Recent Wharton research on how commodity trading firms respond to environmental regulations brings broad insights into the effects of enforcement and transparency. Wharton accounting professor Sandra Schafhäutle studied sourcing patterns of commodity trading firms in Brazil’s soybean industry from 2006 to 2018, and her findings could sharpen environmental regulation.
Schafhäutle detailed these findings in a paper titled “The Spillover Effects of Environmental Transparency and Enforcement Regulation: Evidence From Commodity Trading Firms.” The regulation in this case aims to prevent deforestation of Brazil’s rainforests. Regulators enforce deforestation rules on farmers and blacklist municipalities where severe deforestation and violations occur; trading firms are not directly affected except for increased transaction costs due to embargoed farms, and the potential for reputational damage they may face for indirectly contributing to deforestation.
The study sample included approximately 320 firms, which covered two groups: trading firms that were exposed to regulation and those that were not exposed to regulation. The study compared firm-level sourcing outcomes between the two groups of firms to arrive at its findings.
Commodity trading firms make up the “midstream” of the supply chain. They source commodities from upstream producers, and distribute them downstream to entities such as food companies. The study sample included Brazilian trading firms, large U.S. companies like Cargill and Archer-Daniels-Midland, China’s COFCO, and Japanese firms like Marubeni. The largest multinational commodity trading firms account for more than 70% of global soybean trade, the paper noted.
How Trading Firms Respond to Regulation
Schafhäutle’s study produced three broad insights. First, it challenged conventional wisdom that firms subject to regulatory constraints would systematically relocate operations away from regulated into unregulated areas and thereby avoid regulatory costs and other external pressures. It found that trading firms in fact do not respond to deforestation regulation via reallocation of sourcing operations as there are constraints associated with reallocating their sourcing from regulated to unregulated locations.
Trading firms may be reluctant to reallocate their sourcing because of the high costs of switching. Many trading firms make large capital investments in local storage facilities, processing plants, and transportation networks. Also, trading firms may be reluctant to reallocate because the farm-level improvements in blacklisted municipalities allow them to source soybeans sustainably after regulation.
Second, trading firms show greater reductions in their exposure to deforestation and CO2 emissions associated with their sourcing in both regulated and unregulated locations compared to other trading firms not affected by the regulation. The positive spillover effect across unregulated areas suggests that trading firms enhance the sustainability of their firm-wide sourcing activities.
Third, these firm-wide spillover effects in unregulated municipalities are driven by external pressures, exposure to enforcement actions by Brazil’s government, and trading firms’ commitment to zero-deforestation sourcing and verification strategies such as third-party audits.
“Commodity trading firms are massive, and yet we don’t fully understand their economic incentives and the role they play, especially in terms of sustainability outcomes.”— Sandra Schafhäutle
The Power of Enforcement and Transparency
Brazil is home to the world’s largest rainforest and introduced more stringent laws in 2008 to contain deforestation, with intensified transparency and enforcement in selected deforestation-intense locations. Transparency increased with the government disclosing the names of “worst deforesting municipalities” or a blacklist. Offending producers or farmers faced embargoes, fines, and other economic sanctions.
“This transparency and enforcement regulation can induce changes in trading firms’ sourcing decisions, significantly enhancing the sustainability of local production and trade flow,” the paper stated. Local enforcement actions and expected enforcement risk drive these changes, along with sustainability commitments by trading firms such as pledges to do zero-deforestation sourcing coupled with third-party sourcing verifications.
How Trading Firms Could Drive Sustainability
Environmental regulations are limited in scope at local levels without global coordination covering all firms, Schafhäutle said. Therefore, global supply chain participants like trading firms are crucial for sustainable sourcing that reduces environmental externalities such as deforestation and the resulting greenhouse gas emissions.
Schafhäutle learned from discussions with key stakeholders that trading firms play an important role in shaping local production practices even in regulated locations. The current and future expected costs induced by such regulation incentivize them to adopt new technologies and policies that help mitigate deforestation outcomes.
Schafhäutle’s paper is timely, given the challenges related to combating climate change. The study provides insights into the strategies of global commodity trading firms, most of which are privately held and are secretive in their operations. “Commodity trading firms are massive, and yet we don’t fully understand their economic incentives and the role they play, especially in terms of sustainability outcomes,” she said.
The study focuses on soybeans, but its findings could apply to other commodities like palm oil and beef, but also other products with deforestation issues such as timber and industrial settings that are similarly shaped by the importance of commodity trading firms, she added.
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