The Impact of Soft Law Rules on the Effective Enforcement of Sustainability Standards

Abstract

The study explores the emergence and interpretation of ESG rules within diverse social, cultural, and economic contexts, with a particular focus on the European region. The authors aim to identify potential limitations of these rules within these contexts. In our research we analyze how listed companies in the studied countries adhere to their capital market responsibilities and comply with ESG rules in the form of soft law. The objective of this study is to illustrate that listed companies in Central-Eastern European nations with lower level of income, higher corruption rate and bigger black-economy have a weaker ESG compliance and more stock market irregularities compared to Western European countries with higher individual incomes, lower corruption, and a smaller black economy. As such, our research indirectly emphasizes that the effectiveness of sustainability regulations established by international organizations could be significantly improved by implementing segmented and binding rules that account for the compliance, cultural, and financial contexts of different societies, rather than relying solely on soft law regulations and recommendations.

Introduction

Evaluating the performance of companies in today’s world involves more than just measuring shareholder profits, as companies are increasingly expected to contribute to the public good. The development of the ESG system marked the beginning of a shift towards value-based norms in business, which allowed for the measurement and visibility of corporate sustainability efforts.

As consumers became more aware and principled, businesses recognized the need to integrate sustainability and well-being considerations into their operations, and voluntarily take responsibility for preserving the environment, minimizing their carbon footprint, and promoting equal opportunities. ESG rules have been developed as a legal framework to support these requirements and help business leaders operate in an environmentally responsible manner (Zaccone – Pedrini, 2020). This has been exemplified by recent events, such as the Russia-Ukraine conflict, where companies that failed to act on ethical principles faced a significant loss of customers. Conscious customers, working alongside progressive governments and international organizations (Zaccone – Pedrini, 2020), can now apply pressure on market players to embrace sustainability and well-being, making it a fundamental aspect of modern business practice (McWilliams – Siegel, 2001 and Hemingway – Maclagan, 2004).

The legislative process towards sustainability began 35 years ago when the World Commission on Environment and Development’s Group of Experts adopted a recommendation on environmental compliance in 1987, entitled „Our Common Future.” (World Commission on Environment and Development, 2022) and the Rio+20 UN Conference in 2012, the 2030 Agenda was adopted in 2015, based on the principles of balanced social development, sustainable economic growth, and environmental protection. As part of this legislative process, EU Member States adopted the Paris Agreement in 2016, in which they pledged to tackle climate change and reduce greenhouse gas emissions by 40% by 2030 compared to 1990 levels. The Paris Agreement under the UN Framework Convention on Climate Change is the first legally binding global agreement to enter into force (United Nations, 2022). This was a regulatory change because previously the emphasis in sustainability legislation had been on voluntary compliance based on soft law norms. After all, the leaders of international institutions were confident that these progressive principles and norms would be incorporated into national legislation. The international conventions were primarily aimed at setting strategic objectives and left the detailed rules to the Member States. As a result, governments were free to decide on the financial, legal, and timeframe for implementation and the legal and economic instruments to be used. Initially, voluntary compliance also had some impressive results because of the widespread public support for environmental protection and the discernible signs of climate change. Looking at the results of this process in Europe, EUROSTAT data show that greenhouse gas emissions in EU countries fell by 22% between 1990 and 2017 and that most countries have introduced some form of environmental or energy tax and the share of renewable energy in Europe has been steadily increasing since 2004 (Szuchy, 2021). Central-Eastern European countries have steadily reduced their specific energy use over the last decades (Szuchy, 2016), so their production has become more efficient (MNB, 2021).

Despite the undisputed achievements, there is a growing recognition of the limitations of soft regulation and that it is not possible to achieve sustainability goals in the timeframe and in the way foreseen under the current legislative system. A study by the OECD has shown that differences between OECD countries remain wide in the area of environmental regulation (OECD, 2022) even though there is no significant difference in environmental taxes between countries. For the period from 1994 to 2020, the ratio of eco-tax revenues to GDP for European countries was between 2-2,5% and we did not find either exceptionally high or exceptionally low values for any country. In the United States, this figure fell from 1% in the previous year to below 1% in 2020, while in the United Kingdom it remained stable above the 2% average throughout the period (OECD, 2022). However, in 2018, despite improvements, carbon dioxide emissions per unit of output in Central-Eastern European countries were still almost double the EU average and huge differences remain in the sustainability systems of European countries (MNB, 2021).

