financial risks arising from their greenhouse gas emissions. In the UK, pension funds have been called on to disclose the way they address social and environmental issues in their portfolio decisions. 80


Environmental and social considerations have been incorporated into investment decisions by large pension funds in other countries as well.

4.2.2. Insurance Markets For good reason, environmental issues became embedded earliest and most deeply in property and casualty insurance markets. As early as 1980, the passage of Superfund legislation (CERCLA) in the USA mandating the clean-up of thousands of badly contaminated industrial sites alerted insurers to the possibility that despite policies written to cover only ‘sudden and accidental’ releases, they could be financially liable for huge clean-up costs on policies that had been written decades ago when such coverage was never anticipated. Despite enormous litigation costs, insurance companies have paid out billions of dollars in such claims. Equally large claims have been upheld related to asbestos liabilities. As a result, property and casualty insurers as well as commercial banks, the other deeply involved financial institutions, have invested heavily to inform themselves about contamination risks in order to define and limit their liabilities. In response to demands from financial institutions, the EPA, the SEC, the Accounting Standards Board, and other oversight bodies have placed heavy emphasis on disclosure and proper recognition of these environmental liabilities. As a result, industrial companies have been forced into much fuller disclosure. Using newly available databases, financial institutions and their consultants now routinely evaluate sites and entire neighborhoods for potential contamination. Such evaluations now are important elements in insurance underwriting, mortgage lending, and project finance. Consequently, contamination risks are priced much more efficiently in insurance and other financial markets. New financial products have even been developed to handle such risks. For example, insurance against the discovery of contamination is again available, as is insurance against cost overruns in site remediation. Another environmental alarm for the property and casualty insurance industry was triggered when Hurricane Andrew hit the Florida coast in 1992, causing $16 billion in insured losses, a sum almost 50 percent larger than the premiums collected in Florida over the preceding twenty years. Confronted with a geometrically rising trajectory of insured and total losses from catastrophic natural disasters, the insurance and reinsurance industries came to grips with climate change. They have responded vigorously on several fronts, one of which has been an intensive effort to improve their modeling and estimation of catastrophic risks (Froot 1999). 81

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Also, insurers have aligned themselves to diversify their exposures and to spread risks more broadly throughout the insurance industry and to broader capital markets. In addition, the insurance industry, particularly European reinsurance companies such as Munich Re and Swiss Re, has taken an active role in advocating government and industrial actions to reduce the risk of natural disasters by curtailing greenhouse gas emissions.

4.2.3. New Financial Products to Manage Environmental Costs Increasing attention from financial institutions has stimulated development of innovative financial products and mechanisms with which to allocate environmental risks efficiently. To distribute catastrophic risks to capital markets with more capacity, the insurance sector has successfully marketed catastrophe bonds, which have variable returns linked to the occurrence of extreme weather events. Because of their high expected yield and low risk correlation with economic variables, these have found buyers among large portfolio managers. Sophisticated weather derivatives, such as swaps and hedges, have also come into existence. An even more revolutionary innovation has been the emergence of financial markets on which emission permits can be traded. Beginning in pilot markets in the USA in the 1980s, emission trading emerged nationwide with the passage of the 1990 Clean Air Amendments mandating trading of permits to emit sulfur oxides. The notable success of that initiative in containing costs while accelerating the schedule for reducing pollution has led to the adoption of emission trading as a policy tool in other countries and for other pollutants. Notably, it has become a crucial feature of the Kyoto Protocol on reducing greenhouse gas emissions. The European Trading System, for example, has given rise to an entire industry of investors, brokers, exchanges, and market makers, which has grown up to facilitate emission trading. Emission futures, options, swaps, and other derivatives are now regularly traded on the Chicago Board of Trade and over the counter. These financial instruments allow companies to manage their environmental affairs with far greater efficiency.

4.2.4. Increased Recognition of Environmental Issues by Mainstream Investors More slowly but with increasing momentum, mainstream securities markets have begun to incorporate environmental factors into considerations of risk and return. The insight through which mainstream investors 82


and analysts became aware that environmental factors are relevant came through experience, often painful. Investors have suffered severe and abrupt losses when environmental disasters occurred or news of such situations became public. In addition to such notorious calamities as the Exxon Valdez Alaskan oil spill or the Union Carbide toxic release in Bhopal, many other such events have caused investors pain. For example, the stock of Solutia, a company formed when Monsanto spun off its chemical division, plunged by almost 60 percent within a few weeks when an article in the Washington Post revealed that Monsanto had dumped tons of PCBs in Anniston, Alabama, and had covered up its behavior for decades. The company’s behavior was deemed ‘outrageous’ by an Alabama jury that held the company liable for negligence, suppression of truth, and nuisance, opening Solutia to further lawsuits. In another well-known case, the stock of U.S. Liquids, a Houston waste-management firm, fell 58 percent in one week when employees revealed to government authorities that the company had illegally dumped hazardous wastes and falsified records. Consequently, shareholders filed suit against the company for violation of securities law by issuing false and misleading reports and failing to disclose material information. Many studies have demonstrated that environmental events can have material financial consequences. Repeatedly, so-called ‘event studies’ have found that stock prices have been affected, often by substantial amounts, by spills and accidents, announcements of new environmental regulations, initiation or settlement of environmental litigation, and other environmental matters. Thus, for example, in the five trading days following the 1986 explosion at Union Carbide’s Bhopal, India plant, Union Carbide’s common stock price lost approximately $1 billion or 27.9 percent in value (Blacconiere and Patten 1994). After the Valdez accident, Exxon’s stock was depressed for six months (Jones et al. 1994), with a value loss ranging from $4.7 billion to $11.3 billion. When TRI data were first published in 1989, the stock value of TRI-reporting firms dropped by an average of $4.1 million (Hamilton 1995; Konar and Cohen 1997; Khanna et al. 1998). Most environmental event studies to date find a significant negative impact of pollution news on stock prices. Balancing these negative experiences, investors have found that companies with good environmental performance often outperform others in their industries (Dowell et al. 2000). Such companies may be more efficient in their use of materials and energy and more technologically advanced, leading to higher operating margins, but are also likely to have better management systems in place. Superior environmental 83

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management may signal superior overall management efficiency. In addition, companies that develop and commercialize solutions to environmental problems have found favor with investors, especially venture capitalists. For example, two highly successful companies in the rapidly growing organic foods sector have been Horizon Dairy, which supplies organic dairy products throughout the USA, in Europe, and Japan, and Whole Foods Market, which has achieved a commanding presence as an organic foods retailer. Many other ‘solution-oriented’ firms have been successfully established and brought to market in the energy sector, including firms dedicated to the commercialization of fuel cells, wind energy, and waste-to-energy converters. A rapidly increasing amount of venture capital and private equity is flowing into these sectors. Mainstream investors have come to realize that there is money to be made and money to be lost on account of environmental issues.

4.3. The Key Role of Information Disclosure 4.3.1. Mandatory Disclosure of Environmental Information These developments have underscored the key role of informational transparency in bringing financial markets to bear on industry’s environmental performance. When environmental risks could be hidden behind a veil of corporate secrecy until unfortunate occurrences revealed their extent, investors incurred significant unforeseen losses. When mandatory reporting and disclosure rules required companies to reveal to the public and to investors the extent of their environmental exposures, financial markets reacted in ways that priced those risks more efficiently and allocated them to willing, rather than unwitting, risk-bearers. Mandatory disclosure has become a widespread public policy instrument, employed to protect the public and to improve the performance of businesses and government in fields as diverse as food safety, fuel efficiency, management of toxic substances, sales of financial securities, and many others (Graham 2002). Disclosure is a policy tool that has appealed to both liberals and conservatives because it relies on informed consumer and public choice rather than direct regulation. Disclosure typically increases market efficiency by eliminating informational asymmetries between sellers and potential buyers. Such asymmetries often distort market prices and sometimes deter market transactions altogether (Akerlof 1970). Publicity provides strong incentives for business and 84


government managers to improve performance by eliminating the possibility of shielding inferior or excessively risky products and services behind a veil of secrecy. The effectiveness of mandatory disclosure as a policy instrument has been reinforced in the past two decades by several ongoing trends. The development of the Internet and communications technology has dramatically improved the ease and speed of communication and has lowered its costs. Citizens and consumers can now diffuse information across the globe through decentralized linkages within hours or minutes. Complementing these trends in many sectors of the economy more and more of a company’s market value consists of intangible assets, including its brands and business reputation. The market value of many companies has become an increasing multiple of the book value of its tangible capital. Since strategic alliances, supplier networks, complex chains of financial relationships, and other networks have become an increasingly prominent aspect of the business world, impairment of a firm’s reputation can be a devastating loss. Reputational losses can also undermine consumers’ brand loyalty and make it more difficult for a company to recruit and retain high-quality employees. In the environmental realm, mandatory disclosure programs have been notably successful as tools to promote environmental protection. In the USA, the EPA’s TRI has not only informed the public about potential hazards in their communities, it has also provided a strong stimulus to companies generating reportable quantities of toxic substances to reduce their generation and release (Fung and O’Rourke 2000). Subsequent to the publication of TRI data and the adverse impact on public and investor opinion, prominent companies such as DuPont and Dow Chemicals, among many others, have entered into voluntary commitments to achieve major reductions, largely through pollution prevention initiatives. Explaining these commitments, CEOs of these companies have cited the need to protect their firms’ reputations. In Canada, the National Pollution Release Inventory (NPRI) has had a similar success, prompting many companies to embark on accelerated pollution prevention and reduction programs, especially when also under some regulatory threat (Harrison and Antweiler 2003). Emissions reporting requirements, such as the TRI and NPRI, stimulated managers in some companies to quantify emissions on a plant and company-wide basis for the first time. On the principle that ‘You manage what you measure’, this expanded measurement by itself encouraged better environmental control. In addition, greater transparency discouraged 85

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management from pursuing unduly risky environmental policies that might save money in the short run but would expose the company and the public to excessive potential damages in the longer run. European countries have typically taken a broader view of corporate social responsibility than has the USA. Consequently, a large number and variety of corporate reporting systems are in place, most of them voluntary, by which companies make themselves accountable to stakeholders. In an effort to make such reports more comparable across companies, the GRI and others are attempting to achieve more standardized reporting frameworks. However, since these are not integrated with financial accounting and reporting systems, they have so far been of limited usefulness to investors and financial analysts. Public disclosure can be an even more advantageous policy tool in countries in which the government’s administrative capacities to operate an efficient environmental regulatory system are less fully developed. In such settings, publicity can serve as a powerful instrument with which to mobilize public opinion against those companies with lax environmental practices. A recent World Bank publication has documented the effectiveness of disclosure programs in influencing industrial polluters in countries throughout South and Southeast Asia (World Bank 2000).

4.3.2. Mandatory Disclosure in Financial Markets Disclosure of all financially material information is essential for the protection of investors against fraud, and for the efficient functioning of financial markets. When the Securities and Exchange Acts of 1933 and 1934 enshrined disclosure as the principal means for regulating financial markets in the USA, Justice Brandeis said, ‘Sunlight is the best disinfectant.’ Disclosure is the dominant regulatory mechanism underlying the Securities Act to promote capital market efficiency, as emphasized in a recent law review article (Williams 1999). She quotes the House Report on the Securities Act 1933: The idea of a free and open public market is built upon the theory that competing judgements of buyers and sellers as to the fair price of a security brings about a situation where the market price reflects as nearly as possible a just price. Just as artificial manipulation tends to upset the true function of an open market, so the hiding and secreting of important information obstructs the operation of the markets as indices of real value. (Williams 1999: 1210, n. 59)

Reinforcing this perspective, a leading scholar of securities law states, ‘At its core, the primary policy of the federal securities laws today involves 86


the remediation of information asymmetries’ (Seligman 1995: 604). The recent revelations in the USA of accounting irregularities, executive selfdealing, and other corporate scandals dramatically revealed the risks to financial markets of informational asymmetries between insiders and outside investors. These scandals have reduced investor confidence in corporate management to a minimum and, if anything, have increased the potential damages to companies and investors when hidden information becomes public. To ensure sufficient disclosure by companies, the SEC has established a comprehensive set of guidelines and rules governing what companies should report. In addition to rigorous accounting rules for reporting financial results, the SEC holds firms to demanding standards regarding the disclosure of qualitative nonfinancial information that is needed lest current financial statements be misleading. According to Seligman, ‘The past two decades have witnessed a significant expansion of what must be disclosed by all registrants . . . in their 10K annual reports . . . This expansion can be termed the “soft information revolution” in the mandatory disclosure system’ (Seligman 1995: 610). These requirements include not only information about current conditions affecting the firm that investors would consider relevant but also any known risks and uncertainties that might have future material financial effects. In general, in addition to disclosures specifically required, registrants must disclose any material information needed to prevent statements from misleading investors (17 C.F.R. §240.10b-5(b) 1998; SEC Release Nos. 33-6130, 34-16224, Sept. 27, 1979; 44FR56924–56925). The SEC and the courts have eschewed any numerical measure of materiality such as a fixed percentage of assets or earnings, instead defining it as information that a reasonable investor would be likely to consider important in the context of all the information available. Moreover, SEC guidance states that facts can be considered material if they bear on the ethics of management, its integrity, or its law compliance record, irrespective of the financial sums involved (SEC Staff Accounting Bulletin 99). Omitting to disclose material information is equivalent to making false or misleading statements and is subject to serious penalties. These disclosure requirements explicitly include forward-looking statements. The emphasis on transparency in financial markets is by no means restricted to the USA, of course, although disclosure requirements are more detailed in the USA than in other major financial markets. The principle that all material information should be promptly disclosed is widespread in countries with developed financial markets and, indeed, 87

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has played a significant role in their development. Experiences over the past two decades in international capital markets have also pointed out the importance of transparency. By reducing uncertainty and perceived risk, greater transparency reduces financial volatility and lowers the cost of capital. An important reason for the home-country bias that impedes international investment in particular is the disadvantageous informational asymmetry that investors perceive in venturing outside their own borders. The contagion that aggravated past international financial crises stemmed mainly from investors’ inability to differentiate between one emerging financial market and others, largely because of lack of transparency. Therefore, virtually all programs to reduce international financial market volatility and increase its efficiency have included strong recommendations for improved disclosure.

4.3.3. Disclosing Environmental Information in Financial Reporting Within this framework, the requirement that companies disclose to the investment community the material financial implications of their environmental exposures has become increasingly important. Unless financial market valuations of risk and return accurately reflect the financial risks that companies incur through their environmental management decisions, investors will be endangered and an important market incentive for prudent environmental management will be lacking. Rational investments to reduce future environmental costs, liabilities, or risks may be undervalued in the capital markets and thus discouraged. Because managers who position their companies to gain competitive advantage by virtue of their superior ability to cope with impending environmental challenges might not be rewarded by investors, such strategies might be discouraged. Asymmetric information about companies’ environmental exposures creates principal–agent problems. If external investors cannot accurately value companies’ investments in pollution control, managers may have an incentive to inflate stock prices for short-run gain by neglecting such investments (Milgrom and Roberts 1992). As managers’ compensation is more closely tied to stock market performance through stock options and performance-linked bonuses, and as financial analysts focus ever more closely on quarter-by-quarter earnings, the temptation to manage earnings through shortsighted strategies has become more powerful. Though in recent years this has been seen most obviously in accounting irregularities and financial engineering by such companies as Enron and 88


WorldCom, the temptation to pursue shortsighted environmental practices may be no less strong. The Solutia and U.S. Liquids experiences also illustrate the dramatic damages that can be suffered by companies and investors through lack of transparency regarding environmental risks and exposures. A case has been made by corporate activists and some academics that the SEC should require disclosure of information on environmental performance and other social issues—irrespective of financial materiality— because of its mandate to promote corporate accountability (Williams 1999). The Securities and Exchange Acts were designed to influence corporate governance by increasing management accountability to other stakeholders and the general public as well as to shareholders. Section 14(a) of the Securities Exchange Act empowers the SEC to issue necessary or appropriate rules regulating proxy solicitations ‘in the public interest or for the protection of investors’ (Exchange Act §14(a), 15U.S.C. §78n (1994); emphasis added). Similar language pervades the acts. Moreover, the National Environmental Protection Act (NEPA) authorizes all federal agencies, including the SEC, to include environmental protection as a policy objective when not inconsistent with their primary missions. This case was first put forward in a petition to the SEC by the Natural Resources Defense Council (NRDC) in the early 1970s, shortly after NEPA was enacted, proposing that listed companies should have to report on pollution, environmental practices, and the environmental impacts of their products and operations (NRDC v. SEC, 389 F. Supp. 689, 693–4 (D.D.C 1974)). After lengthy hearings, appeals, and reconsiderations, the SEC decided, with judicial concurrence, that it would continue to rely on an economic criterion of materiality in judging environmental disclosure requirements. The SEC determined that, to the extent that environmental issues are economically material, they must be disclosed under existing disclosure requirements. At the time, Harvey Pitt, who later became chairman of the SEC, argued that much environmental information would be material under a strict definition and would have to be disclosed (Sonde and Pitt 1971). In those proceedings, the SEC argued that its enforcement activities would be applied to elicit disclosure of environmental information in specific cases when appropriate on materiality grounds (Williams 1999). Thus, as far back as the 1970s, the SEC has committed itself to active enforcement of its general and specific disclosure requirements concerning financially material environmental information. As the following pages will indicate, this commitment has not yet been fulfilled. Disclosure 89

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remains incomplete despite considerable evidence that the materiality of environmental information has increased substantially since the early 1970s. For example:

r

r

r

r

Companies have to spend more and more to comply with environmental regulations. Between 1972 and 1994, expenditures by business on pollution abatement and control were more than doubled in real terms (Vogan 1996). In the NRDC proceedings, the SEC demonstrated that only a trivial fraction of institutionally managed assets were in socially screened funds or portfolios. By 1999, it was estimated that more than $1.5 trillion resides in socially and environmentally screened portfolios, while the number of screened mutual funds has risen to 175, from just 55 five years earlier. By 2001, the asset base had grown to $2 trillion. Socially responsible investing can no longer be considered a negligible phenomenon. It has been demonstrated repeatedly that companies’ stock prices have been influenced by disclosure of information regarding emissions (even if legal), or failure to comply with environmental regulations, or potential liability to environmental remediation requirements. Several financial research services that sell environmental performance information to investors have emerged. Most large investment houses also employ environmental managers and undertake in-house research on environmental issues affecting companies. The fact that the generation and sale of environmental information has become an economic activity in the investment community indicates that professional investors consider such information relevant to their decisions—and thus financially material.

However, the availability of information on environmental issues has not kept pace with this growing materiality. According to the research firms that sell information to screened fund managers, environmental information is among the hardest to obtain. Many EPA and state government databases, even those theoretically in the public domain, are hard to access, often inaccurate, inconsistent, or out of date, and not formatted in useful ways for financial or company-specific analysis. Moreover, companies’ own environmental reports are typically selective, unstandardized, and unrelated to financial statements (Birchard 1996). Therefore, the information available through stand-alone environmental reports, from 90


government agencies, or from environmental research services is not a substitute for adequate disclosure by companies of financially material environmental information.

4.3.4. Specific Requirements in the USA Disclosure of environmental exposures is governed both by the SEC’s core rules on materiality and by specific requirements regarding environmental liabilities and compliance with federal and state environmental regulations. General disclosure requirements explicitly include forward-looking statements. Item 303 of Regulation S-K requires a management discussion and analysis (MD&A) of ‘material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or future financial condition’ (17 C.F.R. 229.303). The firm shall disclose ‘where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operations’ (SEC Release Nos. 33-6835, 34-26831, May 24, 1989; 54FR22427). Disclosure of known trends, risks, and other uncertainties affecting future business results is particularly important to investors because asset markets are themselves inherently forward-looking. The value of any financial security is derived from the stream of returns it is expected to bring and the riskiness of those returns. The SEC has strengthened these requirements by narrowing a company’s ability to avoid disclosure on grounds of uncertainty. In its release on MD&A requirements, the SEC indicated that disclosure of uncertain events is necessary unless the registrant ‘determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur’ (54FR22427). In the same release, the SEC warned companies that if a registrant’s future filings reveal a material effect from an event that was a known uncertainty in a prior period, the SEC enforcement staff will ‘inquire as to circumstances existing at the time of the earlier filings to determine whether the registrant failed to disclose a known . . . uncertainty’ (54FR22427, n. 28). Moreover, forwardlooking disclosure is further encouraged by a ‘safe harbor’ rule that protects companies from applicable liability provisions of federal securities laws that might otherwise be relevant (SEC Release Nos. 33-6084, 3415944). Companies cannot be penalized for making ‘reasonably based and adequately presented’ projections that subsequently fail to materialize. 91

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Disclosure requirements of known uncertainties under Item 303 of Regulation S-K apply to environmental uncertainties. While the SEC has recognized Superfund liabilities as known uncertainties requiring disclosure, the requirements of Item 303 of Regulation S-K could reasonably apply to many other environmental uncertainties.

r

r

r

Many firms own contaminated industrial sites that have not yet been identified for mandatory remediation, although contamination might well be discovered through future investigation, particularly if the site is transferred to another owner. Ownership of such contaminated sites might be considered a known uncertainty. EPA regulations are first issued in proposed forms before final promulgation. Affected industries typically submit extensive comments on proposed regulations through their industry associations or sometimes individual companies submit comments directly. Not infrequently, these submissions complain of financial impacts ranging from serious to dire. Many final regulations are challenged in court, with billions of dollars in compliance costs resting on the judicial outcome. Thus, many proposed environmental regulations are known uncertainties with potentially material financial consequences. The Kyoto Protocol to the United Nations Framework Convention on Climate Change, signed by the President in November 1998 though not yet ratified by the Senate, has come into force and must be considered a known uncertainty, especially for multinational firms. Detailed economic studies commissioned by several industry associations have come to generally pessimistic conclusions about the impacts of implementing the protocol’s provisions on the US economy and affected industrial sectors. Individual companies have joined business coalitions that oppose implementation of the protocol, largely on grounds of economic cost. The possible adoption of policies to curb greenhouse gas emissions could be considered a known uncertainty with potentially material consequences for some companies.

Thus, Item 303 of Regulation S-K would seem to require a significant increase in the disclosure of forward-looking financially material environmental information that is essential to protect investors. In addition to these general requirements, SEC rules and GAAP impose specific requirements on companies for environmental disclosure. Item 101 of Regulation S-K, governing the general description of the business, states: 92

Making Disclosure Work Better Appropriate disclosure shall be made as to the material effects that compliance with Federal, State, or local provisions which have been enacted or adopted regulating the discharge of materials into the environment may have on the capital expenditures, earnings, and competitive position of the registrant and its subsidiaries. The registrant shall disclose any material capital expenditures for environmental control facilities for the remainder of the current fiscal year and its succeeding fiscal year and for such future periods as the registrant may deem material. (17 C.F.R. 229.101 (c) (xii))

This requirement evidently covers regulations that have been enacted but not yet adopted because of court challenge. It requires that the registrant apply existing materiality guidelines to financial impacts beyond the oneor two-year expenditure horizon. Many regulations include compliance deadlines several years in the future, such that planned capital expenditures to comply with them are initiated only after considerable time has elapsed. Item 103 of Regulation S-K, governing disclosure of legal proceedings (civil and criminal suits), requires reporting of ‘any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which any of their property is subject’ (17 C.F.R. 229.103). Environmentally related proceedings must be disclosed if they are material, they involve a claim for more than 10 percent of current assets, or they involve the government and potential monetary sanctions greater than $100,000. During the 1980s, the discovery of many contaminated industrial sites requiring remediation under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)—the ‘Superfund’ statute—or under the Resource Conservation and Recovery Act (RCRA), and the rapid escalation of clean-up costs led to an elaboration of disclosure requirements for contingent liabilities. GAAP, as enunciated by the Financial Accounting Standards Board (FASB), requires companies to accrue a contingent liability for future remediation costs if the loss is probable and reasonably estimable (SFAS 5). SEC and FASB guidance added clarification that if a loss is probable, the firm must recognize its best estimate of the loss, despite uncertainty, and cannot wait until only one estimate is likely. New information should be recognized in later disclosures (SEC Staff Accounting Bulletin 92, June 1993; FASB Interpretation 14). Together, these rules impose extensive obligations on corporate management to disclose financially material environmental costs, liabilities, and future risks. 93

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Beginning in the 1980s, financial reporting of Superfund liabilities attracted the SEC’s enforcement attention, in part because of attention drawn to the issue by public interest groups and shareholders. A 1998 report revealed that Phelps Dodge had estimated clean-up costs at a contaminated site to be ten to thirty times smaller than had a federal court, and also questioned the company’s disclosure of remedial costs at thirtynine other of its sites (Lewis 1998). A coalition of public interest groups drew the SEC’s attention to the fact that Viacom had stated in a filing that it did not believe its clean-up obligations were financially material, even though it had been identified as a Potentially Responsible Party at dozens of Superfund sites, implying a total liability of more than $300 million as against a 1995 total profit of $165 million (Friends of the Earth 1997). In addition to accounting guidances and releases mentioned above and a flurry of articles by environmental lawyers, it became known that the EPA was sharing information with the SEC about companies’ potential liabilities. Consequently, a few SEC letters of inquiry were sufficient to put companies on notice that improved disclosure of site remediation liabilities was expected. By and large, US corporations have responded. Disclosure of potential Superfund liabilities is by far the most complete and detailed of all environmental information to be found in corporate financial reports. As a result, banks, insurance companies, and other financial sector actors can now evaluate such risks more accurately. This experience indicates that a modicum of enforcement attention is sufficient to produce a fairly high degree of compliance with disclosure obligations.

4.4. Unrealized Opportunities to Make Use of Financial Disclosure 4.4.1. Inadequate Disclosure of Known Environmental Exposures Despite this success in stimulating improved disclosure of material site clean-up costs and the constructive results in financial markets, until now there has been little effort to enforce disclosure of other financially material environmental information. In the USA, over the period 1975–2000, the SEC has initiated only three administrative proceedings and one civil action over inadequate environmental disclosures. In other countries, the enforcement record is even scantier. Enforcement has not been vigorous in past years because environmental issues were not salient among all the securities regulatory issues that the responsible agencies were faced 94


with. Moreover, at least in the USA, those agencies have typically been understaffed and underfunded to the extent that they were able to deal with only the most urgent and egregious issues (US General Accounting Office 2002). In addition, the securities and accounting supervisory bodies have resisted attempts to enlist them in environmental causes, seeing their sole mission as the protection of investors and financial markets. In the absence of enforcement efforts, compliance with existing disclosure requirements by the private sector has been scanty. Many companies have not even complied with the letter of the law, failing to reveal environmental legal proceedings or failing to disclose an accurate estimate of their environmental obligations and liabilities. More conscientious companies have typically complied with the letter of the law but have revealed as little as possible. Very few companies have complied with the spirit of existing securities law that require disclosure of all material information and material risks known to management that would significantly affect the financial conditions or results of the enterprise (Repetto and Austin 2000). Reports typically discuss in any detail only those regulations that have already been issued in final form and have survived court challenges, while mentioning legal actions in which the reporting companies are involved. If companies mention other pending environmental regulations, legislation, litigation, or other issues at all, they usually take refuge in uncertainty, claiming inability to estimate likely or possible financial outcomes, even within a range.

EVIDENCE FROM THE US PULP AND PAPER INDUSTRY Recent research has provided strong evidence that US corporations in environmentally sensitive industries have not been adequately disclosing known financially material environmental exposures and risks in their MD&A, as required by Item 303d of Regulation S-K. The first of these studies examined thirteen of the largest publicly listed companies in the US pulp and paper industry, a sector with a wide range of environmental issues, including air and water pollution, toxic releases, and land use practices. The study estimated the impacts of known, impending environmental issues on the capital expenditures and future earnings (Repetto and Austin 2002). It found that those impacts were likely to materially affect the value of stockholder equity, the firms’ competitive position within the industry and their financial risks. The study found that these exposures and financial impacts were not disclosed or adequately discussed in the firms’ 10Ks or other financial reports. The study was unique in that the 95

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companies themselves participated in identifying important impending environmental issues affecting the industry and in estimating probable outcomes of those issues. The methodology of the study involved the following steps: 1. Impending environmental issues affecting companies in the industry were identified and categorized with respect to their potential financial impacts on those companies. 2. For issues deemed to have potentially significant financial impacts, scenarios were developed regarding their evolution and outcomes. For impending regulatory issues, for example, scenarios were developed regarding final regulatory designs. 3. Through consultation with industry and environmental experts, likelihoods were estimated and assigned to each scenario. 4. Each company’s exposure to each scenario was assessed through a facility-by-facility investigation of location, product mix, installed technology, input use, emission rates, and other relevant parameters. 5. The financial impact of each scenario on each company was estimated by applying estimates of regulatory compliance costs, impacts on input prices, site remediation costs, and the ability of firms in the industry to pass along higher costs through output price increases. 6. The likelihoods previously estimated were applied to all scenarios so as to construct a probability distribution of potential financial outcomes for each firm, including the mean impact on the discounted present value of earnings over a ten-year horizon and the variance of discounted future earnings. 7. Those measures of financial impact for each company were normalized by dividing the change in the discounted present value of future earnings by the market value of stockholder equity. 8. The financial statements of companies whose material financial impacts were estimated from known, impending environmental issues were examined to see whether such impacts had been disclosed in the MD&A. This methodology is particularly revealing of the inadequacy of MD&A disclosure of known, financially material environmental information, because senior representatives of the companies participated in identifying environmental issues with potentially significant environmental 96


impacts, through the cooperation of the American Forests and Paper Association’s Regulatory Policy Committee. Company representatives also reviewed scenarios for plausibility and provided their estimates of the probabilities that should be assigned to each scenario. The study found that companies in the industry were differentially exposed to most of the environmental issues. Differences among companies in exposure stemmed from many causes: the location of their facilities, the extent of their present and past pollution releases, the technologies installed in their mills, their energy and fiber sources, and other factors. As a result, the issues impinging on the industry are likely to create competitive advantages and disadvantages that should be discussed as known risk factors. Overall financial risks across all issues were estimated by weighting each scenario by the likelihood assigned to it by industry representatives and other experts. These probabilities were used to estimate the joint probability of a ‘worst case’ outcome, in which all the most costly scenarios for a company would come about, and the probability of a ‘best case’ outcome, in which all the least costly scenarios would come about. Other scenario combinations were used to generate the probabilities of all intermediate outcomes. In this way, probability distributions of financial outcomes were generated for all companies in the study. A summary of these findings, comparing the financial exposures of all companies in the study, shows material financial risks. The mean values indicate that at least half the companies in the group face expected financial impacts of at least 5 percent of shareholder equity and that several face expected impacts approaching or exceeding 10 percent. These magnitudes are impressive because the expected effects of environmental issues on earnings in the pulp and paper segment are being compared with the total market value of the companies, which for many firms include the value of their other business segments, including wood products and converted paper products. Even relying on the most likely outcomes, estimates show that companies’ environmental exposures involve them in significant financial risks. The estimated variances of financial outcomes tell an even stronger story. Several companies are virtually immune to environmental risk: Their earnings will be relatively unaffected, whatever the outcome of the salient impending issues. At the other extreme, other companies face significant probabilities that impending environmental issues will be resolved in ways that will reduce the value of their companies by as much as 15 or 20 percent. Table 4.1 shows the estimated probabilities 97

Robert Repetto Table 4.1. Probability of a reduction in company shareholder value by more than 10% or 5% Firm

A B C D E F G H I J K L M

Expected (mean) impact (percentage of market value)

Variance of expected impact (percentage of market value)

Probability of loss greater than 10% of market value

Probability of loss greater than 5% of market value

−10.2 −0.6 −3.4 −2.7 −6.9 −10.8 −8.4 −0.9 −6.8 −4.2 −10.8 −6.3 2.9

3.6 0.5 0.8 4.4 2.8 9.3 6.1 0.8 6.9 3.4 9.1 2.4 3.2

64 0 0 0 24 63 44 0 34 0 61 24 0

90 0 37 33 87 86 88 0 69 60 80 79 0

Source: Repetto and Austin (2002).

from the study that each company’s shareholder value will be reduced by 10 percent or more. Three companies are more likely than not to suffer a 10 percent loss. In total, 7 of the 13 companies have a greater than 20 percent chance of experiencing a loss of this magnitude. The environmental statutes and regulations analyzed in the study would be likely to have quite different financial impacts, individually and collectively, across companies in the same industry, and these differential impacts can have material consequences on firms’ competitive positions. They should have been disclosed in MD&A. However, only three of thirteen companies even mentioned in their SEC filings any of the issues that were deemed significant by their senior environmental officers. Some companies, while disclosing little information about the financial impacts of impending regulations, minimized their likely effects on their own competitive positions. For example, according to one company, ‘In the opinion of . . . management, environmental protection requirements are not likely to adversely affect the company’s competitive industry position since other domestic companies are subject to similar requirements.’ Or, according to another company, ‘[Company X] does not anticipate that compliance with environmental statutes and regulations will have a material effect on its competitive position since its competitors are subject to the same statutes and regulations to a relatively similar degree.’ A third company stated, ‘[S]ince other paper and forest product companies also 98


are subject to environmental laws and regulations, the company does not believe that compliance with such laws and regulations will have a material adverse effect on its competitive positioning.’ In view of the differences revealed in Table 4.1, these statements are quite inaccurate and could be considered misleading. According to the results of the study, all three of these companies have above-average financial exposure to pending environmental issues and will probably suffer adverse competitive impacts.

EVIDENCE FROM THE OIL AND GAS PRODUCING INDUSTRY A second recent study used a similar methodology to examine the exposures of sixteen oil and gas producing companies to policies to reduce greenhouse gas emissions and to potential future restrictions on access to areas holding petroleum resources (Austin 2002). Climate policy scenarios assumed either ratification of the Kyoto Protocol, alternatively with and without US participation, or nonratification of the Protocol, alternatively with and without other restrictions on the use of carbon fuels. Subscenarios explored alternative approaches to implementation, especially with regard to the disposition of ‘rents’ arising from restrictions on fossil fuel availability. The results of the analysis are strikingly similar to those found in the pulp and paper study. Companies differed widely in their financial exposures to these environmentally related risks. Exposures varied due to differences among companies in the composition and geographical location of their reserves, their reliance on earnings from exploration and production versus earnings from refining and distribution, and other factors. For the most exposed firms, the most likely financial impacts were found to be highly material. Figure 4.1 plots these impacts for all sixteen companies. The central ‘dot’ for each company represents the probability-weighted mean, or expected, financial impact across all scenarios, expressed as a percentage of shareholder’s equity in the company. The vertical lines represent the range of outcomes, from worst-case to best-case. For seven companies, expected impacts exceed 5 percent of shareholder value and for four companies, worst-case impacts approach 10 percent. As in the pulp and paper industry, few companies made any reference to these financial exposures in their SEC filings. Only two of the sixteen mentioned climate change as a known risk to future operations of financial conditions, indicating that the financial impacts could be substantial. 99

Robert Repetto 10.00

Change in shareholder value (%)

8.00 6.00 4.00 2.00 0.00 −2.00 −4.00 −6.00 −8.00 −10.00 −12.00 AHC

APA

BP

BR

CVX

COP

E

ETP

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OXY

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SUN

TOT

VLO

UCL

Companies

Figure 4.1. Oil and gas company exposures

Three others mentioned the issue in their annual reports, but did not elaborate on any possible business implications. The other eleven made no mention of the issues. EVIDENCE FROM THE ELECTRICITY GENERATING INDUSTRY A more recent study of a third environmentally-sensitive industry, the electric power generating sector, strongly confirmed the findings of these two earlier reports (Repetto and Henderson 2003). Forty-seven of the largest investor-owned electric utility holding companies in the USA were analyzed to estimate the potential financial impacts of environmental legislation now before the US Congress. The methodology followed the same approach used in the two studies described above. It estimates the least-cost option to comply with pending air quality regulations, for each of the companies. The least-cost option is defined as the minimized, discounted present value of adopting leastcost controls on all generating units owned by each utility holding company to bring them into compliance. The compliance options include a suite of combustion controls, postcombustion pollution controls, and permit trading. Available compliance options and associated costs are tailored to the specific technological characteristics of each generating unit, and take into account pollution control equipment already installed. 100


Least-cost combinations of emissions controls and permit trading are derived by minimizing discounted estimated capital and operating costs over a twenty-five-year horizon. This methodology is used to analyze the following scenarios:

r r r

The financial impacts of a three-pollutant cap-and-trade bill that imposes stricter future controls on emissions of nitrogen oxides, sulfur oxides, and mercury; A four-pollutant cap-and-trade bill that adds restrictions on future emissions of carbon dioxide to the preceding environmental requirements; and A third hybrid scenario constructed on the assumption that controls on carbon emissions would be announced belatedly, after decisions to comply with the three-pollutant caps had been finalized, with a later compliance deadline.

These policy scenarios were chosen to resemble proposed legislation submitted to the current and the previous Congresses, but do not exactly replicate these bills’ provisions. Under one set of scenarios, financial impacts were estimated under the assumption that permits would initially be grandfathered to utilities in proportion to their historical 1998 emissions, the most likely outcome. In order to facilitate comparison of environmental exposures among companies, the present value of future compliance costs in constant year 2000 prices, discounted at 8 percent per year to the year 2000, were benchmarked to each company’s revenues in the year 2000. These benchmarks indicate the financial materiality of the companies’ environmental exposures to pending environmental issues and allow their exposures to be compared. Two limitations of this analysis should be acknowledged. First, the approach does not allow for adjustments by companies in the dispatch of their various generating units in order to achieve compliance. In reality, companies may reduce the hours operated by particular units rather than installing pollution control equipment if the former is the least-cost option. Second, the calculation does not allow for the fact that companies may recover some or all of their environmental costs if market or regulatory processes pass through these cost increases to electricity product prices. However, under current securities laws financially material costs of compliance with environmental regulations, such as those estimated through this methodology, must be disclosed in financial statements without netting these costs against possible future cost recovery. 101

Robert Repetto 50 Compliance costs as % of 2000 revenues

45 40 35 30 25 20 15 10 5 0

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Figure 4.2. Three-pollutant cap-and-trade, permits grandfathered

If a three-pollutant cap-and-trade policy similar to that endorsed by the current US administration and submitted in proposed legislation is adopted, many large US electric utility holding companies will face significant financial impacts. The required cuts in emissions would ensure that utilities would be forced to install expensive internal controls and that permit prices in an allowance trading market would remain high. Figure 4.2 illustrates the finding that more than half of the forty-seven major utility holding companies included in the study would face compliance costs with a discounted present value greater than 10 percent of their total year 2000 revenues. Over a quarter would face costs in excess of 20 percent of year 2000 revenues. Total revenues include not only revenues from sales of generated electricity, but also revenues from distribution, transmission, and unrelated business activities. To put these magnitudes into perspective, operating profits among these companies average only 4 or 5 percent of operating revenues. Figure 4.2 also shows that different companies within the electric power sector are exposed in markedly differing degrees to future environmental restrictions of this kind. Differences in exposure to impending environmental restrictions stem from several factors that reflect past investment decisions: 102

Making Disclosure Work Better 35

Compliance costs as % of 2000 revenues

30 25 20 15 10 5 0

47 1

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−5 −10 Utilities from most to least exposed

Figure 4.3. Four-pollutant cap-and-trade, announced carbon, permits grandfathered

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The importance of generating revenues in total revenues; The fuel mix used in generating electricity, especially the degree of reliance on coal; The effectiveness of emission controls already in place; The efficiency of the company’s generating operations in converting fuel to electricity; and The ease of retrofitting additional emission controls onto existing plants.

The analytical results representing the impacts of a four-pollutant capand-trade policy show striking differences compared with the threepollutant results. Figure 4.3 shows that if a requirement that carbon emissions be reduced 7 percent below a 1990 baseline, with a compliance deadline of 2015, and if permits were grandfathered to utilities, then under the assumptions of the scenario, compliance costs would be lower for many companies than in the three-pollutant scenarios. The explanation lies in the assumed carbon permit price. If it is as high as $32 per ton of carbon dioxide ($100 per ton of carbon), utilities that repower to natural gas would make considerable money by selling excess carbon permits, since repowering would reduce carbon emissions by far more than necessary to meet the requirement. Moreover, in reducing carbon dioxide emissions by switching plants to run on natural gas, companies 103

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Compliance costs as % of 2000 revenues

45 40 35 30 25 20 15 10 5 0

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Figure 4.4. Four-pollutant cap-and-trade, carbon later, permits grandfathered

will avoid the need to install expensive equipment to control emissions of mercury, sulfur, and (to some extent) nitrogen emissions. Since the natural sulfur or mercury content of natural gas used as power plant fuel is low, switching to natural gas not only reduces carbon emissions, it also, as a side benefit, helps meet other emission constraints. In fact, adding a carbon constraint would induce so many companies to make the fuel switch that the prices of nitrogen and sulfur permits would fall precipitously. Companies differ greatly in their exposures to a four-pollutant regime. For most companies, the prospect of a four-pollutant cap-and-trade policy that includes carbon constrains represents a material financial risk and a potential source of competitive advantage or disadvantage. One or two companies face negative compliance costs in some scenarios, because of their potential revenue gains in selling permits. More broadly, for some companies with relatively small compliance burdens, profits would likely increase as electricity prices rose in response to higher industry operating costs. Figure 4.4 shows that for most companies, the worst of all worlds would be one in which they make least-cost decisions to comply with a threepollutant cap-and-trade policy regime but are then faced, a few years later, with a new carbon reduction requirement. The ability to defer carbon control expenditures would not make up for the wasted costs of pollution 104


control equipment for the other three pollutants and the loss of potential revenues from selling excess carbon permits. The costs of dealing with this situation would be higher for most companies than the costs of dealing with an integrated four-pollutant cap-and-trade regime. At this point few companies among the forty-seven large investorowned electricity generating companies have disclosed in their financial reports the implications of proposed three- or four-pollutant capand-trade policies, particularly in any quantitative detail. Though some companies have provided fuller disclosure than others, a perusal of SEC filings would be of little help to investors and analysts in understanding the distribution of exposures of electric utility companies to these environmental risks. In the case of a proposed government regulation, the registrant is required to make two determinations in deciding what to disclose. First, it must determine that there is not a reasonable likelihood that the regulation or provision will be enacted. If it cannot make that determination, it must disclose the impacts on the firm’s financial conditions under the assumption that the law or regulation will be adopted, unless it can make a second determination that, if enacted, the provisions will not have a material financial effect. In the case of the three- or four-pollutant policies, most firms in the electric utility sector would find it difficult to reach the latter conclusion. Nonetheless, there is currently little information in many companies’ financial reports regarding these issues. Moreover, there is little evidence that companies with the least exposures have tried to set a higher standard of transparency for the industry, though it would seem to be in their interests to do so. No systematic differences in the completeness of disclosure are evident between the reports of the least and most exposed companies. Investors get little help from financial reports in understanding the complicated financial exposures of companies in this sector to pending environmental legislation.

4.4.2. Growing Shareholder Demand for Environmental Information Financial markets are now asserting a growing demand for transparency, in part because of these experiences. According to a recent Standard & Poor’s Transparency and Disclosure Study (Standard & Poor’s 2003): Public companies around the world are increasingly under pressure from the ongoing ‘corporate governance revolution’ in which large institutional investors are intensifying the pressure on management to disclose all material information.

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A corroborating study by the accounting and consulting firm Ernst & Young found, after a study of share performance in 1,000 largest global companies, that poor investor relations was the third most frequent cause of sudden and major drops in share value. Companies that are lax on disclosure are more vulnerable to share price volatility than those that provide qualitatively good information. Moreover, investors have shown that they are willing to pay a premium for companies with superior disclosure records (Investor Relations on the Net 2002). The demand for more disclosure extends to environmental information. An increasing number of shareholder resolutions are being filed asking management for disclosure of material environmental information. These resolutions are often organized by coalitions of socially responsible investors and environmental activists but are increasingly being supported by mainstream institutional investors as well. In the USA, earlier this year an investor coalition that includes the State of Connecticut’s [Retirement] Plans and Trust Fund filed resolutions with five of the largest US electric power companies requesting that they disclose to shareholders the economic risks associated with emissions of carbon dioxides and other air pollutants and the business benefits associated with reducing those emissions. In an important recent development, Institutional Shareholder Services, an organization that advises pension and mutual fund managers on how to vote their proxies, endorsed these shareholder resolutions (Ball 2003). This endorsement potentially adds institutional money managers controlling hundreds of billions of dollars in assets to those demanding more environmental transparency. Partly as a result, the resolution commanded 27 percent of the vote of American Electric Power’s shareholders, a very high percentage for resolutions not backed by management, even though AEP has one of the best disclosure records in the industry. The Carbon Disclosure Project, an even larger initiative backed by thirty-five of the world’s largest institutional investors, has been urging companies to disclose their greenhouse gas emissions and the risks they pose to the companies, and the extent of their emission reduction programs. In the oil and gas sector, a similar climate resolution submitted to Exxon Mobil captured 20 percent of the vote. In Canada, shareholders of Imperial Oil recently submitted a resolution requiring the company to spell out potential financial liabilities associated with its greenhouse gas emissions and to put in place a plan to reduce those liabilities.

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4.4.3. Government Responses In the USA, in the wake of corporate scandals, the Sarbanes–Oxley Act has been adopted requiring CEOs and CFOs to certify the accuracy and completeness of their financial statements, requiring more independence of corporate directors from management, requiring corporation lawyers to take action if accounting or reporting irregularities are discovered and not corrected, and requiring separation of auditing and advisory functions. This Act also requires auditors to issue an opinion on the reliability of companies’ internal controls in capturing all material information. In addition, the administration and Congress have markedly increased appropriations of funds to strengthen the enforcement capabilities of the SEC, which itself has taken steps to tighten disclosure standards, particularly of off-balance sheet arrangements and contingent liabilities. Last year the US Senate requested the General Accounting Office to investigate the adequacy of environmental disclosure by corporations publicly listed on US securities markets, and of the SEC’s enforcement of its own requirements (SriMedia 2003). This request followed the release of a 1998 study by EPA that found that 74 percent of the companies subject to environmental legal proceedings that should have been disclosed under SEC rules had failed to do so. A report recently made public by the SEC on their review of financial statements filed by the Fortune 500 largest US companies stated: We found that we issued more comments on the MD&A discussions of the Fortune 500 companies than any other topic. Item 303 of Regulation S-K requires . . . [a discussion of] known material events and uncertainties that would cause reported financial information not to be necessarily indicative of future operating results or of future financial conditions. . . . Our comments addressed situations where companies simply recited financial statement information without analysis or presented boilerplate analysis that did not provide any insight into the companies’ past performance or business prospects as understood by management.

