While the EU is the front runner in green incentives, others are following. In the US, IRC Section 48C has allocated US$2.3b billion in tax credits to clean energy manufacturing projects and looks set to expand the provision.1 And while most developing countries don’t yet offer sustainability-specific incentives, they are likely to follow suit in due course
“It will come,” says Brian Smith, EY Global Incentives, Innovation and Location Services Leader. “Southeast Asia is looking to adopt more green incentives, focusing on R&D technology, to make assets more green-friendly. China is adopting more green policies, to encourage production in certain industries. As we head towards things like the electric vehicle economy, everyone’s going to have to follow.”
Governments are upping their game
When it comes to penalties, many governments are introducing carbon taxes and other pricing instruments to reduce carbon emissions and other negative environmental outcomes such as waste in the supply chain, and to instead drive investment towards more sustainable manufacturing and logistics.
One of such pricing instruments is the EU’s Carbon Border Adjustment Mechanism (CBAM) which is set to come into force in 2026, albeit the reporting requirements will commence in 2023 for specific group of products. Unlike carbon taxes and costs emission trading system related costs, which apply to stationary production facilities, CBAM costs as they are currently proposed, apply at the point of importation into the EU but are also impacted by the carbon regimes in the country of the origin.
“As more environmental externalities, whether carbon related or not, are identified and written into the green legislation, supply chains will be subject to taxes and pricing measures at multiple places in the supply chains,” says Alenka Turnsek, EY EMEIA Sustainability Tax Leader. “The environmental tax and regulation legislation landscape is increasingly complex and fragmented.”
And it’s set to get even more complex with the introduction of new style plastic packaging taxes from 2022, expansion of the extended producer responsibility schemes, and other waste-reduction related pricing tools, all of which target reduction of waste and increase of reuse and recycling of plastic packaging and other materials. Water preservation and biodiversity pricing and preservation measures are expected to rise up the international agenda too.
Chief operating officers (COOs) and chief supply chain officers will have their work cut out. In the pursuit of resilience, they may well need to embed end-to-end visibility and risk monitoring in their supply chains; design versatile and agile networks; develop solid operating models and workforces; and secure alternative sources of supply.
To that list, they can add the demands of sustainability – ensuring sustainable products and designs that enable resource preservation through circular economy, which requires moving closer to customers or exchanging materials with more positive environmental and social footprint; decarbonizing the value chain; and establishing a culture of traceability, transparency and disclosure across the supply chain.
But this, says Hein Brinkmann, Associate Partner, Supply Chain and Operations, Ernst & Young Abogados SLP, is merely the first step in a longer journey. To be able to fully comply with governments’ targets, he believes companies will need to adopt circular business models, lengthening product lifecycles and taking responsibility for the product at the end of product life. This will enable them to further improve their energy consumption and material efficiency. This presents a significant business opportunity.
“How are you going to define a new business model, that does not target ever increasing production volumes?” asks Brinkmann. “This requires a redefinition of the product and services catalog and a host of different capabilities and supply chain processes, which then triggers a lot of other discussions, including around tax and incentives.
“I think there will be a tsunami of change coming towards us in the next 5 to 10 years. It’s a positive thing, but there’s a risk that companies won’t manage the transformation well. They can either be one of the leaders in the circular economy or a laggard.”
The role of the tax function
If it’s clear this all puts pressure on COOs and chief supply chain officers, the tax function has a key role to play in the shift too. For one thing, the rise of sustainability means new products and services bringing new value, or new value being placed on existing processes and products because of their positive economic, environmental and societal impact on the companies and their stakeholders. And this “value-led sustainability” will have tax implications.
“It’s a direct tax issue,” says Camillo. “Who in the business is funding and driving the added value? And which entity within the corporate structure is going to own the innovations? Innovation driven by mechanisms like CBAM, will require monitoring and analysis of the development of value-adding solutions to ensure the income tax consequences are well known in advance.”