EU leaders were aware of the limitations of the soft law harmonization process and wanted to help European companies operate more transparently by making more detailed recommendations and binding rules. In 2007, the European Parliament held a debate on the use of soft law instruments, during which several experts pointed out the dangers of their use (European Parliament, 2007) and believed that these regulatory tools should not be used (Cho et al, 2015) As a result of ongoing discussions, in its Directive 95/2014 on the disclosure of non-financial and diversity information, the EU removed the voluntary requirement for companies with more than 500 employees and made it mandatory for them to disclose information on their business models and key performance indicators on environmental, social and employment performance, respect for human rights and the fight against corruption as part of their annual financial report (European Parliament and Council, 2014). However, it should be noted that this directive also left it to the Member States to lay down the detailed rules for compliance. As a further step, the EU 2020 created the Taxonomy Regulation for green lending, which was still voluntary, and then adopted the European Climate Law proposal, which developed a sustainable finance strategy with three main guidelines (European Parliament and Council, 2021), which the EU has moved towards a mandatory corporate disclosure regime. A common sustainability rating system and standards and labels for financial products have been defined, money has been encouraged to flow into such projects and sustainability benchmarks have been set, so there has been a move away from soft law towards indirect and mandatory regulation (MNB, 2021).

The creative interpretation of sustainability rules is not only the prerogative of governments because companies also implement their sustainability tasks according to the spirit of their company, its financial situation, and the expectations of their owners (Avi-Yonah, 2008). While some companies’ business culture rejects (Lanis – Richardson, 2012) even harmful tax planning, others seek to meet sustainability requirements by modernizing their fleet of aircraft or vehicles. Many business actors deliberately misuse the positive social image of greening and have created the phenomenon of greenwashing by confusing the marketing of technological improvements with actual climate protection. Energy utilities can call it greenwashing when they install solar parks on the tailings piles of their depleted mines while increasing carbon emissions from their conventional operations. The gap between voluntary compliance and the effectiveness of hard and fast rules is reflected in the trajectory of the organic farming of European farmland. While agricultural enterprises were able to convert their land to green farming at their discretion and without Community support, only a negligible part of the land was under sustainable management (Ogachi et.al.,2021). After 2010, when the EU supported greening with hectare-based agricultural subsidies and administrative discounts, easily obtainable financial instruments, the majority of farmers took advantage of the opportunity and the amount of land under organic farming increased dramatically (Zaccone – Pedrini, 2020). This case showed that voluntarism cannot work effectively in most business contexts and the practical implementation of ESG rules was determined by the fact that developed countries’ laws did not make ESG compliance mandatory and left the practical implementation of compliance to the companies’ managers (Lanis – Richardson, 2012). ESG regulation has also emerged in the money and capital markets, where soft law recommendations based on voluntary action have not become a binding norm for many years. What is crucial in the development of financial markets is that in most cases, listed companies at the top of the private money market are the first to introduce new standards and principles, which are then transferred to the operations of OTC companies. Traditionally, the regulation of listed companies has been at several levels, with international capital market norms typically providing a framework, supplemented by detailed rules set by national stock exchanges. In the European Union, a lack of consensus has led to the prevalence of soft law regulation of listed companies and the emergence of a comply-or-explain corporate governance regime (Kecskés, 2023). Under this system, the issuing company can choose to follow the general rule or to deviate from it and justify its reasons for doing so (United Nations, 2022). On a positive note, financial company executives, like other business actors, have perceived the increased consumer (Gáspár e.t. al, 2023) and legal demands for environmental protection (Jonsdottir e.t al., 2022), which is why many have developed and are voluntarily complying with ESG standards, whose effective implementation has been influenced by the fact that even in the most developed countries (Ogachi e.t.al, 2021), the laws do not make their implementation mandatory and leave the interpretation and implementation of the rules to the companies’ executives (Jonsdottir e.t al., 2022). Despite the uncertainties, the number of listed companies that regularly report on their sustainability performance has increased, but in the absence of uniform standards, these reports were often of poor quality and unreliable, disclosing irrelevant facts and missing material aspects (MNB, 2021). Financial practitioners have recognized the need for binding sectoral action plans to replace soft law recommendations (MNB, 2021). This harmonization work continued in April 2006, when the United Nations formulated the Six Principles for Responsible Investment, in the spirit of which institutional investors voluntarily committed to integrating environmental, social, and governance considerations into their operations. This standard set out detailed guidelines for the use of ESG data (Portfolio, 2022). The operating environment for financial firms in the West was transformed by the creation in 2017 of the Greening the Financial System Network (NGFS), a network of 49 banks from 18 countries, which has made six recommendations to central bank financial supervisors. This process has also been reflected in the Asian financial sector. China’s central bank issued a green bond and organized a Project Approval Catalogue and removed fossil fuel-related projects from this list, and the Governor of China’s central bank in December 2020 developed a green development incentive program. Similar programs have been launched in Singapore and Indonesia and Malaysia. Then the EU also regulated the financial sector and the March 2021 EU SFDR Regulation on regulatory disclosures changed the system based on under-regulated market formulas and self-certification and brought sustainable investment products into a more regulated and transparent path. At the UN Climate Change Conference (COP 27) in November 2022, the International Organization of Securities Commissions (IOSCO) proposed that mandatory rules should play a greater role in the voluntary carbon market, reducing the voluntary nature of the market. According to IOSCO Chairman Jean-Paul Servais, no market can function without sufficient integrity, transparency and liquidity. However, the important and necessary recommendations made so far are no longer enough and further action is needed, working with governments and regulators.