The SEC review of Fortune 500 company disclosures found specifically that information on environmental exposures and liabilities was frequently deficient (US Securities and Exchange Commission 2003). In Europe as well, the European Commission issued stricter nonbinding guidelines in 2001 for disclosure of environmental costs and liabilities, in response to a finding that unreliable and inadequate information about environmental performance ‘makes it difficult for investors . . . to form a clear and accurate picture of the impact of environmental factors on

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a company’s performance or to make comparisons between companies’ (Sutherland 2001). Despite these steps, further governmental action is needed. If financial markets are to evaluate financial risks arising from companies’ environmental exposures accurately and thereby to exert a useful influence on corporate management, further disclosures must be encouraged, especially of known environmental exposures and financial risks. Fortunately, relatively small actions can bring substantial results. Corporations are advised by legal counsel whose function is to protect the company from legal difficulties, prominent among which would be difficulties with securities regulators. If a government notification or an action taken against a single company signals that new emphasis is being placed on environmental disclosure, those signals reverberate powerfully through corporate boardrooms and executive suites. Therefore, a signal from the SEC that environmental disclosures will be scrutinized more carefully would have substantial effects. This might take the form of a speech by an SEC Commissioner or Enforcement Chief, a Staff Release reinforcing existing disclosure obligations, or a well-publicized enforcement action taken against one or a few companies. The increased budget for enforcement should make such an action feasible. There are also relatively simple and low-cost initiatives that environmental ministries and agencies can take. For example, in October 2001, following release of its study showing inadequate compliance, the US EPA issued an enforcement alert emphasizing the obligation of publicly listed companies to disclose environmental legal proceedings and other material environmental information (US Environmental Protection Agency 2001). In that document, the EPA revealed that it had begun notifying companies subject to certain enforcement actions of their potential duty to disclose and had established informational links to the SEC’s enforcement division. Further steps to strengthen liaison with securities regulators could be taken. Securities regulators are often handicapped by lack of information about environmental matters that are not disclosed but perhaps should be. They have scant resources with which to deal with their growing and increasingly complex responsibilities. Without assistance, they often experience difficulty in finding out what regulated companies are not disclosing. Environmental ministries and agencies can help in providing this needed information. As a start, they could establish a small liaison office to facilitate contacts with securities regulatory agencies. This liaison office can be responsible for facilitating the flow of information from the 108


environmental agency to the securities regulator and for redirecting questions from the former to the appropriate branches of the latter. Certain kinds of information could be shared between the two agencies on an ongoing and regular basis. Such information might include: 1. Texts of proposed major new regulations, and timetables for finalization, promulgation, and compliance; 2. Accompanying regulatory impact analyses, including analyses submitted by industry groups, estimating compliance costs and economic impacts on significantly affected industries and subsectors; 3. Emissions and waste generation inventories organized by company; and 4. Nonconfidential information regarding ongoing litigation, enforcement actions, etc. Information of this kind would be helpful to securities regulators in enabling them to form judgments regarding the kinds of disclosures that should be expected from companies within an industry. In addition to interagency cooperation of this kind, environmental agencies can greatly enhance their role as an information resource to investors and investment analysts. At present, investors and analysts typically do not see the environmental agency as a potentially useful source of information, and most within these groups lack any knowledge of how information from the environmental agency might be accessed. To some extent, analysts’ perceptions regarding the paucity of useful information available from environmental agencies have been justified. Many databases maintained by these agencies, though ostensibly public, have been difficult to access and manipulate. On some, the data can be outdated or of questionable accuracy, or the data are formatted in ways that are not useful to investors or analysts. For example, emissions data should be readily aggregated by company but often cannot be. To remedy this situation, the environmental agency could review their publicly available databases and attempt to make them more accessible and more useful. This effort, of course, would be of benefit to many users, not only to the investment community. A step in this direction would be to establish within the agency an Internet website for investors and analysts containing links and directories to potentially useful information. Such information would likely include materials in the categories (1) through (4) above. Direct Internet access to relevant information would be a valuable resource for investors and 109

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analysts, who often must make decisions under time pressure. A website would be even more useful if it contained a search engine capability that enabled users to search for information by industry, company, or environmental issue. Steps such as these merely illustrate the possibilities of closer cooperation between environmental agencies and securities regulators and the investment community. The benefits would be substantial: greater protection for investors, increased efficiency in financial markets, and stronger incentives for responsible environmental management.

References Akerlof, G., ‘The Market for Lemons’, Quarterly Journal of Economics, 84 (1970), 488–500. Austin, D., ‘Changing Oil: Emerging Environmental Issues and Shareholder Value in the Oil and Gas Industry’, World Resources Institute, Washington, DC, 2002. Ball, J., ‘Global Warming Is a Threat to Health of Corporations’, Wall Street Journal, April 16, 2003. Birchard, W., ‘Make Environment Reports Relevant’, CFO Magazine, 79 (June, 1996). Blacconiere, W. G. and Patten, D. M., ‘Environmental Disclosures, Regulatory Costs, and Changes in Firm Value’, Journal of Accounting and Economics, 18 (1994), 357–77. Dowell, G., Hart, S., and Yeung, B., ‘Do Corporate Global Environmental Standards Create or Destroy Market Value?’, Management Science, 46/8 (2000), 1059–74. Friends of the Earth, Citizen Action and Sierra Club, ‘Viacom, Inc.—A Hidden Legacy of Hazardous Waste’, Friends of the Earth, Washington, DC, 1997. Froot, K. A. (ed.), The Financing of Catastrophe Risk (Chicago, IL: University of Chicago, 1999). Fung, A. and O’Rourke, D., ‘Reinventing Environmental Regulation from the Grassroots Up: Explaining and Expanding the Success of the Toxic Release Inventory’, Environmental Management, 25 (2000), 115–27. Graham, M., Democracy by Disclosure: The Rise of Technopopulism (Washington, DC: Brookings Institution, 2002). Hamilton, J. T., ‘Pollution as News: Media and Stock Market Reactions to the Toxics Release Inventory Data’, Journal of Environmental and Economic Management, 28 (1995), 98–113. Harrison, K. and Antweiler, W., ‘Incentives for Pollution Abatement: Regulation, Regulatory Threat, and Non-Governmental Pressures’, Journal of Policy Analysis and Management, 22/3 (2003), 361–82.

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Making Disclosure Work Better Hawken, P., Lovins, A. B., and Lovins, L. H., Natural Capitalism: The Next Industrial Revolution (London: Earthscan, 1999). Investor Relations on the Net, ‘Going with the Flow’, October 15, 2002. Available at http://www.irmag.com Jones, J. D., Jones, C. L., and Phillips-Patrick, F., ‘Estimating the Costs of the Exxon Valdez Oil Spill’, Research in Law and Economics, 16 (1994), 109–49. Khanna, M., Quimio, W. R. H., and Bojilova, D., ‘Toxics Release Information: A Policy Tool for Environmental Protection’, Journal of Environmental and Economic Management, 36 (1998), 243–66. Konar, S. and Cohen, M. A., ‘Information as Regulation: The Effect of Community Right to Know Laws on Toxic Emissions’, Journal of Environmental and Economic Management, 32 (1997), 109–24. Labatt, S. and White, R. R., Environmental Finance (New York: John Wiley & Sons, 2002). Lewis, S., ‘The Investor’s Right to Know Less: A Case Study of Environmental Reporting to Shareholders by Phelps Dodge, Inc.’, The United Steelworkers of America, 1998. Available at www.PhelpsDodgeWatch.org Milgrom, P. and Roberts, J., Economics, Organization, and Management (New York: Prentice-Hall, 1992). Reilly, D., ‘Checks on Internal Controls Pay Off’, Wall Street Journal, May 8, 2006. Repetto, R. and Austin, D., ‘Coming Clean: Corporate Disclosure of Financially Significant Environmental Risks’, World Resources Institute, Washington, DC, 2000. ‘Quantifying the Financial Implications of Corporate Environmental Performance’, Journal of Investing, 11 (2002), 77–85. J. Henderson, ‘The Complexities of Strategic Environmental Management in the Electric Utility Sector’, Corporate Environmental Strategy, 10 (2003), 1–15. Schmidheiny, S. and Zorraquin, F. J. L., Financing Change: The Financial Community, Eco-Efficiency, and Sustainable Development (Cambridge, MA: MIT Press, 1996). Seligman, J., The Transformation of Wall Street (Boston, MA: Northeastern University Press, 1995). Social Investment Forum, ‘2001 Report on Socially Responsible Investing Trends in the United States’, SIF Industry Research Program, 2001. Available at www.socialinvest.org Sonde, T. and Pitt, H., ‘Utilizing the Federal Securities Laws to “Clear the Air! Clean the Sky! Wash the Wind!”’, Howard Law Journal, 16 (1971), 832–69. SriMedia, ‘Disclosure of Potential Environmental Liabilities in the Wake of Sarbanes–Oxley’, SriMedia, Corporate Governance News, January 18, 2003. Available at http://www.srimedia.com/artman/publish/article_347.shtml Standard & Poor’s, ‘Standard and Poor’s Transparency and Disclosure Study for International Investors’, available at www.standardandpoors.com Sutherland, D., ‘Europe Tightens Corporate Environmental Accounting Rules’, Environmental News Service, Brussels, October 5, 2001.

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Robert Repetto US Environmental Protection Agency, ‘U.S. EPA Notifying Defendants of Securities and Exchange Commission’s Environmental Disclosure Requirements’, Enforcement Alert, 4/3 (October 2001). Available at http://www.epa.gov/ oeca/ore/enfalert US General Accounting Office, SEC Operations: Increased Workload Creates Challenges (Washington, DC: Govt. Printing Office, March 2002). US Securities and Exchange Commission, ‘Summary by the Division of Corporate Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies’, February 27, 2003. Available at http://www.sec.gov/divisions/corpfin/fortune500rep.htm Vogan, C., ‘Pollution Abatement and Control Expenditures, 1972–1994’, Survey of Current Business, 9 (1996), 48. Williams, C., ‘The Securities and Exchange Commission and Corporate Social Transparency’, Harvard Law Review, 112 (1999), 1197–1231. World Bank, Greening Industry: New Roles for Communities, Markets, and Governments, New York, 2000.

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5 Bringing in Social Actors: Accountability and Regulation in the Global Textiles and Apparel Industry Dara O’Rourke

5.1. Introduction In the area of labor rights, the distance between global governance institutions and locally accountable regulation seems as wide as the oceans separating consumers in the North from producers in the South. Governments, intergovernmental agencies, and NGOs have all been frustrated in their attempts to build locally accountable governance institutions that have global reach. However, a new class of institutions has emerged that seek to bridge this divide. They involve private and nongovernmental stakeholders in negotiating labor, health and safety, and environmental standards, monitoring compliance with these standards, and establishing mechanisms of certification and labeling that provide incentives for firms to meet these standards. These nongovernmental systems of regulation are expanding extremely rapidly across industries and regulatory arenas— from garments, to shoes, toys, forest products, oil and gas, diamonds, chemicals, coffee, electronics, and even tourism 1 —in response to recent trends in the weakening of national regulatory systems, the strengthening of multinational corporations, increasing importance of brands, and growing demands from civil society actors for new mechanisms of corporate accountability.

1 Herrnstadt (2001), Gereffi, Garcia-Johnson, and Sasser (2001), Wick (2001), Cashore (2002), and Utting (2002).

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Proponents argue these initiatives are more flexible, efficient, democratic, and effective than traditional labor regulation, 2 while critics conversely assert that nongovernmental regulation is a cynical attempt to free industry from the last vestiges of state regulation and union organizing. 3 Some fear nongovernmental systems of regulation will preempt or ‘crowdout’ worker organizing efforts and the current role of unions, while others believe these systems can support worker empowerment and participation in shop-floor negotiations. Some believe monitoring and certification will provide consumers with a false sense that problems have been solved and will demobilize international labor and environmental campaigns, while others see the information generated by nongovernmental regulation as key to transforming how we produce, consume, and regulate global products and processes. Perhaps the most damning critique of nongovernmental governance systems is that they represent a new form of privatized, elite regulation, and that these systems are mainly designed to protect multinational brands, rather than to actually solve labor or environmental problems. From this perspective, much that falls under the heading of global governance is suspect, unaccountable, and likely to benefit multinationals more than workers, communities, or the environment. Even labor governance regimes driven by NGOs from the North can be viewed as top-down, consumer-oriented, ‘elite’ forms of regulation. 4 It is within this critical frame that new systems of nongovernmental labor standards, monitoring, and regulation must be evaluated: first, for their general effectiveness; second, for their accountability to local stakeholders; and third, for their impact on state regulation. This chapter seeks to critically and constructively engage this heated debate and assess emerging systems of multistakeholder labor monitoring and regulation. Based on interviews with staff of the leading initiatives in the USA and Europe, interviews with multinational managers and advocacy organizations, a review of the existing literature and program documents, and direct evaluation of monitoring initiatives in China, Indonesia, and Mexico, this chapter details efforts at multistakeholder labor regulation, explains how these systems function, describes the challenges they face, and evaluates their effectiveness in improving labor practices. The concluding concern of this chapter is whether and through what institutional designs these systems could more effectively improve conditions 2

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See Bernstein (2001).

3

See Justice (2001).

4

Rodriguez-Garavito (2005).

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in factories, and more broadly operate as effective, credible, and locally accountable systems of global governance. A critical issue is whether these initiatives bolster or undermine local regulation, and whether they can begin to make connections between consumers and advocates in the North, and workers and communities in the South. This chapter begins by describing and evaluating the leading nongovernmental labor regulatory programs in the USA and Europe: the Worldwide Responsible Apparel Production (WRAP) certification program, Social Accountability International (SAI), the Fair Labor Association (FLA), the Ethical Trading Initiative (ETI), the Fair Wear Foundation (FWF), the Workers Rights Consortium (WRC), and a range of private internal monitoring initiatives. The chapter comparatively assesses these systems, discusses their different models of regulation, and proposes a set of criteria for evaluating their effectiveness. The chapter then discusses several cases that appear to be examples of successful nongovernmental governance, interrogating their underlying dynamics, and drawing implications for broader efforts to make global governance more democratically accountable to those most directly impacted. This chapter identifies critical factors which appear to support more effective nongovernmental regulation, such as: substantive participation of local stakeholders; public transparency of methods and findings; and mechanisms that bring market pressures to bear on multinational corporations, and simultaneously support processes of multistakeholder problemsolving within factories and global supply chains. The chapter concludes with thoughts on strategies for states, international institutions, and civil society to foster and advance these principles and practices in future regulation.

5.2. Nongovernmental Labor Governance Nongovernmental systems of labor monitoring and regulation are both more diverse and messier than traditional government stipulated fixed rules and standards, monitoring and enforcement, and judicial review. 5 Nongovernmental initiatives involve multiple actors in new roles and relationships, experimenting with new processes of standard setting, monitoring, benchmarking, and enforcement. They include chains of 5

Arthurs (2001), Lipschutz (2000), and Reinicke (1998).

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standard setters, layers of monitoring and enforcement, and competing systems of incentives and action. To some degree this reflects the move from factory-centered, state regulation focusing on individual sites of production, to supply chain and ‘brand’ regulation, focusing on multiple actors in a production chain. The aim of the new nongovernmental governance is to create a network of regulators, involving multiple stakeholders along global supply chains using NGOs, firms, and sometimes government agencies in setting standards and monitoring protocols. Enforcement relies largely on market sanctions—either through interfirm purchasing decisions or through NGO consumer campaigns that seek to influence consumer purchasing. A diverse family of regulatory strategies is involved. In this chapter, I use ‘internal monitoring’ to refer to monitoring conducted by brands and retailers, ‘external monitoring’ to refer to monitoring conducted by thirdparty organizations, and ‘verification’ to refer to independent evaluations (not paid for by those being monitored) of the results of monitoring systems. Detailed descriptions of existing programs can help elucidate these different models. The codes themselves are diverse. 6 Some detail precise rules of action, while others present only general principles of good practice. Many appear to be converging now around the ILO core standards, 7 and basic principles regarding the protection of health and safety, wages and hours, and treatment of women. 8 While the general range of issues addressed in these systems is now fairly similar, 9 the details of codes can vary considerably. Appendix A presents a summary of the codes of conduct advanced by the four primary US monitoring systems. Key debates, however, continue around issues such as freedom of association, wages (minimum vs. prevailing vs. ‘living’), and the scope of ‘nondiscrimination’ clauses. Systems for implementing and evaluating code compliance are obviously critical to the credibility of these codes. Increased pressure from labor and human rights groups has motivated a growing number of multinational corporations to adopt codes of conduct and to submit to some form of external monitoring. 10 To these ends a number of initiatives have emerged over the past several years to foster the implementation, monitoring, and verification of codes. 6

Varley (1998), Diller (1999), and Compa and Hinchliffe-Darricarrere (1995). Maquila Solidarity Network (2004). 8 As Nadvi and Wältring (2001), 34 note ‘despite the toothless nature of core labour standards, they have become a model for private social standards’. 9 van Tulder and Kolk (2001). 10 For comparisons of company codes, see van Tulder and Kolk (2001), or company web pages such as www.nikebiz.com, www.gapinc.com, etc. 7

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5.3. Firm Internal Compliance Monitoring Many large brands and retailers have developed procedures for monitoring supplier compliance with their newly created codes of conduct. The Gap, for instance, has a Vendor Compliance department with over 100 staff responsible for monitoring the implementation of the company’s code of conduct throughout its global supply chain. Levi’s, Disney, Wal-Mart, H&M, and other companies have established similar programs. These corporations and others have spent literally millions of dollars on these internal monitoring systems. This has been motivated in part by perceived (and realized) costs of being accused of ‘sweatshop’ practices by NGOs or the media. Although the evidence is still quite limited, recent research has shown statistically significant negative stock market responses to public disclosures of poor labor and environmental practices. 11 These systems can either be extensions of existing supply chain management programs—simply adding labor, human rights, and environmental concerns into current systems for evaluating quality, timeliness, price, etc.—or they can involve entirely new systems for internal monitoring and evaluation. Some companies are asking their quality control and purchasing staff to take on code compliance as an additional task, while others are hiring dedicated staff to conduct precertification audits of contractors and ongoing assessments of code compliance. Nike was one of the first companies in the apparel and footwear industries to develop an internal compliance division. In 1992, Nike established a code of conduct on labor and environmental practices for its network of suppliers (now over 950 factories around the world—none of which Nike owns—employing over 700,000 workers). Supplier compliance with the code is monitored through a program of internal evaluation conducted first by Nike staff and then reviewed by external accounting, health and safety, and environmental consulting firms. Nike has developed internal monitoring tools such as its ‘SHAPE’ audit (Safety, Health, Attitude of Management, People Investment, and Environment), ‘MESH’ program (Management, Environment, Safety, and Health), and its latest ‘M-audit’ that allow the company to integrate the evaluation of labor and environmental issues into broader management practices and training. 12 MESH and the M-audit resemble the ISO 14000 management system, though it seeks to go further by evaluating actual factory performance. Nike now 11

Rock (2001).

12

See www.nikebiz.com/labor/mesh.shtml

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has approximately eighty staff who monitor labor and environmental conditions in the company’s contractor factories. Reebok and Adidas, Nike’s main competitors, have established similar programs that combine in-house assessment with audits by consulting firms. Reebok, for instance, has instituted a worldwide ‘Human Rights Production Standards Factory Performance Assessment’ system, while Adidas has created ‘Standards of Engagement’ for labor practices, health, safety, and the environment for all its subcontractors. 13 Through these auditing tools, companies like Nike, Reebok, and Adidas now regularly rate their subcontractors for environmental and labor performance. In the case of Nike, points are assigned for performance in a wide range of categories, with additional weight given to labor and environmental performance rankings. Subcontractors are then told how they rate against other subcontractors in the same country. High scorers can garner more lucrative orders, while low scorers risk losing contracts. Nike bases these labor and environmental programs on quality control management systems for evaluating and ranking subcontractors. Requirements to improve labor conditions simply extend the scope of commitments agreed to in the code of conduct and subcontractor memorandum of understanding. Providing some evidence that this effort is earnest, Nike, Reebok, and Adidas have each cancelled a handful of contracts due to poor performance and an unwillingness of contractors to meet their code. It is hard to determine how much improvement firm-led codes of conduct and monitoring programs have achieved. Little public research exists on the impacts of codes and self-monitoring on workplace conditions. Firms naturally assert that these systems respond effectively and sufficiently to labor concerns. Many companies continue to argue that they alone (perhaps with the assistance of a consulting firm) have the knowledge and ability to solve labor problems in their supply chains. However, judging by press reports, neither activists nor the general public appear to put much credence in corporate self-evaluation and monitoring. 14 Based on recent cases in which codes and monitoring have been used for public relations rather than improving labor conditions, many stakeholders criticize voluntary codes and internal monitoring for their vulnerability to corporate manipulation. 15

13 14

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Based on interviews with staff of Nike, Reebok, and Adidas in 2000, 2001, and 2003. 15 Connor (2001a, 2001b). O’Rourke (2002).


5.4. External Monitoring and Certification Growing public awareness and further activist pressure have led to a recent profusion of programs in the USA and Europe to establish standardized codes of conduct and systems of monitoring that are conducted by accredited third-party auditors. A significant number of multinational corporations have chosen to participate in these multistakeholder experiments alongside activists, union officials, and government organizations. These corporations have been motivated to move beyond internal programs because of increasing criticism and cynicism about corporate ‘selfregulation’. External monitoring and certification systems offer MNCs the opportunity to learn from other firms and critics, gather resources for problem-solving, and gain legitimacy for their actions. Six major initiatives of this type have emerged: WRAP, SAI, the FLA, the ETI, the FWF, and the WRC. Each of these programs has a code of conduct informed largely by ILO core standards, and five of the six have a system for accrediting external organizations to monitor compliance with their codes (the WRC does its own monitoring). A small army of monitors is emerging to provide these third-party monitoring services including large accounting firms, professional service firms, quality testing firms, and small nonprofit organizations. 16 These monitoring systems differ in key procedures for auditing (who conducts the monitoring and how), certification (whether a factory or a brand is certified), and reporting (what is publicly disclosed). Appendix B highlights some of the differences in these systems.

5.5. Worldwide Responsible Apparel Production The WRAP certification program is the most corporate-focused, and least publicly participatory, of the external monitoring and certification systems. WRAP was developed in 1998 by the American Apparel Manufacturers Association (now the American Apparel and Footwear Association 16 Bartley (2001); private, for profit monitors include PwC (recently spun off as Global Social Compliance), Cal-Safety Compliance Corporation (CSCC), Société Générale de Surveillance-International Certification Services (SGS-ICS), Det Norske Veritas (DNV), Bureau Veritas Quality International (BVQI), Intertek Testing Service (ITS), Merchandise Testing Labs (MTL), MFQ, Sandler & Travis (STR), Centro per l’Innovzione e lo Sviluppo Economico (CISE), RWTUV Far East Thailand, Global Standards-Toan Tin Vietnam, and KPMG. Nonprofit groups include the US NGO Verité, the Guatemalan Commission for the Monitoring of Code of Conduct (COVERCO), the Independent Monitoring Group of El Salvador (GMIES), Phulki (a Bangladeshi NGO), and the Honduran Independent Monitoring Team (EMI).

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(AAFA)), and began certifying factories in June 2000. WRAP’s board members include major apparel brands such as Vanity Fair Corporation, Sara Lee, Kellwood, and Gerber Childrenwear. The WRAP Certification Board consists of individuals primarily from the private sector, though the majority of its board members are not directly affiliated with the apparel industry. 17 WRAP began by creating its own code of conduct called the ‘WRAP Principles’. The twelve WRAP Principles include standards for child and forced labor, and workplace and environmental protections. However, the WRAP Principles also contain unique requirements for customs compliance and drug interdiction, which support tight security controls over suppliers and shipments. The WRAP Principles are widely viewed as the weakest standards of any of these systems and the least transparent monitoring and certification program. 18 WRAP’s program certifies individual manufacturing facilities not brands. The WRAP Certification Board accredits firms to be external monitors of manufacturing facilities. WRAP has accredited twelve monitors to date, primarily professional service firms such as ITS, Global Social Compliance (formerly a division of PwC), and Cal-Safety Compliance Corporation. These external monitors submit Facility Monitoring Reports to the WRAP Certification Board, which then reviews each report and makes the decision for or against certification. If a facility meets the WRAP standards, it is granted certification valid for one year, and may be required to undergo self-assessment and submit to external monitoring. Facilities may or may not be subject to unannounced inspections. As of April 2004, approximately 1,200 factories had paid to go through the WRAP certification process; however, WRAP officials have not disclosed how many of those have been certified to meet its code. 19 The countries in which WRAP has certified the most factories include China, Mexico, and the Dominican Republic. WRAP has been criticized by a range of stakeholders for its perceived industry bias and low level of public transparency. WRAP does not disclose the names or locations of certified or audited factories and has not disclosed any audit findings (or even what an audit looks like). WRAP currently has no plans for providing information to consumers or other stakeholders. WRAP certification is designed to be used by factories as a selling point in their negotiations with retailers and brands. WRAP 17 19

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18 Maquila Solidarity Network (2001a). Maquila Solidarity Network (2001b). Personal communication with K. Naah, WRAP (March 26, 2004).


also currently lacks NGO and civil society participation in monitoring or verification. Audits are primarily preannounced, and conducted by firms paid directly by the factories being audited.

5.6. Social Accountability International (SA8000) Social Accountability 8000 (SA8000), a voluntary workplace standard patterned on the International Organization of Standards system (for example, ISO 9000 and ISO 14000), was created in 1997 by the Council on Economic Priorities (a US NGO), and now administered by an NGO called Social Accountability International (SAI), with an advisory board made up of representatives from multinational firms, international unions, and NGOs. SAI seeks to motivate factories as well as member brands to implement the SA8000 code of conduct and to be audited by accredited auditors. SAI is responsible for accrediting these auditing firms, conducting trainings for auditors, factory managers, and workers on the standards, and for publishing a list of factories meeting the SA8000 standard. The SA8000 code, while based on the ILO core standards, has some unique components regarding the issues of wages, worker representation, and certification. SA8000, for instance, may be interpreted to include the requirement that factories pay workers a ‘living wage’, or what SAI refers to as a ‘basic needs’ wage. The SA8000 also requires firms to ‘facilitate parallel means of independent and free association and bargaining’ in countries where it is not possible to form free trade unions. Both of these provisions remain highly controversial as it is not clear, for instance, exactly what qualifies as effective parallel means of representation in countries such as China. The SA8000 also includes a section on management systems that ‘requires policies and procedures and documentation systems that demonstrate ongoing compliance with the standard’. The SA8000, similar to WRAP, certifies manufacturing facilities, not brands or retailers. The idea behind this system is that brands and merchandisers will seek out factories that have received SA8000 certification, as they look to ISO 9000 certification to verify quality standards. SAI is also developing a Signatory Member program 20 which requires members to move their supplier factories toward SA8000 compliance, and to periodically report progress in meeting this goal. 20 Member organizations include Amana, Avon Products, Cutter and Buck, Dole Food, Eileen Fisher, Otto Versand, Toys R Us, and the UN Office of Project Services.

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SAI discloses lists of certified facilities and their locations but does not publicly disclose which facilities have lost their certification or which were rejected in their applications. A total of 354 factories in thirtynine countries had been certified under SA8000 as of March 2004. The largest percentage of these facilities, 26 percent (93 factories), are apparel or textile firms. It is not clear whether or what percentage of Signatory Members’ contract facilities has received SA8000 certification. A number of concerns have been raised about the SAI strategy. Critics have argued that it is impossible to ‘certify’ that any factory is in compliance with the SA8000 standard based on a one-day audit, once per year. Others point out the limitations of a voluntary, factory-centered initiative that has to date certified less than 100 apparel factories out of an estimated 100,000 factories producing for the US market (a critique which can leveled at all of these systems). The SA8000 auditing procedures have also been criticized by NGOs for a perceived corporate bias and weak controls on the quality of monitors. 21 No NGOs have been accredited within the SAI system as auditors. As with WRAP, auditing is conducted by professional service firms and quality testing companies. Nine firms have been accredited by SAI to conduct audits under the SA8000 standard.

5.7. Fair Labor Association The FLA, convened originally by the Clinton administration in 1996 as the Apparel Industry Partnership (AIP), is both the oldest and most controversial of current initiatives to establish monitoring and verification. The FLA originally focused only on the apparel and footwear industries but has recently expanded to cover other industries producing universitylogo goods. As of April 2004, the FLA consisted of twelve ‘participating companies’, primarily large brand apparel and footwear merchandisers, several NGOs, and about 175 university affiliates. 22 Through these universities, over 1,100 collegiate licensees (companies producing goods that bear one of these universities’ logos) are participating in the FLA monitoring program. 21

LARIC (1999). FLA members include Adidas, Eddie Bauer, GEAR for Sports, Gildan Activewear, Liz Claiborne, New Era Cap, Nike, Nordstrom, Patagonia, Phillips Van-Heusen, Puma, Reebok, Zephyr Graf-X, Human Rights First, and the National Consumers League. Notably, several union and NGO members of the original AIP left the organization when it evolved into the FLA in protest of what they believed were insurmountable flaws in the organization and its monitoring procedures. 22

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The FLA has developed a ‘Workplace Code of Conduct and Principles for Monitoring’, accredits monitors, reviews audits, and reports on audit results. The FLA advances a monitoring system which requires companies seeking certification to first inspect internally all of their contract factories by the end of their ‘implementation period’. Companies are also required to hire external monitors to evaluate at least 30 percent of their supplier factories during the first 2–3 years of the certification process. 23 Over 2,000 internal company audits have been conducted, and 292 external audits have been submitted to the FLA as of April 2004. The FLA model has also come under fire from a number of unions, NGOs, and student activists for being overly controlled by industry. 24 Critics pointed out that firms could select and directly pay their own monitors, had a say in which factories were audited, and only disclosed summaries of auditing results. Student activists have also criticized the FLA for failing to advance a living wage and for not sufficiently supporting union and women’s rights. The board of the FLA responded to these criticisms in April 2002 by announcing major changes in the program’s external monitoring and disclosure procedures. 25 The FLA is now taking much more control over external monitoring, with the FLA staff selecting factories for evaluation (from a sample of ‘high risk’ contractors), choosing the monitoring organization, requiring that inspections be unannounced, and receiving all audit reports directly. The FLA then works with the brand and factory in a remediation process, and publicly discloses the results of the original audit and remediation efforts. The FLA staff conduct their own follow-up inspections to verify that remediation has occurred. The FLA is expanding its external complaint procedures and internal management systems reviews of brands. The FLA also recently unveiled a transparency initiative that provides ‘tracking charts’ of individual factories (without names or locations), detailing noncompliance findings by FLA-accredited monitors and tracking progress of participating brands in remediating these problems. Eighty-four tracking charts have been published to date on the FLA website, with a goal of publishing all external audit reports by the end of 2004. 23 The FLA has to date accredited eleven organizations to carry out this ‘external’ monitoring. Each of these monitors is accredited to inspect factories in specific countries. These include A&L Group, Cal Safety Compliance Corporation, Cotecna Inspections, COVERCO, Global Standards/Toan Tin, ITS, Kenan Institute Asia, LIFT-Standards, Merchandise Testing Labs Brand Integrity, Phulki, and Verité. As of June 2002, 982 companies had applied for certification, the majority of which were small university licensees. 24 25 Benjamin (1998) and Maquila Solidarity Network (2001a). FLA (2002).

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5.8. Ethical Trading Initiative The ETI was initiated in England in 1998. The ETI is an alliance of companies, NGOs, trade unions, and the British government, working to ‘identify and promote good practice in the implementation of codes of conduct of labor practice, including the monitoring and independent verification of the observance of code provisions’. The ETI was established explicitly as an experimental ‘learning initiative’, designed to help identify and disseminate information on how best to implement labor codes that benefit workers in global supply chains. The ETI runs pilot projects and commissions research, in collaboration with partner firms and NGOs, which seek to examine specific challenges of code implementation, monitoring, and remediation of problems in supply chains. The ETI has conducted pilot projects in a number of countries, evaluating for instance, code implementation and monitoring in apparel production in Sri Lanka, India, and China, horticulture in Zimbabwe, bananas in Costa Rica, and wine in South Africa. These pilots are key to the ETI strategy as they generate information on issues such as how to monitor for child labor, how to evaluate the quality of one-day audits, how different actors can contribute to auditing, how best to establish worker complaint systems, etc. The ETI reports the detailed findings of these pilot projects and internal auditing conducted by companies to member organizations (although this information is not made available to the public). The ETI also holds public meetings and workshops where more general findings are reported. The ETI recently began a two-year assessment process of its initiatives. The organization has hired outside researchers to evaluate whether, how, and under what conditions participation in ETI programs and implementation of the ETI base code improves working conditions, and what problems and challenges implementers face.

5.9. Fair Wear Foundation The Dutch Clean Clothes Campaign, in collaboration with trade union representatives and Dutch retailers, established the FWF in 1999 (after five years of discussions and negotiations on code issues) to work with associations of small- and medium-sized enterprises in the Netherlands and to oversee the implementation of a code of conduct through retail supply chains. The FWF has developed a ‘code of labor practice’, based 124


closely on the ILO core standards, and requires companies to monitor their supply chains and to establish independent verification and worker complaint procedures. The FWF will certify companies that are implementing the code and have a system in place to gather evidence on factory conditions in their supply chains. The FWF is responsible for verifying that the code is being implemented in a percentage of each firm’s factories. The FWF has conducted pilot studies in garment factories in India, Poland, Romania, and Indonesia to test its monitoring and verification procedures. Within the context of these pilot projects, participating companies have conducted internal inspections of their supply facilities and the FWF has performed external verifications to spot-check these findings. This process has led to FWF now requiring member companies to use a management system that stipulates the maintenance of a supplier registry, establishment of management and worker training programs, implementation of internal monitoring (in which the Dutch retailer monitors working conditions in its suppliers), and follow-up procedures for evaluating corrective action plans to address code violations. Participating companies submit audit reports and corrective action plans to the FWF office. The FWF then makes public the names of brands participating in the FWF, their countries of operation, and the number of suppliers in each country. Specific information on business practices and worker interviews is kept confidential.

5.10. Workers Rights Consortium The WRC was developed by the United Students Against Sweatshops (USAS) in cooperation with the Union of Needletrades, Industrial and Textile Employees (UNITE), the American Federation of Labor-Congress of Industrial Organizations (AFL-CIO), and a number of human rights, labor, and religious NGOs in 1999. The WRC had 121 college and university members as of March 2004, and focuses primarily on factories producing apparel for the university market. The WRC employs three broad strategies: (a) inspecting factories from which the WRC has received worker complaints; (b) proactive inspections in countries with patterns of poor labor practices; and (c) information disclosure requirements. The WRC does not certify company compliance with a code of conduct, conduct systematic monitoring, or accredit monitors. Instead, the WRC encourages (but does not require) participating 125

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universities to adopt codes of conduct that closely resemble the WRC’s ‘model code’, which includes strong provisions for a living wage, women’s rights, and recognition of worker’s rights to freedom of association. The WRC requires member universities to commit to broad public disclosure and to develop mechanisms to verify information reported by companies and their suppliers. The WRC’s goal is to ensure that factories which produce university branded apparel comply with the ‘model code of conduct’, and in particular with rights to freedom of association and collective bargaining. The WRC also seeks to educate workers themselves about university codes, so that workers may report code violations to local NGOs or the WRC. The WRC’s investigative efforts rely on collaboration with local NGOs and activists, personnel from either the WRC, its board, or affiliated university members, and labor and human rights experts. To date, the WRC has conducted detailed investigations at about a dozen factories around the world. 26 The WRC makes all of these factory investigation reports public. The WRC is also developing a database of manufacturing facilities, which allows the public to search by factory name, licensee name, location, or university affiliate. 27 The WRC is increasingly focusing on remediation processes, working with universities and buyers (usually the brands), and workers’ organizations to negotiate solutions to problems raised by workers, with the hope that there will be some ‘ripple effect’ to other factories in these regions. The WRC is not without its critics. The WRC has been criticized (and publicly opposed) by a number of firms and university administrators. 28 Opponents have accused the WRC of representing a ‘gotcha’ model of monitoring, more focused on identifying problems and embarrassing firms than on resolving problems. 29 And the WRC’s in-depth inspection system has been criticized for having a limited scope and coverage. Interestingly, the WRC, along with ETI, FLA, FWF, and SAI are now collaborating on a joint initiative in Turkey 30 that seeks to produce ‘guidance 26 These include the high-profile Kukdong garment factory (now known as Mexmode) in Puebla, Mexico; the New Era baseball cap factory in Buffalo, New York; the BJ&B cap factory in the Dominican Republic; and, the PT Dada apparel and stuffed toy factory in Indonesia. Other investigations have been conducted in India, El Salvador, Indonesia, and Mexico. These investigations have involved 6 to 8 people for 5–6 days each. 27 See www.workersrights.org/fdd.asp 28 Phil Knight, the CEO of Nike Inc., withdrew a planned $30 million donation to the University of Oregon after their joining the WRC. 29 30 Brown Daily Herald (2000). See www.jo-in.org

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notes’ on best practices in the monitoring and implementation of freedom of association, wages, and hours of work. The project is working to collaboratively assess the quality of audits, remediation and corrective action programs, and complaints mechanisms. The joint initiative also seeks to analyze ways in which leverage could be enhanced through cooperation across these MSIs. After a slow start, eight multinational brands have joined the five NGOs in the Joint Initiative, they have selected a group of factories to study, and they have extended the project to run through the end of 2007. Several other initiatives, while not explicitly focused on codes and monitoring, are also potentially supportive or complementary to nongovernmental labor regulation. These include the GRI and the UN Global Compact initiative, created by the UN General-Secretary in 2000. 31 It should be noted, however, that neither of these initiatives requires external or independent monitoring or verification of any kind, but rather remain essentially self-reporting and disclosure systems.

5.11. Models of Nongovernmental Governance The diversity of current codes and monitoring systems has led to both confusion and debate about the benefits and costs of nongovernmental regulatory strategies. Versions of nongovernmental regulation range from individual factories paying to be certified, to multinational brands internally monitoring their contractor factories, to MSIs accrediting third-party organizations to inspect factories, and to independent NGOs inspecting factories individually or in coordination with worker campaigns. In these different forms of nongovernmental governance, the substance, scope, implementation, participation, accountability, and transparency of inspection results can vary considerably. And more importantly, these systems also vary in their underlying models for improving labor practices in global supply chains. Traditional labor regulation, now often disparaged as ‘command-andcontrol’ policy, might be thought of as largely a state-centric, local ‘policing’ model of governance. Clear, fixed rules are established, and government inspectors police compliance with these standards to advance a kind of ‘interventionist’ regulation. 32 Nongovernmental labor regulation 31

See www.unglobalcompact.org

32

Knill and Lehmkuhl (2002).

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represents a significantly different model of regulation, involving multiple stakeholders participating in standard-setting, monitoring, and sanctions (or incentives). And as we have seen, these nongovernmental regulatory initiatives often vary in their underlying regulatory models. The FLA, SAI, FWF, and WRAP are all firmly centered around enlisting market drivers for improved supplier performance. WRAP and SAI advance a system based largely on factory certification. These initiatives certify that management systems are in place to guarantee acceptable performance in individual factories. Certification provides a stamp of approval that is designed to attract customers to self-selecting factories. WRAP and SAI tap into the motivations of individual factories seeking to connect into socially concerned corporate buyers, as factories are audited only if they ask (and pay) for the evaluation. These systems involve an advanced form of ‘privatized regulation’. 33 The FLA, FWF, and ETI deploy market pressures by creating supply chain policing systems involving multiple stakeholders. This advances a kind of ‘collaborative regulation’ or ‘regulated self-regulation’ 34 that depends on top level commitment to the code from a brand or retailer, both internal and external monitoring of suppliers and participation of NGOs in providing legitimacy to the system. The FLA, FWF, and ETI also provide information to buyers to use to influence supply chains. The WRC advances essentially a ‘fire alarm’ model of regulation 35 that focuses on creating new mechanisms of accountability for both firms and government agencies by gathering information from workers and local organizations and then helping them to organize to win demands. Alarms are triggered through complaints from workers and local NGOs, which motivate WRC inspections. Factories, and the brands purchasing from them, are targeted through this bottom-up process. The WRC then puts pressure on brands to improve conditions, and at the same time works to facilitate worker empowerment and organizing to negotiate improvements. Supporting freedom of association and collective bargaining are primary goals of the WRC. These different systems create a spectrum of new regulatory processes: from ‘privatized’ regulation, to more ‘collaborative’ regulation, to more ‘socialized’ governance of global production networks.

33 35

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Knill and Lehmkuhl (2002). McCubbins and Schwartz (1984).

34

Ayres and Braithwaite (1992), Teubner (1983).


5.12. Limits to Nongovernmental Regulation There are obviously a number of weaknesses and challenges to making these different regulatory systems effective. Nongovernmental governance faces many of the same mundane challenges as traditional government monitoring and enforcement, including coverage, training and capacity of inspectors, incentives of monitors, corruption, and so forth. The long and mobile nature of apparel supply chains, and the difficulty of sometimes even locating garment factories, is a critical challenge for nongovernmental monitoring systems. Major apparel companies such as the Gap source their products from over 3,300 factories in 70 countries. Disney is estimated to source from over 30,000 factories, Wal-Mart from even more. 36 The ability of firms to move production quickly between factories and to hide behind multiple layers of ownership makes systematic inspections extremely difficult. 37 A number of critics have raised concerns that nongovernmental monitoring involves visits to factories that are too infrequent to evaluate normal day-to-day operations. ‘Parachuting’ monitors are able to identify the most obvious problems, but may miss many of the largest issues, and are not around long enough to actually solve problems. 38 Critics surmise quite reasonably that NGOs will not be able to duplicate national labor inspectorates, as they cannot track the moving targets of factories that make up global supply chains, 39 and they cannot access critical information on these factories without brands and retailers ‘voluntarily’ providing this information. Thus the first challenge of nongovernmental regulation is simply accessing information on factory locations, workplace conditions, audit findings, remediation efforts, and worker concerns. There are also clear power asymmetries between multinational corporations, nongovernmental inspectors, advocacy groups, and workers. 40 Some critics warn that companies are controlling these processes, coopting NGOs by changing them from watchdogs to ‘partners’, and undermining strong local laws and unions. 41 Having NGOs play the role of regulators may also ultimately undermine traditional regulatory processes. 42 While all of the MSIs assert a concern for local participation, some are much better than others at connecting with and respecting the interests of 36

Wach and Nadvi (2000). As one retailer in the ETI commented, ‘I can know my supply chain at 9 a.m., then by 10 a.m. it’s all different’, ETI (2001). 38 39 40 O’Rourke (2002). Justice (2001). Rodriguez-Garavito (2005). 41 42 Justice (2001). Nadvi and Wältring (2001) and ILO (1998). 37

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local stakeholders and government officials. Other critics fear that elected governments are actually ceding some of their sovereignty to consumers through these systems. 43 Clearly the shift to nongovernmental regulation focuses more attention on consumers (rather than the state or unions) as the key constituent of monitoring and enforcement. A number of critics have also noted that codes and monitoring activities can actually hurt workers. 44 Monitoring reports can lead firms to cut contracts with poor performing factories, leading to job losses. Firms may reduce overtime at a factory working beyond a code of conduct’s limit, despite workers needing these wages to survive. Workers may also be punished after complaining to auditors as these systems often have limited protections for workers who complain. Even when monitoring is effective, some of the most hazardous jobs may be shifted further down the supply chain or into the informal sector to avoid the selective gaze of nongovernmental regulation. Some critics also argue that monitoring, when it is conducted by local NGOs, can impede unionization or ‘crowd out’ the efforts of local worker organizations. Compa 45 discusses several cases in Central America where NGOs appear to be ‘supplanting the unions’ role as worker representatives by discussing wages and working conditions with factory managers’, a process which will actually help ‘powerful companies to avoid union organizing, enforceable collective agreements, and government regulation’. Others on the ground in Central America disagree with this assessment, arguing conversely that NGO monitoring has supported several union campaigns in El Salvador and Guatemala. 46 This debate in Central America underscores the sense that NGOs and unions continue to be ‘wary allies’ 47 and that many stakeholders in these processes do not feel that they control or are benefiting from Northern-led nongovernmental regulatory systems. Finally, critics also point to a number of problematic versions of nongovernmental regulation. For example, Global Social Compliance (formerly a division of PwC), a monitor for many large multinationals, depends largely on data provided by management, conducts very cursory inspections of factories, and holds worker interviews inside the factories. 48 Factory managers often know who is being interviewed, for how long, and on what issues. This kind of monitoring can divert attention from the real issues in a factory, provide a false impression of performance, 43 45 48

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Esbenshade (2001). Compa (2001). O’Rourke (2002).

46

44 Esbenshade (2001) and Liubicic (1998). 47 Quinteros (2001). Compa (2001).


certify that a company is ‘sweat-free’ based on very limited evidence, and actually disempower the workers it is meant to help. While there is no single perfect way to monitor a factory, there are clearly problematic monitoring practices that are not transparent, accountable, or beneficial to workers.