This has major implications for the common practice of transfer pricing. In the latest EY Transfer Pricing Survey, published in October 2021, 68% of respondents said that ESG and sustainability policies in their organization would have a medium or high impact on their approach to transfer pricing. And 74% said supply chain change would have a similar medium or high impact.
Why? Because in order to deliver this added sustainability and potentially move to a circular model – providing lower cost goods while realizing a higher margin – the business will need to make investments in its supply chain, for which its R&D function needs to be compensated. This may fundamentally shift the weighting of value across the organization.
“It may be that a function is being performed in a different country to what it was before, or it’s a completely new function that will need to be remunerated,” says Ronald van den Brekel, EY Global Transfer Pricing Market and Innovation Leader.
Van den Brekel cites the experience of a client in commodity trading that had developed software to prove the origins of its products and track them across the value chain. Software development would ordinarily be considered a cost of doing business, but as the insights from this software solution were clearly key for the business, it became a major value driver. The company then had to face questions around where the software had been developed and decide whether it should charge a royalty or license fee.
“Very often, companies deal with sustainability like it’s business as usual, with a theoretical understanding that it’s sparked a change in value drivers,” says van den Brekel. “But often they haven’t fully thought it through, and they haven’t changed their profit allocation to fit.”
Plotting the way forward
Transfer pricing is just one area in which, having rethought its supply chain, a company may find itself exposed. Indeed, while greater sustainability brings potential opportunities, organizations will need to address exposure to the aforementioned sustainability taxes through supply chain transformation enabled by abundant incentives.
Restructuring and environmental and societal future-proofing the supply chain should mitigate exposure to many of the taxes and regulations now being introduced. It should also manage business risk, in both reputation and supply chain security.
Businesses stand to gain a lot by striking this balance. To achieve it, the C-suite and tax leaders should consider the following key steps:
- Understand the emerging green legislation and taxes, as well as the changing incentives landscape: Are tools and measures already in place? Where are they anticipated? And what do they look like?
- Know who owns and contributes to sustainability strategy: Green taxes are called tax, but in nature they are above the line costs, aimed at changing behaviors. Responsibility for the sustainability tends to vary between companies and does not always rest with a single role/ function. The implementation of the sustainability strategy requires collaboration across functions in a way that may not have been required historically. A common goal spanning functions and geographies stretches the current organizational structures and performance indicators.
- Convert that understanding into what it means for the business in financial terms: Establish supply chain sustainability goals that apply to the entire ecosystem.
- Keep the tax function close to operations: The tax department must be connected with the chief supply chain officer, chief procurement officer and COO, from as early in the process as possible, because many sustainability measures in the supply chain may take three to five years to have any effect. It’s the job of the tax function to feed the latest information around incentives, tax, and other pricing measures into high-level planning. Failure to do so will invite extra costs.
Take a holistic view. Sustainability is a major undertaking and may require the company to adopt a new approach to collaborate across functions.
Conclusion
The world is currently witnessing the first stages of a radical overhaul of global supply chains. Faced with a range of threats, businesses around the world are seeking supply chain resilience, while looking at environmental and sustainability concerns.
With governments seeking to change companies’ behavior around emissions and waste, we can expect the use of more environmental taxes, levies and other costs. And, by necessity, more incentives to enable countries to soften the blow and remain attractive as a business location.
As such, the tax function has a significant role to play in supply chain change. If a company doesn’t know its environmental tax footprint, or how it’s set to change, it may be exposed to unnecessary costs or it could under-utilize tax incentives on its transformation journey.
To succeed, sustainability needs clear accountability. Additionally, the tax function needs to remain in close step with operations to feed its insights into broader strategic planning from the start.
“Tax really needs to integrate with the business across all areas,” says Camillo. “This includes the carrot, the stick, transfer pricing and income tax, in order to ensure that the company not only avoids tax problems, but that it harnesses the vast opportunity that the creation of sustainable supply chains can bring.”