Materials and Methods

In our work, we have begun from the premise that most of the instruments of environmental legislation today are soft law, in which the role of voluntary compliance is decisive, and its enforcement is determined by a combination of cultural and material factors. We believe that compliance in the environmental field cannot be separated from the general level of societal norm enforcement and that we cannot expect a deeper commitment to sustainability than in other fields of law. We have examined the issue raised at the micro levels by measuring the activities of a few selected public limited companies in European countries. We considered the fulfillment of ESG criteria as an established indicator of voluntary compliance in the financial sector, which showed the firm’s commitment to sustainability (European Parliament and Council, 2014). We analyzed the practical application of ESG rules and the average number of capital market non-compliance cases and used these to determine the level of compliance of listed firms. Our work drew also on the findings of Lanis and Richardson, who found a significant relationship between CSR, Corporate Social Responsibility, compliance, and tax compliance levels in 408 Australian listed companies. A similar finding on the relationship between ESG and compliance levels was made by López-González and co-authors (López-González et al, 2019), who found that firms committed to CSR engaged in fewer tax avoidance activities based on data from 28 countries (Montenegro, 2021).

The Regulatory Environment and the Degree of Compliance of Public Companies Listed on Stock Exchanges – Micro Level Analysis

We examined the operations of listed companies in selected European Union Member States. We assumed that the managers of these companies are more ethical in following soft-law rules than the players in the SME sector. In other words, we investigated how companies from countries with different financial cultures follow industry-specific and voluntary environmental rules. To understand this, we analysed the implementation of ESG rules in corporate governance and hypothesised that there is a correlation between the voluntary compliance of listed companies with ESG rules and the compliance status of their environment, i.e. the general level of compliance with the norms and corporate culture of society determines the performance of listed companies. We expected that the lower income level of the Central-Eastern European population and the higher black economy and corruption rates would result in weaker ESG compliance and more stock market irregularities in the life of the companies studied. In our analysis, we investigate compliance with capital market rules transposed into national legislation and sanctions for deviations from the rules in the picked countries. Data on the non-compliant behaviour of capital market participants in each Member State was collected and published by ESMA, the European Securities and Markets Authority, the securities markets supervisory authority of the Member States. The data published on ESMA’s website, broken down by country, present the mandatory information on markets in financial instruments (MIFID II) and the sanctioned activity on markets in financial instruments (MAR). The data on capital market compliance failures are analysed on an annual and regional basis, with a regional average.