5.13. Local Participation in Global Governance While there are clearly problematic versions of nongovernmental regulation, and variations among even the most promising of these initiatives, there has been movement over the short history of these programs to address critical concerns about forms and levels of stakeholder participation, public disclosure of information, and mechanisms of accountability over firms and their monitors. In particular, there have been a number of efforts to increase the accountability of these systems to local stakeholders, consumers, and Northern advocacy organizations. Several of these initiatives have experimented recently with new forms of local participation and new processes of collaboration and cooperation between local actors and international organizations. The primary goal of these efforts is both to root nongovernmental governance in local interests and concerns and to connect these interests directly or indirectly to consumer concerns (and pressures) in the North. This involves developing new connections between the US and European NGOs that work to mobilize consumers in advanced industrialized countries (or invoke their concerns in their corporate accountability campaigns), with unions, NGOs, workers, and communities in producer countries. This combines top-down pressure campaigns with bottom-up organizing, often justified or protected by formal codes and monitoring systems. These dynamics can be viewed most clearly through specific cases, which might actually be considered failures of corporate internal monitoring. These cases involve garment factories that produced for MNC brands or retailers in which major problems were identified that had either not been found or not been remediated by these firms. Strategic alliances of NGOs and unions have used codes and monitoring systems as a framework within which to exert pressure and demand accountability over these factories and to expand space for local worker organizing. Brands and retailers that are members of the FLA, and that have publicly committed themselves to codes of conduct and monitoring systems, have been targeted in this organizing. Membership of the FLA which was originally 131

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dismissed by many activists as largely PR, 49 appears to have created a window of accountability over multinational brands and retailers that NGOs have been able to work through. In fact, an interesting complimentarity seems to be emerging between the FLA and WRC efforts—which only a few years ago were viewed as diametrically opposed. In a series of cases involving both the FLA and the WRC, including factories in Mexico, Indonesia, the Dominican Republic, Guatemala, and the USA, a pattern of internal and external, top-down and bottom-up, worker-to-consumer, strategies have been employed to resolve problems in specific factories and to build local worker organizing efforts. For example, in the now famous Kukdong case in Mexico, 50 there was an important combination of formal procedures of inspection and remediation carried out through FLA and WRC investigations, and new forms of local participation and cooperation between workers, union representatives, NGOs, and student activists to support and protect the formation of an independent union. This combined strategy led to the signing of a new contract with factory management and important gains in pay and health and safety conditions. 51 The international spotlight of formal codes and monitoring procedures, and external pressure brought to bear by NGOs and student activists were critical in the case in not only motivating resolution of specific grievances in the factory but also in protecting the fledgling union organizing. Similarly, though locally unique dynamics occurred in cases at the PT Dada factory in Indonesia, the BJ&B factory in the Dominican Republic, the Choi Shin factory in Guatemala, and the New Era factory in upstate New York. 52 These cases offer a potential model of more locally participatory, and accountable, global governance. This model involves:

r r r

NGOs and/or unions targeting factories producing for branded MNCs that can garner media attention in the USA or Europe. These groups often look for companies that are in one of the MSIs; NGOs and unions conduct research on potential cases on the ground in countries in which they have local partners or researchers; When a promising case (i.e. one with egregious conditions and potentials for solutions) is identified, the groups begin organizing to ensure that there is worker capacity and the potential for a successful

49 52

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50 51 See Benjamin (1998). Barenberg (2003). Brown (2001). See reports on these cases at the WRC and FLA websites.


r r r r r r

r r r r r r

campaign. These groups need worker voices for legitimacy and effective accountability over solutions; The local and international groups jointly develop a strategy for the campaign; Sometimes a specific incident ignites the campaign, sometimes a research expose; The ‘fire alarm’ is pulled, and media attention is generated; A code of conduct is publicly invoked to show that the brand or retailer is not living up to their own public pronouncements and is violating the terms of their participation in a monitoring initiative; The monitoring group or groups are asked to evaluate the problem. A process is initiated where the WRC and FLA conduct investigations and negotiate with the brand and the contractor; External pressure is generated on the brand, such as through the USAS organizing a letter writing campaign, protests in front of company stores, email organizing, etc. Advocacy groups demand the brand or retailer solve the problems in the contractor factory, and explicitly not cut their contract; An international spotlight is directed at the case while a local ‘deliberation’ is conducted; The brand works with the contractor to clean up the worst problems; If, or usually when, the contractor tries to oppose or co-opt the workers or renege on the agreement, international pressure is initiated again, focusing on the brand; Local organizing tries to take hold and to establish a union that can survive without outside support and monitoring; Local bargaining occurs over remediation of the problems in the factory and seeks to create ongoing means for negotiation between workers and management; and The FLA and WRC conduct follow-up monitoring and establish systems of communication from local groups to Washington, DC to verify problems have been remediated and the worker rights are being respected.

This model—or some variant of it—which combines both top-down exposes and pressures in consumer countries, with bottom-up organizing and worker mobilization in producer countries, and sometimes surprising 133

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roles for brands in pushing contractors and local regulators, has been successful in a handful of cases around the world. And while it is extremely labor intensive and expensive, it appears that it can produce successful, participatory, and locally accountable improvements in factory conditions.

5.14. Designing More Accountable Global Governance This schematic of more participatory and accountable nongovernmental labor regulation, while certainly not proof of global trends, provides at least the outlines of strategies for promoting more effective and democratic nongovernmental governance. These experiments highlight potential responses to current power asymmetries, information asymmetries, and legitimacy problems of existing initiatives. They also point to critical design features of more locally accountable global governance, such as: increased transparency, fuller local participation, mechanisms of local accountability, avenues for countervailing pressures, and space for local deliberation. Increased transparency is the first, and perhaps most critical, element in advancing more accountable nongovernmental governance. If concerned critics, and the public, cannot see for themselves where and how products are being produced, and how problems are being resolved, these systems will continue to face widespread skepticism. Key stakeholders need information on locations of factories, results of inspections and audit reports, and details of progress in remediating problems. The FLA is moving toward increased transparency of this kind. And the WRC has established explicit systems for transferring information to both local stakeholders— unions, NGOs, workers, etc.—and international organizations, students, and the media. Support for fuller and more meaningful worker participation in nongovernmental regulation is also critical. Workers obviously should play a central role in identifying problems in these factories—as they are on the factory floor every day and have clear incentives (although also disincentives) to raise issues. But they should also be involved in negotiating solutions to problems and determining workplace conditions for the future. The WRC has experimented with local ‘Accountability Teams’ that include workers (although not workers or union representatives from the factory involved in the dispute in order to avoid conflicts of interest), local NGOs, and other local experts (such as human rights lawyers, academics, 134


etc.). The WRC and Clean Clothes Campaign have also been pushing for greater worker participation in remediation and problem-solving processes, the creation of ‘deliberative arenas’, and systems through which remediation efforts are incorporated into collective bargaining processes. As Barenberg 53 explains, ‘the substantive goal is to generate compliance norms that are, in some meaningful sense, autonomously shaped by local interests, and pragmatically suited to local problem-solving’. A number of other experiments in worker participation have been advanced recently around the world that point to similar goals and dynamics. One interesting experiment in worker participation recently took place in two Reebok shoe factories in China. In factories in Fujian and Guangdong provinces in southern China, workers conducted open elections for their trade union representatives. 54 These elections are likely the first of their kind in foreign-invested enterprises in China and represent an important precedent in showing that workers can organize and elect their own unions. Reebok played a critical role in supporting and pushing the local factories (which are managed by Taiwanese and Hong Kong investors) to allow these elections. As one reporter noted, Reebok’s aim with these elections is to produce a sustained improvement in working conditions by promoting better communication between management and the shop floor. . . . ‘It’s our hope that issues can be taken up by the worker representatives’, says Mr. Cahn [a Reebok Vice President]. ‘We have inspections of factories, both announced and unannounced. But you just don’t have the assurance that things will be the same the next day. Factories in China are incredibly sophisticated at finding ways to fool us. The best monitors are the workers themselves.’

The Reebok experiment represents a small step forward on worker participation in China, and similar experiments have been reported recently in other foreign-invested factories in Guangdong, Fujian, Zhejiang, and Shandong provinces. 55 Although it is still too early to evaluate the impact of these elections, the cases do show that MNCs can create windows of opportunity for worker organizing and real representation even in countries that seek to control or repress unions. Another experiment of this nature involved creating and supporting workplace health and safety committees in contract factories for multinational footwear companies in Guangdong province in China. 56 This project sought to support worker participation in identifying and 53 56

54 Barenberg (2003), 8. Maitland (2002). Szudy, O’Rourke, and Brown (2003).

55

Xinhua (2003).

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resolving problems inside factories, and in advancing broader systems of monitoring and corporate accountability. Participating factories (producing shoes for Adidas, Nike, and Reebok—all members of the FLA) created or expanded health and safety committees, began regular inspections of production areas, and worked with managers to eliminate or reduce identified hazards. The committees also worked to develop new and better mechanisms for workers to report problems, new processes for identifying and eliminating hazards, and new systems of worker–management communication. In a number of cases, the committees have been able to identify and correct previously unrecognized hazards as well as to highlight long-standing concerns of workers. These committees and elections show that multinational firms can play a critical role in supporting, protecting, and even funding worker participation. While the space for independent worker organizing remains constrained in many countries, foreign firms can open small spaces for workers to participate in important factory decisions, and can create mechanisms to respond to worker complaints and concerns. Codes and monitoring organizations provide one arena through which to advance these experiments. Voluntary initiatives of these kinds of course are more rare than regular. It is thus necessary to design nongovernmental governance systems to take advantage of their main motivating force—civil society pressures on multinational firms. Adversarialism, pressure, and credible threats of lost sales are important motivators for the positive collaboration and joint problem-solving that some of these initiatives facilitate. It is thus necessary to design into these programs mechanisms for public input and countervailing pressure. Continuous pressure on firms both to be more open, and to accept that labor and environmental issues require continuous improvements, have been central in motivating changes and in addressing the most intractable problems of sweatshop production. Effective nongovernmental regulation thus must facilitate public mechanisms of external pressure on brands and factory managers, and at the same time, motivate internal corporate mechanisms for finding problems, conducting root cause analysis, benchmarking solutions, experimenting, and implementing new systems of management and accountability. Essentially, there is a need to create a balance between fostering conditions for workers, activists, and consumers to participate in finding and solving problems (often through pressuring firms), and creating conditions for collaborative problem-solving. Creating space for local 136


deliberation and worker participation, and supporting key enabling rights, are central to including workers more meaningfully in these processes and supporting their efforts to organize themselves. Finally, there is a critical need to design these initiatives to strengthen and complement, rather than replace or weaken local state regulation. In two of the WRC investigations—in Indonesia and Mexico—it appears that external pressures and spotlights on local factories have actually helped to support local labor inspectors to do their jobs (over the objections of other state interests), and created space for compliance with local laws. 57 This dynamic is rarely the focus of participants in MSIs. However, it shows that there is at least the potential to use external pressures more strategically to bolster local regulation. The long-running Nike campaign shows the broad potential for supporting local regulation through global advocacy. A global network of NGOs and activists has worked to expose problems in Nike factories in developing countries. This can sometimes open a window of opportunity for local regulators to go in and examine the claims of the activists, where in the past they might have been nervous to regulate Nike for fear of capital flight. Global activism in a sense provides cover for often weak labor and environmental inspectors. Ironically, firms such as Nike now often assert that local government capacity is a critical concern for them. This often takes the form of a response to critics, saying essentially, ‘It’s not our fault these factories in country X are violating the law. If only the country X government would do its job, these factories would be better.’ Activists are responding in turn by demanding that Nike allow—or even help—these local agencies do their jobs. Through this unlikely alliance of international actors demanding improved regulation, there appears to be real potential to support and build the capacity of local community members and to provide room and capacity for state agencies to more effectively regulate workplace conditions.

5.15. Conclusions New nongovernmental regulatory systems hold out both potential and peril. They offer the potential of opening up and strengthening regulatory systems, and bringing in new voices and mechanisms for motivating improvements in global supply chains. They also harbor the peril of 57

Barenberg (2003).

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privatizing regulation, effectively closing off democratic forms of regulation and bypassing local regulation by advancing top-down, elite governance systems. In some regards, the distinctions between these systems are beginning to break down. There is some convergence under way in codes and monitoring regimes that is blurring the boxes presented in this chapter. Factory monitoring now sometimes includes union officials. Supply chain monitoring is employing NGOs to monitor factories. And NGO investigations are sometimes coordinated with powerful brands. Nonetheless, there are still critical distinctions between these initiatives on issues such as the roles of workers and advocacy organizations, transparency of results, and strategies for remediation of problems. And there is certainly no guarantee that voluntary codes of conduct and monitoring schemes will naturally converge on more complete or democratic systems of regulation. They are just as likely to diverge into a plethora of initiatives competing for the hearts and minds of consumers, serving to confuse the public and undermine the credibility of nongovernmental initiatives. However, with strategic policies and coordinated efforts, nongovernmental regulation could instead move toward more credible, transparent, and accountable systems. A critical first step in this direction would involve monitoring organizations simply committing to making their factory audits and auditing methodologies public. Another potentially promising avenue forward would involve efforts to build complementarity and interoperability between these systems. Different models of nongovernmental regulation are effective at different processes. Factory monitoring identifies willing factories and gives managers information to support change. Supply chain monitoring helps move standards down outsourced chains of production and provides brands with information to better manage their suppliers. Independent investigations help to expose the worst actors, provide information to workers, and create incentives for brands to prevent problems in their contractors. Connecting these initiatives in some interoperable way might help to overcome the challenges of access, scope, and credibility. Recent successful cooperation between the FLA and WRC indicates the potential of combining complementary strategies and systems. In addition, there are clearly roles for international agencies and governments to support more accountable and effective forms of labor regulation. Agencies such as the ILO could play a critical role in not only specifying more fully the ‘core standards’ that all MSIs and local 138


governments would implement, but also in helping to facilitate interaction between firms, NGOs, unions, and government agencies. The UN might also support processes for identifying ‘best practices’ among MSIs and governments, creating mechanisms to learn across these initiatives, and then facilitating upward movement in laws and regulatory programs. MSIs themselves could be proactive by including local stakeholders—such as NGOs and government agency staff—on inspection teams, helping to train these groups in best practices in monitoring and regulation, and promoting the idea of ‘co-production’ of regulation more broadly. Finally, developing country governments also have a role to play in enabling and supporting the types of civil society and multistakeholder interactions which are key to the effective and democratic functioning of regulation. Each of these emerging systems has clear weaknesses and challenges. Nonetheless, under certain conditions, nongovernmental regulation can influence factory labor practices. With increased transparency, improved technical capacities, and new mechanisms of accountability to workers and consumers, nongovernmental monitoring could complement existing state regulatory systems. As they develop, new nongovernmental regulatory systems should be evaluated along a number of criteria: (a) legitimacy—are key stakeholders involved in all stages of standardsetting, monitoring, and enforcement?; (b) rigor—do codes of conduct meet or exceed ILO conventions and local laws; are standards measurable; and is monitoring technically competent?; (c) accountability—is monitoring independent, transparent, and accountable to local stakeholders?; and (d) complementarity—do nongovernmental regulatory systems support state regulation and help to improve standards and monitoring methods? Governance in the global economy remains a daunting challenge. If these experiments in nongovernmental regulation can be made more transparent, accountable, and democratic, it may be possible to build nongovernmental governance into an important response to the adverse impacts of globalization. At a minimum, nongovernmental regulation offers a glimpse of emerging strategies to regulate global supply chains and to begin the process of building new systems of governance over a fast changing world. Locally accountable global governance may still sound like a paradox, contradiction, or at the minimum a daunting challenge, but it is exactly this challenge that is central to collective efforts to regulate the adverse impacts of global production systems, with admittedly new and fragile governance institutions. 139

Appendix A: Variations in Codes of Conduct

Child labor

Harassment and abuse

Fair Labor Association (FLA) www.fairlabor.org

Social Accountability International (SA8000) www.sa8000.org

Minimum age: 15; or 14 if country of manufacture allows; or age for completing compulsory education. No employees shall be subject to any physical, sexual, psychological, or verbal harassment or abuse.

Minimum age: 15; or 14 if meets developing country exemption; or local minimum age if higher. No corporal punishment, mental or physical coercion, or verbal abuse. No sexually coercive or exploitative behavior. No discrimination in hiring, compensation, access to training, promotion, termination, or retirement on the basis of race, caste, national origin, religion, disability, gender, sexual orientation, union membership, or political affiliation. Where right restricted by law, employer facilitates parallel means for free association and bargaining.

Nondiscrimination

No discrimination in hiring, salary, benefits, advancement, discipline, termination, or retirement on the basis of gender, race, religion, age, disability, sexual orientation, nationality, political opinion, or social or ethnic origin.

Freedom of association and collective bargaining

Where right restricted by law, employer shall not seek state assistance to prevent workers exercising right to FoA.

Worldwide Responsible Apparel Production (WRAP) www.wrapapparel.org Minimum age: 14; or age for completing schooling; or minimum age established by law; whichever is greater. No harassment, abuse, or corporal punishment in any form.

No discrimination on the basis of personal characteristics or beliefs. Question about discrimination based on seniority.

Lawful right of free association, including right to join or not join association.

Workers Rights Consortium (WRC) www.workersrights.org Minimum age: 15; or 14 if consistent with ILO practices for developing countries. No employee shall be subject to any physical, sexual, psychological, or verbal harassment or abuse. No corporal punishment. No discrimination in employment, including hiring, salary, benefits, advancement, discipline, termination, or retirement on the basis of gender, race, religion, age, disability, sexual orientation, political opinion, or social or ethnic origin. No employee shall be subject to harassment, intimidation or retaliation in their efforts to freely associate.

Health and safety

Safe and healthy working environment required. Standard also applies to employer-operated facilities apart from production facilities (e.g. housing).

Wages

Local minimum wage or prevailing industry wage, whichever is higher, and legally mandated benefits. 48 hours per week and 12 hours overtime or the limits on regular and overtime hours allowed by the law of the country. One day off in every seven-day period.

Hours of work

Safe and healthy working environment required. If provided, housing should be clean and safe. Steps taken to prevent accidents and injury. Regular health and safety training. Legal or prevailing industry wage and meet basic needs/provide discretionary income. 48 hours per week and 12 hours overtime maximum. Personnel shall be provided with at least one day off in every seven-day period. All overtime work shall be reimbursed at a premium rate.

Sources: Organizational websites and Maquila Solidarity Network (2001b).

Safe and healthy working environment required. If provided, housing should be safe and healthy.

Safe and healthy working environment required.

Legal minimum wage.

Legal minimum wage and benefits. WRC code requires paying a ‘living wage’.

Shall not exceed the legal limitations of the countries in which apparel is produced. One day off in every seven-day period, except as required to meet urgent business needs.

Not be required to work more than the lesser of (a) 48 hours per week or (b) the limits on regular hours allowed by the law of the country of manufacture, and be entitled to at least one day off in every seven-day period as well as holidays and vacations.

Appendix B: The US Monitoring and Certification Systems

Scope Governance

Monitoring process

Fair Labor Association (FLA) www.fairlabor.org

Social Accountability International (SA8000) www.sa8000.org

Apparel and footwear companies. Licensees of affiliated universities. 12-member board with 6 industry reps., 5 NGOs, and 1 university rep.

Factories producing a wide range of products. Governing board has 5 members, composed of 1 rep. from Council on Economic Priorities (CEP), 3 lawyers, and 1 businessperson. SAI also has an advisory board with more diverse membership. Manufacturers or suppliers are granted the status of ‘applicants’ for 1 year until they are verified by an accredited Certification Auditor. The SA8000 Certificate must be renewed every 2 years. Specially trained local audit teams will be briefed by local NGOs and unions, speak to managers and workers and check the records of the factories. The SA8000 ‘guidance document’ is the SAI manual that assists the accredited auditors in fulfilling this task. The NGOs are also encouraged to undergo the process of becoming an accredited SAI auditor. Factories self-select for certification.

Companies must conduct internal monitoring of at least one-half of their applicable facilities during the first year, and all of their facilities during the second year. Companies commit to use independent external monitors accredited and selected by the FLA to conduct periodic inspections of at least 30% of their facilities during their initial 3-year participation period. Factories are selected by FLA staff, with a focus on the largest and those with greatest risk of noncompliance. All monitoring must involve consulting local NGOs. Monitors will use a combination of announced and unannounced visits.

Worldwide Responsible Apparel Production (WRAP) www.wrapapparel.org Apparel industry. Board of 3 officers and 8 directors form the Independent Certification Board. Primarily industry reps.

Factories must undergo a three-step process: Self Assessment, Independent Monitoring, and Final Review and Follow-up. Factories contract and schedule selected Independent Monitors to perform onsite evaluations. Based on this evaluation, the Independent Monitor will either recommend that the facility be certified or identify areas where corrective action must be taken before such a recommendation can be made. Factories self-select for certification.

Certification

FLA certifies an entire brand. A service mark will be developed so consumers know which companies are participating and which have met the standards for certification. Timely remediation, assessed by monitors and FLA staff, is required for certification.

Certification means that a facility has been examined in accordance with SAI auditing procedures and found to be in conformance. Auditors look for evidence of effective management systems and performance that prove compliance. Certified facilities are subject to semiannual surveillance audits.

Company requirements

Companies must implement the FLA Code; internally monitor every factory every year according to FLA monitoring principles; and participate in independent external monitoring every year. All internal and external monitoring must include local NGOs.

Manufacturers/suppliers adopt a program to pursue SA8000 certification. Retailers become ‘SA8000 Members’ and publicly announce their commitment to seek out socially responsible suppliers and assist suppliers in meeting the SA8000 social standards.

Reporting

All internal and external monitoring reports will be provided in full to the FLA staff. The FLA will evaluate audits, jointly develop remediation plans, and then publish summary reports of audit remediation results. Annual reports on each company based on internal and external monitoring. Participating companies are publicly listed on website. No disclosure of locations of certified factories.

Audit reports go to the companies and to SAI. Other parties can only receive them after having signed a confidentiality agreement with the company management and the audit company.

Public disclosure

Sources: Organizational websites and Maquila Solidarity Network (2001b).

The public is informed only of factories granted certification.

The WRAP Certification Board will review the documentation of compliance and decide on certification. The term of certification will be specified by the Board, based on criteria of risk factors. Over the term of the certification, the facility may or may not receive an unannounced inspection to verify continued compliance. Factories must meet WRAP Principles and bear all costs of certification. Factories must apply, be registered in the WRAP Certification Program, and perform self-assessment of its facility with the WRAP Handbook to determine if their facility complies with the WRAP Principles. Audit reports are provided to factories and the WRAP Board.

No public reporting. No mention of sites that receive, fail, or lose certification.

Dara O’Rourke

References Arthurs, H., ‘Reinventing Labor Law for the Global Economy: The Benjamin Aaron Lecture’, Berkeley Journal of Employment and Labor Law, 22/2 (2001), 271– 94. Ascoly, N., Oldenziel, J., and Zeldenrust, I., Overview of Recent Developments on Monitoring and Verification in the Garment and Sportswear Industry in Europe (Amsterdam: SOMO—Centre for Research on Multinational Corporations, May 2001). Ayres, I. and Braithwaite, J., Responsive Regulation: Transcending the Deregulation Debate (Oxford: Oxford University Press, 1992). Barenberg, M., ‘Toward a Democratic Model of Labor Monitoring: Two Case Studies’, Unpublished manuscript, (New York: Columbia Law School, 2003). Bartley, T., ‘The Professionalization of Scrutiny: The Rise of Labor-Standards Monitoring Organizations’, Paper presented at the American Sociological Association 2001 conference, Anaheim, CA, August 2001. Bendell, J., ‘Towards Participatory Workplace Appraisal: Report from a Focus Group of Women Banana Workers’, Occasional Paper, New Academy of Business, September 2001. Benjamin, M., ‘What’s Fair about the Fair Labor Association (FLA)?’, Sweatshop Watch. Available at www.sweatshopwatch.org/swatch/headlines/1998/gex_fla. html, 1998. Bernstein, A., ‘Do-It-Yourself Labor Standards: While the WTO Dickers, Companies are Writing the Rules’, Business Week (November 19, 2001). Block, R., Roberts, K., Ozeki, C., and Roomkin, M., ‘Models of International Labor Standards’, Industrial Relations, 40/2 (April 2001), 258–92. Braithwaite, J. and Drahos, P., Global Business Regulation (Cambridge: Cambridge University Press, 2000). Brown, G., Maquiladora Health and Safety Support Network Newsletter (Berkeley, CA, Fall 2001). Brown Daily Herald, ‘Nike Refuses to Comply with WRC, Cancels U. Contract’, April 3, 2000. Cashore, B., ‘Legitimacy and the Privatization of Environmental Governance: How Non State Market-Driven (NSMD) Governance Systems Gain Rule Making Authority’, Governance. 15/4 (October, 2002), 503–52. Chan, A., China’s Workers Under Assault—The Exploitation of Labor in a Globalizing Economy (Armonk, NY: M.E. Sharpe, 2001). Clean Clothes Campaign Newsletter. Multiple issues. Available on the web at http://www.cleanclothes.org/, 2001. Compa, L., ‘Wary Allies’, The American Prospect, 12/12 (July 2, 2001). Hinchliffe-Darricarrere, T., ‘Enforcing International Labor Rights Through Corporate Codes of Conduct’, 33 Columbia Journal of Transnational Law, 663 (1995).

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Bringing in Social Actors Connor, T., ‘Thoughts on Monitoring Codes of Conduct’, Email to the Nike International List, on file with the author (September 25, 2001a). ‘Still Waiting for Nike to Do It: Nike’s Labor Practices in the Three Years Since CEO Phil Knight’s Speech to the National Press Club’ (San Francisco, CA: Global Exchange). Available at www.globalexchange.org/economy/corporations/nike/, 2001b. Cutler, C., Haufler, V., and Porter, T., Private Authority in International Politics (Albany, NY: SUNY Press, 1999). Diller, J., ‘A Social Conscience in the Global Marketplace? Labour Dimensions of Codes of Conduct, Social Labeling, and Investor Initiatives’, International Labour Review, 138/2 (1999), 99–129. Douglas, W., Who’s Who in Codes of Conduct. New Economy Information Service. Available at www.newecon.org/global/trade/CodesofConductDouglas-0102-01.html#enforcing, 2001. Elliott, K. and Freeman, R., ‘White Hats or Don Quixotes? Human Rights Vigilantes in the Global Economy’, NBER Working Paper No. W8102, January 2001. Esbenshade, J., ‘Globalization and Resistance in the Apparel Industry: The Struggle over Monitoring’, Paper presented at the American Sociological Association, Washington, DC, 2000. ‘The Social Accountability Contract: Private Monitoring from Los Angeles to the Global Apparel Industry’, Labor Studies Journal, 26/1 (Spring, 2001), 98–120. Ethical Trading Initiative (ETI), Learning Our Trade, Annual Review 2000–01, London, 2001. Evans, P., ‘The Eclipse of the State? Reflections on Stateness in an Era of Globalization’, World Politics, 50/1 (1997), 62–87. Fair Labor Association (FLA), ‘New Changes to Increase the Transparency, Independence, and Scope of the FLA’, Press release, April 28, 2002. Frenkel, S. and Scott, D., ‘Compliance, Collaboration and Codes of Labor Practice: The Adidas Connection’, Draft paper, March 28, 2002. Gereffi, G., Garcia-Johnson, R., and Sasser, E., ‘The NGO-Industrial Complex’, Foreign Policy (July–August 2001), 56–65. Herrnstadt, O., ‘Voluntary Corporate Codes of Conduct: What’s Missing’, The Labor Lawyer, 16 (2001), 349–70. Hughes, S. and Wilkinson, R., ‘International Labour Standards and World Trade: No Role for the World Trade Organization?’, New Political Economy, 3 (1998), 375–89. International Labor Affairs Bureau (ILAB), The Apparel Industry and Codes of Conduct: A Solution to the International Child Labor Problem (Washington, DC: US Department of Labor, 1996). International Labour Organization (ILO), ‘Overview of Global Developments and Office Activities Concerning Codes of Conduct, Social Labelling, and Other Private Sector Initiatives Addressing Labour Issues’, Geneva, ILO, Papers of the Governing Body, 273, November 1998.

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Dara O’Rourke Jeffcott, B. and Yanz, L., ‘Voluntary Codes of Conduct: Do They Strengthen or Undermine Government Regulation and Worker Organizing’, Maquila Solidarity Network, October 18, 1999. ‘Shopping for the Right Code: What’s to be Gained from Codes of Conduct’, in R. Thamotheram (ed.), Visions of Ethical Sourcing (London: Financial Times Prentice-Hall, 2000). Justice, D., ‘The New Codes of Conduct and the Social Partners’, International Confederation of Free Trade Unions. Available at www.icftu.org/, 2001. Kearney, N., Letter to the Editor, Financial Times, London, January 31, 2000. Knill, C. and Lehmkuhl, D., ‘Private Actors and the State: Internationalization and Changing Patterns of Governance’, Governance, 15/1 (2002), 44–63. LARIC, ‘No Illusions: Against the Global Cosmetic SA8000’, Hong Kong: Labor Rights in China, June 1999. Lee, E., ‘Globalization and Labour Standards: A Review of Issues’, International Labour Review, 136/2 (Summer, 1997), 173–89. Lipschutz, R., ‘Regulation for the Rest of Us? Global Civil Society, Social Regulation, and National Impacts’, Paper prepared for workshop on Human Rights and Globalization, UC-Santa Cruz, December 1–2, 2000. Liubicic, R., ‘Corporate Codes of Conduct and Product Labeling Schemes: The Limits and Possibilities of Promoting International Labor Rights Through Private Initiatives’, Law and Policy in International Business, 30/1 (1998), 111– 58. Maitland, A., ‘Sewing a Seam of Worker Democracy in China’, Financial Times, London, December 11, 2002. Maquila Solidarity Network, The Changing Terrain in the Codes of Conduct Debate. Available at www.maquilasolidarity.org/resources/codes/, 2001a. Codes Update, issues number 3–9. Available at www.maquilasolidarity.org/ resources/codes/, 2001b. Codes Memo Number 16. Available at: www.maquilasolidarity.org/resources/ codes/, 2004. Maskus, K., ‘Should Core Labor Standards Be Imposed Through International Trade Policy’, World Bank Development Research Group, Policy Research Working Paper No. 1817, 1997. McCubbins, M. and Schwartz, T., ‘Congressional Oversight Overlooked: Police Patrols versus Fire Alarms’, American Journal of Political Science, 28 (1984), 165– 79. Nadvi, K. and Wältring, F., ‘Making Sense of Global Standards’, Draft IDS-INEP Working paper, Sussex: Institute for Development Studies, 2001. Organisation for Economic Cooperation and Development (OECD), Guidelines for Multinational Enterprises, Annex 1 to the Declaration on International Investment and Multinational Enterprises (Paris: OECD, 1991). Codes of Corporate Conduct: An Inventory (Paris: Trade Directorate, 1999).

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Bringing in Social Actors O’Rourke, D., ‘Monitoring the Monitors: A Critique of Corporate Third-Party Labor Monitoring’, in R. Jenkins, R. Pearson, and G. Seyfang (eds), Corporate Responsibility and Ethical Trade: Codes of Conduct in the Global Economy (London: Earthscan, 2002). Pearson, R. and Seyfang, G., ‘Codes of Conduct as Enclave Social Policy’, in R. Jenkins, R. Pearson, and G. Seyfang (eds), Corporate Responsibility and Ethical Trade: Codes of Conduct in the Global Economy (London: Earthscan, 2002). Posner, M. and Nolan, J. ‘Can Codes of Conduct Play a Role in Promoting Workers Rights?’, Paper presented at the Stanford Law School Conference on International Labor Standards, May 21, 2002. Quinteros, C., ‘Independent Monitoring Seen from the Central American Region’, Paper prepared for the SOMO Conference: From Codes to Compliance, Brussels, October 2–3, 2001. Reinicke, W., Global Public Policy: Governing without Government? (Washington, DC: Brookings Institution Press, 1998). Rock, Michael, ‘Public Disclosure of the Sweatshop Practices of American Multinational Garment/Shoe Makers/Retailers: Impacts on Their Stock Prices’, Technical Paper No. 252, Washington, DC, Economic Policy Institute, 2001. Rodriguez-Garavito, C., ‘Global Governance and Labor Rights: Codes of Conduct and Anti-Sweatshop Struggles in Global Apparel Factories in Mexico and Guatemala’, Politics Society, 33/2 (June 2005), 203–333. Ross, R., ‘Sweatshop Police’, The Nation, September 3, 2001, 6–7. Schmidt, V., ‘The New World Order Incorporated: The Rise of Business and the Decline of the Nation State’, Daedalus, 124/2 (1995), 75–106. Strange, S., The Retreat of the State (Cambridge: Cambridge University Press, 1996). Szudy, B., O’Rourke, D., and Brown, G., ‘Developing an Action-Based Health and Safety Training Project in Southern China’, International Journal of Occupational and Environmental Health, 9/4 (October/December 2003), 357–67. Teubner, G., ‘Substantive and Reflexive Elements in Modern Law’, Law and Society Review, 17 (1983), 239. van Tulder, R. and Kolk, A., ‘Multinationality and Corporate Ethics: Codes of Conduct in the Sporting Goods Industry’, Journal of International Business Studies, 32/2 (2001), 267–83. Utting, P., ‘Regulating Business via Multistakeholder Initiatives. A Preliminary Assessment’, in NGLS/UNRISD, Voluntary Approaches to Corporate Responsibility: Readings and a Resource Guide, NGLS, Geneva, 2002. Varley, P. (ed.), The Sweatshop Quandary: Corporate Responsibility on the Global Frontier (Washington, DC: The Investor Responsibility Research Center, 1998). Wach, H. and Nadvi, K., ‘Global Labour and Social Standards and their Implications for Developing Country Producers: A Bibliographic Overview’, Working paper, Sussex: Institute for Development Studies, 2000.

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6 Responsive Regulation and Developing Economies1 John Braithwaite

6.1. Introduction Responsive regulation is an approach designed in developed economies. 2 Most of the critiques of it are also framed within the context of developed economies. 3 This chapter explores the potential of responsive regulation in the context of weak states and struggling civil societies. It addresses the limitations of responsive regulation as a strategy in developing economies and poses some solutions to those limitations. First, it is argued that developing countries mostly have less regulatory capacity than developed ones. Yet herein also lies some of the potential of responsive regulation for developing countries as a strategy that mobilizes cheaper forms of social control than state command and control. Nevertheless, responsive regulation does require a big stick at the peak of an enforcement pyramid and big sticks are expensive, as well as demanding on state capacities in other ways. Two new strategies of networked governance are then developed for networking around these capacity deficits. One is based on pyramidal 1 I owe an unusually heavy debt in this work to four coauthors of mine. Ian Ayres, Peter Drahos, Brent Fisse, and Christine Parker have stimulated all the foundations on which this chapter is built. My thanks also to Cecily Stewart and Sascha Walkley for research assistance with a creative edge and to Hilary Charlesworth, David Graham, David Levi-Faur, Christine Parker, Rod Rhodes, Declan Roche, and Ngaire Woods for invaluable comments on an earlier draft. 2 Ayres and Braithwaite (1992). 3 Black (1997), Gunningham and Grabosky (1998), and Haines (1997), but see Haines (2003).

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escalation of network branching. The second is legislating for qui tam actions (bounty hunting by whistle blowers). When public enforcement fails to take charge, the qui tam alternative is private markets in bounty hunting where a whistle blower (usually someone at a senior level inside a law-breaking organization who knows what is going on) prosecutes and claims 25 percent of a regulatory penalty. Before considering responsiveness as an ideal for developing countries, the next section of the chapter considers responsiveness as a democratic ideal.

6.2. Responsiveness as a Democratic Ideal For Philip Selznick, 4 the challenge of responsiveness is ‘to maintain institutional integrity while taking into account new problems, new forces in the environment, new demands and expectations’. This means responsiveness becomes a democratic ideal—responding to peoples’ problems, environments, and demands: ‘responsiveness begins with outreach and empowerment . . . The vitality of a social order comes from below, that is, from the necessities of cooperation in everyday life.’ 5 Responsiveness means having respect for the integrity of practices and the autonomy of groups; responsiveness to ‘the complex texture of social life’. 6 Tom Paine in the Rights of Man and James Madison share with Selznick the project of conceiving empowered civic virtue as at least as important to democracy as constitutional checks and balances: ‘power should check power, not only in government but in society as a whole.’ 7 So, for example, business custom shapes responsive business regulatory law, and state regulators check abuse of power in business self-regulatory arrangements, and both should have their power checked by the vigilant oversight of NGOs and social movements. Developing countries mostly have less oversight by NGOs and social movements to mobilize, less state regulatory capability and less settled, less powerful, business custom, at least in the larger business sector. Restorative and responsive regulatory theory has evolved into a deliberative, circular theory of democratic accountability, as opposed to a hierarchical theory, where the ultimate guardians of the guardians are part of the state. 8 This ideal is for guardians of accountability to be organized in a circle where every guardian is holding everyone else in the circle accountable, where each organizational guardian holds itself internally 4 7

Selznick (1992: 336). Selznick (1992: 535).

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5 8

6 Selznick (1992: 465). Selznick (1992: 470). Braithwaite (2002, 2006) and Braithwaite and Roche (2000).

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accountable in deliberative circles of conversation and where such circles are widened when accountability fails. Circles of widening deliberative circles. Rules remain important under a restorative and responsive model of democratic accountability, but less important than under Dicey’s hierarchical accountability up to a sovereign parliament. Rules are just one of the things that emerge from the circled circles of deliberation. Another is the interpretation of rules—interpretation comes from circles of conversation, in which courts might be particularly influential, but where the interpretations that matter mostly do not come down from a court or a canonical papal interpretation of God’s will. In this regard, my conception of responsiveness differs from Gunther Teubner’s 9 reflexiveness and Niklas Luhmann’s autopoiesis. 10 I do not see law and business systems as normatively closed and cognitively open. In a society with a complex division of labor, the most fundamental reason social systems are not normatively closed is that people occupy multiple roles in multiple systems. A company director is also a mother, a local alderman, and a God-fearing woman. When she leaves the board meeting before a crucial vote to pick up her infant, her business behavior enacts normative commitments from the social system of the family; when she votes on the board in a way calculated to prevent defeat at the next Council election, she enacts in the business normative commitments to the political system; when she votes against a takeover of a casino because of her religious convictions, she enacts the normative commitments of her church. In extremis, wealthy business people sometimes dismantle their empires to give away their wealth for a charitable foundation. So much of the small and large stuff of organizational life makes a sociological nonsense of the notion that systems are normatively closed. Nor is it normatively desirable that they be normatively closed, as Christine Parker 11 has argued. Rather, there is virtue in the justice of the people and of their business organizations bubbling up into the justice of the law, and the justice of the law percolating down into the justice of the people and their commerce. That said, responsive and reflexive regulatory theories are mostly on the same wavelength. Teubner’s 12 regulatory trilemma is a real one. A law that goes against the grain of business culture risks irrelevance; a law that crushes normative systems that naturally emerge in business can destroy virtue; a law that lets business norms take it over can destroy its own 9 11

Teubner (1986). Parker (2002).

10 12

Teubner (1988). Teubner (1986).

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virtues. I am at one with Teubner in seeing it as essential to regulate by working with the grain of naturally occurring systems in business. 13 We agree that it is through the ‘structural coupling’ of reflexively related systems (or nodes of networked governance) 14 that the horns of the regulatory trilemma can be escaped. Abuse of power is best checked by a complex plurality of many separated powers—many semiautonomous nodes of networked governance. 15 All nodes of separated private, public, or hybrid governance need enough autonomy so that they cannot be dominated by other nodes of governance. Equally, each needs enough capacity to check abuse of power by other nodes so that a multiplicity of separated powers can network to check any node of power from dominating all the others. The required structural coupling among a rich plurality of separated powers is not only about checking abuse, it is also about enhancing the semiautonomous power of nodes of governance to be responsive to human needs. 16 Nodes of governance must not only check one another’s abuses, they must also assist with building one another’s capacity to responsively serve human needs, to have integrity in Selznick’s 17 terms. A regulatory node can do this, for example, through assisting to build the learning capacity of a business node to solve its environmental problems. The same idea is found in Habermas, 18 where on one hand he notes the dangers of law as ‘medium’ which colonizes the lifeworld, and on the other hand notes the virtues of law as ‘constitution’ which enables the lifeworld to more effectively deliberate solutions to problems that are responsive to citizens. Circled circles of guardians can include audit offices, ombudsmen, appellate courts, public service commissions, self-regulatory organizations, ministers, and NGOs. But again the deliberative capacities of all such kinds of actors tend to be less in developing economies. Responsiveness is enabled by a society with a strong state, strong markets, and strong civil society, where the strength of each institution enables the governance capabilities of the other institutions. 19 Developing countries have weaker markets that hold back the development of state capacity and a weaker state that holds back the development of all other institutions, 20 including the institutions of civil society that can compensate for the failures of states. 13 15 16 19

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14 Braithwaite (2005a: ch. 13). Drahos (2004). Braithwaite (1997: 311–13) and Braithwaite (2005b). 17 Teubner (1986: 316–18). Selznick (1992). 20 Braithwaite (1998). Evans (1995).

18

Habermas (1987).


From a responsiveness perspective, it follows that economies with developed, well-funded institutions of guardianship enjoy a richer democracy than do nations that cannot afford them. On the other hand, responsive regulatory theory offers a more useful theory of ‘what is to be done’ in developing countries than statist theories. If we believe that democracy is fundamentally an attribute of states, when we live in a tyrannous state or a state with limited effective capacity to govern, we are disabled from building democracy—we are simply shot when we try to, or we waste our breath demanding state responses that it does not have the capacity to provide. But when our vision of democracy is messy—of circles of deliberative circles—there are many kinds of circles we can join that we believe actually matter in building democracy. Democracy is then not something we lobby for as a distant utopia wherein the tyrant is displaced by free elections, democracy is something we start building as soon as we join the NGO, practice responsively as a lawyer, establish business selfregulatory responses to demands from environmental groups, deliberate about working conditions with our employees or employers, educate our children to be democratic citizens, participate in a global conversation on the Internet, and so on.

6.3. Responsiveness as an Effectiveness Ideal The basic idea of responsive regulation is that governments should be responsive to the conduct of those they seek to regulate in deciding whether a more or less interventionist response is needed. 21 In particular, law enforcers should be responsive to how effectively citizens or corporations are regulating themselves before deciding whether to escalate intervention. The most distinctive part of responsive regulation is the regulatory pyramid. It is an attempt to solve the puzzle of when to punish and when to persuade. At the base of the pyramid is the most deliberative approach we can craft for securing compliance with a just law. Of course, if it is a law of doubtful justice, we can expect the dialogue to be mainly about the justice of the law (and this is a good thing from a democratic perspective). As we move up the pyramid, more and more demanding interventions in peoples’ lives are involved. The idea of the pyramid is that our presumption should always be to start at the base of the pyramid first. Then escalate to somewhat punitive approaches only reluctantly and 21

Ayres and Braithwaite (1992).

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only when dialogue fails. Then escalate to even more punitive approaches only when the more modest forms of punishment fail. The crucial point is that it is a dynamic model. It is not about specifying in advance which are the types of matters that should be dealt with at the base of the pyramid, which are the more serious ones that should be in the middle, and which are the most egregious ones for the peak of the pyramid. Even with the most serious matters—flouting legal obligations to operate a nuclear power plant safely that risks thousands of lives—we stick with the presumption that it is better to start with dialogue at the base of the pyramid. 22 A presumption means that however serious the lawbreaking, our normal response is to try dialogue first for dealing with it, to only override this presumption if there are compelling reasons for doing so. As we move up the pyramid in response to a failure to elicit reform and repair, we often reach the point where finally reform and repair are forthcoming. At that point responsive regulation means that we put escalation up the pyramid into reverse and de-escalate down the pyramid. The pyramid is firm yet forgiving in its demands for compliance. Reform must be rewarded just as recalcitrant refusal to reform will ultimately be punished. Responsive regulation has been an influential policy idea because it comes up with a way of reconciling the clear empirical evidence that sometimes punishment works and sometimes it backfires, and likewise with persuasion. 23 The pyramidal presumption of persuasion gives the cheaper and more respectful option a chance to work first. The more costly punitive attempts at control are thus held in reserve for the cases where persuasion fails. When persuasion does fail, the most common reason is that a business actor is being a rational calculator about the likely costs of law enforcement compared with the gains from breaking the law. Escalation through progressively more deterrent penalties will often take the rational calculator up to the point where it will become rational to comply. Quite often, however, business regulators find that they try dialogue and restorative justice and it fails; they try escalating up through more and more punitive options and they all fail to deter. Perhaps the most common reason in business regulation for repeated failure of restorative justice and deterrence is that noncompliance is neither about a lack of goodwill to comply nor about rational calculation to cheat. It is about management not having the competence to comply. The manager of the nuclear power plant simply does not have the engineering know-how to 22

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See Rees (1994).

23

Braithwaite (1985) and Ayres and Braithwaite (1992).

Responsive Regulation and Developing Economies Assumption Incompetent or irrational actor

Rational actor

Virtuous actor

Incapacitation

Deterrence

Restorative justice

Figure 6.1. Toward an integration of restorative, deterrent, and incapacitative justice

take on a level of responsibility this demanding. He must be moved from the job. Indeed, if the entire management system of a company is not up to the task, the company must lose its license to operate a nuclear power plant. So when deterrence fails, the idea of the pyramid is that incapacitation is the next port of call (see Figure 6.1). This design responds to the fact that restorative justice, deterrence, and incapacitation are all limited and flawed theories of compliance. What the pyramid does is cover the weaknesses of one theory with the strengths of another. The ordering of strategies in the pyramid is not just about putting the less costly, less coercive, and more respectful options lower down in order to save money. It is also that by only resorting to more dominating, less respectful forms of social control when more dialogic forms have been tried first, coercive control comes to be seen as more legitimate. When regulation is seen as more legitimate, more procedurally fair, compliance with the law is more likely. 24 Astute business regulators often set up this legitimacy explicitly. During a restorative justice dialogue over an offense, the inspector will say there will be no penalty this time, but that she hopes the manager understands that if she returns and finds the company has slipped back out of compliance again, under the rules she will have no choice but to shut down the production line. When the manager responds yes this is understood, a future sanction will likely be

24

Tyler (1990), Tyler and Dawes (1993), Tyler and Blader (2000), and Tyler and Huo (2001).

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viewed as fair. Under this theory, therefore, privileging restorative justice at the base of the pyramid builds legitimacy and therefore compliance. There is also a rational choice account of why the pyramid works. System capacity overload 25 results in a pretence of consistent law enforcement where in practice enforcement is spread around thinly and weakly. Unfortunately, this problem will be at its worst where lawbreaking is worst. Hardened offenders learn that the odds of serious punishment are low for any particular infraction. Tools like tax audits that are supposed to be about deterrence are frequently exercises that backfire by teaching hardened tax cheats just how much they are capable of getting away with. 26 The reluctance to escalate under the responsive pyramid model means that enforcement has the virtue of being highly selective in a principled way. Moreover, the display of the pyramid itself channels the rational actor down to the base of the pyramid. Noncompliance comes to be seen (accurately) as a slippery slope that will inexorably lead to a sticky end. In effect what the pyramid does is solve the system capacity problem with punishment, by making punishment cheap. The pyramid says unless you punish yourself for lawbreaking through an agreed action plan near the base of the pyramid, we will punish you much more severely higher up the pyramid (and we stand ready to go as high as we have to). So it is cheaper for the rational company to punish themselves (as by agreeing to payouts to victims, community service, and paying for new corporate compliance systems). Once the pyramid accomplishes a world where most punishment is self-punishment, there is no longer a crisis of the state’s capacity to deliver punishment where it is needed. One of the messages the pyramid gives is that ‘if you keep breaking the law it is going to be cheap for us to hurt you because you are going to help us hurt you’. 27 This feature of the theory of responsive regulation is attractive for developing countries. Precisely because responsive regulation deals with the fact that no government has the capacity to enforce all laws, it is useful for thinking about regulation in developing countries with weak enforcement capabilities. Yes certain minimum capacities must be acquired, but then the theory shows how such limited capacity might be focused and leveraged. Paternoster and Simpson’s 28 research on intentions to commit four types of corporate crime by MBA students reveals the inefficiency of going straight to a deterrence strategy. Paternoster and Simpson found that 25 27

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26 Pontell (1978). Kinsey (1986: 416). 28 Ayres and Braithwaite (1992: ch. 2). Paternoster and Simpson (1996).


where the MBAs held personal moral codes, these were more important than rational calculations of sanction threats in predicting compliance (though the latter were important too). It follows that for the majority of these future business leaders, appeals to business ethics (as by confronting them with the consequences for the victims of corporate crime) will work better than sanction threats. So it is best to try such ethical appeals first and then escalate to deterrence for that minority for whom deterrence works better than ethical appeals. Because states are at great risk of capture and corruption by business, even greater risk where regulatory bureaucrats are poor, Ayres and Braithwaite 29 argue for the central importance of third parties, particularly NGOs, to be directly involved in regulatory enforcement oversight. But NGOs do more than just check capture of state regulators; they also directly regulate business themselves, through naming and shaming, restorative justice, consumer boycotts, strikes, and litigation they run themselves. Responsive regulation comes to conceive of NGOs as fundamentally important regulators in their own right, just as businesses are important as regulators as well as regulatees. 30 Pyramid design is a creative, deliberative activity. Stakeholders can design pyramids of actual sanctions like a ‘warning letter’ or ‘civil penalty’. Or they can design a pyramid of regulatory strategies—for example, try regulation by the price mechanism of the free market first, then try industry self-regulation, then a carbon tax regime, and then a command and control regime that permits license revocation for power plants that fail to meet pollution reduction targets. Regulators that think responsively tend to design very different kinds of pyramids for different kinds of problems—for example, the Australian Taxation Office has a different kind of pyramid for responding to transfer pricing by multinational companies than it deploys with the same companies when they ‘defer, delay, and deny’ access to company records. 31 As with responsiveness as a democratic ideal, so with responsiveness as an effectiveness ideal, the theory appears to be one where developing countries are less likely than wealthy states to enjoy the conditions to make it work. Not only are state regulatory bureaucrats more vulnerable to corruption because of their poverty, NGOs have fewer resources to do the oversight to guard against this than do NGOs in rich nations. More fundamentally, weaker states lack the organizational capacity to 29 30 31

Ayres and Braithwaite (1992: ch. 3). See also Gunningham and Grabosky (1998) and Parker (2002). Braithwaite (2005a: part II).

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be responsive. They have fewer regulatory staff and less educated staff to come to grips with the more reflexive approach of responsive regulation. Perhaps factory inspectors in weak states do have the capacity for some of the more important kinds of command and control regulation, such as ensuring that hazardous machinery is guarded, but they are less likely to have the analytic resources to assess a ‘safety case’—an occupational health and safety self-regulatory plan. Developing country tax officials might do quite well at taxing immobile assets like land, but may not have enough highly educated staff to implement responsive regulatory strategies that states like Australia can use against international profit shifting to recover a billion dollars in avoided tax for every million dollars spent on the enforcement. 32 Empirical studies of developing states show great variation in state capacity. 33 While in general Peter Evans 34 does not find the problem of developing economies as too much bureaucracy, but of not enough, he discerns huge differences between predatory states like Mobutu’s Zaire where bureaucratic competence is systematically destroyed, developmental states such as Korea where it is nourished, and in-between states such as India and Brazil where state capacity in the early 1990s was uneven, but where bureaucratic learning and construction of state capacity did occur.

6.4. Networking Around Capacity Deficits Braithwaite and Drahos 35 concluded from their interview-based research that the most important regulators of corporate fraud and accounting standards in developing economies were the major global accounting firms. In comparison, developing country corporations and securities regulators mostly have very limited standard setting capability, let alone enforcement capability. Professions and other nonstate gatekeepers did more of the regulating of business in what are today developed economies as we go back through their histories to when they were developing economies. Even in the USA we only need to go back to the 1920s for a pre-SEC world where accountants and private partnerships called stock exchanges did all the work that mattered in the regulation of corporations, securities, and accounting standards. 36 Until quite late in the 32

33 Braithwaite (2005a: ch. 6). See, for example, Evans (1995) and Kohli (2004). 35 Evans (1995: 12–70). Braithwaite and Drahos (2000). 36 McCraw (1984); on the history of the legal profession as a regulatory partner of the US state, see Halliday (1987). 34

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twentieth century, the city of London flourished through a gentlemen’s club model of regulation, where accounting standards that entered commerce through the accounting profession were internalized by ‘decent chaps’ who learnt the standards they had to meet to avoid being ostracized to the margins of the City’s circles of gentlemen. 37 Arguably it was only in the twentieth century that the Bank of England became a more important prudential regulator than the Rothschilds, that JP Morgan ceased being the most important prudential regulator in the USA. 38 Many decades after the West’s Industrial Revolution began, we see very different ways in different metropoles that regulation is networked by a plurality of private, professional, and state actors. Only slowly after the New Deal do we see the transformation of regulatory thinking to the ideal of a state regulator being ultimately in charge of a regulatory domain. No sooner had this transformation been consolidated when what some like to refer to as a postregulatory state 39 began to develop—a social order where regulation pluralizes again as NGOs find new capacities and competition policy drives professions to innovate into new markets in regulatory evasion and new markets in private regulation of such evasion (‘markets in vice, markets in virtue’). 40 Law firms that specialize in product liability litigation become important new regulators of business, NGO environmental regulators form partnerships with retailers to regulate the certification of forest products or the certification of coffee as organically grown. 41 Transparency International regulates corruption through publicizing where high levels of corruption prevail, as do ethical investment funds and their analysts. New kinds of ratings agencies like Reputex rate corporate social responsibility. 42 Indeed, the older ratings agencies like Moody’s and Standard & Poor’s are becoming increasingly important regulatory threats to businesses with major environmental and ethical risks to their operations that can peg back their credit rating. Finally, international regulators such as the Basle Committee, environmental treaty secretariats, and the International Telecommunications Union become increasingly important. Braithwaite and Drahos 43 conclude that in shipping regulation and some other domains, the era when state regulators are more in charge than private regulators, such as Lloyd’s of London, and global ones, such as the International Maritime Organization, is 37

38 Clarke (1986) and Moran (2003). Braithwaite and Drahos (2000: ch. 8). Teubner (1986) and Scott (2004). Obviously, I am uncomfortable about the concept of the postregulatory state because I think that for most of human history a large part of the regulation that matters most has not been undertaken by states. 40 41 Braithwaite (2005a). Courville (2003). 42 43 Reputation Measurement (2003). Braithwaite and Drahos (2000). 39

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John Braithwaite Network partner Network partner

Network partner

Network partner

Network partner

Network partner

Network partner

Networked regulation plus-plus Networked regulation plus

Network partner

Network partner

Networked regulation

Network partner

Network partner

Network partner

Self-regulation

Figure 6.2. A responsive regulatory pyramid for a developing economy to escalate the networking of regulatory governance

remarkably short. Anne-Marie Slaughter 44 sees regulation as the area where transgovernmental networks become preeminently important as fonts of governance. Like Slaughter, 45 Castells, 46 Drahos, 47 Rhodes, 48 and others, I have become persuaded that we live in an era of networked governance. An implication of this is that developing countries might jump over their regulatory state era and move straight to the regulatory society era of networked governance. Developing states might therefore cope with their capacity problem for making responsive regulation work by escalating less in terms of state intervention and more in terms of escalating state networking with nonstate regulators. Figure 6.2 represents this idea; it comes from Peter Drahos’s 49 insight that networked governance could be of service to responsive global regulation that works better for developing countries. At the base of the pyramid, the developing state relies on business self-regulation. When self-regulation fails, it networks two other nonstate regulators. When that fails, it networks two more, and so on. 44 47 49

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Slaughter (2004). Drahos (2004). Drahos (2004).

45 48

46 Slaughter (2004). Castells (2000a, 2000b, 2000c). Rhodes (1997) and Bevir and Rhodes (2003).


In Figure 6.2, the developing state enrolls 50 more and more NGOs, industry association co-regulators, professions, other gatekeepers, and international organizations to its regulatory project. In addition to such nonstate actors, it might also enroll other states as regulators within its own boundaries. For example, an Indonesian state with weak capacity to control people smuggling businesses that move desperate people from states such as Afghanistan on boats that stop in Indonesia (often in transit to Australia) enrolls the regulatory and intelligence capabilities of officers of the Australian state based in Indonesia. In some domains of regulatory enforcement, such as that against pirating of intellectual property rights, developing states rely less on state regulators than on foreign enforcers with an interest in the enforcement. In many developing country capitals, the most powerful regulatory agency in town has a red and white striped flag out the front. This kind of regulation is not enacted by a monolithic foreign state, but by functionaries of specific agencies that are part of the same transgovernmental network as the domestic state regulator. Slaughter 51 explains that contemporary state power is disaggregated into the hands of distinct regulators and then re-aggregated into transgovernmental networks. The police attaché in a foreign embassy may have more allegiance to some of the domestic police she works with than to her own nation’s ambassador. She may share more secrets with her police network than she would ever share with her ostensible boss, the ambassador. In extremis, she might even do things like conspire within a transnational policing and security network in assassination plots aimed at major transnational criminals in circumstances where the ambassador would view this as abhorrent and unauthorized. While Slaughter goes too far in conceiving the networks that matter in regulatory space as fundamentally transgovernmental, as opposed to networks of private and public regulators, she might concede that there are some developing countries where the most effective regulator of corporate abuses of human rights is an NGO. This is especially likely in one of Peter Evan’s ‘predatory states’ that mostly has little interest in securing human rights. One reason that the domestic NGO can be the more potent human rights regulator than the domestic state is that, unlike its state, this NGO is interested in networking with an international NGO that has people on the ground like Human Rights Watch, with UN Human Rights agencies, with the woman in the US Embassy with a watching brief on human rights, investigative journalists, and so on. Figure 6.3 50

Latour (1986).

51

Slaughter (2004).

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Human Rights Watch

UN Human Rights agencies

Amnesty International

Investigative journalist

EU Embassy

Networked naming and shaming plus

US Embassy

Networked naming and shaming

Human Rights Watch

US Embassy

Naming and shaming of human rights abuses by domestic NGO

Human rights self-regulation

Figure 6.3. Regulatory pyramid for a developing country human rights NGO seeking to escalate networked regulation for human rights

represents the responsive regulatory strategizing such an NGO might do to enforce human rights norms. Note that in Figure 6.3 the NGO as regulator can be conceived as either a regulator of business human rights abuses, or as a regulator of states— either for their failure to regulate corporate human rights abuses or for the state’s own abuses. There is, of course, still a capacity problem in the fact that Figure 6.3 imagines developing country NGOs as initiators of responsive regulation when we know that NGOs are thinner on the ground than they are in developed economies and more poorly resourced. On the other hand, the evidence is that while NGOs are growing fast in both the developed and developing world, the growth rate is fastest in the developing world. 52 Second, the growth of international NGO presence on the ground in developing countries has been considerable in recent decades. Hence, where there is no local human rights NGO, or where 52

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Commission on Global Governance (1995: 33).


all its key players have been murdered, Human Rights Watch might step in to network the naming and shaming, networking with investigative journalists, and to nurture the creation of new domestic human rights NGOs. Either way, it is the networking of responsive escalation that is advanced as a path around the developing economy’s capacity problem for enforcing standards. Obviously, existing networks of governance in many developing countries are more oriented to crushing human rights than to enhancing them. Extant networks of global governance are more oriented to advancing the interests of the G7 and the European Union (EU) than those of developing nations. Even within developed economies, networked NGO power or the networked governance capabilities of state regulators is often miniscule compared with networked corporate power. But the question of interest here is how a developing nation’s regulators, or NGOs with the interests of the poor at heart, might act in such a world of networked governance where extant networking favors the rich and the abusers of human rights. The answer proffered is to network. It is that weaker actors can become stronger by networking with other weaker actors. Beyond that, Braithwaite and Drahos 53 show that the interests of the strong are not monolithic, that the weak can often enroll the power of one strong actor against another. The human rights or environmental NGO can enroll the clout of the EU against the behavior of the USA or its corporations in developing economies, or the USA can be enrolled against the EU. 54 In a world of networked power, however much or little power you have, the prescription for potency is not to sit around waiting for your own power to grow (by acquiring more wealth or more guns, for example). Rather, the prescription is to actively network with those with power you do not yourself control. Clearly, responsively escalating networked regulation is something states can do by enrolling NGOs, and NGOs can do by enrolling state agencies of different kinds. Business actors, like accounting firms regulating corporate accounting standards, can also responsively escalate networked regulation by enrolling state agencies and NGOs. Networked governance is about the observation that all these kinds of actors do interact in networks and do enroll one another, sometimes in conflicting projects, sometimes in synergy. Figure 6.4 shows a network of governance actors of these different kinds, where only two of the actors—X and Y—have a sufficiently nodal set of ties to mount a pyramid of escalating networked 53

Braithwaite and Drahos (2000).

54

See, e.g., Braithwaite and Drahos (2000: 264–7).

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John Braithwaite Nodal actor X escalating networked regulation

X Escalates networking

Nodal actor Y escalating networked regulation

Y Escalates networking

X Networks

Y Networks

X Regulates

Y Regulates

X

Y

Network partners (actors)

Partner enrolled into network

Networked relationship

Partner enrolled into networked escalation

Figure 6.4. A network of governance in which just two nodal actors have a capacity to escalate networked regulation

regulation. The other actors in the network do not have enough links to enroll the networked escalation required for responsive regulation. In Figure 6.4, where X and Y have a shared regulatory objective— say improving the integrity of accounting standards or anticorruption measures in a developing country—the synergies between their regulatory pyramids create the potential for considerable regulatory potency. This potency is based on a redundancy where the weaknesses of a state regulator may be compensated by the strengths of NGO or business regulators. The concomitant danger is that the very sharing of the regulatory objective by the only actors with the capability to escalate networked regulation means that their convergent power may be unchecked. 55 If the consensual synergies among different pro-regulation constituencies are excessively hand in glove, overregulation is a risk. In developing economies the greater risk is the reverse: big business networked with ruling families dominates an antiregulation consensus 55 Rod Rhodes made the following insightful comment on an earlier draft of this chapter: ‘I worry policy networks are a form of political oligopoly. They privilege some interests and specifically exclude others. Moreover, they colonize specific policy arenas. So there is no competition/regulation within either a network or an arena, only between networks, and that is restricted because their interests are often too confined to one arena and do not span them.’ I am indebted to Rod Rhodes for stimulating the reflections in this paragraph.

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lubricated by bribery and extortion. The civic republican ideal 56 is that pro-regulation and antiregulation actors can both mobilize effective networked escalation as a check on domination by any one form of networked power. When fundamental labor rights are being crushed, the local trade union can escalate up to networked support from a state ministry of labor, the International Confederation of Free Trade Unions, the labor attaché at the US Embassy, the Campaign for Labor Rights, the Clean Clothes Campaign, or Oxfam International. When a firm is at risk of being driven out of business by unsustainable demands from a trade union with formidable ability to enroll political elites and industrial muscle, the firm can network escalated resistance from pro-business agencies of the state, industry associations, and the like. The republican ideal is that such contestation should occur to prevent domination; the responsive ideal is that it happens responsively. The combined ideal is that pyramidal escalation to contest domination drives contestation down to the deliberative base of the pyramid, so that regulation is conversational 57 rather than based on deterrence or incapacitation (see Figure 6.1). The capacity of the labor union to escalate to strikes, networked naming and shaming, and networked state enforcement drives the company down to restorative justice at the base of the pyramid. The capacity of the company to escalate to litigation or political pressure to halt the union’s tactics drives the union down to negotiated problem-solving at the base of the pyramid. Credible capacity of both sides to escalate in ways that threaten win–lose outcomes gives both the incentive to deliberate collaboratively in search of a win–win solution. Of course extant realities of power in any society are unprincipled, fraught with countless dominations of the weak by the strong. The perspective here does no more than supply a perspective on a direction to struggle and a way to struggle, however weak one’s constituency, for more principled checking of any and all abuses of power. The intersection of the theories of networked governance, responsive regulation, and republican separation of powers is a fruitful topic for more detailed research, especially for developing economies: ‘The more richly plural the separations into semi-autonomous powers, the more the dependence of each power on many other guardians of power will secure their independence from domination by one power.’ 58 Contrary to Montesquieu’s 59 clear conception of separation of public 56 58

57 Pettit (1997) and Braithwaite (1997, 1998). Black (1997). 59 Braithwaite (1997: 312). Montesquieu (1989).

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powers between executive, judiciary, and legislature, there is virtue in many unclear separations of public and private powers. This republican virtue is especially present where each separated power can enroll others through networks of governance. Regulators have powers separated between the public and the private, within the public and within the private sphere, where separations are many and transcend private–public divides. 60 Nodes of governance need to be sufficiently networked to be able to check the power of one node from dominating other nodes of governance. In developed economies, there is what some regulatory scholars call a dual economy 61 where very different regulatory strategies may be required with large businesses than with small and marginal businesses. In developing economies, we need to take this further down to a third village-level informal economy that is typically untaxed and almost entirely unregulated by the state. Village reputation networks often regulate this economy more effectively than the regulation of national companies and multinationals that congregate in the large cities. Village elders may have persuasive means of sitting down local traders in some sort of traditional restorative justice process when, for example, they cheat on weights and measures. This was also true for the eighteenth century informal ‘police’ of European towns and parishes that we see discussed in the writings of the likes of Adam Smith. 62 One policy option for rural areas of developing countries is to revert to something closer to the preindustrial ideal of policing, where a local constable (like a district officer in British colonial administration) was not a specialist in policing crime, but regulated business as well. In the Internet age, generalist police/regulatory constables could be paid and trained as parttime information points on what approaches a village court might take to dealing with environmental harm caused by a local business, for example. At the level of national companies in developing economies we hypothesize that national NGOs can sometimes network with state regulators to improve the responsiveness of regulation. And it is at the level of regulating Northern multinationals that it is hypothesized that international NGOs, disaggregated fractions of Northern states, and auditors from the multinational’s own corporate headquarters must be enrolled to the (much more difficult) regulatory challenge of exploitation by global corporations. 60

166

Braithwaite (1997).

61

Haines (1997).

62

Smith (1978).


6.5. Bounty Hunting Around Capacity Deficits In 2002, ranking US Republican on the Senate Finance Committee, Charles E. Grassley, called for public disclosure of corporate tax returns. 63 The call was motivated by the vast difference between the numbers in Enron and WorldCom’s tax returns and their financial statements to the stock exchange. The argument was that if investors had access to the tax return data, analysts might have detected the fraudulent books before the company went down. Canellos and Kleinbard 64 have argued that this would not work: What would be more useful for both tax auditors and investors would be to have access to a public book-tax reconciliation schedule, which would ‘provide a useful platform for highlighting transactions which are likely to involve manipulation for tax and accounting concepts’. Theodore Sims 65 suggested that making corporate returns available in a useful form on a web site would enable a system of rewards for private auditors (bounty hunters) who brought new tax shelters to light. To motivate private auditors to pick over corporate tax returns in search of shelters, Sims suggests a bounty of say 20 cents in every dollar recovered by the tax authority payable by the taxpayer to the private auditor on top of any other tax penalty. ‘The most effective way of channelling sufficient resources into prevention is to make it as profitable to police corporate shelters as it has obviously become to purvey them.’ 66 The idea is an old one that can be applied to all domains of regulation. 67 During the fourteenth and fifteenth centuries, when the English state was weak in its enforcement capability, qui tam suits were relied on heavily. 68 An offender against laws subject to qui tam could be compelled to pay half the penalty incurred to an informer. Abuses of private prosecutions became so rife that qui tam fell into disrepute and disuse. Five centuries later in the USA, Senator Grassley sponsored 1986 revisions to the False Claims Act that put qui tam on a more principled footing. 69 Since then, over US$12 billion, $2.1 billion in 2003, has been recovered in qui tam actions concerning false claims to the US government, mostly for defrauding federal health programs or the defense budget. 70 This 63

64 65 Stratton (2002: 220). Cannelos and Kleinbard (2002: 2). Sims (2002). Sims (2002: 736): on the effectiveness of private bounties for detecting corporate wrongdoing generally, see Fisse and Braithwaite (1983: 251–4, 283). 67 Crumplar (1975). 68 The Latin ‘qui tam pro domino rege, quam pro se ipso in hac parte sequitur’ translates as ‘who as well for the king as for himself sues in this matter’. 69 Grassley (1998) and Department of Justice (2003). 70 Department of Justice (2003), www.falseclaimsactatpaceandrose.com 66

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historically recent American qui tam has proved less rife with abuse than its English precursor because the whistle blower against say a defense contractor who is fraudulently extracting payments from the Pentagon must first give the Department of Justice a chance to take over the action. If Justice wins, the whistle blower gets 15–25 percent of any settlement or judgment attributable to the fraud identified by the whistle blower. Justice decides to take on most of the meritorious False Claims Act actions because if the case is meritorious and Justice declines to take it over, the whistle blower’s legal team can still take a private action and win 30 percent of the penalty, leaving the revenue poorer and the Justice Department embarrassed by an error of judgment. On the other hand, legal counsel for a whistle blower with an unmeritorious case will counsel caution once the Department of Justice declines to take over the prosecution. Most whistle blowers who launch qui tam actions are middle managers or senior management from the corporation complained against. Hence, just as Slaughter’s transgovernmental networks disaggregated states, qui tam disaggregates corporations, turning one part of a corporation (the whistle blower cum bounty hunter) against lawbreaking parts of the same organization. Qui tam in effect networks whistle blowers with law firms, state regulators, and prosecutors, extending the intelligence, evidence-gathering, and litigation capabilities of the state in big, difficult cases. The reason qui tam was invented in fourteenth-century England was to compensate for weakness in state regulatory capacity. The 1863 False Claims Act was first introduced by a Lincoln administration in the USA that had little federal prosecutorial capacity to go after fraudulent overbilling of the Union Army. Across the globe today it still might be true that where state capacity is weakest the case for reliance on qui tam is strongest. Obversely, where state regulatory capacity is strong, private prosecution to fill gaps left gaping by failed public enforcement is less critical. In this sense, qui tam in the USA should be a least likely case of qui tam adding value. 71 That it clearly has added value there in the context of False Claims Act enforcement 72 should give hope that qui tam might prove valuable in weak states where opportunities for bounty hunting are more plentiful. On the other hand, if the court system and justice bureaucracy themselves in a developing country are so inefficient or corrupt that they cannot cope with surges of qui tam actions, then these greater opportunities may simply not be practically available to be seized. Even in such 71

168

Eckstein (1975).

72

Department of Justice (2003) and Grassley (1998).


circumstances, a strategy that can rely on private resources to do much of the justice bureaucracy’s work for it has more prospects than reliance on a wholly public process. The new Grassley proposals on making corporate tax returns more effectively public on the Internet so that a private tax auditing industry might emerge need not depend on courts. It could work by practitioners in this new private market in tax virtue taking the finding of their private analysis to the public tax authority. If the tax authority administratively assesses an extra $10 million in tax that the corporation voluntarily pays or settles (which is what normally happens) then the private tax auditor might win her $2 million qui tam payout without going near a courthouse. Note also how the private auditor can help make responsive regulation work by being a check on corrupt tax officers, prosecutors, and other officials. 73 When the corrupt official reaches a cosy settlement with the corporation that fails to collect the tax owed, the private auditor has an interest in exposing this to his administrative and political masters who have an interest in higher tax collections, and to the courts if necessary, in order to collect the full bounty owed to the private auditor. Enforcement of labor standards is another area where qui tam has been advocated. 74 Private prosecutions by trade unions for underpayment of wages, where the union could collect 30 percent of the penalty imposed on the company, would mostly work by threatening the private prosecution in order to trigger settlement negotiations, while rarely in practice having to rely on an overburdened court system. If the international trade union movement managed to get this kind of private enforcement capability implemented in developing countries through Free Trade Agreements, the ILO, and WTO negotiations, they could also be used by MSIs for global labor rights, of the kind discussed in O’Rourke’s chapter in this volume. The idea would be that an organization like the FLA would threaten qui tam actions against both developing country manufacturers who breach the labor laws of that country and the multinationals behind the brand who benefit from those breaches. Because globally strategic qui tam test case litigation might be self-funding, a credible new lever for the weak to negotiate settlements of underpaid wages and other labor rights might be created. Networking with lawyers who specialize in qui tam actions against multinational companies would be networking with lawyers who in some cases could mount actions in foreign courts against multinationals, 73

See Ayres and Braithwaite (1992: ch. 3).

74

Braithwaite (2004).

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thereby obviating the need to rely on courts in the poor country. While it is unimaginable that False Claims statutes to compensate developing states could be enforced in Western courts, in tort cases like the Bhopal chemical pollution disaster in India and the litigation against BHP 75 by Papua New Guinea villagers over the destroying of their livelihoods by the pollution of the Fly River, globally networked law firms have had major impacts on multinationals.

6.6. Conclusion We have argued that developing economies are more lacking in all the capacities necessary to make responsive regulation work well than are wealthy societies. In attempting to lay a foundation for policy ideas to compensate for this, this chapter overgeneralizes these deficits. Some larger developing societies such as India have strong democratic states with substantial, sophisticated bureaucracies, and courts. Many ‘failed states’ such as Afghanistan are strong societies with formidable regulatory capacities in civil society through institutions such as jirga. 76 Whatever the level of these deficits, in an era of networked governance, weaker actors can enroll stronger ones to their projects if they are clever. Anne-Marie Slaughter’s 77 work suggests that the globe is strewn with disaggregated bits of strong states that might be enrolled by weak ones (and by weak NGOs). The developing country civil aviation regulator can enroll the US Federal Aviation Administration to stand up to an airline that flouts safety standards in the developing country; the developing country health regulator can enroll the FDA to audit the unsafe clinical trials on a new drug being conducted on its people. Developing country NGOs may be weak, but are becoming stronger both in their own right and in their capacity to enroll Northern NGOs and international regulatory organizations into projects to compensate for the weak regulatory capacities of developing states. Responsive escalation up a regulatory pyramid can hence be accomplished not only by escalating state intervention, but also as Peter Drahos 78 has suggested, by escalating the networking of new tentacles of domestic and transnational governance. The core idea of responsive regulation as a strategy actually has special salience for resource-poor states. This is the idea that no regulator has the resources to consistently enforce the law across the board and therefore limited 75 78

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Now BHP Billiton. Drahos (2004).

76

Wardak (2004).

77

Slaughter (2004).


enforcement resources need to be focused at the peak of an enforcement pyramid. Networking escalation is an interesting elaboration of how to make the most of limited regulatory capacity. Finally, we have seen that mobilizing public virtue to regulate private vice is not the only path around capacity deficits. Private markets in virtue can also be mobilized to regulate vice, indeed to flip markets in vice to markets in virtue. 79 One example is enabling bounty hunting by privatized tax auditors through making crucial information on corporate tax returns public on the Internet. Another is the kind of qui tam actions under the False Claims Act that have significantly cleaned up the US defense contracting industry since 1986. Where state capacity is weakest, both qui tam and responsive escalation via networking with progressively more private and public enforcers should pay the highest dividends. Moreover, networking regulatory partnerships also structurally reduces the benefits of capture and corruption in those developing economies that are endemically prone to corruption. Responsive regulation is a worrying strategy in corrupt societies because it puts more discretion in the hands of regulatory bureaucrats who can use that discretion to increase the returns to corruption. Both the strategies of networking around state incapacity and mobilizing private markets for enforcing virtue have the attractive feature of exposing and preventing regulatory corruption.

References Ayres, Ian and John Braithwaite (1992). Responsive Regulation: Transcending the Deregulation Debate. New York: Oxford University Press. Bevir, M. and Rhodes, R. (2003). Interpreting British Governance. London: Routledge. Black, Julia (1997). Rules and Regulators. Oxford: Oxford University Press. Braithwaite, John (1985). To Punish or Persuade: Enforcement of Coal Mine Safety. Albany, NY: State University of New York Press. (1997). ‘On Speaking Softly and Carrying Sticks: Neglected Dimensions of Republican Separation of Powers’, University of Toronto Law Journal, 47: 1–57. (1998). ‘Institutionalizing Trust: Enculturating Distrust’, in V. Braithwaite and M. Levi (eds), Trust and Governance. New York: Russell Sage. (2002). Restorative Justice and Responsive Regulation. New York: Oxford University Press. (2004). ‘Thinking Laterally: Restorative and Responsive Regulation of OHS’, in E. Bluff, N. Gunningham and R. Johnstone (eds), OHS Regulation for a Changing World of Work. Sydney: Federation Press, 194–208. 79

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John Braithwaite Braithwaite, John (2005a). Markets in Vice, Markets in Virtue. New York and Sydney: Oxford and Federation Press. (2005b). ‘Contestatory Citizenship: Deliberative Denizenship’, in M. Smith (ed.), Pettit Book. New York: Oxford University Press. (2006). ‘Accountability and Responsibility Through Restorative Justice’, in M. Dowdle (ed.), Public Accountability: Designs, Dilemmas and Experiences. Cambridge: Cambridge University Press. Peter Drahos (2000). Global Business Regulation. Melbourne: Cambridge University Press. Declan Roche (2000). ‘Responsibility and Restorative Justice’, in M. Schiff and G. Bazemore (eds), Restorative Community Justice. Cincinnati, OH: Anderson. Cannelos, Peter C. and Edward D. Kleinbard (2002). Disclosing Book-Tax Differences. Available at www.tax.org/readingsintaxpolicy.nsf/ Castells, Manuel (2000a). The Information Age: Economy, Society and Culture, Volume 1: The Rise of The Network Society. Oxford: Blackwell. (2000b). The Information Age: Economy, Society and Culture, Volume II: The Power of Identity. Oxford: Blackwell. (2000c). The Information Age: Economy, Society and Culture, Volume III: End of Millenium. Oxford: Blackwell. Clarke, Michael (1986). Regulating the City: Competition, Scandal and Reform. Milton Keynes, UK: Open University Press. Commission on Global Governance (1995). Our Global Neighbourhood: The Report of the Commission on Global Governance. Oxford: Oxford University Press. Courville, Sasha (2003). ‘Social Accountability Audits: Challenging or Defending Democratic Governance?’, Law and Policy, 25: 269–98. Crumplar, Thomas C. (1975). ‘An Alternative to Public and Victim Enforcement of the Federal Securities and Antitrust Laws: Citizen Enforcement’, Harvard Journal on Legislation, 13: 76–124. Department of Justice (2003). ‘Justice Department Civil Fraud Recoveries Total $2.1 Billion for FU 2003 False Claims Act Recoveries Exceed $12 Billion Since 1986’, Department of Justice, Washington, DC. Available at http://www.usdoj.gov/opa/pr/2003/November/03_civ_613.htm Drahos, Peter (2004). ‘Towards an International Framework for the Protection of Traditional Group Knowledge and Practice’. Draft paper prepared for the Commonwealth Secretariat. Eckstein, Harry (1975). ‘Case Study and Theory in Political Science’, in F. Greenstein and N. Polsby (eds), Handbook of Political Science, Vol. 7: Strategies of Enquiry. Reading, MA: Addison-Wesley. Evans, Peter (1995). Embedded Autonomy: States and Industrial Transformation. Princeton, NJ: Princeton University Press. Fisse, Brent and John Braithwaite (1983). The Impact of Publicity on Corporate Offenders. Albany, NY: State University of New York Press.

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Responsive Regulation and Developing Economies Grassley, Senator Chuck (1998). Floor Statement of Senator Chuck Grassley: A Historical Treatise on the False Claims Act, July 8, 1998. Available at http://grassley.senate.gov/releases/1998/p8r07-07.htm Gunningham, Neil and Peter Grabosky (1998). Smart Regulation: Designing Environmental Policy. Oxford: Clarendon Press. Habermas, Jurgen (1987). The Theory of Communicative Action: Volume 2: Lifeworld and System: A Critique of Functionalist Reason. Boston, MA: Beacon Press. Haines, Fiona (1997). Corporate Regulation: Beyond ‘Punish or Persuade’. Oxford: Clarendon Press. (2003). ‘Regulatory Reform in Light of Regulatory Character: Assessing Industrial Safety Change in the Aftermath of the Kader Toy Factory Fire in Bangkok, Thailand’, Social and Legal Studies, 12: 461–86. Halliday, Terrence (1987). Beyond Monopoly: Lawyers, State Crises, and Professional Empowerment. Chicago, IL: University of Chicago Press. Kinsey, Karyl A. (1986). ‘Theories and Models of Tax Cheating’, Criminal Justice Abstracts, September: 402–25. Kohli, Atul (2004). State-Directed Development: Political Power and Industrialization in the Global Periphery. Cambridge: Cambridge University Press. Latour, Bruno (1986). ‘The Powers of Association’, in John Law (ed.), Power, Action and Belief: A New Sociology of Knowledge? Sociological Review Monograph 32. London, Boston, MA and Henley, UK: Routledge and Kegan Paul. McCraw, T. (1984). Prophets of Regulation. Cambridge, MA: Harvard University Press. Montesquieu, C. de Secondat (1989). The Spirit of the Laws, A. M. Cohler and B. C. Miller (trans. and eds). Cambridge: Cambridge University Press. Moran, Michael (2003). The British Regulatory State: High Modernism and HyperInnovation. Oxford: Oxford University Press. Parker, Christine (2002). The Open Corporation. Melbourne: Cambridge University Press. Paternoster, Raymond and Sally Simpson (1996). ‘Sanction Threats and Appeals to Morality: Testing a Rational Choice Model of Corporate Crime’, Law and Society Review, 30: 549–83. Pettit, P. (1997). Republicanism: A Theory of Freedom and Government. Oxford, Oxford University Press. Rees, J. (1994). Hostages of Each Other: The Transformation of Nuclear Safety Since Three Mile Island. Chicago: University of Chicago Press. Pontell, Henry (1978). ‘Deterrence: Theory Versus Practice’, Criminology, 16: 3–22. Reputation Measurement (2003). RepuTex Report 2003. Melbourne: Reputation Measurement. Rhodes, R. (1997). Understanding Governance. Buckingham, UK and Philadelphia, PA: Open University Press. Scott, Colin (2004). ‘Regulation in the Age of Governance: The Rise of the PostRegulatory State’, in J. Jordana and D. Levi-Faur (eds), The Politics of Regulation:

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John Braithwaite Institutions and Regulatory Reforms for the Age of Governance. Cheltenham, UK: Edward Elgar. Selznick, Philip (1992). The Moral Commonwealth: Social Theory and the Promise of Community. Berkeley, CA: University of California Press. Sims, Theodore S. (2002). ‘Corporate Returns: Beyond Disclosure’, Tax Notes, July 29: 735–7. Slaughter, Anne-Marie (2004). A New World Order. Princeton, NJ: Princeton University Press. Smith, Adam (1978). Lectures on Jurisprudence, ed. R. L. Meek, D. D. Raphael, and P. G. Stein. Oxford: Clarendon Press. Stratton, Sheryl (2002). ‘Closing the Credibility Gap by Disclosing Corporate Returns’, The Insurance Tax Review, 23: 220–1. Teubner, G. (1986). ‘After Legal Instrumentalism: Strategic Models of PostRegulatory Law’, in G. Teubner (ed.), Dilemmas of Law in the Welfare State. Berlin: Walter de Gruyter. (ed.). (1988). Autopoietic Law: A New Approach to Law and Society. Berlin: Walter de Gruyter. Tyler, Tom (1990). Why People Obey the Law. New Haven, CT: Yale University Press. Steven Blader (2000). Cooperation in Groups: Procedural Justice, Social Identity, and Behavioral Engagement. Philadelphia, PA: Psychology Press. Robyn M. Dawes (1993). ‘Fairness in Groups: Comparing the Self-Interest and Social Identity Perspectives’, in Barbara A. Mellers and Jonathan Baron (eds), Psychological Perspectives on Justice: Theory and Applications, Cambridge: Cambridge University Press. Yuen J. Huo (2001). Trust and the Rule of Law: A Law-Abidingness Model of Social Control. New York: Russel Sage. Wardak, Ali (2004). ‘Building a Post-War Justice System in Afghanistan’, Crime, Law and Social Change, 41: 319–41.

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7 Using International Institutions to Enhance Self-Regulation: The Case of Labor Rights in Cambodia Sandra Polaski

7.1. Introduction The small and recently war-torn Southeast Asian nation of Cambodia has been the unlikely setting for a path-breaking and successful international policy experiment over the past seven years. The project centers on an effort to improve labor conditions in the factories of Cambodia’s apparel sector, the key source of national exports. The ILO, an international public agency, conducts ongoing monitoring of conditions in the factories. 1 The results are published in highly transparent reports that detail compliance or noncompliance by each of the factories with national labor laws and internationally agreed basic labor rights. 2 Until the end of 2004, these reports were used by the US government as a key input for decisions under an innovative scheme that allowed increased access to the US market in response to improved working conditions and labor practices. A further element of the experiment that was largely unanticipated but has proven critical to its ongoing success is the use of the ILO reports by private retail apparel firms that buy from Cambodian producers. These 1

The ILO is a specialized agency of the UN system. The member states of the ILO, currently 178 nations, have agreed that all workers have certain fundamental rights, regardless of the level of development of their country. These include the right to freedom of association and collective bargaining, freedom from forced labor, restrictions on employment of children and elimination of the worst forms of child labor, and freedom from discrimination in employment. ILO Declaration on Fundamental Principles and Rights at Work, Geneva, June 1998. Available at www.ilo.org 2

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buyers, conscious of their brand reputations, use the reports to determine whether their supplier firms comply with labor standards, to encourage remediation of problems, and to shift orders in some cases. The project combines roles for national governments, international organizations, and local actors in previously untried ways. The experiment warrants attention by policymakers elsewhere for two reasons. First, it introduces novel and needed policy tools into the arena of global regulation and self-regulation of private sector actors. These new elements now have established a record of effectiveness that can be examined. Second, the project relies on a combination of voluntary corporate selfregulation with limited but essential public interventions. The public interventions—at both national and international levels—corrected deficiencies that typically arise in purely voluntary corporate self-regulation. The resulting system changed the incentives facing private actors, effectively aligning their interests more closely with public objectives. As policymakers search for effective ways to improve the public role in global regulation and to realize more of the potential of private self-regulatory efforts, the Cambodia experiment offers new and successful methods that can be replicated, as well as important analytical lessons.

7.2. Genesis of the Project Cambodia is one of the least developed countries in the world. It entered the modern global economy late, partly because of civil strife from the 1960s through the 1980s. As the country stabilized in the 1990s, it sought to play catch up in its economic development. One important strategy aimed to transform a handful of state-owned textile and apparel factories into an export industry, to attract new foreign direct investment into the apparel sector, to earn foreign exchange, and to create new jobs for the underemployed Cambodian workforce. The apparel industry requires relatively low levels of investment and limited skills on the part of workers. It is typically the first step in the process of industrialization and Cambodia was eager to take it. The global apparel trading system was governed for forty years by a system of quotas that set limits on the textile and apparel products from any one country that can be sold in large, affluent markets like those of the USA and the EU. 3 The quota system was codified in the Agreement on 3 The quota system dates back to the 1960s and reflected the fact that these industries were important sources of exports, income, and jobs in many countries, both rich and poor.

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Textiles and Clothing of the WTO, in force until January 2005. 4 Because Cambodia was a latecomer to the apparel industry, it was not party to that system and therefore had no quotas. It was free to sell into the US and EU markets, but at the same time those countries were free to limit or cut off access at will in the absence of negotiated agreements. Notwithstanding that risk, willing investors from Taiwan, China, South Korea, and other East Asian countries bought, leased, or built apparel factories in Cambodia. Buyers from the USA and Europe also arrived, in part to circumvent the export limits they faced when purchasing from other countries under the global quota system. The infant apparel industry grew rapidly. From virtually no apparel exports in 1994, exports had grown to almost half a billion dollars in value by 1998. 5 The share going to the USA increased rapidly, to the point that in 1998 the domestic US textile and apparel industries called for import restraints. The US government concurred and initiated negotiations with Cambodia to bring it under the quota system. Meanwhile in Cambodia, the burgeoning workforce in the apparel factories became increasingly discontent with conditions. The workers turned for help to labor unions, many affiliated with political parties. Demonstrations and strikes became increasingly common. In June 1998, supportive labor groups in the USA petitioned the US government to review claimed abuses of workers’ rights in Cambodia’s apparel factories. These converging issues formed the backdrop for the quota negotiations. They came at a time when the US government was increasingly interested in linking trade privileges with support for labor rights. 6 US and Cambodian negotiators worked out a three-year apparel trade agreement for the period 1999–2001 that established quota limits on the twelve largest categories of apparel exports. However, in a unique step, they agreed that if the Cambodian government were able to ensure substantial To address concerns of domestic industries and workers in rich countries, while allowing poor countries to grow out of poverty, successive international agreements were negotiated over several decades that allocated shares of guaranteed access to rich country markets. As developing countries’ capacity grew, they began to push for a phaseout of the system, and this was finally agreed in the negotiations that created the WTO in 1995. The quota system was phased out over ten years and completely eliminated on January 1, 2005. 4 The Agreement on Textiles and Clothing succeeded the Multi-Fibre Arrangement or MFA in 1995. 5 ‘Cambodia: Selected Issues and Statistical Appendix’, IMF Country Report No. 03/59, International Monetary Fund, Washington, DC, March 2003, 9. 6 Polaski, Sandra, ‘Protecting Labor Rights through Trade Agreements: An Analytical Guide’, Journal of International Law and Policy, 10/1 (Fall 2003), 14.

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compliance by the apparel factories with national labor laws and internationally agreed labor rights, the new quotas would be increased on an annual basis. 7 The parties agreed to consult twice each year during the three-year agreement to identify the key challenges involved in meeting that overall goal. These consultations established practical goals for each semi-annual period, which were used as benchmarks to determine whether to grant the quota increase for the subsequent year. Both parties recognized that a reliable source of information on the actual practices and conditions in the factories would be needed for the quota determination. The capacity of the Cambodian government to inspect private firms and enforce national labor laws was extremely weak. It was tacitly acknowledged that reporting by government inspectors was not credible as a basis for the quota decisions. Alternatively, private for-profit and not-for-profit monitoring groups existed, but none were deemed to have the credibility to provide the basis for significant government decisions that would have broad economic impacts. To fill the gap, the two countries turned to the ILO, which is the arm of the UN system assigned responsibility for setting international labor standards and supervising compliance. The ILO had an elaborate, if bureaucratic, supervisory system that was oriented toward reviewing the conduct of governments, both through periodic examinations of their compliance with ratified labor conventions and in response to complaints raised by labor unions and others. 8 The organization had never monitored the private sector and had never engaged in on-the-ground inspection of workplaces. The request from the USA and Cambodia to take up a new role evoked a cautious response from the Director General of the organization, Juan Somavia, and provoked debate within the ILO bureaucracy and governing body. 9 After a deliberative process, Somavia decided that the ILO should support a project that was seen to have value by the member states involved and that had the backing of both employers and labor unions in the target country. 10 7 US–Cambodia Bilateral Textile Agreement, available at http://199.88.185.106/tcc/data/ commerce_html/TCC_2/Cambodiatextilebilat.html 8 See ILO website, www.ilo.org 9 The ILO is governed by a unique structure that includes the governments of the 178 member countries (controlling half of the votes in decisions), employers’ organizations (one quarter of votes), and labor unions (one quarter of votes). 10 Conversation with the author, Geneva, Switzerland, January 19, 2000. See also Elliott, Kimberly Ann and Richard B. Freeman, Can Labor Standards Improve under Globalization? Washington, DC: Institute for International Economics, June 2003, 117.