Table 1 shows compliance failures with the mandatory disclosure requirements between 2012 and 2021, which have been sanctioned by national capital market supervisory authorities due to their severity or recurrence. The published data shows a significant divergence in compliance behaviour between Central-Eastern and Southern Europe and between Western and Northern Europe. In the Western European region, the only country with a more significant deviation from the regional average is Belgium, which almost exclusively includes fraud on online trading platforms. For Southern Europe, the zero Portuguese data is worth highlighting and could be the subject of further research. However, the high breach rates in Italy and Greece put the region at seven times the Northern European average and almost double the Western European average. The Central European region with low dispersion is 14 times the Northern European average and nearly four times the Western European average. The multiple differences at the level of the averages clearly indicate a significant behavioural difference between the two Northern and the two Southern regions.

Another aspect of stock exchange rules is the analysis of the strict ESG criteria for stock exchange listing, based on the Sustainable Stock Exchange Initiative (SSEI) resources. The SSEI was established in 2005 at the suggestion of UN Secretary-General Kofi Anan with the involvement of 20 major institutional investors. Its aim is to integrate ESG considerations into the investment and decision-making process. By 2021, the organisation had 3,750 signatories and the signatories collectively managed USD 130 trillion in assets. The SSEI provides a global platform for stock market investors, issuers, policy makers and relevant international organisations to improve outcomes on ESG issues and promote sustainable investment. Table 5 summarises the mandatory ESG compliance requirements for listing based on the SSEI database.

The table shows that in Western Europe, most of the leading national stock exchanges (except Deutsche Börse and Euronext Amsterdam) have introduced mandatory ESG rules, while in Central-Eastern Europe none of the countries surveyed have introduced mandatory ESG rules as a condition for listing. In Southern Europe, only the Portuguese stock exchange (Euronext Lisbon) has a mandatory ESG rule, while in Northern Europe, due to high compliance, no mandatory ESG regulation has been established. Our analysis illustrates that a mandatory regulatory regime has been introduced by countries that are already compliant, while less compliant countries rely on soft-law rules. In our view, the reverse should be the case, whereby Central-Eastern and Southern European countries apply ESG regulation on a mandatory basis, while Northern and Western Europe may be able to apply soft-law rules because of their high compliance rates.

Conclusions

In our study, we presented and investigated the link between sustainability and finance. We examined the emergence of the idea of sustainable development in the business sphere and highlighted some of the main achievements and future challenges. We started from the premise that the current legal framework, which mainly leaned on a soft regulatory environment or discretionary environment, was not effective enough to achieve sustainability goals within the desired timeframe. We also noted that countries with lower national incomes and higher corruption were lacking mandatory regulations, whereas nations with greater financial literacy had more stringent rules regarding sustainability and ESG factors. Our hypothesis had been that law-abiding societies also performed better in the area of sustainability than less law-abiding societies. To support our statement, we prepared a micro-level analysis. In our investigation, we contrasted the activities of a few selected public limited companies in European countries. We had expected that the lower income level of the Central-Eastern European population and the higher rates of grey economy and corruption would result in weaker ESG compliance and more stock market irregularities in the companies studied. In our analysis, we investigated compliance with capital market rules transposed into national legislation and sanctions for deviations from the rules in the selected countries.

Our findings supported our hypothesis, leading us to propose that a segmented and stricter regulatory regime, particularly in countries with lower financial literacy, would be a more effective solution for achieving sustainability goals. In our view, Central-Eastern and Southern European countries should apply ESG regulation on a mandatory basis, while Northern and Western Europe may be able to apply soft-law rules because of their higher compliance rates. However, we must note that the data we examined was limited to the largest companies, and further research would be beneficial in creating a broader understanding of the current environmental compliance situation.

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Dr. Csaba Szilovics Professor,
University of Pécs, Faculty of Law Financial and Business Law Department,

Dr. Zsolt Bujtár Associate professor,
University of Pécs, Faculty of Law Financial and Business Law Department,

Dr. Alexander Szívós PhD candidate,
University of Pécs, Faculty of Law Financial and Business Law Department