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7.3. Key Mechanisms of the Project Two of the fundamental mechanisms on which the project is based have been identified: the creation of a trade agreement that provides positive market access incentives as a reward for improved labor conditions; and the inauguration of a new oversight role in international governance for an international agency. These innovations are highly significant new policy instruments that are now available as options for policymakers elsewhere and therefore deserve a fuller exposition here. The idea of linking trade privileges and labor rights had been discussed since at least the early twentieth century, but the first practical applications date from the mid-1980s. 11 The first such instruments to be created arose under a system of special trade preferences for developing countries. Wealthy nations are permitted to extend extra market access privileges unilaterally to such countries without violating international trade rules under the WTO that forbid discrimination among trading partners. In 1984, the USA made such additional trade privileges conditional on respect for labor rights by the developing country recipient. 12 In 1993, the USA included labor provisions in a negotiated free trade agreement, in the form of a side agreement to the North American Free Trade Agreement (NAFTA). 13 This pact included commitments by the trading partners to enforce their own labor laws, with the possibility of being fined or losing some of the trade benefits created by the pact if they failed to carry out that commitment. Both types of instruments linking trade and labor rights operated primarily as negative incentives, since trade privileges already granted could be withdrawn for a failure to comply with labor obligations. 14 The US– Cambodia textile agreement, by contrast, created a positive incentive that could be granted annually for progress in the previous period. This incentive had the potential to elicit ongoing improvements in performance in order to qualify for a greater quota bonus in the subsequent year. The effectiveness of the reward was enhanced by the close temporal 11

Polaski, op. cit., 13–15. Such programs are permitted under the Generalized System of Preferences (GSP) of the WTO. The EU also created a similar link between respect for labor rights and market access under its GSP programs. 13 The North American Agreement on Labor Cooperation (NAALC) agreed between Canada, Mexico, and the USA in August 1993. Available at www.naalc.org 14 Verma, Anil, ‘Global Labour Standards: Can We Get from Here to There?’, Centre for Industrial Relations and Rotman School of Management University of Toronto, December 2002. Available at: http://www.fu-berlin.de/iira2003/papers/track_3/Workshop_3_4_Verma. pdf 12

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connection between the behavior of firms and government in one year and the rewards that would flow from good behavior during the following year. As it turned out, the US government decided to award a 9 percent increase in quotas during 2000 and again in 2001. 15 The parties were pleased with their experiment and agreed to extend the trade pact for three additional years, from 2002 through 2004. Quota bonuses of 9, 12, and 18 percent were awarded for those years. The second innovative mechanism in the Cambodian experiment is the novel role for the ILO. To make the quota decisions, the USA needed credible and timely information on actual labor conditions in Cambodian apparel factories. The Cambodian government was not an effective source of such information. As noted above, Cambodia had been engaged in civil strife or outright war for much of the past thirty years, and is still struggling to establish full rule of law. The state is generally weak and faces severe resource constraints. Civil servants, including labor inspectors, are woefully underpaid. As a result, it is difficult to attract and retain competent inspectors. The average wage of a civil servant is the equivalent of US$28 per month. 16 By contrast, the minimum wage in the apparel industry in Cambodia is $45 per month, and average monthly wages in the sector are about $72. 17 By any account, the pay of government inspectors does not provide an acceptable minimum standard of living, and therefore second and third jobs that compete for inspectors’ time are the norm, not the exception. Taking bribes from employers is also common. Under these circumstances, the role of the national public authorities in inspecting workplaces and ensuring compliance with labor laws was a goal to be pursued over the medium term. It was not a reliable source of information for the immediate purposes of the textile agreement. At the same time, a growing apparel sector that created jobs and profits was part of the solution to the problem of government capacity, as it would increase the tax base and resources for essential government functions. So while building public capacity to enforce laws was desirable, a short-term solution was needed to fill the information gap. It was theoretically possible to engage private actors to monitor the worksites. Over the course of the 1990s, the creation of corporate codes of conduct and the need to monitor their implementation created a 15

Elliott and Freeman, op. cit., 117–18. IMF Country Report No. 03/59, op. cit., 27. 17 ILO, Better Factories Cambodia, ‘Cambodian Garment Industry: One Year Later’, May 31, 2006. Available at http://www.betterfactories.org 16

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body of experience among an array of private actors. They ranged from for-profit accounting organizations such as KPMG and PWC and specialized for-profit auditing groups like ITS, to nonprofit social auditing groups such as Verité and nonprofit multistakeholder groups like the ETI and SAI. However, none of these groups had established credibility at an international level and among the diverse groups affected by the textile agreement, including employers, investors, buyers, labor unions, and governments. The entire field of social auditing is still at an early, experimental stage with no clear leader or widely accepted methodology. In the absence of either national public capacity or satisfactory international private capacity, the two governments faced the necessity of finding an agent to supply a missing function: provision of internationally credible workplace inspection and information. Although the ILO lacked specific experience in factory monitoring, it possessed an established record of neutrality and expertise and was acceptable to all concerned parties. The ILO had been established by the Treaty of Versailles in 1919 and was the oldest agency in what would become the UN system. Over the years, it had gained extensive experience in evaluating labor rights in countries at all levels of development. As global economic integration accelerated in the 1990s, labor markets became increasingly integrated as well, causing greater competition between workers of different nations and greater scrutiny of labor conditions in distant workplaces. Rich country governments felt increasing pressure from constituents to maintain labor conditions and standards at home while improving them abroad. It was natural that government policymakers grappling for means to address the new challenges would turn to the ILO to play new roles. For most of the 1990s, however, the new roles envisioned were in the public sphere, and entailed functions such as technical assistance and capacity building for ministries of labor in the developing world. The unprecedented US–Cambodia agreement, with its requirement for reliable, timely, and credible information about actual factory conditions was a breakthrough that pushed the ILO to move beyond its traditional public sphere. Arguably, this foray into the private domain may prove to be a critical element of continued relevance for the ILO, as global production chains increasingly elude the control of national labor ministries and labor inspectorates. The experiment was put in place through two formal agreements: the textile agreement that began January 1, 1999, and an agreement between the ILO, the Cambodian government, and Cambodian garment 181

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manufacturers to launch the monitoring initiative, signed on May 4, 2000. 18 The two agreements operated independently, but in complementary ways. The potential quota bonus created an incentive for the Cambodian government and the factory owners to improve labor conditions in order to obtain economically valuable increases in access to the US market; and the ILO monitoring program provided critical information for the bonus decisions. However, there were shortcomings in the basic arrangement launched by the two agreements that might have greatly limited its effectiveness. A key shortcoming was that the ILO monitoring program, as created, provided for voluntary participation by factories. However, the quota bonus was awarded to the country as a whole, based on overall performance. The voluntary nature of participation meant that information would be incomplete, and perhaps unrepresentative, to the extent that factories chose not to participate. Further, it created a perverse incentive for firms to stay out of the monitoring program, because those factories that did participate would bear the burden of improvement while nonparticipating firms could share the increased bonus without the increased costs of better labor practices (a ‘freerider’ problem, in economic terms). The government of Cambodia recognized these distortions quickly, as they began to emerge. It stepped in to remedy the shortcoming in the plan design by issuing a regulation (‘prakas’) that limited the availability of export quota to the USA to those firms participating in the monitoring program. 19 This resulted in full participation and allowed the ILO monitors to generate information on the entire sector. The Cambodian government’s innovative action demonstrates that even a relatively weak and resource-constrained government can find ways to extend the effectiveness of self-regulation and move beyond voluntary compliance, by leveraging those instruments that it does control, such as export licensing and issuance of quotas. A second potential shortcoming was that the ILO monitoring program required reports on conditions in factories, but left unclear whether the information would be provided in aggregate form or would identify conditions in individual factories by name. As the monitoring program began, this issue remained unsettled. After discussions with the multiple stakeholders, the ILO decided to issue reports that aggregated results in the first instance. These ‘synthesis reports’ would give a profile of 18 Because of delays in launching the monitoring project, decisions on the quota increases for 2000 and 2001 were made without the benefit of information from the ILO monitoring project. 19 Prakas No. 108 MOC/M2001, Cambodian Ministry of Commerce, March 28, 2001.

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problems in the sector, without naming individual firms. However, after a period of time was allowed for remediation of any problems found, the ILO monitors would re-inspect each factory for compliance. Factories that had not remedied violations of national labor laws or international labor rights found on the first visit would be identified by name in a subsequent report. This decision established a level of transparency regarding factory conditions that was significantly higher than information provided by any private monitoring programs that currently exist. These two seemingly small public interventions, one by the Cambodian government to make participation in monitoring a requirement for receiving quota allotments, and the other by the ILO to provide full transparency of monitoring results, together created a situation that was unprecedented in the realm of global corporate self-regulation. Once the monitoring and reporting system became fully functional, the two interventions resulted in the provision of extensive, specific information to all actors regarding labor conditions and legal compliance in the entire Cambodian apparel sector. This transparency changed the incentives facing private actors, including both the factories producing garments and the international buyers. The latter now knew the full range of conditions in their existing supplier firms and all other garment firms in the country. 20 Under conditions of transparency, the factory owners now had multiple incentives to come into compliance with labor laws and improve working conditions. They stood to gain increased market access to the USA through the quota bonus system. They faced peer pressure from other firms, whose own quota bonus would be at risk if other factories failed to comply. Perhaps most importantly, international buyers who were concerned about working conditions and/or their brand reputations now were able to choose between supplier factories on the basis of good information about their labor practices. Good information is a prerequisite for any well-functioning market. 21 The Cambodia experiment marks the first time that credible information about labor conditions in a developing country’s workplaces has been widely accessible to both public and private actors at the local, national, and international levels. The experiment provides an unprecedented 20 Interviews with factory managers and buyers, reported in Kolben, Kevin, ‘Trade, Monitoring, and the ILO: Working to Improve Conditions in Cambodia’s Garment Factories’, Yale Human Rights & Development Law Journal, 7 (2004), 105–6. 21 The problem of imperfect information is a widely recognized impediment to wellfunctioning markets. See e.g. Joseph Stiglitz, ‘Information and the Change in the Paradigm in Economics’, in Tore Frangsmyr (ed.), The Nobel Prizes 2001 (Stockholm: The Nobel Foundation, 2002), pp. 472–540.

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opportunity to witness the effect on market participants’ behavior. As noted above, the first effect was to align the incentives facing private firms with Cambodia’s twin public objectives of achieving better labor conditions while winning more market access to the USA. A second effect, operating purely between private actors, was the shifting of orders to compliant firms. While the public incentive of quota increases was the more readily apparent, the private incentive for firms to improve their labor standards to attract reputation-conscious buyers was very significant as well, perhaps dominant in some cases. 22 This can be seen by examining the evolution of apparel exports over the period of the experiment. From 1999 through 2002, apparel exports from Cambodia to the USA of items that were covered by quota limits increased by 44.8 percent, from a value of US$433 million in 1999 to US$627 million in 2002. Over the same period, exports of garments that were not covered by the quotas increased by 302 percent, albeit from a smaller base of US$83 million in 1999 to US$334 million in 2002. 23 This pattern indicates that buyers were attracted to place orders with factories that were seen as compliant with labor norms even when they were making decisions on items that were not restricted by quota and thus would not benefit from the labor-based quota increases. Collectively, these buyer decisions shifted the composition of Cambodia’s apparel exports over the course of the experiment. In 1999, only 19 percent of exports were of nonquota items, while by 2002, 53 percent of exports were not under quotas. This experience led the Cambodian government and the country’s apparel manufacturers to conclude that the value of good labor standards and transparency would survive the end of the quota system. 24 In 2003, they asked the ILO to continue the monitoring program for another three years, beyond the end of the quota system. As the end of the quota system neared in 2004, the World Bank Group’s Foreign Investment Advisory Service (FIAS) conducted surveys among apparel buyers. These surveys revealed that buyers rated Cambodia’s labor standards higher than those of regional competitors, and that the buyers would continue to purchase garments from Cambodia if credible monitoring by the ILO were to continue. 25 After quotas ended on January 1, 2005, the Cambodian government and the ILO developed a long-term plan to 22

23 Kolben, op. cit., 106. IMF Country Report No. 03/59, op. cit., 9. Siphana, Sok, Secretary of State for Commerce, Royal Kingdom of Cambodia, speaking at the World Bank Group’s International Conference on Public Policy for Corporate Social Responsibility, Country Session 1, October 8, 2003. 25 World Bank, ‘Overseas Buyers Plan to Continue Purchasing Cambodian Garments after 31 December’, Press Release No. CMB2004/01, December 3, 2004. 24

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continue the monitoring program and eventually turn its operation over to an autonomous Cambodian monitoring organization. The current plan is to have a robust local organization that can maintain credibility with international actors in place by January 2009. The ILO will continue to supervise the monitoring project during a transition period through 2008, while building the capacity of a new Cambodian monitoring agency to assume responsibility thereafter. The project has been renamed ‘Better Factories Cambodia’ and expanded to include training for factories on how to achieve and maintain good labor standards. The results of ILO monitoring are now reported through a sophisticated Internet-based system that allows closer tracking of violations and improvements. 26 The Cambodian government ensured that the project will continue to operate on an industry-wide basis after the quotas expired by making continued participation in monitoring a condition for receiving export licenses. 27 The economic basis for this strategy can be understood as a risk mitigation or insurance function. The ILO monitoring and reporting system provides a form of reputation risk insurance to global apparel retailers who source their goods in Cambodia. While labor conditions are still far from perfect in the country’s apparel factories, as discussed below, ILO inspections reveal any serious abuses, allowing buyers to insist on rapid remediation or shift orders to other factories with better practices. The detailed ILO factory monitoring reports that form the basis of the public reports discussed above are provided to the individual factories soon after the monitoring visit, to allow them to begin remediation. Many buyers now routinely require their suppliers to share those reports when they are received, rather than waiting for the periodic public reports issued by the ILO. 28 Although most apparel buyers have their own internal codes of conduct and undertake factory compliance inspections themselves or contract with for-profit or not-for-profit monitoring agencies to do so, none of these efforts have the credibility of the ILO system. Purely self-regulatory schemes may assure buyers that their suppliers are not violating laws or codes of conduct, but they have little credibility with the public and other interested actors. The skepticism of these outside actors is founded on the 26 Agence France Presse, ‘Cambodia: UN Labour Body Expands Monitoring of Cambodia’s Garment Factories’, February 9, 2005. 27 ILO, Better Factories Cambodia, ‘About Better Factories’. Available at http:// www.betterfactories.org 28 Kolben, op. cit., 105–6.

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potential conflict of interest between the firm’s incentive to cut costs and its desire to avoid reputation risk. This perceived conflict of interest is compounded by the lack of transparency of private sector self-monitoring efforts, creating a potentially large credibility gap. A respected third party, such as the ILO, whose governance structure includes governments, worker representatives, and employer organizations, has interests in the monitoring process that broadly correspond to the combined interests of the workers, firms, and governments involved in the monitoring scheme. The high level of transparency that the ILO adopted in its reporting further enhances the credibility of results, because the specificity of the reports allows for challenges by any actors that hold information to the contrary. This operates as a reality check and reinforcement of the credibility of the ILO. It is hard to imagine a purely self-regulatory scheme that could achieve this level of credibility.

7.4. Results in the Factories The impact of the quota bonus and monitoring experiment has been positive for employment and working conditions in Cambodia’s apparel sector by many measures. 29 At the most basic level, the increases in quota and the sourcing decisions of reputation-conscious buyers have been key determinants of a very large increase in output and employment in the sector. In 1998, before the textile agreement took effect, apparel factories employed about 80,000 workers. By the middle of 2006, apparel employment stood at 293,000. 30 These jobs make up an important share of scarce formal sector employment and are among the highest paid jobs in the country for low skilled workers. The overwhelming majority of employees in the sector are young women. To put the desirability of these jobs in context, the minimum monthly wage in the sector (US$45) is greater than the entire average monthly household income in rural areas (US$40). 31 Average monthly apparel wages are about US$72. A second measure of the impact of the experiment can be found in the ILO monitoring reports. Sixteen reports had been issued by 29 e.g., an extensive list of positive results is included in a speech by Lorne W. Craner, US Assistant Secretary of State, ‘Corporate Social Responsibility at the State Department’, March 11, 2004. Available at http://www.state.gov/g/drl/rls/rm/30962.htm 30 Cambodia, National Institute of Statistics, 2006. 31 IMF Country Report No. 03/59, op. cit., 13.

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mid-2006. 32 Each report covers a group of factories that were visited by the ILO monitors. After the first visit, the details of compliance or noncompliance with each of 156 items on a checklist are reported for that group of factories, in an aggregated form. The ILO then allows those factories a period of several months for remediation of problems found, while it goes on to visit a different group of factories. Later, it revisits each group, noting which recommendations (called ‘suggestions’ in the ILO reports) have been acted on and which have not been remedied. In a subsequent report, the ILO publishes these findings, identifying by name each factory and whether it has complied with the suggestions or not. The reports show that on their first visit, ILO monitors typically found a mixed pattern of compliance and noncompliance by factories. 33 Compliance was good in two key areas of basic labor rights: there was little or no child labor and no forced labor. Gender discrimination was not a widespread problem in hiring or wages, however discrimination on the basis of pregnancy was fairly common and isolated instances of sexual harassment were found. Widespread problems were found in incorrect payment of wages and excessive hours or forced overtime. Violations of health and safety laws were common, including both minor and more serious infractions. Problems with freedom of association—the right to form unions and bargain collectively—were found in a relatively small number of factories, although the violations found were sometimes very serious. The pattern of initial findings was in itself somewhat encouraging. Before the advent of the ILO monitoring project, a British Broadcasting Corporation (BBC) program had interviewed two ostensibly underage workers in a factory that supplied apparel products to Nike. While many knowledgeable observers questioned the accuracy of the program, Nike ended its contracts with the factory and left Cambodia. After the ILO began its monitoring program and issued its first report, Nike returned to place orders in Cambodia and continues to do so. This demonstrates the value of the ILO’s credibility to global firms. Although Nike had internal monitoring mechanisms in place before the BBC report, the company knew that its own internal findings would not be sufficiently credible to counter the damaging report. The ILO’s findings, by contrast, command global respect.

32 ILO Synthesis Reports on the Working Conditions Situation in Cambodia’s Garment Sector. Available at: www.ilo.org/public/english/dialogue/ifpdial/publ/cambodia.htm 33 Ibid.

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The ILO monitors made detailed suggestions to each factory to correct the deficiencies that were identified. Factories were subsequently reinspected. At the first reinspection, monitors found that some progress had been made by the majority of factories in correcting the problems identified. Sixty-one percent had implemented between one-third and twothirds of the ILO’s suggested corrections, while an additional 8 percent of factories had implemented more than two-thirds of the recommendations. A small group of factories came into full compliance with the ILO recommendations. Due to the sheer volume of practices reviewed by the monitors (156 items are on their checklist) and the number of suggestions for improvement, it can be difficult to see the patterns in the ILO reports. Figure 7.1 is an attempt to quantify the results, through a schematic that groups the responsiveness of factories to ILO recommendations. The factories are sorted into four categories: those with relative few deficiencies on the first inspection (fewer than 20 of the 156 items required improvement), those with 20–39 deficiencies, and those with 40 or more deficiencies. For each group, the figure presents the percentage of problems that were corrected between the first and second visits (less than one-third, one-third to two-thirds, or greater than two-thirds of suggestions implemented). 50 Less than one-third of suggestions implemented∗

Number of factories

40

One-third to two-thirds of suggestions implemented∗

30

Greater than two-thirds of suggestions implemented∗

20 10 0

∗

< 20 Suggestions Total: 36 factories

20--39 Suggestions Total: 71 factories

> 40 Suggestions Total: 14 factories

Includes suggestions partly implemented and in the process of being implemented.

Figure 7.1. Reinspected factories: response to ILO suggestions Source: Tabulation of ILO Third, Fifth, and Eighth Synthesis Reports on the Working Conditions Situation in Cambodia’s Garment Sector.

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Using International Institutions Enhance to Self-Regulation 5 Not impl.

4.5

Partly impl.

Implemented

Avg. suggestions per firm

4 3.5 3 2.5 2 1.5 1 0.5 0 1st follow-up

2st follow-up

3rd follow-up

Figure 7.2. Incidence and remediation of wage problems Source: Tabulation of ILO First through Fifteenth Synthesis Reports on the Working Conditions Situation in Cambodia’s Garment Sector by Kristopher Nordstrom, Terry Sanford Institute of Public Policy, Duke University, April 2006.

As factories have been revisited in ensuing years, there has been a general declining trend in the number of problems found. In some important areas, such as wages, compliance with laws on minimum wage and other payments has improved considerably. Figure 7.2 summarizes reinspection results for wages. In the factories that had been inspected through October 2005, the number of violations found on each follow up visit declined. In addition to improvement in compliance with wage laws, the ILO reports show progress over time on freedom of association and collective bargaining. Other measures tend to confirm this. For example, while there were few examples of unions successfully establishing themselves in apparel factories before the US–Cambodia textile agreement and the ILO monitoring program began, by 2004 there were about 500 registered factory-level unions. 34 The monitoring reports also document some progress in health and safety, although few firms were in full compliance with the law and ILO suggestions. The ILO reports continue to provide a source of useful and reliable information both about initial conditions in the factories and progress 34 Raghwan, Raghwan, ‘Uncomfortable but Taking Part—Cambodia’s Unions and the PRSP’, in ILO (ed.), ‘Trade Unions and Poverty Reduction Strategies’, special issue of Labour Education, Vol. 2004/1–2, No. 134–5, 55–8. Available at http://www.ilo.org/public/english/ dialogue/actrav/publ/134/index.htm

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on remediation of problems. Although many problems remain, it is remarkable that so many factories have made rapid changes and corrections to practices that routinely confront apparel workers in many countries. The Cambodia experiment also gave rise to progress in the factories through channels other than the ILO monitoring program. Significant benefits arose from collaboration between the Cambodian and US governments to fill gaps in Cambodia’s regulatory regime that had hindered the implementation of labor laws. The Cambodian labor law, which was drafted with the assistance of the ILO and adopted in 1997, is a modern law incorporating all of the basic international norms. However, the law left many institutional and procedural lacunae that were meant to be filled in through regulations, known in Khmer as prakas. Few of these regulations had been enacted and the resulting procedural gaps included such basic matters as the method for a union to establish its status as the legitimate representative of workers in a factory and thus gain the legal right to engage in collective bargaining with the employer. Another missing regulation involved the creation of an arbitration council, which was foreseen in the law as a venue to resolve workplace disputes without the need for strikes and lockouts by private sector actors or for intervention by government inspectors and courts. These gaps came to be a major focus of the semiannual meetings between the Cambodian and the US governments. Progress on drafting and issuing the most critical prakas sometimes served as a benchmark to be used by the USA in judging whether to award a quota bonus. 35 In drafting the procedural regulations, the USA assisted the Cambodian government when invited to do so, and further help was sought from the ILO. Draft prakas were reviewed with employers’ organizations and trade unions for further modification before being enacted. Gradually, procedures were put in place that allowed for orderly determination of worker, union, and employer rights and obligations. 36 The arbitration council prakas was issued and the body was established with further assistance from the ILO. The arbitration council is now functioning and commands wide respect from employers, trade unions, and workers in the private sector. Two hundred and seventy-five cases had been filed 35 Public meetings between the US and Cambodian governments, June 4, 2001 and November 30, 2001, in which the author chaired the US government delegation. 36 e.g., Prakas No. 305 established procedures to determine the representation status of unions. Issued by MOSALVY (Cambodian Ministry of Social Affairs, ‘Labor, Vocational Training and Youth Rehabilitation’), November 22, 2001.

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with the council between its establishment in 2003 and mid-2006. 37 A digest published by the council after its first year of existence showed that 85 percent of the disputes had been resolved, either through awards or agreement. 38 Thus, the labor consultations mandated by the textile agreement provided an impetus and contributed to the articulation of procedures and institutions that extended the rule of law and dispute settlement in Cambodia. Large numbers of workers (and smaller numbers of managers) have now had the experience of peaceful settlement of disputes based on neutral interpretation of laws and contracts, as well as the more intangible but significant experience of participation in a rules based system that serves their interests. These mechanisms are likely to have positive spillover effects on the broader political system. Lessons from other developing countries suggest that nations that create institutions to successfully resolve distributional conflicts enjoy stronger and steadier growth than those that do not. 39

7.5. Benefits and Costs Some of the benefits of the quota bonus and monitoring experiment are direct, quantifiable, and substantial. The quota bonus itself constituted a clear benefit to the Cambodian government, apparel firms, and workers. For example, in 2002, the value of the quota bonus was US$56.4 million (calculated by multiplying the 9% quota bonus for that year times the share of exports under quota, valued at US$627 million). 40 By the same calculation, about 13,000 jobs were created by the increased exports that year, and workers earned total wages of US$9.5 million in those jobs. As the quota bonus grew to 12 percent in 2003 and 18 percent in 2004, the value to all parties increased dramatically. The earnings of apparel firms and workers also translated in increased tax revenue for the government. Beyond the quantifiable contribution of the quota bonuses, the risk mitigation that the labor practice and monitoring offered to buyers was also significant. The ILO monitoring program confers additional direct benefits to Cambodian apparel workers. They are now more likely to be paid the wages 37

See Arbitration Council website at http://www.arbitrationcouncil.org/eng_index.htm Ibid, see Digest #2 of 2004. 39 See e.g. Dani Rodrik, ‘Institutions for High-Quality Growth: What They Are and How to Acquire Them’, Studies in Comparative International Development, 35/3 (Fall 2000). 40 IMF Country Report No. 03/59, 9. 38

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to which they are entitled under law, to receive appropriate overtime pay and bonuses, to work in safer and healthier workplaces that pose less risk to their well-being, and to enjoy freedom of association, with the attendant possibility of increasing wages and benefits through their collective bargaining strength. 41 The costs of the program have been surprisingly modest. The initial three-year monitoring project was funded at US$1.4 million. The US and Cambodia governments contributed US$1 million and US$200,000, respectively, and the Garment Manufacturers Association of Cambodia contributed US$200,000. Spread over three years, with an average of 200,000 workers in the sector, the annual cost per worker was US$2.33 and the annual cost per factory was US$2,333. These costs compare very favorably to private monitoring schemes in the region, where the cost of factory inspections and certification that the factory conforms to a buyer’s code of conduct can range as high as $10,000. 42 The program has been cost effective primarily because of personnel costs. The project director and assistant director are hired by the ILO at competitive international salaries, reflecting substantial international experience and expertise. However, the twelve monitors are hired locally in Cambodia, at salaries that are attractive by Cambodian standards, but very economical by international standards. The director trains the local monitors and exercises oversight to ensure that the monitoring meets international norms. The local monitors are carefully selected and generally have been praised by all parties. 43 Because the monitors are paid at levels that are attractive in Cambodia, they are less vulnerable to the temptation to corruption faced by low-paid government labor inspectors. (In addition, all inspections are carried out by teams of two and the teams visiting particular factories are rotated to minimize the risk of bribes.) The structure of salaries in the project makes it possible to carry out activities at an internationally credible level of competence while paying most salaries at the local level. One reason for the high costs of many private monitoring programs is that auditors are typically 41

Elliott and Freeman, op. cit., 118. Nguyen, Manh Cuong, Deputy Director, International Cooperation Department, Ministry of Labor, Invalids and Social Affairs, Government of Viet Nam, speaking at the World Bank Group’s International Conference on Public Policy for Corporate Social Responsibility, Country Session 1, October 8, 2003. 43 International Labour Organization and US Department of Labor, Mid-term Evaluation Report of the project, ‘Ensuring that Working Conditions in the Textile and Apparel Sector in Cambodia Comply with Internationally-Recognized Core Labour Standards and the Cambodian Labour Law’, Phnom Penh, February 2003. 42

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paid at international salary or consultant levels and are often flown in for inspections from distant locations with attendant travel, housing, and per diem costs. The cost-effectiveness of the local hires is further enhanced by equally important nonmonetary contributions. The local hires speak Khmer and thus are able to communicate with both workers and employers. As local residents, they are well positioned to meet with workers and unions away from the workplace if necessary. By contrast, private auditors who are not locally based may have difficulty in communicating with workers and may not inspire their confidence, particularly if the only contact is in the workplace where workers may feel intimidated by their employers. A final benefit of this approach is that the locally hired monitors acquire important technical, process, and conflict management skills that add to the store of the society’s human capital. The distribution of costs of the Cambodia program was less than optimal until recently in one respect. International buyers, who gained substantial economic benefit from the project, did not contribute directly to the costs of the project. In effect, the project provided reputation insurance for the buyers, without requiring that they pay a premium. That deficiency is currently being addressed to some extent as major international buyers have begun to contribute modest sums to sustain the project.

7.6. Prospects for the Future As already noted, the Cambodian government and apparel factory owners decided that there is an international market for good labor standards that are verified through credible, transparent monitoring. They have decided to continue the strategy indefinitely, despite the end of the quota system. 44 Financial support for the project has broadened considerably in recent years, as international development agencies witnessed the complementary gains in economic development, improvement of employment and living standards, and poverty alleviation that Cambodia was able to achieve through this innovative approach. Funding continues to be provided by the Cambodian government, Cambodian garment industry, and the US government, with small amounts contributed by the Cambodian trade unions. Now major additional funding is also provided 44

Financial Times, ‘Cambodia Favoured in Asian Labour Survey’, December 3, 2004.

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by the World Bank, the Agence Française de Developpement (AFD), the Asian Development Bank (ADB), and New Zealand’s International Aid and Development Agency (NZAID). In an important breakthrough already noted, the major international buyers of Cambodian garments also began to contribute to the costs of the program in 2005. 45 The transition in 2009 to a structure and program that does not involve the ILO will test the possibility of transferring the ILO’s credibility to another organization. There is reason for optimism. From the beginning, the actual monitors have been Cambodian nationals, trained and supervised by ILO managers, as noted above. They have now gained several years of experience. Local trade unions and NGOs can be expected to demand continued transparency and accuracy in the factory reports going forward, to maintain the improvements already achieved and to make further progress. The government, the firms in the apparel sector and their international buyers will want the program to maintain its global credibility, since this provides the key advantage enjoyed by the Cambodian industry in an increasingly competitive international environment.

7.7. Conclusion The Cambodian policy experiment can be judged as a success measured against its own objectives: to increase apparel exports, thereby improving economic growth and to improve working conditions and worker rights in the country. The indicators of success in meeting these goals have been cited above. A largely unanticipated benefit was the importance of the reputational advantage that international apparel buyers found under this regime. In fact, the policy continues beyond the temporal framework in which it was conceived, namely the apparel quota system that ended in 2005, primarily because of this benefit. The project also generated unanticipated spillover benefits to the wider society, as it fostered dialogue between economic and social actors and created a neutral, credible dispute settlement mechanism that provided a binding, rapid alternative to a court system plagued by weaknesses typical of low-income countries. The experience of participation and inclusion by groups such as workers, who had been largely excluded from decision-making processes of the 45

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ILO, Better Factories Cambodia, ‘Funding’. Available at http://www.betterfactories.org


government and private firms, creates a precedent and expectation of wider democratic participation. New policy ideas and their successful deployment are relatively rare in the international system. When such successes occur, it is useful to search for lessons that can be learned at the analytical level and to inform policymaking elsewhere. Five distinct characteristics of the innovative Cambodian policy were essential to its success. (1) Positive incentives: An important innovation in Cambodia was the manner in which trade privileges were linked with improved labor rights. Labor provisions had been included in other trade agreements and trade preference programs by the USA and some other governments, but those provisions operated as negative incentives. 46 In those arrangements, trade privileges were granted to the trading partner with the condition that they could later be revoked if labor conditions deteriorated, if governments failed to improve severe existing problems, or if new violations were discovered. In negotiating terms, the privileges were ‘front-loaded’. By contrast, the textile agreement with Cambodia created a positive incentive that operated prospectively. The additional market access (quota) was not granted until the Cambodian employers and government met pre-established benchmarks of progress on labor conditions, resolution of specific problems, and upgrading of legal instruments. The improvements had to be demonstrated first, and then the commercial reward followed. The difference in impact of positive and negative incentives can be substantial. Looking from the perspective of the recipient country, a positive incentive system requires real changes in behavior in order to access the desired market reward. Under a negative incentive system, continuing improvement in labor standards may be less likely once the desired market access has been granted. The deterrent effect of a general and vague conditionality may be discounted by the recipient. From the perspective of the granting country, it may be politically unappealing to employ a negative incentive, because revoking privileges already granted can disrupt ongoing economic activities. Partly as a consequence of these considerations, negative incentives are typically employed only in cases of egregious abuse of labor rights. This can limit the efficacy of such systems to achieve sustained progress on labor rights and conditions. In this case, innovation went beyond the substitution of positive for negative incentives. The positive incentives were structured in a way that 46

Polaski, op. cit., 21–2.

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required progress in each annual period to gain a quota increase for the following year. The repetitive nature of the exercise elicited more progress than a one-time qualifying period could achieve. It allowed modest, feasible steps to be taken and rewarded rapidly, as part of the repeated annual exercise. This aspect of the policy design is particularly important, because many of the labor problems encountered in developing countries are difficult to solve in one stroke. The precise incentive granted at the outset of the Cambodia experiment is not available because the quota system has ended. However, many restrictions on developing countries’ exports still exist in markets abroad and policymakers could find many other opportunities to link prospective trade benefits to progress on labor rights and other desirable developmental objectives. (2) Goal setting: The semiannual consultations between the two governments proved to be an important mechanism for harnessing the positive incentives to practical goals. Benchmarks were set that could be achieved in a six- to twelve-month period. The goals ranged from major structural changes, such as the issuance of necessary regulations and creation of institutions to the remediation of specific, egregious problems in particular factories. Once the ILO monitoring reports became available, an overall goal in each period was the demonstration of effort and steady progress by factories in remedying any identified problems. The short-term goals were agreed in consultations between the two governments, after consultations with apparel factory managers and workers’ organizations. The specificity of goals meant that all actors understood what was expected. The involvement of all relevant Cambodian actors in the discussions that led to goal setting produced goals that were achievable in the time period agreed. The challenge faced by the parties was to identify goals that were sufficiently ambitious to contribute to significant and sustained progress in labor rights while recognizing the constraints on the Cambodian actors. Policymakers seeking to replicate this approach should include a frequent consultative process and give thought to including all affected actors in the consultations. (3) Role of an international intergovernmental organization: As noted above, the Cambodia monitoring program marked the first time the ILO had inspected factories or directly monitored private sector behavior. The organization proceeded in a careful, deliberative manner, which slowed

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the development of the program somewhat but allowed it to build consensus among relevant actors at each step. It gained experience through an iterative process of inspections and a problem-solving approach to issues that arose. This careful process was an important factor in the success the monitoring program has enjoyed. The experience has built a strong new capacity within the ILO that is highly relevant to the needs of its constituencies elsewhere. As countries struggle to balance economic and social policies, and to advance trade while promoting acceptable levels of labor standards, the ILO could be called on to use its newly developed skills to monitor and provide credible information in a wide range of situations. Such an invitation could come from governments, and it is likely that the ILO would act only if the governments involved explicitly requested its participation. However, the private sector could also initiate ideas and projects involving the ILO, and then solicit their governments to endorse or join the project. The role of the ILO is illustrative of a function that could be assigned to other intergovernmental agencies that deal with different substantive issues. It is not difficult to imagine a role in monitoring and oversight of private sector actors, including those engaged in self-regulation, on issues such as environment or impact on local communities. (4) Transparency: One aspect of the Cambodia monitoring program that has been indispensable to its success is the high level of transparency that the ILO provided through its reports. As discussed above, this transparency allowed governments, firms, trade unions, and other interested parties equal access to the information generated. The reports served a multiplicity of purposes in the hands of different actors and reinforced the common interests they shared. Any future monitoring role for the ILO or other intergovernmental agency should replicate at least this level of transparency. The question arises whether private auditing groups could substitute for an intergovernmental organization to provide monitoring with a similar degree of transparency and credibility. Currently, no private sector group has attempted this level of transparency. Those groups that monitor labor conditions in factories abroad have been unwilling to identify the specific factories inspected and the findings, both positive and negative, in those factories. (Some multistakeholder monitoring groups, such as the FLA, have improved their transparency in recent years, but reporting covers only a small percentage of factories or buyers.) Without specific

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information about a particular factory and its performance, outside actors are not in a position to act on the information. In addition, the credibility of reporting is undermined and a useful check on the accuracy is lost if workers or others who might possess conflicting information about a particular firm’s behavior are not able to identify firms in the reports. The reputation risk to factories and buyers is not effectively mitigated by reports that lack adequate transparency and credibility. Unless private monitoring groups report with full transparency to all interested actors, it is unlikely that they could fill the role of providing sufficient information to improve the functioning of markets and generate the progress on overall performance that was achieved by the ILO in Cambodia. (5) Role of governments: The apparel industry in Cambodia was a major beneficiary of the policy experiment, but did not initiate it. The multiple firms in the sector faced a classic coordination problem in which all firms would be better off with increased market access in the form of quota and increased activity by international buyers. However, individual firms did not want to lead the effort, without assured participation of all, to avoid bearing disproportionate costs of improved labor conditions. The role of the Cambodian and US governments in initiating the policy, and the role of the Cambodian government in requiring sector wide participation were essential. The Cambodian government had a strong self-interest in creating the policy and making it work. The self-interest encompassed economic, social, and political objectives. In the economic realm, the obvious gains to be achieved were increased exports, which contributed strongly to overall economic growth, increased employment, and increased fiscal revenues. The societal interest of the government was to improve the employment, income, and working conditions of Cambodian workers. Employment in the apparel sector offers the best salaries available to unskilled workers in Cambodia; expanding the number of positions was a major goal of the government. The largely young, female workforce is mainly drawn from rural households. The women’s remittances have the effect of lifting those households out of poverty, with attendant possibilities such as keeping younger children in school and investing in productive resources for farming activities. At the political level, worker unrest was rising in the years after Cambodia achieved peace in 1991. In a polity where disputes had long been resolved through violence, the creation of a peaceful alternative to distributional disputes was a significant breakthrough.

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Because of resource and capacity constraints, the government had very limited ability to achieve its goals through direct governmental interventions such as inspection, fines, or judicial settlement of disputes. In this case, the government effectively leveraged the policy instruments it did possess, such as the ability to negotiate market access abroad and the granting of export licenses, to elicit greater compliance by firms. Even least developed countries such as Cambodia have an interest in, and instruments with which to achieve, more effective self-regulation by private sector actors.

References Agence France Presse, ‘UN Labour Body Expands Monitoring of Cambodia’s Garment Factories’, February 9, 2005. Cambodian Ministry of Commerce, Prakas No. 108 MOC/M2001, March 28, 2001. Cambodian Ministry of Social Affairs, ‘Labor, Vocational Training and Youth Rehabilitation’, Prakas No. 305 MOSALVY, November 22, 2001. Craner, Lorne W., ‘Corporate Social Responsibility at the State Department’, March 11, 2004. Available at http://www.state.gov/g/drl/rls/rm/30962.htm Elliott, Kimberly Ann and Richard B. Freeman, Can Labor Standards Improve under Globalization? Institute for International Economics, Washington, DC, June 2003. Financial Times, ‘Cambodia Favoured in Asian Labour Survey’, December 3, 2004. International Labour Organization, ILO Declaration on Fundamental Principles and Rights at Work, Geneva, June 1998. Available at www.ilo.org Synthesis Reports on the Working Conditions Situation in Cambodia’s Garment Sector. Reports 1–16, 2001–6. Available at www.ilo.org/public/english/dialogue/ ifpdial/publ/cambodia.htm International Labour Organization and US Department of Labor, ‘Ensuring that Working Conditions in the Textile and Apparel Sector in Cambodia Comply with Internationally-Recognized Core Labour Standards and the Cambodian Labour Law’, Mid-term Evaluation Report, Phnom Penh, February 2003. International Monetary Fund, ‘Cambodia: Selected Issues and Statistical Appendix’, IMF Country Report No. 03/59, International Monetary Fund, Washington, DC, March 2003, 9. Kolben, Kevin, ‘Trade, Monitoring, and the ILO: Working to Improve Conditions in Cambodia’s Garment Factories’, Yale Human Rights & Development Law Journal, 7 (2004). Nordstrom, Kristopher, ‘Trade and Labor Standards: A Role for Monitoring?’, Terry Sanford Institute of Public Policy, Duke University, April, 2006. Mimeo on file with author, available on request from [email protected]

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Sandra Polaski Nguyen, Manh Cuong (Deputy Director, International Cooperation Department, Ministry of Labor, Invalids and Social Affairs, Government of Viet Nam) speaking at the World Bank Group’s International Conference on Public Policy for Corporate Social Responsibility, Country Session 1, October 8, 2003. Polaski, Sandra, ‘Protecting Labor Rights through Trade Agreements: An Analytical Guide’, Journal of International Law and Policy, 10/1 (Fall 2003). Rodrik, Dani, ‘Institutions for High-Quality Growth: What They Are and How to Acquire Them’, Studies in Comparative International Development, 35/3 (Fall 2000). Siphana, Sok (Secretary of State for Commerce, Royal Kingdom of Cambodia) speaking at the World Bank Group’s International Conference on Public Policy for Corporate Social Responsibility, Country Session 1, October 8, 2003. Stern, Robert M., ‘Labor Standards and Trade Agreements’. The University of Michigan. Gerald R. Ford School of Public Policy. Discussion Paper No. 496. August 18, 2003. Available at http://www.fordschool.umich.edu/rsie/ workingpapers/Papers476-500/r496.pdf Stiglitz, Joseph, ‘Information and the Change in the Paradigm in Economics’, in Tore Frangsmyr (ed.), The Nobel Prizes 2001 (Stockholm, Sweden: The Nobel Foundation, 2002), pp. 472–540. US–Cambodia Bilateral Textile Agreement. Available at http://199.88.185.106/ tcc/data/commerce_html/TCC_2/Cambodiatextilebilat.html Verma, Anil, ‘Global Labour Standards: Can We Get from Here to There?’, Centre for Industrial Relations and Rotman School of Management University of Toronto, December 2002. Available at http://www.fu-berlin.de/iira2003/papers/ track_3/Workshop_3_4_Verma.pdf

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8 Local Politics and the Regulation of Global Water Suppliers in South Africa Bronwen Morgan

8.1. Introduction This chapter explores the changing incentives faced by global water companies in light of the political and legal struggle in South Africa over the growing trend of supplying urban drinking water on a commercial, for-profit basis. 1 The inclusion of a chapter on water service delivery in this book reflects a remarkable shift over the past ten to fifteen years in the salience of private corporations with a global reach in the water sector. The delivery of domestic water services has historically been determinedly local, markedly regulated, and typically embedded in the public sector. But the global policy trajectory concerning water, beginning with a series of UN conferences and gatherings dating from the 1970s 2 and the socalled ‘International Drinking Water and Sanitation Decade’ during the 1980s, has taken a distinct turn toward the private sector since the 1990s. In 1992, an important UN conference endorsed for the first time the 1 The research project from which this chapter draws was funded by the ESRC and the AHRB under Research Grant 143-25-0031, in the Research Programme on Cultures of Consumption, and their support is gratefully acknowledged. The larger research project focuses on six case studies, selected to vary along a number of different dimensions that explore a cross section of possible governance contexts. They all involve one or more of the three largest multinational water companies. They include both developing countries and OECD countries (Argentina, Bolivia, Chile, France, New Zealand, and South Africa), and a full range of different legal structures (one concession, two management contracts, two privatizations, one public–private partnership). 2 In particular from the Mar del Plata Conference 1977.

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principle that water be treated as an economic good. 3 Private sector investment in water between 1990 and 1997 increased 7,300 percent on 1974–90 investment levels. 4 This prompted an intensification of intergovernmental activities in relation to water 5 which increasingly incorporates the private sector as a key partner of governments. At the same time, private sector actors are themselves forging ahead on their own terms. In May 2000, the business magazine Fortune 500 declared water to be the oil of the twenty-first century; in April 2003, Schwab Capital Markets hosted a Global Water Conference for investors in Washington, DC, and in 2004, the World Economic Forum at Davos announced a new Water Initiative. 6 It is true that more recent short-term trends mute this enthusiasm (private sector investment in water and sanitation has declined to an absolute level of half the 1997 peak, totaling 11% of all water and sanitation investments: Simpson 2005: 15). But there are two reasons why the ‘politics of necessity’ 7 generated around urban water services remain significant: the enduring importance of commercialization even for public sector delivery, and the distributional issues raised by relations between the North, where most transnational water companies are located, and the global South, where much of the investment has been concentrated. Distributional issues are core to both national public sector commercialization trajectories and North–South transnational investment patterns. Both involve a shift toward giving greater discretion and self-regulatory power for water service operators over crucial issues such as water tariffs and bill collection procedures for consumers, and employment conditions for water services employees. This shift has catalyzed a political and legal struggle which intersects not only with changes in national regulation 3 International Conference on Water and the Environment, Dublin 1992. The Dublin conference endorsed four principles in addition to the notion of treating water as an economic good: the other three recognize the importance of participatory approaches in water development and management, the importance of the role of women, and the status of water as a finite, essential, and vulnerable resource. 4 Private sector investment in the water sector between 1974 and 1990 was US$300 million; between 1990 and 1997 it rose to US$25 billion: see Silva et al. (1998), ‘Private Participation in the Water and Sewerage Sector—Recent Trends’, 147 Public Policy for the Private Sector, 1–8, The World Bank Group: Finance, Private Sector, and Infrastructure Network. 5 One of the Millennium Development Goals set at the UN Summit of 2000 committed to halve the 1.5 billion people in the world without access to safe drinking water. The 2002 World Summit on Sustainable Development in Johannesburg extended this goal to the 2.5 billion lacking sewage, also to be halved by 2015. The UN Commission on Sustainable Development has chosen water, sanitation, and human settlement as the focus of its implementation cycle for 2004 and 2005. In January 2004, the European Commission launched the EU Water Facility: http://europa.eu.int/eur-lex/en/com/cnc/2004/com2004_0043en01.pdf 6 http://www.weforum.org/site/homepublic.nsf/Content/The+Water+Initiative 7 See The Politics of Necessity, special issue of the Journal of Consumer Policy, December 2006 (Morgan and Trentmann eds).

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and norms within developing countries, but also with a range of protest, reactions, and participation by local NGOs, some of whom are supported by transnational social movements. As a result, there are changes on three levels—global, national, and local—which are affecting the strategies and behavior of companies in this sector. The emerging patterns at each level are constructed by conflicts endemic to what John Ruggie refers to as the process of embedding liberalism, which he defines as piecing together ‘a grand social bargain whereby all sectors of society agree to open markets . . . but also to contain and share the social adjustment costs that open markets inevitably produce’. 8 The substantive issues he identifies are taken up in global water politics through an oft-repeated trope: ‘is water a human right or a commodity?’ While this opposition is oversimplified, it captures the substantive implications of the changes I discuss in each of the three spheres of global, national, and local. I will, however, focus in this chapter on the changes in rules and institutions rather than their substantive effects. But the tension between redistributive equity and productive efficiency implied by the human right/commodity distinction is an important force shaping those rules and institutions. South Africa focuses the three levels of investigation in a particularly interesting way. First, South Africa is a developing country possessing a relatively high level of state capacity and fiscal autonomy, making it an interesting case for exploring the relative salience of national and international dynamics in the process of trying to embed liberalism, or soften capitalism’s harsher distributive effects. Second, South Africa has made a formal constitutional commitment to a human right to water, meaning that at the national level of norms and regulation there is a formal opportunity, rarely present in cross-national terms, 9 for human rights to balance commodification. Third, the historical trajectory of South African politics combines powerful politically organized civil society, both in labor and in social movement terms, with extremely low or nonexistent social provision for communities of color. As a consequence, South Africans who protest dynamics of liberalization and globalization are not fighting to maintain the status quo, as in established European welfare states, but rather draw on strong political will at the national level to supplement the constitutionally embedded legal commitment to provide 8 John Ruggie, ‘Taking Embedded Liberalism Global: The Corporate Connection’, in David Held and Mathias Koenig-Archibugi (eds), Taming Globalization: Frontiers of Governance (Cambridge: Polity Press, 2003), p. 1. 9 Uganda makes a constitutional commitment to a right to water, and Gambia, Ethiopa, and Zambia include constitutional aspirations endeavoring to provide clean safe water.

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universal access to water to previously disadvantaged communities. For the above three reasons, the case of water in South Africa demonstrates how a legal and constitutional framework constrains the political space available for self-regulation from two related directions: first, by virtue of the top-down effects of the national regulatory framework, and second, by bottom-up pressures from local actors, some of which are enabled by the constitutional and legal rights granted to these local actors, others of which are extralegal and even illegal in nature.

8.2. The Changing Global Framework This section sketches the emerging skeletal architecture that is being constructed at the global level by key actors involved in funding, managing, regulating, and consuming water services. I contend that this architecture supports a policy of corporate welfarism in water provision at the global level. The reference to welfarism is intended neutrally, simply to convey the fact that these developments at a global level are portrayed by their proponents as policies that will, among other goals, alleviate the plight of those who lack access to water or the means to pay for such access. The likelihood of succeeding in this goal, or even the sincerity of the motivation, is bitterly contested by those who challenge the trajectory of commodification of water. This reflects the tension inherent in this regime of global water welfarism, between on the one hand expanding opportunities for profitable investment in water and on the other hand ensuring the broadest possible diffusion of the resulting benefits. There are echoes of older debates here on the question of whether national welfare state policies established in postwar industrial democracies served merely to legitimate the basic structures and results of capitalism, or to genuinely modulate it as a form of political economy. Placing my sketch of the global water sector in this historical context serves another purpose too: it suggests an implicit analogy between what is happening in a particular sectoral space across state boundaries, and the growth of state institutions at the national level. I do not wish to overstate this analogy, 10 but I believe this serves a useful purpose of at 10 In particular, it is important to note that none of the institutional developments I trace are anchored in structures of representation and accountability that even mildly resemble those that characterize state institutions. This chapter makes no evaluation of such issues: its goals are confined to description and analytical mapping, and the analogy with state institutions is intended in a functional way only.

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least temporarily anchoring the readers’ institutional imagination, as well as gesturing to the political significance of private sector influence and involvement at this level. In short form, global water welfarism entails a vision of a regime where public aid supplements the private investment of multinational corporations to solve the social and environmental problems of global water provision, catalyzed by a hopeful mix of corporate social responsibility and the probing eye of government and civil society monitors. In what follows, I elaborate this vision by reference to three dimensions: the fiscal capacity, the administrative capacity, and the ideological character of this emerging ‘regulatory space’. The ‘welfare goal’ that animates the field of global water welfarism can be envisaged succinctly by reference to the water-related Millennium Development Goals that aim to halve the numbers of people in the world who lack clean drinking water (1.5 billion) or sewage (2.4 billion) by 2015. 11 In effect, the three dimensions of global water welfarism discussed in the following paragraphs could be projected to a ‘shadow water state’ at the global level. In this ghostly image, legislative potential haunts the World Water Council (WWC), the UN Committee on Economic, Social and Cultural Rights (ESCR) and ISO Technical Committee 224 on Water and Wastewater. Loan conditionalities from the multilateral development banks intersect with the activities of the Global Water Partnership to flesh out these developments in executive fashion while bilateral investment treaties (and possibly the General Agreement on Trade in Services (GATS)) adjudicate the inevitable conflicts. In what follows, I flesh this out. The fiscal capacity of global water welfarism is provided by an intermeshing of private investment capital and official development aid (ODA). Multilateral development banks have for some time imposed loan conditionalities that require private sector participation in the water sector, and this continues to be the case. 12 Further, since 1999, when the high 11 While this statistic dominates the debate on global water issues, there are of course innumerable other factors driving the emergence of structural reform and the rise of private sector involvement in water service provision worldwide. The most important of these in the developed world include aging infrastructure and heightened environmental standards, while in developing countries, the gap in access just quantified is the major catalyst, made significantly worse by rapidly increasing rates of urbanization (in 1975 27% of developing country people lived in urban settlements: by 2015, 48.5% will do so). 12 In fiscal year 2002, the World Bank lent $546 million for water sector projects generally. This increased to $1.4 billion in fiscal year 2003, and in 2004 the board of the World Bank decided to increase its focus on water infrastructure and provide an annual US$4 billion for that purpose. Although the Bank has occasionally stated that it does not make its water infrastructure loans conditional on privatization, in the pending pipeline of proposed loans, there are twenty-two separate loans, totaling $1.458 billion, that contain privatization and/or

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1990s level of private sector investment in the water sector, mentioned in the introduction, began to fall, 13 there has been a trend toward mixing aid with investment. This mixing underpins a particular model which is widely disseminated: public–private partnerships where all partners share the goal of efficiently delivered basic goods and services bolstered by a subsidy framework that will facilitate universal or affordable access. 14 This has been specifically endorsed in the water sector by the World Bank, 15 and efforts to develop a regional lending facility in Africa 16 along similar lines are presently ongoing. Such fiscal arrangements have been labeled by civil society critics as ‘a franchising model for global water corporations’. 17 They certainly leave open the question of what kind of organizations will provide the administrative capacity for actually delivering water services, and this is obviously crucial for developing countries such as South Africa with limited resources. In water, direct provision via multinationals is an important carrier of such administrative and technical capacity. The global water market is growing 18 and is dominated by three firms, in particular from France and Britain: Ondeo, Veolia, and Thames Water. 19 All three of these cost-recovery policies: Public Citizen, World Bank Watch, January 2003, vol. 1, received directly by email, but available at www.wateractivist.org 13 David Hall, ‘Water Multinationals in Retreat’, Public Services International Research Unit, January 2003, www.psiru.org. The causes of the decline are not yet well-established, but the political risks engendered by the widespread social protests against private sector participation in water are thought by many to be an important factor. 14 For example, aid pays for subsidies (sometimes even bypassing national governments), national government funds the upfront capital costs and private capital funds operating costs and ongoing investments. 15 Following their decision to develop key recommendations of the influential Camdessus Panel on Financing Water Infrastructure, headed by the previous head of the IMF, that reported in 2003. For the Camdessus Panel, see M. Camdessus (2003). Financing Water for All— Report of the World Panel on Financing Water Infrastructure, http://www.worldwatercouncil.org/ download/CamdessusReport.pdf. For discussion of the World Bank’s response, which includes developing guarantee mechanisms against political risks, protection against currency risks, and even structuring municipal bond finances so that they support private sector involvement, see David Hall (2003), ‘Public solutions for private problems—responding to the shortfall in water infrastructure investment’, Public Services International Research Unit, available at http://www.psiru.org/reports/2003-09-W-strats.doc 16 Africa Water Facility, shortly to be established under the NEPAD (New Economic Partnership for African Development) framework. 17 Karl Flecker, Polaris Institute, Canada, quoted in ‘Civil Society Delegations Break from World Water Council Consensus’, March 20, 2003, http://cupe.ca/www/news/3827, last accessed November 6, 2003. 18 See Water Utilities: Global Industry Guide (Datamonitor 2003). 19 Ondeo (previously Suez and before that Lyonnaise des Eaux) serves 110 million people in more than 100 countries. Veolia (previously Vivendi Environment and before that Generale des Eaux) serves 96.5 million people in 90 countries: see Peter H. Gleick, Gary Wolff, Elizabeth L. Chalecki, and Rachel Reyes, The New Economy of Water, Pacific Institute, 2002, pp. 24–5. Thames Water serves twenty-two million people: see Yaron, ‘The Final Frontier’, Polaris

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firms participate in the water and wastewater sector in South Africa, and Saur and Biwater, two additional companies also with South African contracts, are respectively French and British and within the top ten global water companies in terms of market share. At the global level, those with the administrative capacity to deliver water services are increasingly trying to collectively shape the environment in which they operate in several ways: through standard-setting, policy, advocacy, and implementation. France spearheaded the formation by the ISO 20 of a new Technical Committee on Water and Wastewater Standards in late 2001, with the objective of developing standards on service activities relating to drinking water supply and sewerage. Many major companies in water (including construction and engineering as well as water service delivery and management) are members of the WWC, as are the major multilateral development banks. The WWC, legally incorporated in France as a UNESCO-affiliated NGO, describes itself as ‘the International water policy think-tank dedicated to strengthening the world water movement for an improved management of the world’s water’. It functions as a forum for policy and advocacy and hosts a tri-annual World Water Forum, until recently perhaps the only global forum not chaired by the UN to include a formal Ministerial Meeting. 21 Finally, the private sector has also taken a lead in fostering a more implementationoriented kind of support for building administrative capacity via technical assistance and capacity building. The Global Water Partnership, a network that complements the work of the WWC, funds a wide range of water-related activities globally, at twelve regional levels, and develops and promotes management norms and principles applicable at practical implementation level. 22

Institute, 2000. Despite these very large figures, it remains the case that globally the private sector serves no more than 15% of the world’s population in the provision of water services: the public sector provides the remaining 85%. 20 The ISO (International Organization for Standards) is a private standard-setting organization based in Geneva. It is a federation of national standards bodies (some governmental, some private sector business associations) from more than 100 nations. ISO is often criticized for its skew toward industry: its procedures preserve a large formal role for industry in standards development, and industry representatives dominate its more than 2,000 technical working groups. Technical Committee 224 is still in the very early stages of defining its scope of work, and its long-term survival or salience is not yet clear. 21 In December 2003, the World Summit on Information Institute followed this format, arguably presaging a growing agenda-setting role for the private sector at the global level. 22 See e.g. Global Water Partnership (2003). Toolkit for Integrated Water Resources Management.

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Ideologically, the activities of this web of primarily nongovernmental actors are underpinned by familiar neoliberal views regarding the merits of market efficiency, widely promoted even in a sector as unpromising as water services, with their characteristics of natural monopoly and very high sunk costs. But it is important to note the tempering of ‘raw’ market reforms with a concern for poverty reduction goals: this is visible both at the general level in development policy 23 and in a range of water-specific documentation. 24 This emergent ‘social face’ of the neoliberal consensus poses a growing dilemma, perhaps more strategic than philosophical, to opponents and activists. Private sector provision of water services has become an increasingly contentious aspect of the World Water Forum and disruptive civil society protests at the second meeting in 2000 resulted in the inclusion of formal NGO panels at the third meeting in 2003. 25 But the dichotomous cleavage in water access politics (whether the provision of safe drinking water should be treated as a commercial service to be purchased or as a human right) that energizes the political divide does not sit comfortably with the welfarism increasingly inflecting the rationale of global water policy. Indeed, the very notion that these are oppositional concepts dissolves if one views the ideological and practical effects of human rights strategies as part of a process of embedding (in Ruggie’s sense of embedded liberalism) the structure of a global market. Take some remarks in 2000 made by Paul Hunt, Rapporteur of the UN ESCR Committee which give to human rights the task of redistributive politics characteristic of national welfare states but transposed now to a global level: [T]he Covenant [for Economic, Social and Cultural Rights]—and other international human rights treaties—can be used as a shield to protect the state’s poorest citizens from the policies of powerful, global non-state actors . . . NHRIs [National Human Rights Institutions] can show how the Treasury’s negotiators can use the Covenant in negotiations with [International Financial Institutions]. They might 23 World Bank (2004), World Development Report: Making Services Work for Poor People. See also Kanishka Jayasuriya, ‘Workfare for the Global Poor: Anti Politics and the New Governance’, Asia Research Centre, Murdoch University, Australia, Working Paper No. 8, September 2003. 24 Examples can be drawn from high-level reports like that of the Camdessus Panel on Financing Water Infrastructure as well as contractual documentation such as concession agreements. 25 Levels of resistance to private sector participation can be mapped along four different trajectories.‘Threatening rebels’ (e.g. antiglobalization activists) use the human rights challenge the most, ‘cooperative allies’ (e.g. often the environmental groups) make a public good argument focused on the need to internalize ecological externalities. A public good approach, with more emphasis on equity than ecology, is also promoted by ‘citizens’ agora’ groups (e.g. reformist NGOS like Wateraid). Those affiliated with public sector unions use the language of public good mainly to oppose privatization per se.

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Local Politics and Regulation of Global Water Suppliers offer human rights training for the Treasury’s negotiators . . . [Moreover] just as the Covenant can be used to tackle unfair inequalities within a state, so it can help to address the grossly uneven distribution of power between the economic north and the economic south.

This sounds admirably progressive, but his concluding words are prophetic: Economic re-structuring still occurs. But it does mean that the reforms are introduced in ways which minimise avoidable suffering, for instance by the introduction of safety nets for vulnerable groups—thereby contributing to the reform’s longterm sustainability (emphasis added).

The UN ESCR Committee has since then asserted the existence of a human right to water. 26 This attempt to formalize and to specify in more detail what has until now been more or less a rhetorical claim points toward ways in which the dichotomy can also be challenged from a more empirical perspective. 27 For the practical implementation of such a right entails a web of regulatory entitlements and obligations that significantly blur the salience of the distinction between water as human right or as commodity. Socioeconomic rights are in practice implemented by regulatory norms that protect consumer (public) interests by establishing minimum standards of provision. Of course humans-rights-motivated regulatory norms may and often will pull in different directions from the governance norms advocated by the like of the Global Water Partnership. 28 But since the regulatory dimension of access to water, whether as a human right or as a commercial service, has at present very little operative institutional presence at the global level, it is only at the level of national case studies that one can map more precisely the implications of this ideological ambiguity of global water welfarism. For the cumulative effect of the fiscal, administrative, and ideological dimensions traced so far is insufficient for the actual execution and implementation of water service delivery. In practice, emergent global water welfarism piggybacks significantly on national-level rule structures. 29 26 General Comment No. 15 (2002), The Right to Water (Articles 11 and 12 of the International Covenant on Economic, Social and Cultural Rights), November 26, 2002. 27 I leave aside in this chapter any normative judgment on whether the reduction of suffering for those without water is or is not outweighed by the support it also provides for stabilizing a global field of market-based provision. 28 Global Water Partnership, Effective Water Governance, 2002. 29 The IADB survey of November 2003 identifies tariff levels and flawed regulatory frameworks as the most important barriers to increased investment in water provision: ‘Survey: Obstacles and Constraints for Increasing Investment in the Waste and Sanitation Sector in Latin America and the Caribbean’, IADB, November 2003. Both issues are still very much

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8.3. The Changing National Framework Despite the development of the global public policy network structure described above, water remains a policy sector that is irredeemably local in many ways—the physical infrastructure for delivering water is a necessarily local asset; the stuff itself is grounded, heavy, and awkward to move, and the power associated with control over water resources gives local politicians strong incentives not to cede that control. Thus the most important filter of global welfarism is the legislative and regulatory framework established at national (and, in South Africa, provincial) levels. 30 In the following discussion, I contrast political and transactional frameworks for the provision of water services. Transactional frameworks minimize political discretion, especially over tariff-setting processes, and emphasize protection against risk (primarily for those funding infrastructure operation and investment), value for money, affordability, and open procurement procedures. Political frameworks preserve political discretion on key issues such as tariffs, and prioritize mechanisms for consultation with labor and consumers over the structure of water services. Political and transactional frameworks are not incompatible alternatives but their coexistence tends to generate tensions between the competing policy goals of equity and efficiency implicit in the ‘human right versus commodity’ dichotomy. Political and transactional frameworks provide different degrees of opportunity and responsiveness for the key actors in the water policy networks. South Africa is, as previously stressed, fiscally much less dependent on foreign aid than many other developing countries. But in the immediate aftermath of winning power, the ANC government substituted their electoral platform, known as the Reconstruction and Development Programme (RDP) with an alternative strategy they called GEAR—the Growth, Employment and Redistribution Strategy. The RDP was a statedriven program of redistribution in the social democratic mold, fed by extensive local consultation and participation, while GEAR was a marketled strategy that prioritizes economic growth and provides redistribution within the domain of the national state, notwithstanding the emergent global regime. The World Bank is increasingly focusing its reform efforts on legislative frameworks and it is notable that many specialized ‘Water Acts’ have recently been passed by developing country governments. 30 The description of the legislative and regulatory framework is based largely on research conducted in late 2003.

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later and residually. 31 This shift, which one commentator has labeled the ‘great U-turn’, 32 was significantly influenced by a deliberative process in which international capital interests played a critical role. 33 The shift from RDP to GEAR had direct implications for water services policy. It included a policy commitment by the government to keep the nontradable input costs of economic production for industrial consumers (electricity and water primarily) as low as feasible for the purpose of attracting foreign investment. At the same time, GEAR also constrained government borrowing, which limited intergovernmental transfers that had been crucial for local government delivery of water services. 34 These pressures fed directly into the new democratic government’s legislative framework for water services, which faced the immense challenge posed by the fact that a mere 34 percent of its citizens had access to piped water. The result is a legislative framework that one interviewee characterized as ‘schizophrenic’, 35 reflecting an underlying legitimation crisis poignantly illustrated by the jarring transition in this 1996 speech by the then-Mayor of Johannesburg: Transformation has a price. Our country has been liberated into an era governed by the fundamental principles of non-racism, non-sexism and justice for all. But please understand the particular conditions of government which require resources to give people the basic services which are their fundamental right as citizens of this country . . . Businessmen from the US are used to fast services. It takes us six months to find out who owns a piece of land. There are danger signals when our councillors and administrators do not meet the investors’ aspirations. Some administrator tells the investor to go to such a room and there they find a

31 In early 2006, GEAR was supplemented by a further economic strategy entitled Accelerated and Shared Growth Initiative-South Africa (ASGI-SA). ASGI-SA largely continues the overall emphasis of GEAR: ‘These interventions amount not to a shift in economic policy so much as a set of initiatives designed to achieve our objectives more effectively’: http://www.pmg.org.za/bills/060206asgisummary.htm. However, the strategies place greater emphasis on taking into account the binding constraints specific to South Africa’s development context, and acknowledge the limited progress GEAR has made on redressing poverty imbalances in South Africa. 32 Allister Sparks, ‘The Great U-Turn’, Beyond the Miracle (Jonathan Ball, 2003). 33 A series of meetings in Europe in the late 1980s between ANC economists and the apartheid government culminated in the 1989 Lausanne Colloquium where a large number of foreign economists were also present; in 1992, Mandela attended the World Economic Forum in Davos and later that year the Mont Fleur colloquia convinced Trevor Manuel, future finance minister, to support a market-led model. Six months before the ANC came to power, Manuel sought a loan commitment from the IMF on that basis: Sparks (2003). 34 The Department of Finance in real terms cut intergovernmental grants which pay for municipal service subsidies by 85% between 1991 and 1997: Patrick Bond (1998: 4), citing the Financial and Fiscal Commission (1997: 18). 35 Interview with senior official of MIIU, Interview September 16, 2003.

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South Africa water welfarism seesaws in similar fashion between the human rights dimension and the needs of investors, as the following compressed narrative will convey. On the one hand, South Africa, as previously noted, has made a formal constitutional commitment to a human right to water. 37 And this legal commitment is backed by a genuine political will to effect major redistributive change in this crucial area of basic socioeconomic need. 38 On the other hand, over the decade 1994–2004, in tandem with the more general shift from RDP to GEAR, three principal trends can be observed: first, the overlay of an initially political framework with a transactional one; second, a distinct muting of an initial preference for public sector provision, and third, marked decentralization to municipal governments mostly stretched very tight for resources and expertise. In what follows, I make a limited commentary on the main trends in regulatory oversight, the extent of private sector participation, legislation, and policy, focusing on punctuated change across time. Regulatory oversight DWAF CWSS Division39 1994

MIIU

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Choosing explicitly from the outset to avoid the creation of an independent regulatory agency, 41 regulatory oversight was initially located 36 Tokyo Sexwale, Mayor of Gauteng Province, September 1996, in a speech relaunching the Masakhane campaign. 37 Section 27 of the 1996 Constitution reads, as relevant: (1) Everyone has the right to have access . . . b) sufficient food and water;(2) The state must take reasonable legislative and other measures, within its available resources, to achieve the progressive realization of each of these rights. 38 In the first ten years the percentage of the population with access to water increased from 34% to more than 76%, though criticisms have been made of both the sustainability and the quality of the access provided: see e.g. David Hemson, ‘The sustainability of community water projects in KwaZulu-Natal’, Human Sciences Research Council of South Africa, 2003, draft manuscript on file with author. 39 Department of Water Affairs and Forestry, Community Water and Sanitation Division. 40 In 2000 fully democratic local government structures came into power for the first time and were given responsibility for infrastructure and basic services in water. The redemarcated jurisdictions merged previously racially and economically divided areas; at the same time budgetary caps on local government were imposed. 41 Interview with official from Department of Water Affairs and Forestry, Interview, September 17, 2003.

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in a Community Water Supply and Sanitation division of the Department of Water Affairs that, in tune with the social democratic spirit of RDP, also worked directly with communities in a participatory fashion to provide water supply. As the U-turn began to become operative, a unique institution for providing technical support to local government gained ascendancy. The Municipal Infrastructure Investment Unit (‘the MIIU’) deserves further comment, since it illustrates well the interpenetration of national and international personnel and knowledge. The MIIU is a government department structured as a nonprofit company, with the objective of facilitating private sector investment in infrastructure, including water and sanitation. It reports to the Department of Provincial and Local Government and relies on its accounting and employment systems, but it operates at arm’s length from that department with considerably more flexibility and autonomy as a result of its company structure. While MIIU has no formal political authority, its capacity to provide both funding and expertise means that it has a powerful influence in shaping the terms of any deal for which it provides support. That influence promotes, broadly speaking, the models, techniques, and norms promoted by the WWC and the Global Water Partnership. 42 USAID provides considerable funding to MIIU to support expatriate advisers who work locally and report through the MIIU governance structures. These advisers have facilitated extensive knowledge transfer about approaches to water services from all over the world. 43 The MIIU’s policy-based influence has been supplemented by greater legal control given to the Treasury under the recent Municipal Financial Management Act 2003. The above trend in regulatory oversight from political to transactional has largely tracked a steady increase in the extent of private sector participation (PSP), at least as measured by population coverage. Between 1995 and 2003, 7 million (roughly 15%) of the total population came to be served by the private sector in water services, and the major actors in this private sector provision are almost all members of the WWC. 44 (See Figure 8.1.) 42 This is despite the fact that there is no significant personnel overlap between the South African institutions and the global ones. But there is much more consensus on the models, techniques, and norms that support commodified delivery of water services than there is on the desirable alternatives. 43 Though the MIIU stressed that ‘USAID doesn’t have any say over what we do, in the South African context that’s probably fairly different [from other developing countries] . . . there’s very very little leverage over the decisions of government here’ (Interview with senior official of MIIU, September 16, 2003). 44 With the exception of Saur. It should be noted that where a contract or concession is made ‘with’ a global water company, it almost always participates as a partner in a consortium

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Figure 8.1. Private sector participation in water: South Africa Notes: 1. 1992: 25 yrs concession to Ondeo for Queenstown water; 2. 1994: 10 yrs lease to Ondeo for Stutterheim water; 3. 1995: 10 yrs lease to Ondeo for Nkonkobe water; 4. 1997: 2–5 yrs management contracts for four province-wide BOTT consortia for rural water; 5. 1999: 2 × 30 yrs concessions to Saur and Biwater for Dolphin Coast and Nelspruit Water; 1 × 20 yr concession to Veolia for Durban wastewater treatment plant; and 6. 2001: 5 yrs management contract to Ondeo for Johannesburg water.

The upward trend of PSP is, however, complicated by the fact that the depth and breadth of legal delegation the government has been willing to commit to private companies has actually seesawed abruptly. Early longterm commitments made in the first three apartheid era contracts (1–3) are now regarded as poor models. These contracts were negotiated after a series of visits by World Bank officials and Ondeo representatives and a seminar on private sector participation hosted by the Development Bank of Southern Africa. 45 The second phase of private sector participation therefore pulled back to 2–5-year management contracts (4). Four consortia, each led by a subsidiary of a global corporation (Suez Ondeo and Saur in particular), aimed to assist local government in four provinces in building infrastructure and delivering water and sanitation to rural areas. 46 Private sector participation was then ratcheted up with the three long-term concessions signed with global water companies in 1997 in of companies that includes local South African companies, thereby leading to a different name for the local subsidiary (e.g. Water Services South Africa for the Suez Ondeo subsidiary). 45 The process was secretive, unstructured, based on poor data, excluded stakeholders and was almost entirely unregulated. Monitoring responsibility fell entirely on local authorities with strikingly weak technical capacity. 46 Direct service delivery occurred in an unregulated setting without risk-sharing. The private sector was paid directly by the South African government and indirectly by US$115 million of aid from the EU over four years. A large NGO—the Mvula Trust—carried out community capacity-building activities in partnership with the consortia.

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Nelspruit, Durban, and the Dolphin Coast (5). 47 But the political cost of this move resulted in a second pullback to more short-term experiments: a 5-year management contract for Johannesburg Water and (not represented on the timeline but discussed further later) a voluntary partnership between Durban Metropolitan Water Services and Veolia (Vivendi) Water. This seesawing in the extent and depth of private sector participation is reflected in an analogous seesawing of the legislative and policy framework shaping that participation. Legislation–policy interaction Sect. 27 Water Services Constitution Act 1994

1997 Water Policy Preamble

Municipal Services Act 1998 Framework Agreement for Restructuring of Municipal Services

Municipal Financial Management Act

2000 2001 Free Basic Water Policy

2003 Strategic Framework Credit Control Code

The commentary developed in the following paragraphs to amplify this timeline suggests a rough pattern of ‘action and reaction’, arguably resulting in a gradual increase in the transactional focus at the hard law level, while tempering it politically with soft law or policy initiatives. The starting point is the unusually eloquent preamble to the country’s first major policy paper on water, which amplifies the constitutional commitment to the full panoply of commitments that a human right to water might entail: The dictionary describes water as colourless, tasteless and odourless—its most important property being its ability to dissolve other substances. We in South Africa do not see water that way. For us water is a basic human right, water is the origin of all things—the giver of life. We want the water of this country to flow out into a network—reaching every individual—saying: here is this water, for you. Take it; cherish it as affirming your human dignity; nourish your humanity. With water we will wash away the past, we will from now on ever be bounded by the blessing of water. 48 47 The funding for these concessions mixed international aid, government funds, and private capital: e.g. Nelspruit concession was financed in substantial measure by 150 million rand over seven years from the Development Bank of Southern Africa (DBSA), who also provided 45% of the finance for the Veolia concession for the Durban waste treatment plant: see Laila Smith, Shauna Mottiar, and Fiona White, Service Delivery Alternatives: The Water Concession in Nelspruit, South Africa, Centre for Policy Studies, Johannesburg, Draft Discussion Paper June 2003, p. 13. 48 White Paper on Water Policy 1997.

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The Water Services Act that later fleshed out the 1997 Policy Paper enacted, somewhat less poetically, an initial framework of political regulation that tried to temper distributive externalities and ensure ongoing democratic input into decisions about water service delivery. 49 The subsequent waxing star of the MIIU and its promotion of the Nelspruit concession provoked considerable conflict with organized labor 50 that was temporarily resolved by the signing of a ‘Framework Agreement for the Restructuring of Municipal Service Provision’. 51 But this was superseded in fairly short order by the Municipal Systems Act 2000, again an uneasy compromise. 52 Decentralization policies have deflected the working through of this compromise to ill-equipped local governments, intensifying political conflict. The expansion of PSP has continued in the face of this conflict, albeit on restricted terms, 53 but importantly, the government did establish in 2001 a Free Basic Water Policy establishing a universal right to access 25 liters of water per person per day within 200 meters of their dwelling. The overall result of this can be summed up as a hard law framework that is increasingly transactional and relatively neutral to the identity of the provider, combined with policy-based, nonstatutory measures to legitimate this approach. The latter do not reinscribe opportunities for 49 In the face of strong resistance from labor to private sector involvement, the Act expressed a legislative preference for public provision and gave the national government a residual power to cap profits from water services: Water Services Act 1997, s10(2)(b). 50 Labor charged that the preference for public provision expressed by the Water Services Act 1997 had not been given adequate attention. Their objections delayed contract negotiations by two years. 51 This reaffirmed a strong preference for public provision as well as a sectoral forum which labor hoped would monitor compliance with the Framework Agreement: Interview with delegate from South African Municipal Workers Union, September 17, 2003. 52 This act was less clearly in favor of public provision as a first option, and clarified that water service providers (including private companies) could be directly involved in service payment collection. The apparent illegality of this under prior legislation had led to the withdrawal of private lenders and the substitution of DBSA funding in the Nelspruit concession: Ross Kriel, ‘Facing Local Government Post-Demarcation: Impact of the Regulatory Framework on the Private Sector—Case Studies and Analysis’, paper prepared for the Development Bank of Southern Africa Symposium on Risk Management, September 1, 2003, p. 3. To labor, the legislation gave elaborate formal procedural protections around the choice to involve PSP (s78), as well as the power for politicians to set tariffs in water services, and a credit control code that tempered the private sector’s newly acquired power to collect payment directly (s94(1)(c)). 53 e.g. the 5-year management contract for Johannesburg Water and (not represented on the timeline) a voluntary tri-sector partnership that Durban Metropolitan Water Services have been experimenting with over the past few years with Veolia (Vivendi) Water, with support and funding from the World Bank and the NGO Business Partners for Development. By virtue of the short length of the Johannesburg contract and the nonlegal nature of the Durban partnership, both of these frameworks for private sector participation bypass the political regulation requirements of Municipal Systems Act (s78).

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political participation and influence into the regulatory framework, but rather ameliorate its harshest side effects. But arguably South Africa’s passionate commitment to a human rights approach has developed over time, in the context of the imperatives of transactional risk and commercial service delivery that dominate the fiscal and administrative support for the emerging strategy of global water welfarism, into a type of soft consumerism. As then executive director of the MIIU commented: You’ve got to be able provide the free basic services, cut the damn thing off when the person’s consumed that amount and be able to bill in a reliable way. [But] your credit control policy must include—as opposed to the hard-line ‘forcing people’ kind of approach—a customer relations function, a complaints centre, a mechanism of incentivising payment and that kind of thing. It’s all about creating new systems, new management capacity and we’re saying, really, that whilst you’re doing that pay attention to the human consumer issue stuff because if you don’t do that you’ve got very little chance of success. 54

‘Cutting the damn thing off’, however, inflames social activism at local levels that continually destabilizes the fragile bargain of soft consumerism described above. In part, of course, it is protest that has brought the legislative and regulatory framework to its current uneasy mix of contradictory signals. Organized labor has played the most important role in tempering the transactional focus of that framework. 55 But locally based resistance in the townships and peri-urban areas to the implementation of this move toward greater cost recovery and marketization in the delivery of water has important implications for the viability of the framework changes. In the rest of this chapter, I look closely at the differences among local reactions in one region of South Africa: the Durban metropolitan region.

8.4. Changing Local Politics In the townships and peri-urban areas of South Africa, there have long been severe problems of mass nonpayment for services, the result of collective political action taken by township residents in protest against apartheid. Apartheid has ended, but now cost-recovery principles applied to previously badly under-serviced areas, even in diluted form, have raised 54 Note here the set of principles governing credit control articulated in the 2003 Strategic Framework (4.5.8), including communication, fair process, warnings, restriction rather than disconnection as a last resort and even, unusually in legislation, compassion. 55 See text at footnotes 50–2.

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tariffs very significantly from the low base flat rate that was charged (but not paid) under apartheid. Township residents continue to boycott payment and in relation to water have mixed marches, protests, payment boycotts, illegal reconnections, political education, and test case constitutional litigation to disrupt the policies of the government. Durban Metro Water Services is a division of municipal government that was corporatized in 2000 56 and serves close to a million customers. It does so in a region with a complex political history that provides a rare counterweight, through Zulu tribal and Indian interests, to the dominance of the ANC in national politics. Interviews carried out with four different focus groups showed that local political dynamics vary with the social characteristics of different groups, but not in a manner that connects one particular group to one particular type of strategy. This can be schematically represented by summarizing the variety of strategies seeking to alter the terms of the social bargain fixed at legislative and regulatory level, and connecting them with a key to the different focus groups that indicates which groups utilize which strategy.

Collective Adversarial Cooperative

Test case litigationa Marches, protests, illegal reconnectionsa,b,c Marches, protestsa,b,c Political education, building social movements and potentially political partiesa,b

Individualistic Legal defensea,b Customer Service Agents/Community Development Officersd

a

Chatsworth focus group: moderate antiglobalization: previously Indian township, historically Democratic Alliance or Minority Front. Young organizers and older members; civics-type structures, significant reliance on legal strategies as well as mass direct action.

b

Mpumalanga focus group: radical antiglobalization: previously black semirural township built on traditional Zulu land, historically IFP and tribal but mixed ANC and IFP more recently. Young students (aged 18 and 19), loosely organized, fluid, often violent activism.

c

Ntuzuma focus group: social democratic welfare state (the ‘RDP’ constituency): previously black township, strongly ANC. Mid–late 30s ‘forgotten generation’ with very little formal education. Primarily involved in community groups pursuing livelihood/survival activities, little direct political action, and no reliance on legal strategies.

d Kwamashu focus group: ‘The Great U-Turn’ (the ‘GEAR’ constituency): previously black township, strongly ANC. Mid-20s in their first or second job, community development approach focusing on pragmatic service delivery problems.

To some extent, a web of overlapping practices cuts across all the groups. Moreover, the different strategies tend to coexist in counterproductive 56 It should be noted that as the principal provider of water services for the region, Durban Metro Water Services is a public and not a private sector actor. While it is itself not one of the global water companies, its transformation into a public corporation has led it to adopt many of the operating assumptions of commercial, for-profit water service providers, and catalyzed very similar patterns of protest to those of ‘anti-privatization’ activists.

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parallel rather than interacting productively to build bridges between regulatory and citizen space. This is in essence because of a conflict between strategies that seek to build political agency and strategies that are aimed at embedding responsible consumer behavior. At present, the former have more mass support and undermine the goals sought by the latter. Mass mobilization strategies swing between cooperative peaceful modes and adversarial violent ones in a pattern one participant calls ‘popcorn politics’. 57 Both these types of strategies, however, aim to create political agency for pursuing (vaguely if at all specified) alternatives to capitalism. This rejects the current models premised on private sector participation altogether: the aim is to harness the current ‘politics of sheer refusal’ 58 into a more proactive, mundane, and sustainable political education that will create a sense of collective identity for those excluded not just from basic provision in water, but also in health, education, and shelter. 59 Some strands of this activism seek to build an alternative political party, but whether or not the activists aspire to this level of representation, they mobilize around pragmatic service delivery issues such as service standards and the cost of water in order to build political agency against the more structural agenda of neoliberalism and privatization. This is in stark contrast to the young activists who work with ‘consumer education’ programs run by Durban Metro Water Services in partnership with Vivendi (Veolia) Water, seeking to build social and political consensus around the direction of reform. Here the focus is on paying bills, managing debt schedules, water conservation techniques, the proper operation of sanitation systems, and the like. The structural questions that are the concern of the more disruptive activists are part of the taken-forgranted background for this work. There has been a limited shift to a more politicized and less technical conception of these programs. Those liaising between citizens and the two partner providers were initially known as ‘Customer Service Agents’ but in the second phase of the project were renamed ‘Community Development Officers’. This reflects the early inefficacy of the technical, problem-solving approach, and the realization by the partners that the preconditions for securing consensus required a less instrumental approach to establishing a dialogue with affected citizens. More recent expansions of this effort to bridge regulatory and citizen 57 Ashwin Desai, We are the Poors: Community Struggles in Post-Apartheid South Africa (New York: Monthly Review Press 2002). 58 Richard Pithouse, Interview, September 11, 2003. 59 The South African ‘Social Indaba’ aims to host cross-sectoral forums that encourage networking across different areas of social activism and that also foster international connections with antiglobalization activists overseas.

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space have contracted, interestingly, not with foreign multinationals but with a local South African firm that has more experience of working with local township communities, and builds into its strategies some attention to structural issues (e.g. hiring only those in the local community who have been unemployed for a certain amount of time). In tandem with these ‘soft’ approaches, formal legal strategies also play two kinds of roles in the activism around water. The first, more procedural one, is a ‘legal defense fund’ that provides pro bono assistance for those involved in direct actions that often lead to arrest, eviction, or assault. This is a strategy that legitimizes, by reference to civil and political rights, the actions of activists. As one organizer said: There is this huge ideological project—the local press and the vast majority of academics are all saying ‘there is one way of doing things, it’s the way that competitive nations do things. We’ve all got to pull together, these [water activists] are messing it up for us, they’re holding us back.’ . . . Now getting a court case can really help with the ideological stuff—it helps show these people are not criminal, they are not lazy, [their actions] are actually in line with the values of the new society that was founded. 60

Procedural legal defense, then, clears a space for political participation on the part of those marginalized by the changes in policy, not just by freeing activists physically to continue their political work, but also by countering tendencies to dismiss the activists as irresponsible hooligans. This is, indirectly, a way of keeping open the possibility of integrating the demands of the activists into the more routine negotiations over the terms of the legislative and regulatory framework. Second, with a more substantive goal in mind, in the hope of enforcing access to water directly as a socioeconomic right in itself, some constitutional test litigation has been brought to challenge disconnection for nonpayment of bills on the basis that it unconstitutionally denies access to sufficient water. The results are mixed and limited. In the two cases decided to date 61 at lower court level, one held that disconnection was a prima facie breach of the constitutional right to water, placing a burden on the water provider to demonstrate that they had provided a panoply 60

Richard Pithouse, Interview, September 11, 2003. A recent challenge was lodged in early July 2006 in the Johannesburg High Court on behalf of residents of Soweto, Johannesburg: Media Release, July 12, 2006, by the Coalition Against Water Privatisation Johannesburg; Contact: Dr. Dale McKinley (011) 726-7487, [email protected]. The lawsuit argues that the decisions of Johannesburg Water to limit free basic water supply to six kiloliters per household per month and to unilaterally install prepayment meters are unconstitutional and unlawful. The outcome is as yet unknown. 61

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of due process rights before disconnecting consumers. 62 The other case declined to grant any remedy, in part on a technical ground 63 but also (albeit indirectly) because the judge considered that the plaintiff’s illegal reconnection to the system had deprived her of the benefit of the rights accorded by the Water Services Act. The cumulative effect of the two legal cases is to provide important but purely procedural protection to citizens who pay what they can afford, and refrain from civil disobedience in their broader demands to the political decision-makers. The litigation has no effect on the principal issue that divides the stakeholders in the broader structural conflict: the justice or appropriateness of a cost-recovery approach to the delivery of water services. 64 It softens the impact of that policy approach, but in a way that accords more dignity to responsible consumers rather than giving more voice to political participants.

8.5. The Responses of Global Water Companies The relationship between global, national, and local levels of ‘water welfarism’ is complex. On the one hand, national norms and regulations continue to be the most important frame for the operations of global water companies in a developing country such as South Africa. On the other hand, the influence of the companies at the global level is presently somewhat masked by their relative institutional invisibility. Arguably, 62 Residents of Bon Vista Mansions v. Southern Metropolitan Local Council 2002 (6) BCLR 625. In the instant case, no such demonstration (either of fair and equitable procedures, of reasonable notice of intent to disconnect, or of provision of an opportunity to make representations) had occurred, and reconnection was therefore ordered. 63 The plaintiffs had neglected to plead the direct constitutional obligation and were relying on the Water Services Act whose regulations specifying the minimum amount of water to which each citizen has a right had not yet been enacted: Manqele v. Durban Transitional Metropolitan Council 2002 (6) SA 423. 64 There has in fact been some other litigation in relation to water with very interesting structural potential. In Pretoria City Council v. Walker 1998 (2) SA 363, a group of white residents in Pretoria refused to pay their electricity and water bills after local government redemarcation amalgamated their suburb with neighboring townships. New water connections in those townships were heavily cross-subsidized by the rates paid by white residents, who claimed this violated their constitutional right to equality. They lost narrowly in the constitutional court, which expressly endorsed the constitutionality of cross-subsidization and characterized it as ‘an accepted, inevitable, and unobjectionable aspect of modern life’. While the courts here endorsed a resource allocation decision aimed at social transformation, however, it is far less probable that they would obligate the political branches to intensify their existing efforts (except perhaps in relation to temporary circumstances of an emergency nature such as the situation of homeless people in the Grootboom case). In other words, this legal strategy probably has little proactive potential from the point of view of the activists.

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what exists at the global level to date is a form of evolving self-regulation negotiated primarily between an epistemic community of funding institutions and corporate providers. At this level, knowledge transfer is the most important mechanism of governance, and so although a network of knowledge-transfer-based governance routines at the international level is currently parasitical on a decentralized arrangement of distinct national institutional frameworks, over time, the network does shape the evolution of these frameworks. This occurs via the promotion of a ‘model’ that is presented as demonstrably more efficacious in terms of a particular coherent intellectual perspective (neoclassical economics), and we can see the influence of this model on the evolution of the South African legislative and regulatory framework over time as it becomes increasingly transactional. There is also some indication that global water companies are moving toward the promotion of a global-level regulatory framework: for example, the French-catalyzed initiative to develop ISO service standards, 65 the recommendation by the Camdessus Panel that a ‘model contract’ be developed at the global level to save on the transaction costs of public– private partnerships, and work currently being undertaken by the French Water Academy on developing a legal framework for public–private partnerships applicable on a cross-national basis by working ‘bottom-up’ from a range of case studies. 66 Global water companies are also recommending more self-regulatory kinds of responses, both at the level of globally disseminated principle and via local-level pilot projects. In 2000, for example, Suez-Ondeo became a member of the UN’s Global Compact ‘to create a permanent platform for dialogue and partnership around sustainable development’ and in 2002, Gerard Mastrallet wrote an open letter declaring a ‘Water Truce’ and committing Suez to improving universal access to clean drinking water in its company publication on public–private partnership in the management of water services. The letter asserts: ‘Fighting against poverty is not an option, it is an obligation. Access to water may be one of the most vital issues to underpin development and prosperity, and to provide hope.’ 67 Vivendi is also a member 65

See n. 20. The French Water Academy was established in 1993 by the French Ministry for the Environment and six French river basin authorities to contribute to information-sharing, relationship-building, and decision-making around water policy in both the French and an international context. The Study Group on Water Governance convenes a series of seminars with international experts who work through case studies to come up with common principles and later more specific recommendations. 67 Gerard Mastrallet, ‘The Water Truce’, Bridging the Divide, Ondeo Services 2000. 66

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of the UN Global Compact, and the South African case study illustrates its attempt to restructure relations with local consumers via a partnership with the municipal government. However, it is also clear from the case study discussion that a model of redressing access to water problems by commercializing water service delivery and in some cases promoting cross-border investment is deeply contested. In the South African case, this is so not only at local levels of implementation but also within the coalitions that shape national policymaking. Consequently, the political space for self-regulatory responses on the part of global water companies continues, at least in the case of South Africa, to be significantly constrained by the national legal and constitutional framework. South Africa’s introduction of the Free Basic Water Policy may seem an appropriate compromise between the model preferred by global water companies and local political pressures, but it is regarded negatively by the World Bank, and countries that are more dependent on international multilateral development funding than South Africa may well find themselves unable to pursue such compromises. In particular, countries with less fiscal and governmental capacity than South Africa may find it more difficult to enact and support the implementation of the kind of detailed regulatory framework which balances affordability and efficiency, though in such cases broad constitutional amendments such as that recently made by Uruguay (prohibiting private sector participation in water service delivery) may still be pursued. Furthermore, states with less capacity can enable their own citizens, by granting civil and constitutional rights in relation to access to basic public services, to pursue bottom-up strategies to balance efficiency and affordability. The resource constraints on such a strategy, and the political limitations of relying on judicial enforcement of politically contentious social compromises, mean that such strategies are reasonably likely to be accompanied by more unruly forms of social protest. Here, the case of water in South Africa strongly suggests that the kind of commitments being made by global companies in response to the demands that water be treated as a human right are not sufficient to satisfy local demands for transparency and political participation at the local level. Indeed, protest can continue to destabilize the contractual environment for global water companies in ways that generate the most extreme response of all: disinvestment 68 and international arbitration 68 See David Hall, ‘Water Multinationals in Retreat’, Public Services International Research Unit, January 2003, www.psiru.org. Investment since 1999 has declined, and while its causes are not yet well-established, the political risks engendered by the widespread social protests

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claiming compensation. While this has not occurred in South Africa, contracts have been terminated in Bolivia, Argentina, the Phillippines, Puerto Rico, and Mozambique, and the slow and expensive grind of international arbitration is in process in several of these. But it is important to realize the protest is not ‘merely’ an unruly response to the limits of enforcing individual rights through courts. It is also because the ‘soft consumerism’ by which corporate welfarism is fleshed out does not address the substantive political conflict regarding larger structural issues underlying the demands for greater political participation. In other words, consumerist versions of local participation fit well with the model disseminated by the global network of actors, but in their focus on ‘responsible consumer behavior’ and micro-technical issues of water and waste practices, they elide macrostructural issues of ongoing poverty and unemployment that underlie the more unruly protest-based modes of participation. Thus we are reminded that debates about governance are increasingly proxy for debates on the appropriate limits of market capitalism and that there are still enormous gulfs between perceptions at different levels and between different social groups about how to ‘share the social adjustment costs that open markets inevitably produce’. 69 The incentive remains, therefore, to find a more productive way of going forward. The deeply politically divisive nature of water issues has already led to what some have hailed as the first true institutional innovation in global governance, the World Commission on Dams (WCD). 70 This hybrid institution, which was tasked with generating general principles to guide the funding and building of dams, could be viewed as a novel way of eliciting a code of conduct to which all players in a particular sector commit to upholding. It was novel in the sense that those generating the code—government, NGOs, activists, and corporations—were interacting on a level playing field in an institutional context unmoored from standard representative and accountability mechanisms, and the process was unprecedented in its transparency and openness as a consequence (to compensate for what might otherwise be perceived as legitimacy deficits). It was also novel in against private sector participation in water are thought by many to be an important factor. This is also reflected in a recent survey by the Inter-American Development Bank that identifies, for almost half those surveyed, social resistance as either a critical issue or one that is both significant and hard-to-solve: ‘Obstacles and Constraints for Increasing Investment in the Waste and Sanitation Sector in Latin America and the Caribbean’, Survey, IADB, November 2003, available on IADB web site. 69 John Ruggie, ‘Taking Embedded Liberalism Global: The Corporate Connection’, in David Held and Mathias Koenig-Archibugi (eds), Taming Globalization: Frontiers of Governance (Cambridge: Polity Press, 2003), 1. 70 Dams and Development: A New Framework for Decision-Making (2000).

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a second sense: that its participants, far from sharing the consensus that underpins epistemic communities of the kind that currently dominate the global level of water welfarism, spanned the full range of positions in the debate, including the most radical grass-roots direct action. It is therefore significant to close by noting that a Global Water Scoping Process 71 has established a multistakeholder review of private sector participation in water supply and sanitation to explore the possibility of establishing another, similar, global institution, this time on private sector participation in domestic water service delivery. A global dialogue driven by the concerns underpinning local conflict may yet generate more explicit, visible links between the three spheres that currently frame this troubled issue. It may also highlight the different strategies available to countries with differing levels of governmental capacity for responding to highly contentious politics around the provision of public goods with crossborder dimensions. References Camdessus, M., ‘Financing Water for All—Report of the World Panel on Financing Water Infrastructure, 2003’. Available at http://www.worldwatercouncil. org/download/CamdessusReport.pdf Desai, A., We Are the Poors: Community Struggles in Post-Apartheid South Africa (New York: Monthly Review Press, 2002). Flecker, K., Polaris Institute, Canada, quoted in ‘Civil Society Delegations Break from World Water Council Consensus’, March 20, 2003. Available at http://cupe. ca/www/news/3827, last accessed November 6, 2003. Gleick, P., Wolff, G., Chalecki, E. L., and Reyes, R., The New Economy of Water (Pacific Institute, 2002), 24–5. Global Water Partnership, Effective Water Governance, 2002. Toolkit for Integrated Water Resources Management, 2003. Hall, D., ‘Public Solutions for Private Problems—Responding to the Shortfall in Water Infrastructure Investment’, Public Services International Research Unit, 2003. Available at http://www.psiru.org/reports/2003-09-W-strats.doc ‘Water Multinationals in Retreat’, Public Services International Research Unit, www.psiru.org, January 2003. 71 Penny Urquhart and Deborah Moore, Global Water Scoping Process: Scoping Report and Executive Summary, April 2004, driven by a Working Group composed of Consumers International (international consumer organization), Public Services International (international labor federation), Wateraid (an international development NGO), RWE Thames Water (the third largest global water company), Environmental Monitoring Group (a South African advocacy NGO), and ASSEMAE (the Brazilian association of public water operators). The report, which is based on consultation with over 300 stakeholders, can be downloaded from the websites of these organizations including, inter alia, www.consumersinternational.org

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Bronwen Morgan Hemson, D., ‘The Sustainability of Community Water Projects in KwaZulu-Natal’, Human Sciences Research Council of South Africa (2003), draft manuscript on file with author. IADB Survey, ‘Obstacles and Constraints for Increasing Investment in the Waste and Sanitation Sector in Latin America and the Caribbean’, November 2003. Available on the IADB web site. Jayasuriya, K., ‘Workfare for the Global Poor: Anti Politics and the New Governance’, Asia Research Centre, Murdoch University, Australia, Working Paper No. 8 (September 2003). Kriel, R., ‘Facing Local Government Post-Demarcation: Impact of the Regulatory Framework on the Private Sector—Case Studies and Analysis’, Paper prepared for the Development Bank of Southern Africa Symposium on Risk Management (September 1, 2003), 3. Mastrallet, G., ‘The Water Truce’, in Bridging the Divide, Ondeo Services (2000). Ruggie, J., ‘Taking Embedded Liberalism Global: The Corporate Connection’, in David Held and Mathias Koenig-Archibugi (eds), Taming Globalization: Frontiers of Governance (Cambridge: Polity Press, 2003), 1. Silva, G., Tyman, N., and Yumaz, Y., ‘Private Participation in the Water and Sewerage Sector—Recent Trends’, 147 Public Policy for the Private Sector (1998), 1–8. Smith, L., Mottiar, S., and White, F., ‘Service Delivery Alternatives: The Water Concession in Nelspruit’, South Africa, Centre for Policy Studies, Johannesburg, Draft Discussion Paper (June 2003), 13. Sparks, A., ‘The Great U-Turn’, in Beyond the Miracle (Jonathan Ball, 2003). Urquhart, P. and Moore, D., ‘Global Water Scoping Process: Scoping Report and Executive Summary’, April 2004. World Bank. World Development Report, Making Services Work for Poor People, 2004. World Commission on Dams, Dams and Development: A New Framework for DecisionMaking (London: Earthscan, 2000). Yaron, G., ‘The Final Frontier’, Ottawa, Polaris Institute, 2000.

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9 Self-Regulation in a World of States Dana L. Brown

The growth of corporate self-regulation has become a hallmark of globalization in the twenty-first century. Especially since the late 1990s, large global firms increasingly are integrating into their regular business practices ‘codes of conduct’, ‘corporate social responsibility’ mandates, or are participating in ‘voluntary initiatives’ that aim to improve their social, environmental, and human rights record. These efforts have largely been prompted by increasing pressure on firms to account for the persistence of social deprivation, environmental decay, and corruption that has accompanied their own enrichment from the global expansion of market activities. Self-regulatory initiatives presumably resolve some of the fundamental challenges that globalization has posed. For one thing, these initiatives place responsibility for the externalities of corporate activities squarely on the perpetrators, who presumably have the most resources at hand to address them. Self-regulation, as opposed to rigid and nationally bound state regulatory regimes, allows firms operating in a highly competitive global arena to retain flexibility and to enter new markets more easily. Self-regulatory initiatives also appear to compensate where states lack capacity to redress the ills that globalization has brought about, a situation thought to exist especially in developing countries. For all of the reasons above, the expansion of corporate self-regulatory initiatives in recent years has been lauded by commentators on both the right and the left. Right-wing ‘liberals’ see self-regulation as a means of keeping states out of the economy, while activists on the left see it as way in which corporations are being held accountable. Consequently, the growth of corporate self-regulation has spawned a plethora of supportive organizations, including private monitoring firms, consultants,

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NGOs, MSIs, and special sections of international organizations. These supporters of self-regulation work with firms to both improve on and expand what firms or industry groups can accomplish on their own. A corporation that signs on to the Global Compact or allows monitors from the FLA not only increases its legitimacy as a responsible global actor, but also gains from the broader knowledge of standards that these organizations have acquired. Many of these groups make large claims about how much supported self-regulation can achieve. They aim to help firms find a way to minimize their exploitation of people and resources without unduly constraining them. In this way, firms become the central actor in resolving critical labor, social, and environmental issues of our age. And, critically, firms are seen as participating in these initiatives mainly out of self-interest; either to avoid or rectify a negative reputation or even to improve the resources on which their competitiveness depends. Corporate self-regulatory initiatives have undoubtedly yielded some positive outcomes both by actually improving social or environmental conditions in some cases and more generally by bringing to the fore important questions about corporate practices. Nonetheless, the hype around self-regulation has tended to obscure serious debate about what it can realistically achieve. Claims about the benefits of self-regulation confer on corporations a central role in tackling the world’s most complex problems. From this starting point, evaluating self-regulation is a matter of assessing how well corporations mitigate their own impacts on society and environments. In a rather circular way, self-regulation has corporations dealing with what are known in the economics literature as ‘externalities’; effects of market activity that are external to the boundaries of normal corporate activity. Addressing externalities is traditionally understood to be the purview of the state and, indeed, advocates of selfregulation see it as a useful substitute for state regulation. But when corporations are seen as standing in for the state, a whole new set of questions comes to the fore. Occasions when one or many corporations agree to reduce the negative impacts of their activities are not the same as a state setting and enforcing rules. There are myriad reasons why this is so. A major reason is that compliance with rules cannot be insured in the absence of mechanisms for enforcement. Nonstate actors may wield carrots and sticks to incentivize compliance, but in general they have no means of enforcing rules on corporations. Only states have the ultimate claim on making and

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enforcing rules on those operating in their borders; in other words, sovereignty. Another difference is that rules implemented by the state apply to all, not a few, corporations and are the result of agreement on the issues to be managed in relation to the general functioning of the economy. On the contrary, rules devised by corporations or supportive organizations usually represent a very particular set of interests, driven or bounded by the interests of the firm itself. In addition to these differences between self-regulation and state regulation, there is a larger question about the limits of corporate self-regulation. The argument, which is commonly heard, that self-regulation can compensate for or replace state action, is rarely made with much contemplation about what states actually do. Legitimate state activity is defined variously as including the provision of internal and external security, possibly in addition to the guarantee of property rights, and a redistributive or directing role in the economy. The activities that self-regulation usually covers are ones that are integral to the functioning of the economy; labor conditions, financial reporting, environmental standards, etc. In this sense, when thinking about selfregulation as a substitute for state regulation, it is appropriate to compare it with states’ role in the economy. The remainder of this chapter will argue that self-regulation is a poor substitute for a state role in the economy, especially in developing countries. In the first section, a brief history of industry regulation in developed countries will show that self-regulation has long been a component of the way economies are organized, but that states have also played an integral role in regulating complex market economies throughout their development. This is true even in this period of globalization, despite myths to the contrary. Next, various current forms of self-regulation will be discussed and it will be argued that these initiatives lack the force and breadth to compensate for a state role, even when they are optimally designed. Even from the business perspective, self-regulation as a substitute for the state makes little sense. Corporations will have difficulty upholding their own codes and standards where state institutions are weak, and realistically have little incentive to invest widely in resolving highly complex social and environmental issues. In the final section, it will be argued that self-regulation can usefully complement state initiatives, but they should then be designed with complementarities in mind. States have a unique and important role to play; one that can be aided but not supplanted by the, albeit growing, role of the modern corporation.

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9.1. Regulation in a Global Economy: The Historical Context To understand what is new about the way corporate activity is regulated today, it is useful to look comparatively at the history of industry regulation, and the various contexts that have supported different regulatory forms. An historical analysis highlights the crucial ways that states structure economies through rules, regulations, and welfare institutions. To phrase this in another way, sociological theories guided by the insights of Polanyi describe economies as being ‘embedded’ within particular state contexts. This interdependence between the state and economy is identifiable in historical examples, but is also a general conceptualization of how economies function. For this reason, the way that today’s developed economies emerged has relevance for today’s developing countries. History illustrates why complete state withdrawal from the economy is an untenable condition and provides a justification for why developing country governments must play a part in directing and organizing economies that function within their borders. An historical perspective also provides insight into how ‘self-regulation’ has achieved prominence in contemporary discussions about regulation. Self-regulation presumably resolves a fundamental problem of the need to reduce the state’s role (deregulate) in a period of globalization; however, the discourse about deregulation does not always match the reality of what states are doing or can do. The fact that this discourse has framed the growth of selfregulation today makes it critical to understand from where it comes and how it has become the basis of much thinking about the possibilities for states, especially in the developing world. Private rule-making by corporations trading internationally is at least as old as the TNC itself. As cross-border trade expanded in the sixteenth century, European merchants often developed their own rules of exchange and dispute settlement to cover domains outside of particular political jurisdictions (Haufler 2001). Evidence of industry self-regulation can also be found even earlier in history. Grief (1989) documents how Maghribi traders in eleventh century Baghdad overcame information asymmetries in their relation with foreign trade agents by organizing into industry groups that shared information and effectively certified agents who could be relied on for honest business practice. Medieval mercantilists also relied on self-organization and voluntary enforcement of rules to govern uncertain areas of interregional trade (Benson 1989). In all these examples of early self-regulation, those engaged in business voluntary restrained their activities in favor of reducing potentially damaging uncertainties in 230


their business environment. However, Grief finds in his study that Genoans facing similar uncertainties to the Magribi failed to self-organize. This makes the point that self-regulation is not necessarily the means by which business people overcome uncertainties and information problems. In these examples, self-organization also addresses only a restricted domain of coordination issues. As economies have become more complex, self-regulation has become only a part of broader, more systematic regulatory forms. The growth of industrial economies gave rise to what is known today as the modern regulatory state. While different theories about this emergence exist and are contested (McLean 2005), it is generally agreed that state regulation was a response to the increasing complexities in burgeoning economies. Economic development led, for one thing, to a larger extent of potentially harmful externalities such as pollution, workplace injuries, and monopolies (McInerney 2005). Urbanization compounded the problems of industrialization. In the new cities, problems of poverty and public health issues developed to an unprecedented scale. The process of urbanization destroyed self-sufficient land holdings and broke down networks of families and communities that traditionally delivered social welfare. Theories of modernity often describe the situation in modern industrial cities as being characterized by alienation, the meaning of which is aptly described by Karl Mannheim as ‘the displacement of selfregulating small groups’ to address social issues (Mannheim 1950 quoted in Lowi 1969: 26). Lowi builds on this understanding to argue that the growing social problems in industrial cities simultaneous with the breakdown of informal and automatic social controls created a gap that had to be filled by rational solutions, or administration. In Lowi’s view, modern government was the most important mechanism of administrative social control (Lowi 1969: 30). Karl Polanyi provides a comprehensive account of increased state regulation from the period of industrialization onward. For Polanyi, the market-driven economy proved socially unsustainable from the outset. Writing about the close of the nineteenth century, he describes a ‘doublemovement’ in which: ‘While on the one hand markets spread all over the face of the globe and the amount of goods involved grew to unbelievable dimensions, on the other hand a network of measures and policies was integrated into powerful institutions designed to check the action of the market relative to labor, land, and money (Polanyi 1944/2001: 79). This occurs, in Polanyi’s view, because the attempt to organize society through market mechanisms requires that labor, land, and money are treated as 231

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‘commodities’. A ‘commodity’ is something that is produced for sale. Polanyi argues that labor, land, and money are inherently something else. To commoditize human labor is to treat mankind as something other than a social and cultural being. Likewise, the use of land in this way treats it as something other than ‘nature’. In both cases, Polanyi shows that historically, attempts to organize the use of labor and land through market mechanisms leads to unsustainable detrimental effects. The Industrial Revolution is replete with examples. Ultimately, society demands protection from the effects of the ‘self-regulating’ market and where more localized forms of protection have been destroyed, the state is called to step in. In the case of money, Polanyi makes a similar argument. In a free market economy the value of money for sale lies in its linkage to a commodity such as gold. The amount of such a commodity cannot be increased in large scale on demand. Yet, the dramatic growth of productive activities that occurs with the expansion of markets requires just such a large scale increase in money. A scarcity of money would by definition lead to deflation and the consequent liquidation of businesses and unemployment; again, an untenable situation. It was for this reason, argues Polanyi that the international gold standard—the epitomizing attempt to allow world markets to self-regulate—ultimately collapsed. Polanyi argues that even as the world was embracing ideals of internationalism and interdependence, which the gold standard represented, measures were being taken to deal with the problem of scarcity of money at the national level (Polanyi 1944/2001: 207). The creation of token currencies, the value of which lay not in gold, but in guarantees by the authority of sovereign central banks, provided needed protection from the detrimental affects of deflation. Token money served a particular purpose; to assure purchasing power among a population; it was not produced to be sold as a commodity, but to fulfill a function. Increasingly in the twentieth century, Polanyi argues, this view of money came to dominate, justifying its regulation at the level of the nation-state. As Polanyi predicted when he wrote in 1944, the role of the state in the economy grew over the course of the twentieth century. Helm (1986) provides a description of the role of the state changing from the provision of minimum services (maintaining value of the currency, defense, and law and order) during the Industrial Revolution to a comprehensive role (allocating resources, macroeconomic management, providing health, social security, etc.; dealing with market failures (health care, education). The expansion of the state’s role in production, labor mobility, and taxation 232


began with the exigencies of economic mobilization in World War I. The interwar period was characterized by the attempt to return to the gold standard and withdraw from a state role, but the result was disastrous and led to growth of social assistance and labor regulation. This period following the depressions of the 1930s saw the increased application of Keynesian demand management policies as well as the array of government social policies under Roosevelt’s New Deal. World War II again expanded the state’s role in mobilizing the economy, but the growth of the welfare state in its aftermath was fundamentally an outcome of lessons from the past and widespread concerns about social justice. Helm’s analysis of the growth of the state fundamentally accords with Polanyi’s. The increased role of the state in his view was at least in part a reaction to the attempt at social organization through market mechanisms, and particularly a reaction to the detrimental outcomes of the ‘first’ globalization of the past nineteenth century. Writing in 1965, Andrew Shonfield argued that increased public intervention in the economy was a characteristic feature of postwar modern capitalism. He identified several ways that power in advanced industrial countries had shifted from the private to the public sphere over the course of the century (Shonfield 1965). These included states’ management of economic systems; demand management and the extension of welfare states; government regulation and planning to ‘tame the market’; and public policies to foster innovation and develop skills. These developments typified the increased regulatory role of the state generally, but what Shonfield underplays is how much the precise forms of state intervention varied. Across the advanced industrial countries there were profound differences in the goals and extent of regulation in different areas and the nature of the welfare state. Many political scientists have tried to capture this variation using typologies such as Esping-Andersen’s ‘liberal,’ ‘conservative’, and ‘social democratic’ welfares states (1990). A new school of thought on ‘varieties of capitalism’ argues that these different welfare models are integrally linked to different structures of economic regulation, industrial policy, and corporate governance laws (Hall and Soskice 2001). What is important to note is that these variations emerged historically out of political debates over the appropriate role of the state in protecting society from market failures and in promoting a particular path of development. In this sense, varieties of capitalism reflect the unique history, culture, and politics of each society. Shonfield attributed modern capitalism’s success—the high rates of economic growth achieved in the immediate postwar period—to ‘political 233

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will and skill’, and was optimistic about the future. The economic crises that befell developed countries in the 1970s, however, prompted a fierce critique of the regulatory state. Falling growth rates, high unemployment, and inflation on one hand pointed to problems with the way that economies were organized. On the other hand, falling growth rates themselves threatened states’ ability to retain the programs, bureaucracies, and commitments they had in the past. As a result, discussions about government’s role in the economy occurred in many countries. The nature of these discussions was by no means predetermined; but some common themes did emerge. In contrast to Shonfield’s contentions, bloated budgets and bureaucracies came to be perceived as impediments to continued economic growth in modern capitalist economies. ‘Government failure’ was the focus of much of the debate in this period; deregulation or dismantling of presumably burdensome state programs became a mantra of the political right and was often accepted as a reality by the left. No amount of ‘political will and skill’ seemed able to resolve the deep economic crises of this period; and hence the idea came to the fore yet again in the 1980s and 1990s that economies and societies could be best organized by ‘the market’. The debates that occurred in Britain, America, and elsewhere at this critical juncture were to a large extent ‘won’ by leaders such as Thatcher and Reagan; less so in terms of what was actually accomplished than in the sense of shifting the way that states’ role in economies was conceptualized. From this point onward, concerns about ‘how’ state governments could promote economic development and growth were largely replaced with debates over ‘how much’ state involvement in the economy was appropriate. Furthermore, the new discourse put a heavy emphasis on the goal of economic efficiency whereas the growth of the state historically was in response to moral concerns. There was an emphasis on ‘government failure’ as an explanation of the economic crises of the 1970s, which outweighed previously held concerns with ‘market failures’ and how governments could address them. Significantly, the focus on market efficiency in these debates took out of play particular moral questions that have always lain at the heart of state economic policies. ‘Market optimists’ made a very specific moral claim in that they linked the primacy of the market over the state to an ideal of individual freedom (see Helm 1989). The concept of freedom that was invoked was akin to Berlin’s definition (1958) of ‘negative liberty’ or freedom ‘from’, as opposed to ‘positive liberty’, which is accomplished through empowerment of citizens to achieve a reasonable standard of 234


living. Positive freedom as a goal requires intervention and it calls up moral questions about how resources in a society are distributed. These questions—about redistribution, equality, etc.—have historically been at the heart of political decisions about states’ role in the economy, yet in the way debates were framed in this period, market efficiency superseded these moral objectives. Reagan’s comprehensive regulatory reforms illustrate how ‘market optimism’ was translated into practice. These reforms served as a model that other developed and developing countries alike tried to follow. A key component of these reforms was the passing of Executive Order 12291 requiring all proposed regulation to pass through rigorous cost–benefit analyses conducted by the Office of Management and Budget (OMB). The objective of this reform was to discourage the growth of regulation and bureaucracy especially through elimination of ‘inefficient’ rules. Cost– benefit analysis as practiced by the OMB did not weigh in ‘values’ when deciding on government programs; it was strictly a quantitative means of assessment. This reform was significant for setting in motion the growth of corporate self-regulation, which required that all alternative means of addressing an issue be considered before any state involvement was permitted. Deregulation was the key component of the ‘market optimists’ program, the objective being a move away from state-led to market-led capitalism. It is useful to ask about the basis for claims that the market optimists in this period were making. Was it true that greater quantities of state involvement impeded economic development and explained the crises of the 1970s? A number of social scientists have evaluated this question. Piore and Sabel (1986) test this thesis for the period of 1973–9, which is generally the reference period of ‘crisis’. In a comparison of social expenditures with average annual per-capita gross domestic product (GDP) growth across seven advanced industrial countries, they find no relation between high expenditure and low growth (Piore and Sabel 1986: 11). In fact, high-growth countries from this period like Austria and West Germany also had higher social expenditures; the UK’s lower expenditures went hand in hand with the lowest growth rate of the seven countries surveyed. In further analysis of the extent of regulation, the authors find that the relationship between this variable and growth was also sporadic. They give as examples the extensive labor regulation in France and the pervasive control of credit markets in France and Japan, both high growth countries at the time (Piore and Sabel 1986: 11–13). The relationship between the state and economic development 235

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was tested from a different angle in a collection of essays edited by Kay, Mayer, and Thompson (1986), which evaluated privatization and deregulation attempts under Thatcher in the UK. The studies in the volume specifically evaluate the claim that less government intervention in businesses (through ownership or regulation) increased efficiency. No clear relationship between less government and more efficiency was found. This is not to dismiss the existence of government failures and inefficiencies; but such findings challenge the general claim that economies function more efficiently the more the state steps out. Regardless of the empirical evidence, ideas that underpinned the deregulation agenda in the advanced industrial countries became predominant in international organizations and through them were exported to the developing world. Starting in the 1980s, the IMF and World Bank especially began to push a strong agenda of deregulation in developing economies. The impetus for arguing that state intervention impeded development was the economic and social crisis that had swept through Latin America (Chaudhry 1993). Crisis had followed a period of stateled growth policies, which had been heavily promoted by development specialists at the time. Thus once again the coincidence of a large state role in economies and crises provided the context in which reducing state involvement in the economy was promoted. With the collapse of Communist regimes in the late 1980s, the case for ruinous effects of state involvement in the economy appeared stronger than ever, and international organizations were able to promote reforms that gave full precedence to allowing ‘the market’ to emerge and function in places like Russia. These reforms, otherwise known as ‘shock therapy’ amounted to a full-scale experiment of the principles that had underpinned the deregulation movement in advanced industrial countries. The deregulation movement that started in the advanced industrial countries was implemented to a much greater extent in the developing and postcommunist countries. This occurred for numerous reasons that had to do with the nature of power in the global economy as well as historical changes that were shaping that economy. Various developments around this time were strengthening the hand of international organizations and of corporations in shaping the rules of the global economy. This was partly illustrated in debates in the early 1970s, which started with efforts by developing countries themselves and eventually the UN to regulate foreign investment and the actions of transnational corporations. At the national level, regulation was intended to mitigate potential negative effects of FDI and to channel investment toward areas of state interest 236


and need. In 1974, following a scandal that revealed ITT’s involvement in an attempt to overthrow the democratically elected government in Chile, the UN produced a Draft Code of Conduct on TNCs and a similar effort by the ILO. These attempts at regulation, however, were eventually abandoned or overwhelmed. Corporations and governments in the Northern countries where they resided pushed to reshape the agenda to their own interests. Thus, the OECD in 1976 passed the Declaration on International Investment and Multinational Enterprise, which called for minimal regulation on TNCs in an attempt to pre-empt anything more restrictive (Jenkins 2001). But, the movement toward deregulation was not just a story of power. Arguments for reducing the state role influenced action because they resonated with developments that characterized the ‘postindustrial’ and ‘globalized’ economy. To understand how we arrived at the current period where self-regulation is on the rise and claims about the ‘end of the state’ continue to be made, it is necessary to look closely not only at the sequence of events but also the way that theories about states and markets have influenced these events. ‘Market optimists’ make a strong case that traditional forms of state regulation are repressive to modern corporations and hence impede positive growth and development. Modern or ‘postindustrial’ corporations are more likely to be in the service sector, operating on lower margins and competing in more crowded markets. These firms compete on being leaner and more flexible in production and work practices than the large, self-contained mass production industries that predominated in the industrial period. Industry regulation of the ‘command and control’ style of the past required a high degree of predictability and stability of firms’ activities and practices. In the postindustrial economy, managerial practices, workforce organization, and relations between companies change rapidly. Government regulatory agencies have a hard time keeping up with these changes and could hold up corporate growth by imposing costs or impeding their ability to explore new opportunities. Self-regulation, contrarily, would give discretion to firms themselves who had the technical knowledge of when to implement such discretion. ‘Globalization’ offered another reason to worry about state regulation. As opportunities for expanding internationally grew, corporations would choose away from locating in places with high regulatory costs to themselves. Developing countries especially were advised to ‘open’ up to the flow of goods and capital by bringing down regulatory barriers that would increase the cost of production, impede the growth of markets, or restrict the mobility of capital. 237

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The argument is often made that ‘postindustrialism’ and ‘globalization’ themselves have made it necessary for governments to reduce their regulatory roles. It is important to closely evaluate that claim. First, deregulation entails policy reforms that need to be proactively decided on. The image of global market forces pushing down the barriers of the state is a simplistic story that leaves out the critical step of decisionmaking. Certainly, changes in production and markets have prompted corporations in many cases to push for lower taxes, less regulation, and fewer barriers to new markets. But across states, corporations vary in their ability to influence government action as well as in their interests. Companies benefit in different ways from what states offer, whether it be skilled labor, funded research, protection from competition, insurance, etc. Much research suggests that firms have historically played a positive role in the construction of welfare states (Mares 2003) and that they may not uniformly push for deregulation. Nonetheless, many national governments, especially in developing countries, have reduced the state’s regulatory role and often to a large extent. This has occurred for a variety of reasons; often as a result of the influence and sometimes direct pressure of international organizations and consultants. Certainly, the IMF with its ability to tie loan conditionality to the implementation of its particular policy agenda has exerted such pressure. The WTO and EU also have competition rules that restrict the use of some forms of intervention. But international organizations have also been influential because theories of pre-eminence of the market are easy to follow and they resonate; just as Polanyi describes their appeal to policymakers in the nineteenth century. Where countries have been in crisis, such was the case in Latin America and Russia, the argument that the market should be allowed to function freely provides a simple and rational answer to a complex problem. Second, the extent to which changes in the international economy have actually forced deregulation has been challenged by empirical evidence. Much of this evidence suggests that the reforms advocated to developing countries on the basis of their necessity in the global economy have not been implemented to nearly the same extent in the advanced industrial countries. A popular line of argument contends that the growth of international trade and financial flows necessarily places constraints on all states (Ohmae 1995; Strange 1995, 1996; Friedman 1999). Competition makes it hard to retain regulations or pursue industrial policy, and increases fiscal competition. The rapid movement of capital around the globe makes it hard for governments to control it, to collect taxes, or to retain fixed exchange rates. For all of these reasons, states are thought 238


to be unable to compensate for social costs to the extent that they could in the past, hence not only regulation, but welfare states are bound to ‘retrench’ (shrink) (Keohane and Milner 1996). The predicted result of these theories is that states will eventually converge on liberal, marketoriented policies because they will have no choice. While the story of constraints on states is by no means untrue, the actual response of states to the pressures of globalization has varied. This is evidenced by the continued variance in welfare states (Pierson 2001), corporate governance, industrial and regulatory policy across the advanced industrial countries (Hall and Soskice 1999). Moreover, several empirical studies have found that pressures on the state have not necessarily changed behavior in the ways predicted by globalization theories. Garrett (1998), for example, finds in his large scale study of the OECD countries that pressures on the state during globalization do not necessarily preclude big government; it is possible for a country such as Sweden to have a balanced budget with 60 percent GDP on government spending. Swank and Steinmo (2002) show in their study that the reduced ability to tax corporations has not necessarily led to fiscal crises because corporate tax in most places usually comprises 10 percent or less of countries’ total budgets. Other authors have found, contrary to what globalization theory predicts and closer to what Polanyi would predict, that there is actually a positive relationship between the size of the welfare state and its openness (Rodrik 1998). There is sufficient empirical evidence also to questions whether or not a reduced state role is necessary for development and growth in the globalized economy. In recent years, the claims of the IMF, World Bank, and others that deregulation and accompanying policies are optimal for the developing world have been put to the test. The strongest counterexamples of such claims are the East Asian ‘tigers’. Phenomenal growth in these countries has been attributed to state-led development efforts, in particular to targeted industrial policy that deliberately protected and grew their export sectors (Amsden 1989, 2001; Fishlow et al. 1994). Other studies have found a weak correlation between the efficiency of enterprises and the extent of state involvement even in Latin America (Chang 2003), where some of the notable examples of government failure can also be identified. In recent years, governments that have closely followed the recommendations of international organizations have often seen their economies collapse. This has been the case both in some parts of Latin America and in the former Soviet Union, especially Russia (see Stiglitz 2002). Failure of these policies has in fact given rise to a slight shift in the policy of these organizations away from the ‘Washington Consensus’ on 239

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the primacy of the market toward a greater acknowledgment of the need for ‘institutions’ to support market development. This change in thinking, however, has not yet yielded a fundamental shift in policy. The recent growth of corporate self-regulation has followed and indeed grown out of the deregulation movement. Deregulation has deliberately and explicitly broadened the scope of responsibility of corporations in tandem with limiting the scope of the state, as we saw with Reagan’s reforms in the 1980s. In developed countries self-regulation has been used as one of many tools for reducing state intervention. It has on the one hand been encouraged by governments and on the other hand used by corporations as a pre-emptive strategy against the possibility of reregulation. Across developed countries, however, the extent of self-regulation and indeed of deregulation has varied greatly. Certainly, nowhere in the developed world have states come even close to fully ceding responsibility for key issues related to the environment, labor, and social welfare to corporations. Even where self-regulation occurs, it is often one of many layers of rules and laws governing what corporations can and cannot do. The construction of regulatory regimes in most developed countries still gives states the right to enforce and implement rules concerning the actions of corporations within their borders. The case is somewhat different, but again varied in developing countries. In recent years, many governments in the developing world have indeed deregulated to a great extent. The impetus for this has largely been to attract investment, as well as to fulfill obligations to international organizations, as described above. But in some cases, the absence of regulation is more a product of history; the weak formation of nation-states, corrupt governments, or limited regulatory capacity. The growth of self-regulation by multinational corporations in recent years is commonly understood to be rooted in new arrangements of power in the global economy. International economic expansion is thought to weaken the authority of the states, especially in developing countries. These weak states exist in a world of increasingly powerful corporations, international organizations, and NGOs. At the same time, the expansion of corporate activity around the globe has given rise to a disparate social movement concerned about the social implications of this expansion. This movement shows itself in protests at meetings of the WTO and WEF; it has shaped ideas in various international organizations especially among the UN and it has spawned a range of NGOs that can tap into the sentiments of worried and information savvy consumers. Self-regulation emerges, in one sense, as a means by which corporations 240


can respond to new pressures that come from activist NGOs, consumers, and some international organizations. In the absence of state authority in many countries, corporations have to take their own actions. John Ruggie explains the growth of self-regulation (in the form of corporate social responsibility) as a form of embedded liberalism—that is, it has become the means by which societies are protecting themselves from the dire effects of the free market, without sacrificing its benefits. In this way of understanding the rise of self-regulation, societies turn to nonstate actors again because states are weak. Corporations step in because they are powerful and perhaps because they have an obligation in being the beneficiaries of the resources that developing countries can provide. The problem with these explanations is that they take the decline of the state as an a priori assumption, rather than problematizing or questioning that decline. States in the developing world are weak for many reasons; historical, cultural, and political. However, international organizations and corporations themselves have a critical role in minimizing the state’s role. In addition to the influential deregulation agenda pushed by various international organizations, corporations have also played an active role in promoting self-regulation as a way to prevent the emergence of ‘harder’ laws and obligations (Utting 2005). This history matters because it is the belief in the inevitability of states’ weakness that legitimates selfregulation as the modern form of response to the problems that the free market creates. To assume this, however, overlooks the critical role that states have always had in allowing market economies to function.

9.2. The Growth of Self-Regulation and Its Limits Regulation in today’s economy takes a range of forms. While ‘command and control’ style regulation has diminished in most places, new regulatory forms that combine roles for the state and private actors have taken its place. Most notably, there has been a significant increase in regulation by corporations themselves (known as self-regulation or private regulation), particularly those operating internationally. Self-regulation involves a corporation defining and implementing its own rules or codes of conduct or voluntarily subscribing to those promoted by an NGO, industry group, or international organization such as the ILO or OECD. The proliferation of codes of conduct since the mid-1990s and their variation in terms of content and coverage has been well documented (UNCTAD 1996; ILO 1998; Kolk, van Tulder, and Welters 1999; OECD 241

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1999; Leipziger 2003). An important distinction must be made, however, between the place of self-regulation in developed and developing countries. In the former, self-regulatory initiatives tend to form a part of a regulatory regime that includes state agencies implementing and enforcing rules to a variety of degrees. Self-regulatory schemes also often directly respond to civil society interests and concerns about the environment, working conditions, ethics, etc. In developing countries, this complementary infrastructure is often missing. Self-regulation minimally deals with market externalities, particularly with the effects of global corporate expansion on labor, environmental, and human rights issues. This presumed function of self-regulatory schemes is particularly important in countries where state capacity is weak. Forms of self-regulation aimed at these ends include company or industry-level codes of conduct on labor, financial reporting, or the environment. These forms sometimes include multistakeholder dialogue and monitoring; environmental management systems; participation in labeling and certification schemes; and triple bottom line reporting. Frequently, corporations partner in their self-regulatory efforts; either with others in their industry, with NGOs, local ‘stakeholders’, or with international groups or organizations. These partnerships can enhance regulatory efforts in a variety of ways, but in such arrangements so far, the corporation has been mainly responsible for defining the scope and scale of such initiatives (see Utting 2002). While corporate action is indeed critical for coping with the issues described above, there are reasons to believe that on its own, selfregulation cannot be extensive enough to deal with key issues in these areas. We will explore four of those reasons here. The first is that even if there are strong market drivers to self-regulate, these will likely motivate only some firms; most of which will be large, international firms or those who would be compliant in any regulatory situation. Related to this, it is complex for a large multinational’s code of conduct to be effectively applied all the way through its supply chain, especially when the chain includes very small factories and home workers. Third, codes of conduct cover internal workplace practices, but do not address broader social problems that often underlie these practices. The most obvious example of this is the effective crackdown on child labor in multinationals; the failure to simultaneously redress the issues that led children to go to work resulted in children often laboring in far more dangerous occupations. Finally, selfregulatory initiatives rarely represent or incorporate the concerns of those whom they affect the most. This is especially the case for self-regulatory 242


schemes that affect firms and people in developing countries where civil society is absent. While the proliferation of codes of conduct suggests that they are becoming more widespread, there are definitive limits as to which corporations adopt and effectively comply with them. For the most part, codes of conduct have been adopted by only the largest of the TNCs. Utting (2005) cites evidence that of the approximately 65,000 TNCs operating globally today, only about 4,000 actually issue CSR reports or have codes of conduct. These tend to be large and visible firms who are likely to suffer if their name is associated with negative activities. In other words, they are generally the Shells and Nikes, which means that most production continues without any form of regulation at all. Moreover, at least 50–60 percent of worldwide employment is with SMEs, whose role in development has been shown to be significant beyond the numbers (UNIDO 2002: 2–3). While SMEs in the developing world are increasingly interested in improving practices and accountability, low-margin operations face serious obstacles, including the costs of implementing codes and standards and threats of competition (UNIDO 2002). SMEs may also have difficulties gaining from the reputational effects of such initiatives. Further, the market factors that often drive large multinationals to adopt codes of conduct are more significant in some cases than others. While a large forestry company selling to European or North American consumers directly might see the benefits of certifying their products for sustainability, others will see a large market for their products in Asia and elsewhere where certification is unimportant. A recent OECD study found that the fact that some companies were doing much better in sustainability had done nothing to change the practices of the worse offenders (OECD 2002). Finally, as McInerney (2005) argues, regulatory scholars have long been aware that there are some firms that tend to comply and others that do not. By extension, firms that have not already adopted standards and put in place compliance programs are not likely to ever do so. In the absence of any sanction, such firms will not see it in their rational interest to act any differently than they do today (McInerney 2005). For all of these reasons, the coverage of private regulatory initiatives will necessarily be limited. A further complication arises when consideration is given to supply chains. It is one thing for a corporation to privately regulate its activities within the operations that it controls; it is quite another to commit to regulate an entire supply chain. Utilizing complex supply chains allows global firms to maximize efficiency by breaking up their production 243

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process and tapping global resources. But, to do so, firms often rely on layers of producers in their supply chains, ranging from large manufacturers to home workers. There are in fact several million companies that make up the supply chains of TNCs, and according to some figures only about 50,000 of them are ISO14001 certified: 366 approved by the Global Reporting Initiative; 1,266 by SA8000; 353 by the FLA (Utting 2002). These numbers put into perspective the real scope of self-regulation. A useful illustration of the complexity of supply chain management is the case of soccer ball production in Sialkot, Pakistan. The supply chain in this case looks as follows: brands deal directly with manufacturers who purchase raw materials and distribute them to stitching contractors, the contractors in turn hire individual stitching workers—about 30,000 in the Sialkot region (Schrage 2004). For a corporation to completely and effectively regulate its supply chain, it would have to insure that the working conditions of each and every stitching worker adhered to its code of conduct, which would likely include standards on hours worked and health and safety conditions in the workplace. The difficulty of doing this is obvious, particularly as the corporation (the brand) has no direct contact with either the stitching contractors or the stitching workers. To effectively monitor its supply chain, the corporation would have to expend tremendous resources in setting up monitoring facilities and gaining local knowledge in every single area that it produced. It could rely on the manufacturer for adherence, but there would be little incentive for the manufacturer to seek full compliance since it would likely be operating under constraints of low margins and in a highly competitive environment. Studies thus find that suppliers tend to prefer weak codes over strong ones (Zadek 2001: 16). These complexities tend to push corporations away from implementing policies that apply to their supply chain. A recent OECD study found that only 20 percent of large global firms based in Europe had a code of conduct or policy that would apply to suppliers (Gunningham and Sinclair 2002). But, if there is only minimal regulation of supply chains, then many of the externalities of global production are not being addressed. Third, private regulation is limited in its extent by virtue of the issues it covers. Private regulatory initiatives most commonly concern three areas: labor rights, environment, and financial accountability. In each of these areas, firms regulate their own activities or those in their supply chain, but they do not address the roots of these problems, which are usually historical, political, or cultural, and highly complex. The idea behind private regulatory initiatives is often that they will have a spillover effect 244


to society in general, but the mechanisms by which this works is not always clear. For example, several firms include a right to organize in their labor codes of conduct, but in the absence of rights to free speech or in the presence of opposition to organization that exists in many countries, this guarantee is functionally meaningless. It is difficult to see how the actions of a few corporations would be a strong enough force to push against such a broad and deeply rooted social tendency. Moreover, resolving issues within a corporation through codes of conduct can sometimes have negative spillover effects. A prominent example is the issue of child labor, which has often been efficiently addressed through corporate codes of conduct. The problem is that unless it is combined with other measures to deal with family poverty and the absence of suitable educational opportunities for children, the elimination of child labor in factories can drive children to even worse situations. Yet, while it might be clearly in the corporation’s interest to eliminate child labor from its production, addressing the broader context of the issue is likely to push the boundaries of what corporations perceive as their legitimate and rational responsibility. Some studies find that corporations are willing to adopt these wider measures, but usually in collaboration with international organizations, NGOs, or government, and not always in a way that will hold them fully accountable (Kolk and van Tulder 2002). The effectiveness of self-regulatory efforts is also limited in that the code of conduct or CSR measure employed is often only one aspect of what a firm is doing. One often finds that the very same corporations that are leaders in improving working conditions through self-regulation are also the leaders in pushing agendas to lower taxes, increase labor flexibility, and lower regulations in the places where they operate (Utting 2005). Moreover, corporations that adopt CSR measures often see them as an addition to regular corporate practices rather than an integral part of those practices. ‘Corporate Responsibility’ is often its own department in large corporations and frequently is largely concerned with PR, rather than with critically evaluating company practices. A good illustration of this phenomenon is the case of Nike, a company that has spent considerable money and effort to improve labor conditions in its supplier factories. While this was undoubtedly an important part of Nike’s strategy, a recent study suggests that the implementation of labor codes of conduct and monitoring system aimed partly at eliminating excess overtime in its supplier factories when hand in hand with buying processes that demanded excess overtime (Locke, Fei, and Alberto 2006). 245

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Finally, private regulatory initiatives can hardly be ‘effective’ unless they address the concerns of those who they are meant to protect. In what has been the most comprehensive survey of codes of conduct to date, the OECD study of 2001 found that 48 percent of codes are issued by corporations themselves and 38 percent from business associations. This means that most codes are self-selected and not necessarily geared to addressing issue areas that may be most critical to potential constituents. Particularly when the primary driver of an initiative is to improve a firm’s reputation among consumers and investors in the developed world, the main concern will be with the interests of those actors. For example, an obvious clash with the interests of societies in the developing world arises when high standards are traded off for jobs themselves. Workers in developing countries are often perplexed that factory closures for violations of standards are meant to be for the good of the worker. Interests in the developing world also are concerned when upholding codes of conduct or standards begins to look like a form of protectionism being imposed by Northern interests. This is not to argue that workers and local communities in the developing world are not interested in having corporate activity regulated and restrained in a variety of areas. While the interests of these groups are not well known, a critical issue is that the way codes of conduct are devised gives them very little ability to influence them. Codes devised at the corporate headquarters of a multinational are less likely to reflect the interests of stakeholders than ones devised through cooperative efforts with local actors, NGOs, IOs, and governments (Kolk, van Tulder, and Welters 1999; Jenkins 2001). Corporate codes of conduct that cover labor, environmental, and financial issues tend to vary significantly in terms of the range of issues they cover and their incorporation of mechanisms for worker or local community input. In the area of labor, the ILO standards represent universal norms to protect basic human rights, even though their representativeness is sometimes contested. Still, according to the OECD study (2001), very few corporate codes of conduct actually cover the full range of ILO labor standards and only about 10 percent even mention them. The same survey found that most codes cover about three issue areas only, and the main ones covered are the creation of a reasonable work environment, adherence to local laws and no discrimination or harassment. Many NGOs from the South and international unions are critical of the fact that codes rarely entitle workers to the right to organize (Kearny 1999; Jenkins 2001). In the absence of this protection, workers have little or no opportunity to have their own interests protected in the workplace. In the 246


area of environmental standards, there is no clear international consensus similar to the ILO standards (Fischer et al. 2005). Again, surveys find that the content of codes of conduct on the environment vary significantly, depending on both the industry and the firm (Smith and Feldman 2003). The important issue in this area is the degree of disclosure of environmental practices. Disclosure, while not resolving environmental issues in itself, is a means by which local communities can evaluate and have input on areas where standards are put in place. Representativeness has also been poor in the creation of financial standards, as Walters argues persuasively in this volume. In this case, standards have been devised and promulgated by international organizations that mainly represent Western business interests. Private regulatory initiatives have the potential to address concerns of stakeholders, depending on how standards are decided and the opportunities they provide for ongoing evaluation and input. Yet, private initiatives that are devised by corporations on their own rarely represent the interests of the stakeholders they aim to protect. Achieving more representativeness in standards pushes corporations to extend their decisionmaking processes outside the boardroom. Many corporations have shown a willingness to extend themselves in this way, whatever their motivation may be. However, few corporations have the resources or knowledge to devise more representative and open standards on their own. Selfregulation is a limited opportunity if it is restricted solely to the initiative of corporations. In sum, while corporate self-regulatory efforts have proliferated in the past decade, they do not function in anywhere near the same way that regulation by states has functioned historically. Self-regulatory initiatives are probably only affecting a small minority of societies around the world as they are undertaken by a limited number of corporations and extend to an even more limited number of producers that function in developing economies. Even where they do exist, self-regulatory initiatives address particular issues, but they address them piecemeal. Corporations do have clear market motivations to try to be more socially, environmentally responsible or ethical, but the methods of self-regulation usually are only addressing a piece of the problem at hand. The problems in developing countries that worry social activists are complex and it is often the case that attempts at simple solutions have unintended and sometimes very harmful outcomes. It is also important to remember that although selfregulation may be an effective complement to scaled down regulation in advanced industrial countries, the situation is different in the developed 247

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world. Not only are complementary state institutions and laws often missing, but the absence of civil society in these countries also restricts the way that the goals of these initiatives are defined, and the ability for them to be checked.

9.3. Bringing States Back In As the contributions to this volume have argued, there are a number of ways in which self-regulatory initiatives can be improved. These include extending the involvement of international organizations, NGOs, and local stakeholders to address problems of compliance, scope, and participation. Many of the studies here have also shown how state governments can play a critical role in making self-regulation more effective. In this section, the role of the state in developing country economies today is explored further. While the argument that states can bolster selfregulation is accepted, it is contended here that the role of the state in the economy is also much more fundamental. As shown historically, states have been integral to the process of economic development everywhere, and even in the unique conditions of globalization, states define the functioning of economies in important ways. This is not to argue that developing countries can or should replicate the regulatory state that is now itself evolving in the developed world. Rather, the argument here is that states have a vital part to play in achieving the social, environmental, and human rights goals that are increasingly being tackled through selfregulatory efforts. State governments should indeed partner with corporations, NGOs, and international organizations to address these complex issues, but to do so effectively they need to have the capacity and authority to govern economies on the whole. The historical sketch in the first section shows that the role states have played in economies has varied across time and space. Debates over the appropriate role of states in economies rages to the current day. There are two ways that the role of the state in the economy can be conceptualized; the distinction is most clearly elaborated in a recent review by Fred Block. On the one hand, the ‘state’ and the ‘economy’ can be viewed as two separate entities, allowing one to ask ‘how much’ of a state role there is in a given economy. Indeed, this is the most common way that the question of the role of the state in the economy has been debated. We think about states existing on a continuum, from the minimal ‘public goods’ state on one end and the socialist, controlling state on the other. In between these 248


two ideal types, we can think of states in the Keynesian sense of having a role in macroeconomic stabilization; as Marshall’s ‘social rights’ states or as the developmental state described by Gershenkron and others (Block 1999), among others. A second way to think about the role of the state in the economy is to argue that ‘state’ and ‘economy’ are not analytically distinct, but in fact mutually dependent. In Block’s words, this perspective rejects the notion of ‘state intervention in the economy’ and sees states as always playing a major role in constituting economies. The empirical basis for this view is the historical work of Karl Polanyi, which shows that market economies have never ‘emerged’ on their own nor did their emergence depend on the dismantling of state structures. To better understand this notion of the state and economy being integrally related, it is useful to think through how states define economies in a variety of ways. Chang (2003) describes states as having two important functions: states act as ‘entrepreneurs’ and as ‘conflict managers’. The entrepreneurial role of the state derives from a problem of information, that is, individual economic actors have information about their own position, but have difficulty gaining information about the economy as a whole. This creates a problem of coordination in any economy; a problem that was identified in early theories of industrial changes, such as those of Hirschman (1958) and others (see Chang 2003: 52). While the state is not necessarily ever fully enabled to take on this role, it is usually the best ‘coordinator’ because it represents society as a whole. As entrepreneur or coordinator, the state defines some form of vision for the economy that can guide decisions about investment, foreign investment, and trade. States build regulatory institutions and grant property rights and in this way allow economies to function in a way that moves toward fulfillment of the vision defined. In Chang’s analysis, states also act as ‘conflict managers’. That is, it falls to states to deal with the social implications of radical changes in the market. For example, in many advanced industrial countries, the phenomenon of technical innovation and structural change in industries has not only had positive implications for economies as a whole, but has led to dislocation among certain communities. States deal with the conflicts that arise in such situations. They may have a role in compensating the ‘losers’ of market solutions, if those are embraced. Or, states might push against market solutions that hurt certain parts of their constituencies through actions such as trade restrictions and state takeovers. States might also seek to modify the market through the use of monetary policy, fiscal transfers, and tax reductions (Chang 2003: 58–61). States also play an important role as guarantors against 249

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the type of risk and investment that innovation in an economy often demands. Historical examples illustrate this view of states and markets as integrally linked. Polanyi’s historical account illustrates the significance of the mercantilist state in integrating local markets into national markets, and expanding those markets to international ones. The state in Polanyi’s account exists prior to the market economy and plays an essential role in prioritizing trade relations over traditional forms of exchange. The state does this by actively revoking some laws on property and price setting and creating new laws to support exchange. The recent example of the attempt at ‘creating’ a market economy in Russia is also illustrative of the importance of states in the creation and sustaining of markets. Russia’s economic reform program was based on the belief, pervasive among international institutions and consultants at the time, that state activity impedes spontaneous market development. Implementation of this program resulted in economic collapse and lawlessness, the reasons for which are clear. Institutions to support property rights and investment were underdeveloped in Russia, meaning that there was functionally no base on which a market economy could function. The value of money in Russia was so indeterminate as to give rise to a barter economy because the state failed to gain control over monetary creation and valuation (Woodruff 1999). Growth in Russia was negative because the absence of the state meant that no attention was given to the determinants of growth, such as skills and improved technology (Herrera 1999). Also, despite the notion that dismantling the state would bring economic ‘freedom’ to Russians, in reality no one had any ‘rights’ because rights depend on a kind of social contract that must be established by the state (Holmes and Sunstein 1999). These examples highlight the integral relation between states and market economies, a fact that renders debates over exact quantitative amount of ‘state involvement’ less important than establishing the need for a state role in supporting the basic functioning of the market economy. This understanding of the relation between the state and economy is a useful starting point for a discussion of corporate self-regulation as a substitute for a state role. The state, first of all, has a variety of roles that are rarely encompassed in self-regulatory initiatives. The most basic and defining role of the state is to provide internal and external security. If the trend is to support self-regulatory initiatives at the expense of helping states build capacity, the ability of states to perform this basic function could be weakened. Again, the Russian example is a classic case of a 250


state becoming so weak as to lose control over security, leading to the well-known development of widespread corruption and lawlessness. If we think about other basic functions of the state, we can immediately identify areas where corporate activity is also unlikely to substitute. Corporations do not establish or implement laws that are fundamental to functioning economies. They do not have sovereignty over any jurisdiction or over the supply of money in a given society. Corporations operating within any given state will be in competition and likely unable to objectively define and implement goals for economic development and growth. It is also difficult to imagine how corporations could individually or even collectively act in the public interest. There will always exist something of a conflict of interest. For example, a large corporation may be willing to put resources toward the eradication of poverty in a country where it operates, but at the same time unlikely to want to pay higher taxes so that a broad array of social issues can be addressed. It also must be questioned to what extent corporations themselves want to stand in for all of the functions historically taken on by states. While large corporations have often had their own motivations for initiating and promoting self-regulatory efforts, the desired scope of these efforts varies considerably. As discussed above, regulating in one area such as child labor often intensifies other problems and reveals the extent to which many of the issues that corporations try to address are in fact systemic and deeply rooted in particular societies. Not only might corporations find it impractical to address such issues, but they are not likely to have the appropriate tools to do so even if they so desired. The wellresearched case of Nike (Locke, Fei, and Alberto 2006) reveals that one of the most common tools that corporations have used to self-regulate labor and environmental conditions in their supply chains—monitoring—is actually often minimally effective; and not at all efficient. Furthermore, corporations find it difficult to function where laws are weak or not enforced. A basic framework of laws on corporate governance, finance, and payment is essential for almost any business to function. Any firm trying to implement labor standards will also find that effective remediation of problems in supplier factories is unlikely if basic labor laws are not enforced or if courts do not function well enough to hold violators accountable (Locke, Fei, and Alberto 2006). Corporations can falter in weak states for other reasons as well; particularly if they depend on a reasonably stable, healthy, or educated workforce. The prevalence of HIV/AIDS, for example, severely impedes operations and productivity of firms operating in certain countries. And, this is a problem that is 251

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impossible for corporations to resolve solely through their own initiatives. Similarly, ‘institutional voids’ often make it difficult for multinational corporations seeking new markets or new production opportunities in developing countries (Khanna et al. 2005). An important reason why developing countries impose only very minimal rules on investing firms is that they perceive the need to compete for the investment by offering firms the least intervention possible. But taking this position assumes that states have no or minimal bargaining power vis-à-vis firms; and, it assumes that firms always seek to invest where states are weakest. Both assumptions are only partially true. The ability of states to bargain with firms largely depends, first, on the sector where investment is being made. When states own critical and rare resources, for example, their bargaining position is potentially quite strong. Second, states may increase their bargaining power by offering other resources as well. For investors seeking new markets, for example, the Chinese government can offer access to a large market; a bargaining chip that the state in this case has certainly used to its advantage. Smaller and weaker country governments can offer other assets, such as stability, peaceful relations with unions, transparent laws on investment, corporate governance, etc. And this brings us to the position of firms. Regardless of their sector, most firms do value the presence of clear, efficient, and fair rules governing business activity. That most investment still takes place within the developed world where regulation is still strongest is a testimony to this fact. The proliferation of private rule-making is also evidence of firms’ need to define certain rules of the game and improve their operating environments. It is not enough to argue that states are one of many equal partners in achieving effective regulation in the developing world today. States have a vital role in creating and sustaining an environment in which corporations can function and survive. They have a role in providing a ‘vision’ for the economy as Chang argues and for deciding critical matters concerning the beneficiaries of development and distribution of resources. Furthermore, while developing country governments require the participation of corporations and other nonstate actors to tackle the complex issues they face, they can only bolster self-regulatory initiatives if they themselves are strong. Even conceptualizations of states having a ‘minimal’ role in making self-regulation more effective require that state governments have sovereignty, are able to define and implement laws, and are taking the initiative to determine what kind of citizen rights should be insured. It is in fact perhaps getting it the wrong way around to 252


argue that states can improve self-regulation. Rather, it is useful to think about how self-regulation can be integrated into a regulatory role that states must assume, even under conditions of minimal resources. Where states have the authority to enforce laws, self-regulatory schemes can enhance a regulatory regime. Self-regulatory schemes contain a number of mechanisms for achieving compliance. They rely on the goodwill of corporations, a number of which will voluntarily comply with rules to the best of their ability. Private schemes also rely on NGOs, MSIs, or IOs to monitor compliance and apply pressures to firms such as threats to their reputation or mild sanctions. Where these schemes are deficient, however, is in restricting possibilities for opportunism, especially among those corporations least likely to exercise voluntary restraint. State governments can bring their efforts to bear on cases where noncompliance is most likely. That is, states can rely on private actors to self-regulate up to a point; but can apply ultimate sanctions or even rewards as a means of securing compliance. This is the idea behind the ‘regulatory pyramids’ that Braithwaite describes in this volume and elsewhere. States have the ability to apply sanctions that other actors cannot by virtue of their ability to tax, fine, and control import and export licenses, among other measures. In addition, states can promote compliance through threats of further regulation and, as Lenox describes in this volume, by rewarding compliance in a variety of ways. States’ involvement also provides other ways of enhancing private regulatory initiatives. Without large investments in staff and procedures, states can have a very important role in leveling the playing field for firms within their borders by simply providing mechanisms for disclosure and transparency. Mandating disclosure and following through with viable threats of sanctions is one way that states can hold all firms in an industry equally accountable while at the same time ensuring that information needed to enforce violations is available. In this way, states enhance the process of self-regulation. They rely on firms themselves for disclosure and they bolster the efforts of private actors to hold firms accountable by providing information and setting clear standards. Studies in this volume by Lenox, Repetto, and Graham/Woods all argue that states can have a ‘minimal’ but powerful role in enhancing regulation through these means. The involvement of states in regulation can resolve other problems with private regulation as well. As the Nike case and others like it suggest, a serious obstacle to effective global regulation is finding the ability to monitor production along complex supply chains, which span numerous localities and employ millions of workers, and then follow through with 253

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remediation where standards are violated. Unlike firms, NGOs, or IOs, governments can organize the necessary local knowledge and local connections to assist in these areas. Indeed, in the Nike case (Locke, Fei, and Alberto 2006), monitoring and remediation of labor issues in Nike’s suppliers was most effective where governments were most involved in regulation. Critics will argue, though, that effective government involvement requires the existence of a loyal and coordinated bureaucratic structure, something that seems beyond the possibilities of many developing countries. But, improving monitoring can be done with ‘minimal’ and ‘flexible’ government involvement. Piore and Shrank (2006) describe the emergence of new labor inspectorates in several Latin American states, including Guatemala, the Dominican Republic, and Costa Rica. They find that in a countermove to the deregulatory efforts of the 1990s, these Latin American governments have developed a model of labor regulation that relies on a single network of inspectors empowered to enforce labor law but given the discretion to respond to the individual situations of firms. The challenges of limited resources for salaries and possibilities of corruption are overcome by hiring people who have other careers or prospects (lawyers or aspiring lawyers) that will both enhance their income and ensure their desire to retain a strong standing in their communities. This model taps critical local knowledge while working within the restraints of resources and corporate pressure for retained flexibility. State involvement is needed to also overcome the problem of representativeness in self-regulatory schemes. Since these schemes often fail to incorporate the perspectives and values of those whom they are meant to protect, the rule-making process would benefit from being more open and responsive to citizen constituents. The ability of citizens to participate in rule-making and accountability is dependent on them being granted basic and specific rights. With minimal resources or effort, states can enhance citizen rights, the effect of which can be twofold. First, increased rights will grant possibilities for participation and enhance the extent to which regulatory efforts reflect collective values in the locations where they are implemented. In addition, enhancing citizen rights will add another check on corporate behavior, since the holders of rights will seek to defend them by holding potential perpetrators accountable. The studies in this volume by Woods/Graham and Morgan argue that states can empower local actors to shape and enforce standards by upholding rights and freedoms and setting clear social goals. This again is a model of state involvement that is ‘minimally’ resource dependent and restrictive, a way of bolstering and not superseding varied regulatory practices in existence. 254


A variety of state actions can help to address the limits of self-regulatory initiatives. Since developing country governments operate under constraints of competition and limited resources, it is necessary to think about ways that states can be involved in a ‘minimal’ way. However, historical and modern empirical evidence suggests that state action is vital to the functioning of economies, thus it is important that in the discussion of states and self-regulation, we do not get stuck on the idea of recommending that states strive toward a quantitatively minimalist role. In fact, if states are to enhance self-regulation in the way that authors in this volume have suggested, they will have to exercise their sovereignty over the law and take initiatives to define citizen rights and place limits on corporate behavior. These actions will bring states back into having an integral role in defining the functioning of economies within their borders.

9.4. Conclusions The growth of self-regulation over the past decade has had a number of implications for societies in developed and developing countries. Although hard to measure in the aggregate, self-regulatory initiatives by corporations and other nonstate actors have had benefits for workers, societies, and environments. If nothing else, the rhetoric around self-regulation, especially when conceived as a part of ‘corporate social responsibility’, has raised awareness about challenges in developing countries and about the significance of corporate activity for development. Nonetheless, as research in this volume and elsewhere has proven, selfregulatory initiatives have natural limits. Even when intentions are completely good, it is difficult for corporations to redress complex problems in societies where they operate. It is also not clear that corporations themselves, no matter how hard they might lobby for deregulation, actually find it in their interest to take on these complex and endemic problems such as corruption, health crises, and poverty. It is for this reason that the call for increased action by the state is beginning to be heard. When we think about what role states can play in developing economies today, it is important to avoid the conceptual trap of viewing states as naturally external to the economies that function within their borders. States have an integral role in allowing economies to function. This role encompasses the granting of basic rights to property, the guarantee of internal and external security, and the implementation and enforcement of laws. Further, state action is what allows an economy to 255

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function in a particular way that meets the goals of political and social actors. State governments have historically defined some form of guiding vision for economies and have played an important role in the allocation of economic resources within society. There is little evidence to suggest that even today, having states ‘step out’ will yield superior outcomes. Rather, the decisions of states over the past two decades to deregulate, to eliminate barriers to capital inflows, and allow unlimited competition for resources has in many ways created the impetus for the expansion of self-regulation. This is because minimal action of the state has just as many, if different, outcomes for society as a lot of action. Self-regulation is an important tool that states can use to organize their economies, ensure flexibility, and operate within resource constraints. But self-regulation cannot replace state action as a means of promoting economic development and allowing economies to function in a more just way. To believe that it can send a dangerous message to the powerful actors in our society who have the means to promote this solution. Making global regulation more effective requires that states are provided the tools and capacity to harness the opportunities that globalization brings. How can this be achieved? Developing country governments would be well advised to reflect on their motivations for minimizing their abilities to collect revenues and step up intervention. They could do so by better understanding where they have bargaining power and marketing a broader array of assets to MNEs than simply cheap inputs, for example. Other actors could also do a great deal to change the incentive structure for states as well. International organizations such as the IMF, for example, have made deregulation a conditionality of loans; and this skews states’ motivations away from involvement in regulation where they are critically needed. Global firms themselves might also do a better job of understanding and communicating the limits of their ability to self-govern, and the specific benefits they gain from operating where states have an effective regulatory function. Breaking the spiral of often misguided motivations would do a great deal toward enhancing states’ ability to regulate effectively. References Amsden, A. (1989). Asia’s Next Giant: South Korea and Late Industrialization. Oxford and New York: Oxford University Press. (2001). The Rise of the Rest: Challenges to the West from Late-Industrializing Economies. Oxford: Oxford University Press.

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Self-Regulation in a World of States Berlin, I. (1958). Two Concepts of Liberty: An Inaugural Lecture Delivered before the University of Oxford. Oxford: Clarendon Press. Block, F. (1994). ‘The Roles of the State in the Economy’, in Neil J. Smelser and Richard Swedberg (eds), The Handbook of Economic Sociology. Princeton, NJ: Princeton University Press. Chang, H.-J. (2003). Globalisation, Economic Development and the Role of the State. London: Zed Books. Chaudhry, K. A. (1993). ‘The Myths of the Market and the Common History of Late Developers’, Politics and Society, 21: 245–75. Espenshade, J. (2004). Monitoring Sweatshops: Workers, Consumers and the Global Apparel Industry. Philadelphia, PA: Temple University Press. Esping-Andersen, G. (1990). The Three Worlds of Welfare Capitalism. Cambridge: Polity Press. Fischer, C., Parry, I., Aguilar, F., and Jawahar, P., for the Foreign Investment Advisory Service of the World Bank Group (2005). ‘Corporate Codes of Conduct: Is Common Environmental Content Feasible?’, Resources for the Future, Discussion Paper 05-09 (March). Fishlow, A., Haggard, S., and Wade, R. (1994). Miracle or Design? Lessons from the East Asian Experience. Overseas Development Council Essay No. 11. Friedman, T. (1999). The Lexus and the Olive Tree. New York: Strauss and Giroux. Garret, G. (1998). ‘Global Markets and National Politics: Collision Course or Virtuous Circle?’, International Organization, 52(4): 787–824. Grief, A. (1989). ‘Reputations and Coalitions in Medieval Trade’, Journal of Economic History, XLIV(4) (December): 857–82. Gunningham, N. and Sinclair, D. (2002). ‘Voluntary Approaches to Environmental Protection: Lessons from the Mining and Forestry Sector’, OECD Conference on Foreign Direct Investment and the Environment, February 7–8, 2002, OECD Headquarters, Paris. Hall, P. A. and Soskice, D. (2001). Varieties of Capitalism: The Institutional Foundations of Comparative Advantage. Oxford: Oxford University Press. Haufler, V. (2001). ‘Public and Private Interests in Global Regulation: An Overview of the Issues’, Found on: http://www.carentieendowment.org/files/ PublicRoleCH1.pdf Helm, D. (ed.) (1989). The Economic Borders of the State. Oxford: Oxford University Press. Herrera, Y. (1999). ‘Lessons from Russia’s Experience with Market-Oriented Reform’, Program on New Approaches to Russian Security, Policy Memo No. 85, November, pp. 81–4. Holmes, S. and Sunstein, C. R. (1999). The Cost of Rights: Why Liberty Depends on Taxes. New York: W.W. Norton. ILO (1998). ‘Overview of Global Developments and Office Activities Concerning Codes of Conduct, Social Labelling and Other Private Sector Initiatives Addressing Labor Issues’, Mimeo.

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259

Index

AA1000 Assurance Standard 18–19 accountability: and nongovernmental labor regulation 134–7 civil society pressures 136 strengthening local state regulation 137 transparency 134 worker participation 134–6 and regulatory theory 150–1 Adidas 10 and internal compliance monitoring 118 adverse selection, and self-regulation 69, 70, 75 Agence Française de Developpement (AFD) 194 alienation 231 altruism, and self-regulation 64 American Apparel and Footwear Association 119–20 American Apparel Manufacturers Association 119 American Chemistry Council 63 see also Responsible Care Code American Electric Power 106 American Federation of Labor-Congress of Industrial Organizations (AFL-CIO) 125 American Forests and Paper Association 97 Amnesty UK 20 Andrew, Hurricane 81 Apparel Industry Partnership (AIP) 122 Argentina 224 Asian crisis: and international financial regulation 35–8 and regulatory failure 35–6 as Western opportunity 57 see also international standards project, and financial regulation Asian Development Bank (ADB) 194 asset managers, and environmental issues 80–1

260

Association of British Insurers 11 and Disclosure Guidelines 14–15 auditing: and external monitoring and certification Ethical Trading Initiative 124 Fair Labor Association 122–3 Fair Wear Foundation 124–5 Social Accountability International 121–2 Workers Rights Consortium 125–7 Worldwide Responsible Apparel Production 119–21 and social and environmental reports 17 and standards of nonfinancial 17–19 Australia, and self-regulation 8 Australian Taxation Office 157 Ayres, I 157 Bank of International Settlements (BIS) 34 Barenberg, M 135 Basle Capital Adequacy Accord (1988) 34 Basle Committee on Banking Supervision (BCBS) 34, 159 and Core Principles 38–9 compliance 51–6 monitoring 45 Basle Concordat (1983) 34 Berlin, Isaiah 234 bilateral investment treaties 25 Biwater 207 BJ&B 132 Block, Fred 248 Bolivia 224 bounty hunting, and overcoming state capacity deficit 167–70, 171 BP 16 Braithwaite, J 157, 158, 159, 163 brand names, and effectiveness of consumer activism 10, 12 Brandeis, L 86 Business in the Community 10

Index Cal-Safety Compliance Corporation 120 Cambodia, and labor rights project 4, 175–6 and benefits and costs of 191–3, 194–5 and characteristics of 176, 195 goal setting 196 involvement of ILO 196–7 positive incentives 195–6 role of governments 198–9 transparency 197–8 and future of 193–4 and genesis of 176–8 growth of apparel industry 176–7 involvement of ILO 178 US-Cambodian trade agreement 177–8 worker discontent 177 and impact on apparel exports 184 and impact on market participants’ behavior 183–4 and key mechanisms of 179–86 government’s role 182 incentives for factory owners 183, 184 involvement of ILO 180–2, 184–6 post-trade agreement period 184–6 role of international buyers 183 shortcomings of 182–3 transparency of monitoring results 182–3 US-Cambodian trade agreement 179–80, 182 and results of 186–91 employment levels 186 impact of ILO monitoring reports 186–90 improvement of labor law 190–1 and success of 194 Camdessus, Michael 36 Camdessus Panel 222 Campaign for Labor Rights 165 Canellos, P C 167 capitalism: and state regulation 233–4 and varieties of 233 Carbon Disclosure Project 106 Castells, M 160 Central America, and nongovernmental labor regulation 130 Chang, H-J 249, 252 chemicals industry: and reputation of 66–7 and Responsible Care Code 2–3, 63 and self-regulation: activist stakeholders 65–6 advantages of 75 adverse selection problem 69, 70, 75

challenges to 67–70 enforcement 68, 70 forestalling government regulation 64–5 free riding problem 68–9, 70–1, 75–6 government promotion of 73–4 importance of 75 incentives for 63–7, 75 laggard firms 71 leading firms 71–2 monitoring of 72–3 moral hazard problem 69, 70, 75 strategic implications 70–3 unilateral self-regulation 72 value of 72 child labor 242, 245 Chile 237 China 120, 124 and worker participation 135–6 Christian Aid 20 civic republicanism, and regulation 165 civil society: and creating framework for 23–4 and mobilization of 26 and requirements for activism by 23 Clean Air Amendments (USA, 1990) 82 Clean Clothes Campaign (Holland) 124, 135, 165 climate change, and insurance markets 81–2 closed systems 151 collective action problem, and disclosure 8, 15, 20 collective goods, and self-regulation 67 community-driven regulation 24 Compa, L 130 compliance: and costs and benefits of 42–4 and domestic political factors 45–7 and environmental information disclosure 95 and external monitoring and certification: Ethical Trading Initiative 124 Fair Labor Association 122–3 Fair Wear Foundation 124–5 Social Accountability International 121–2 Workers Rights Consortium 125–7 Worldwide Responsible Apparel Production 119–21 and failures of 42 and firm internal compliance monitoring 117–18 and implementation 41 and international pressures 44–5

261

Index compliance: (cont.) and international standards project 39–40, 47–8 Basle Core Principles 51–6 International Accounting Standards 48–51 market incentives 39–40 official incentives 40 Specific Data Dissemination Standard 48–51 and legitimacy of international standards 42–3, 56 and mock compliance 45, 56 and monitoring of 45–6 and nature of 41–2 and regulatory forbearance 42, 56 and regulatory pyramid 155–6 and self-regulation 253 and voluntary codes 2 Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) (USA) 93 consumer activism, and promotion of self-regulation 9–10 limited impact 12 consumer boycotts 10, 12, 65 Convention on Biological Diversity (CBD) 26 CORE coalition, and mandatory disclosure 20–1 corporate crime 156–7 Corporate Sunshine Working Group (CSWG) 21–2 corruption: and codes of conduct 6 and compliance failure 42 and regulation of 159 Costa Rica 124, 254 Council on Economic Priorities (USA) 121 credibility, and voluntary disclosure 17–19 democracy: and nature of 153 and responsiveness 150–3 deregulation 234, 235, 236–7, 238 and extent of 240 and self-regulation 230, 240 developed countries, and self-regulation 242 developing countries: and enforcement 22 and lack of regulatory capacity 1, 8, 149, 152, 170

262

overcoming through bounty hunting 167–70, 171 overcoming through networking 158–66, 170 responsive regulation 156, 157–8 and multinational corporations 6–7 and responsive regulation 149, 153, 157–8 regulatory pyramid 156 system capacity problem 156 and risks of regulation 8–9 and self-regulation 242 and state’s role 248, 249, 252, 254–6 Development Bank of Southern Africa 214 disclosure: and collective action problem 8, 15, 20 and enforcement 3, 22 and environmental risk 3 and importance of 78 and mandatory 2, 8, 20–2 and Responsible Care Code 2–3 and standardized performance indicators 15–16 and voluntary 2, 14–15 enhancing credibility of 17–19 improving comparability of 15–16 limits of 19–20 see also environmental information disclosure Disney 117, 129 Dominican Republic 120, 132, 254 Dow Chemicals 85 Drahos, P 158, 159, 160, 163, 170 dual economy 166 DuPont 85 Durban Metropolitan Water Services 215, 218, 219 East Asia 57 and Asian crisis: international financial regulation 35–8 regulatory failure 35–6 as Western opportunity 57 and compliance: Basle Core Principles 51–6 International Accounting Standards 49–51 Specific Data Dissemination Standard 49–51 and international standards project 33 Basle Committee’s Core Principles 38–9 compliance costs 44 external compliance mechanisms 39–40

Index impact of Asian crisis 35–8 key international standards and codes 36–8 regulatory neoliberalism 39 and self-regulatory failure 33 see also international standards project, and financial regulation economic development: and state intervention 235–6 and state regulation 231 and state-led development 239 economy, and the state 230 alleged harmful impact on 237 conflict management 249–50 coordinating role 249 creation of markets 250 economic efficiency 235–6 expanded role of 232–3 functions of 249 globalization 237, 238 impact on economic growth 235–6 integrally related 249, 250, 255–6 market optimists 234–5, 237 postindustrial economy 237, 238 role in 234, 248–9 state-led development 239 effectiveness, and responsive regulation 153–8 electricity-generating industry: and disclosure 3 and environmental information disclosure 100–5 emerging markets, and financial regulation 32–3 emission trading 82 employees, and promotion of self-regulation 10 enforcement: and developing countries 22 and disclosure 2, 3, 22 and eliminating free riders 73 and eliminating laggard firms 72–3 and environmental information 79 inadequacy of 94–5 and reciprocal actions 68 and social forces 23 and the state 228–9 Enron 88, 167 environmental codes and standards 6 and auditing of 17–18 and disclosure 3 and Global Reporting Initiative 16 and growth of 62 and importance of self regulation 75

and international law 24 and mandatory disclosure 20–2 and trade associations 62–3 see also chemicals industry; environmental information disclosure environmental information disclosure 78 and compliance 95 and enforcement 79 inadequate 94–5 and environmental and sustainability reporting 78–9 and European Commission 107–8 and government’s role 107–10 and increased attention to environmental issues 79–80 asset managers 80–1 insurance markets 81–2 investor recognition of 82–4 new financial products 82 and key role of 84 financial markets 86–8 financial reporting 88–91 mandatory disclosure 84–6 and pricing environmental risk 78 and shareholder demand for 105–6 and United States 86–7, 91–4 electricity-generating industry 100–5 oil and gas industry 99–100 pulp and paper industry 95–9 environmental management, and corporate performance 83–4 Environmental Protection Agency (EPA) (USA) 22, 74, 85, 89, 92, 107, 108 Ernst & Young 106 Esping-Anderson, G 233 ethical investment 10–11 and asset managers 80–1 and growth of 90 Ethical Trading Initiative (ETA) 115, 124, 128 European Commission 107–8 European Union 238 Evans, Peter 158, 161 externalities, and self-regulation 228, 242 Exxon Valdez oil spill 83 Fair Labor Association (FLA) 115, 122–3, 128, 131–2, 134 Fair Wear Foundation (FWF) 115, 124–5, 128 False Claims Act (USA) 167, 168, 171 Financial Accounting Standards Board (FASB) (USA) 93 financial crises 32–3

263

Index financial markets, and environmental information 86–8 demand for 105–6 financial regulation, and voluntary international standards 32 see also international standards project financial reporting, and environmental information 88–91 Financial Sector Assessment Programme (FSAP) 40 and monitoring of 46 Financial Stability Forum (FSF) 32 and key international standards and codes 36–8 Food and Drug Administration (FDA) (USA) 22 foreign aid, and global water welfarism 205–6 foreign direct investment 236–7 and state’s bargaining power 252 Foreign Investment Advisory Service (FIAS) 184 free riding: and collective goods 67 and eliminating free riders 73 and self-regulation 68–9, 70–1, 75–6 freedom, and role of the state 234–5 Freedom of Information Act (UK, 2000) 13, 14 Friends of the Earth 20, 21 G7 countries 32 and Asian crisis 35–6 game theory, and self-regulation 68 Gap 117, 129 Garment Manufacturers of Cambodia 192 Garrett, G 239 General Agreement on Trade in Services (GATS) 205 General Data Dissemination Standard (GDDS) 35 Gerber Childrenwear 120 Global Reporting Initiative (GRI) 15–16 Global Social Compliance 120, 130 Global Water Conference (2003) 202 Global Water Partnership 205, 207, 213 Global Water Scoping Process 225 Global Witness 7 globalization: and self-regulation 1, 5, 7, 227 and state regulation 237, 238 and state response to 239

264

government: and creating framework for nonstate actors 23–4 and environmental information disclosure 107–10 and implementation 41 and mock compliance 45, 56 and promotion of self-regulation 73–4 and regulatory forbearance 42, 56 and role of 8, 23 see also state, the Grassley, Charles E 167 Grief, A 231 Guatemala 132, 254 H&M 117 Habermas, J 152 Helm, D 232–3 Hong Kong 55 Horizon Dairy 84 human rights: and codes of conduct 6 and Global Reporting Initiative 16 and international law 24 and nongovernmental organizations as regulators 161–3 Human Rights Watch 161, 163 Hunt, Paul 208–9 Imperial Oil 106 implementation 41 and compliance 41 incapacitation, and regulatory pyramid 154–5 incentives, and self-regulation 8, 63 and chemical industry 63–7, 75 market-based 8 financial regulation 39–40 information requirements 13–14 limitations of 11–13 pressure from consumers and activists 9–10 pressure from investors 10–11 pressure to retain/attract employees 10 voluntary disclosure 14–15 nonmarket means 23 activist stakeholders 65–6 civil society 23–4 financial regulation 40 forestalling government regulation 64–5 international conventions 26 international law 24–5

Index local activists 23 social organizations 23 India 124, 125 Indonesia 125, 132, 137 and compliance with Basle Core Principles 53, 54 and regulatory forbearance 56 industrialization, and state regulation 231 information: and assessment of environmental performance 66 and commercial confidentiality 13–14 and international financial regulation 35 and market-based incentives for self-regulation 13–14 and self-regulation 8 see also disclosure; environmental information disclosure information technology, and disclosure 85 Institute of Social and Ethical Accountability 18–19 Institutional Shareholder Services 106 insurance markets, and environmental issues 81–2 new financial products 82 International Accounting Standards (IAS) and compliance 48–51 and monitoring of 45–6 international actors, and role of 5 International Center for the Settlement of Investment Disputes 25 International Confederation of Free Trade Unions 165 International Drinking Water and Sanitation Decade 201 international financial institutions (IFIs) 32 and Asian crisis 35–6 and compliance assessment 40, 46 International Labour Organization (ILO) 4, 138 and Cambodian labor rights project 175, 178, 180–2 monitoring reports 186–90 post-trade agreement period 184–6 transparency of monitoring results 182–3 international law 24–5 and investors’ rights 25 International Maritime Organization 159 International Monetary Fund 32 and Asian crisis 35 and compliance assessment 40 and deregulation 236, 238

and Financial Sector Assessment Programme 40 monitoring 46 and international financial regulation 35, 36 and monitoring of compliance 45 International Standards Organization, and water services 205, 207, 222 international standards project, and financial regulation: and Basle Committee’s Core Principles 38–9 and compliance 39–40, 47–8 Basle Core Principles 51–6 influence of domestic political factors 45–7 International Accounting Standards 48–51 international pressure 44–5 market incentives 39–40 monitoring 45–6 official incentives 40 Specific Data Dissemination Standard 48–51 and impact of Asian crisis 35–8 regulatory failure 35–6 and implications for self-regulatory reform 56–8 and (in)appropriateness of 57–8 and key international standards and codes 36–8 and mock compliance 45 and origins of 32–3, 34–5 and regulatory neoliberalism 39, 56 and Reports on the Observance of Standards and Codes 40 and shortcomings of 33 as Western opportunity 57 International Telecommunications Union 159 Investment Promotion and Protection Agreements 25 Investor Network on Climate Risk 80 investors: and environmental information 10–11, 82–4 asset managers 80–1 financial reporting 88–91 mandatory disclosure 86–8 reporting of 78–9 shareholder demand for 105–6 and promotion of self-regulation 10–11 limited impact 12 and protection of 25

265

Index ITS 120, 181 ITT 237 Japan 33 and compliance with Basle Core Principles 54–5 and regulatory forbearance 56 Johannesburg Water 215 Kay, J 236 Kellwood 120 Keynesianism 233 Kleinbard, E D 167 Korea, and regulatory forbearance 56 KPMG 181 Kukdong case 132 Kyoto Protocol 82, 92, 99 labor standards 113 and codes of conduct 6 and external monitoring and certification 119 Ethical Trading Initiative 124 Fair Labor Association 122–3 Fair Wear Foundation 124–5 Social Accountability International 121–2 Workers Rights Consortium 125–7 Worldwide Responsible Apparel Production 119–21 and firm internal compliance monitoring 117–18 and Global Reporting Initiative 16 and monitoring of 17 and nongovernmental labor regulation 115–16 accountability 134–7 building complementarity 138 dangers of 137–8 evaluation of 139 growth of 113–14 international agencies 138–9 limits to 129–31 local participation 131–4 models of 127–8 potential of 137 and qui tam actions 169 see also Cambodia, and labor rights project law, and regulatory trilemma 151–2 legitimacy: and international standards 42–3, 56 and regulatory pyramid 155–6 Levi’s 117 liberalism, embedded 203, 241

266

Lloyd’s of London 159 local actors: and nongovernmental labor regulation 131–4 and role of 5, 23 and South African water services 217–21 Lowe, V 25 Lowi, T J 231 Luhmann, Niklas 151 Madison, James 150 Malaysia, and regulatory forbearance 56 mandatory disclosure 2, 8, 20–2 and enforcement 22 developing countries 22 and environmental information 84–6 United States 91–4 Mannheim, Karl 231 Mastrallet, Gerard 222 Mayer, C 236 Mexico 120, 137 and financial crisis (1994–95) 34–5 and Kukdong case 132 and self-regulatory failure 33 Millennium Development Goals, and global water welfarism 205 Modernizing Company Law (UK, White Paper) 21 money, and state regulation 232 Monsanto 83 Montesquieu, Charles, Baron de 165–6 Moody’s 159 moral hazard, and self-regulation 69, 70, 75 Mozambique 224 multinational corporations (MNCs): and international law 24–5 and limited disclosure 19–20 and self-regulation 6–7 Municipal Financial Management Act (South Africa, 2003) 213 Municipal Infrastructure Investment Unit (MIIU) (South Africa) 212–13 Municipal Systems Act (South Africa, 2000) 216 National Pollution Release Inventory (NPRI) (Canada) 85 natural disasters, and insurance markets 81–2 Natural Resources Defense Council (NRDC) 89, 90 neoliberalism: and global water welfarism 208–9 and regulatory 39, 56

Index Nestlé 12 networked governance: and regulatory capacity deficits 149–50 overcoming 158–66, 170 and regulatory trilemma 152 and transgovernmental networks 161 New Deal 233 New Era 132 New Zealand International Aid and Development Agency (NZAID) 194 Nike 12, 187, 245, 251, 254 and internal compliance monitoring 117–18 and response to consumer activism 10, 137 nongovernmental labor regulation 115–16 and accountability 134–7 civil society pressures 136 strengthening local state regulation 137 transparency 134 worker participation 134–6 and building complementarity 138 and dangers of 137–8 and evaluation of 139 and external monitoring and certification 119 Ethical Trading Initiative 124 Fair Labor Association 122–3 Fair Wear Foundation 124–5 Social Accountability International 121–2 Workers Rights Consortium 125–7 Worldwide Responsible Apparel Production 119–21 and firm internal compliance monitoring 117–18 and growth of 113–14 and international agencies 138–9 and limits to 129–31 and local participation 131–4 and models of governance 127–8 and potential of 137 nongovernmental organizations (NGOs): and conditions for effectiveness 23 and consumer activism 9–10 and mandatory disclosure: United Kingdom 20–1 United States 21–2 as regulators 161–3 and responsive regulation 157 and self-regulation 7 nonstate groups, and role of 23 norms, and self-regulation 7

North American Free Trade Agreement (NAFTA) 179 Office of Management and Budget (OMB) 235 official development aid (ODA), and global water welfarism 205–6 oil and gas industry, and environmental information disclosure 3, 99–100 Ondeo 206–7, 214, 222 Organization for Economic Cooperation and Development (OECD) 6, 237 and auditing standards 17–18 O’Rourke, D 9, 12–13 Oxfam International 165 Paine, Tom 150 Parker, Christine 151 Paternoster, R 156–7 pension funds, and environmental information 80–1, 106 Performance of Companies and Government Departments (Reporting) Bill (UK) 20–1 pharmaceutical industry 26 Phelps Dodge 94 philanthropy, and self-regulation 64 Philippines 224 Piore, M 235–6 Poland 125 Polanyi, K 230, 231–2, 238, 239, 249, 250 policy standards, and compliance 44 predatory states 161 Pricewaterhouse Coopers (PwC) 181 and labor standards monitoring 17 private prosecutions, and overcoming state capacity deficit 167–70, 171 PT Dada 132 public choice theory, and self-regulation 7–8 public goods 26–7 public-private partnerships: and global water welfarism 206 and water services 222 Puerto Rico 224 pulp and paper industry, and environmental information disclosure 3, 95–9 qui tam actions, and overcoming state capacity deficit 167–70, 171 rational choice theory, and regulatory pyramid 156 Reagan, Ronald 234, 235

267

Index reciprocity, and self-regulation 68 Reebok 10, 135 and internal compliance monitoring 118 regulatory state, and emergence of 231 Reports on the Observance of Standards and Codes (ROSCs) 40 reputation: and chemical industry 66–7 and mandatory disclosure 85 and self-regulation 10, 11, 67 Reputex 159 Resource Conservation and Recovery Act (RCRA) (USA) 93 Responsible Care Code 2–3 and activist stakeholders 65–6 and adverse selection problem 69, 70 and enforcement 68, 70 and forestalling government regulation 64–5 and free riding problem 68–9, 70–1 and laggard firms 71 and leading firms 71–2 and moral hazard problem 69, 70 and strategic implications 70–3 and unilateral self-regulation 72 and value of 72 responsive regulation 3–4, 149 and basic idea of 153, 170–1 and developing countries 149, 153, 157–8 bounty hunting around capacity deficits 167–70, 171 lack of regulatory capacity 156, 157–8, 170 networking around capacity deficits 158–66, 170 and dynamic nature of 154 and influence of 154 and networked governance 149–50 and nongovernmental organizations 157 and regulatory pyramid 153–5 design of 157 incapacitation 154–5 legitimacy 155–6 rational choice theory 156 system capacity problem 156 and responsiveness as democratic ideal 150–3 and responsiveness as effectiveness ideal 153–8 Rhodes, R 160 Romania 125 Ruggie, J G 7, 203, 241

268

Russia 239 and economic reform 250 and state weakness 250–1 Sabel, C F 235–6 Sara Lee 120 Sarbanes-Oxley Law (USA) 107 and environmental reporting 79 Saur 207, 214 Schwab Capital Markets 202 screened funds 90 and environmental information 80 Securities and Exchange Acts (USA) 86, 89 Securities and Exchange Commission (SEC) (USA) and enforcement 22, 94, 107 and environmental information disclosure 87, 89, 91–4, 108 and mandatory disclosure 21 securities markets: and environmental information 86–8 and environmental issues 82–4 self-regulation: and benefits of 228, 255 and collective goods 67 and compliance 253 and definition of 62, 241 and deregulation 230, 240 and developed countries 242 and developing countries 242 and embedded liberalism 241 and extent of 240 and externalities 228, 242 and globalization 1, 5, 7, 227 and government promotion of 73–4 and growth of 1, 6, 227, 240–1, 255 and historical context 230–1 and improvement of 248 and limits of 5, 229, 242–3, 247–8, 255 adoption of codes 243 conflicting firm goals 245 failure to represent stakeholder interests 246–7 limited coverage of 244–5 negative spillover effects 245 small and medium-sized enterprises 243 supply chains 243–4 and motives for 227 and new global politics 7 and optimistic view of 7 and praise of 227 and public choice theory 7–8 and punishment 68

Index and reciprocity 68 and reputation commons problem 67 and responsive regulation 3–4 and the state: inadequate substitute for 250–2, 256 involvement of 252–5 and state capacity 242 and state regulation 228–9 reduced role of 240 and supply chains 243–4 state’s role 253–4 and supportive organizations 227–8 see also incentives, and self-regulation Seligman, J 87 Selznick, Philip 150, 152 separation of powers 150, 165–6 Sexwale, Tokyo 211–12 shareholders: and demand for environmental information 105–6 and promotion of self-regulation 11 Shell 10 and campaign against 12 and social and environmental reports 14, 15 Shonfield, Andrew 233–4 Sialkot, and soccer ball production 244 Simpson, S 156–7 Sims, T 167 Singapore 55 Slaughter, Anne-Marie 160, 161, 170 small and medium-sized enterprises (SMEs), and self-regulation 243 Smith, Adam 166 soccer ball production 244 Social Accountability International (SAI) 115, 121–2, 128 social forces, and enforcement 23 social reporting: and auditing of 17–18 and Global Reporting Initiative 16 and mandatory disclosure 20–2 Solutia 83, 89 Somavia, Juan 178 South Africa, and water services 4–5, 201, 203–4 administrative capacity 206–7 changing framework of 210–17 changing local politics 217–21 constitutional test litigation 220–1 Free Basic Water Policy 216, 223 human right to water 203, 212, 215, 220 legislative framework 211–12, 215–17

Municipal Infrastructure Investment Unit 212–13 policy framework 215–17 political frameworks 210 private sector participation 213–15 protests 217, 218, 219, 223 regulatory oversight 212–13 transactional frameworks 210 Specific Data Dissemination Standard (SDDS) 35 and compliance 48–51 and monitoring of 45 Sri Lanka 124 Standard and Poor 159 and Transparency and Disclosure Study 105 state, the 5, 229 and alleged harmful effect of 237 and bargaining power of 252 and constraints on 238–9 and critical role of 241 and debate over role of 234 and deregulation 230, 234, 235, 236–7, 238 and developing countries 248 and the economy 230 central role in 248 conceptions of role in 248–9 conflict management 249–50 coordinating role 249 creation of markets 250 economic convergence 239 economic growth 235–6 expanded role in 232–3 integrally related 250, 255–6 integrally related with 249 state-led development 239 state’s functions 249 and enforcement 228–9 and foreign direct investment 236–7 and freedom 234–5 and globalization 237, 238 response to 239 and market optimists 234–5, 237 and modern capitalism 233–4 and money 232 and moral objectives 234–5 and origins of regulatory state 231 and postindustrial economy 237, 238 and protection against market mechanisms 231–2 and regulatory reform 235 and responsive regulation 4 and role of 250–1, 255–6

269

Index state, the (cont.) and self-regulation: involvement in 252–5 no substitute for 250–2, 256 and sovereignty 228–9 Suez-Ondeo 222 supply chains, and self-regulation 243–4 state’s role 253–4 Sweden 239 technical standards, and compliance 43–4 Teubner, Gunther 151, 152 textile and apparel industry: and consumer activism 10 and external monitoring and certification 119 Ethical Trading Initiative 124 Fair Labor Association 122–3 Fair Wear Foundation 124–5 Social Accountability International 121–2 Workers Rights Consortium 125–7 Worldwide Responsible Apparel Production 119–21 and firm internal compliance monitoring 117–18 and nongovernmental labor regulation: accountability 134–7 building complementarity 138 dangers of 137–8 evaluation of 139 international agencies 138–9 limits to 129–31 local participation 131–4 models of 127–8 potential of 137 and quota system 176–7 and regulation of labor conditions 3 see also Cambodia, and labor rights project Thailand: and compliance with Basle Core Principles 53–4 and regulatory forbearance 56 Thames Water 206–7 Thatcher, Margaret 234 Thompson, D 236 trade agreements, and labor rights 179–80 trade associations, and self-regulation 62–3 trade unions, and nongovernmental labor regulation 114, 130, 132, 135 transgovernmental networks 161 transparency: and accountable nongovernmental governance 134

270

and Cambodian labor rights project 197–8 and importance of 78, 88 and Mexican financial crisis (1994–95) 35 Transparency International 159 Turkey 126–7 Union Carbide 67, 83 Union of Needletraders, Industrial and Textile Employees (UNITE) 125 United Kingdom, and mandatory disclosure 20–1 United Nations: Charter of Rights and Duties of States 25 Commission on Human Rights 24, 25 Committee on Economic, Social and Cultural Rights 205, 208–9 Framework Convention on Climate Change 92 Global Compact 6, 26, 127, 222, 223, 228 and nongovernmental labor regulation 139 and water services 201–2, 208–9 United States 132 and Cambodian labor rights project 175 trade agreement 177–8, 179–80, 182 and environmental information disclosure: electricity-generating industry 100–5 government action 107 oil and gas industry 99–100 pulp and paper industry 95–9 and mandatory disclosure 21–2 environmental information 86–7, 91–4 United States Council for International Business (UNCIB) 24–5 United Students Against Sweatshops (USAS) 125 Unocal 11 urbanization, and state regulation 231 Uruguay 223 US Liquids 83, 89 Utting, P 243 Vanity Fair Corporation 120 Veolia (Vivendi) 206–7, 215, 219, 222–3 Verité 181 Viacom 94 Wal-Mart 117, 129 Washington Consensus 34, 239 Washington Convention (1965) 25

Index water services: and changing global framework 204–9 and changing national framework 210–17 and global water companies 221–5 contested role of 223–4 global regulatory framework 222–3 neoclassical model 222 and Global Water Scoping Process 225 and global water welfarism 204–5 administrative capacity 206–7 fiscal capacity 205–6 ideological character 208–9 ignores structural issues 224 and human right/commodity distinction 203, 208, 209 and political and legal struggle over 202–3 and private sector participation 225 growth in 201–2 and South Africa 4–5, 201, 203–4 administrative capacity 206–7 changing framework of 210–17 changing local politics 217–21 constitutional test litigation 220–1 Free Basic Water Policy 216, 223 human right to water 203, 212, 215, 220 legislative framework 211–12, 215–17 Municipal Infrastructure Investment Unit 212–13 policy framework 215–17 political frameworks 210 private sector participation 213–15 protests 217, 218, 219, 223 regulatory oversight 212–13 transactional frameworks 210 and World Commission on Dams 224–5

Water Services Act (South Africa) 216, 220 welfare states: and retrenchment of 238–9 and typology of 233 welfarism, and global water services: administrative capacity 206–7 fiscal capacity 205–6 ideological character 208–9 whistle blowers, and overcoming state capacity deficit 167–70 Whole Foods Market 84 Williams, C 86 worker participation, and nongovernmental labor regulation 134–6 Workers Rights Consortium (WRC) 115, 125–7, 128, 132, 134, 135, 137 World Bank 32, 194 and deregulation 236 and environmental information 86 and Financial Sector Assessment Programme 40 monitoring 46 and water services 206, 214, 223 World Commission on Dams (WCD) 224–5 World Economic Forum 202 World Resources Institute 21 World Trade Organization (WTO) 25 and Agreement on Textiles and Clothing 176–7 and deregulation 238 World Water Council (WWC) 205, 207 World Water Forum 207, 208, 213 WorldCom 89, 167 Worldwide Responsible Apparel Production (WRAP) 115, 119–21, 128 Zimbabwe 124

271

Making Global Self-Regulation Effective in Developing Countries

Global Agricultural Trade and Developing Countries

SMEs in Asian Developing Countries

Child Welfare in Developing Countries

Capacity Building in Developing Countries

Foreign Investments in Developing Countries

Medical Tourism in Developing Countries

Developing Countries in the WTO

SMEs in Asian Developing Countries

Public Transport in Developing Countries

Trade Policy in Developing Countries

Sustainable Cities in Developing Countries

Financial Reform in Developing Countries

Trade Policy in Developing Countries

Electronic Business in Developing Countries

Networks of Influence?: Developing Countries in a Networked Global Order

Economics of Developing Countries

Macroeconomics for Developing Countries

Transport and Developing Countries

Regionalism Among Developing Countries

Developing Effective Teacher Performance

Developing Effective Engineering Leadership

Law and Economics in Developing Countries

Computerization in Developing Countries: Model and Reality

Domestic Wastewater Treatment in Developing Countries

Finance and Competitiveness in Developing Countries

Finance and Competitiveness in Developing Countries

The VAT in developing and transitional countries

WTO Law and Developing Countries

Tax reform in developing countries, Volume 235

Making Global Self-Regulation Effective in Developing Countries

Global Agricultural Trade and Developing Countries

SMEs in Asian Developing Countries

Child Welfare in Developing Countries

Capacity Building in Developing Countries

Foreign Investments in Developing Countries

Medical Tourism in Developing Countries

Developing Countries in the WTO

SMEs in Asian Developing Countries

Public Transport in Developing Countries

Trade Policy in Developing Countries

Sustainable Cities in Developing Countries

Financial Reform in Developing Countries

Trade Policy in Developing Countries

Electronic Business in Developing Countries

Networks of Influence?: Developing Countries in a Networked Global Order

Economics of Developing Countries

Macroeconomics for Developing Countries

Transport and Developing Countries

Regionalism Among Developing Countries

Developing Effective Teacher Performance

Developing Effective Engineering Leadership

Law and Economics in Developing Countries

Computerization in Developing Countries: Model and Reality

Domestic Wastewater Treatment in Developing Countries

Finance and Competitiveness in Developing Countries

Finance and Competitiveness in Developing Countries

The VAT in developing and transitional countries

WTO Law and Developing Countries

Tax reform in developing countries, Volume 235

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