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08 Apr ESG Risk Management: Increasingly Important to Corporate Supply Chain
The COVID-19 pandemic has created greater challenges than ever for most companies, CEOs of which started to shift their focus to resilience of business models. According to a research conducted by KPMG, 67% of the respondents said they had to rethink their global supply chains, which was believed to be a crucial component of the corporate future operating model. As consumers increasing concerned sustainable products and services, CEOs are taking this opportunity to make their supply chains a competitive advantage. Sustainable procurement, business continuity issues, and ongoing uncertainty and disruption management are nowadays of growing importance for global companies.
Early in 2019, EY also conducted a global investor survey, where 52% of investors said that they would consider immediate divestment or non-active investment, when the target enterprises failed to disclose information to deal with the environmental and social risks of their supply chains. Back in 2017, only 15% of the investors had such consideration.
To better understand the relation between ESG risk management and supply chain, the report will start with the concept of supply chain risks.
What is supply chain risk?
In recent years, many companies have done a lot of initiatives to reduce their own environmental and social impacts, while ignoring those related to their supply chains and failing to completely address ESG issues. According to the Global Real Estate Sustainability Benchmark Foundation (GRESB), in France, the supply chain is responsible for over 50% of total GHG emissions of a real estate company, which means even if it makes effort to reduce its emissions, the indirect GHG emissions remain and continue counting as a large part of its environmental footprint.
The two examples below will help better understand the ESG related risks in supply chains. In 2017, German auto parts supplier Schaeffler Group suffered a supply chain crisis in China after local authorities shut down its needle supplier’s factory due to environmental violation. In response to the incident, Schaeffler claimed it would take three months to find a new supplier, resulting in an expected needle supply gap exceeding 1,500 tons. Besides, its shortage also led to the lack of auto parts provided to its Chinese clients, 49 automotive producers, preventing 3m vehicles from rolling off the lines as planned, with an estimated economic loss of USD43bn.
In 2018, the Institute of Public & Environmental Affairs (IPE) and another environmental NGO accused one of Xiaomi’s [1810:HK] supplier of discharging wastewater illegally. This occurred at the point of Xiaomi’s ongoing IPO, causing concerns that Xiaomi might violate HKEX’s comply or explain requirements related to environmental pollution. Xiaomi acknowledged alleged environmental risks by its suppliers and admitted the shortcomings in its IPO filings. Although Xiaomi successfully was listed on the HKEX, the case implied potential compliance controversies and market disputes regarding a company’s supply chain risk management.
The examples indicated that stakeholders should be increasingly aware of the importance of ESG-related supply chain risk management, as this could also affect the decision making of investors.
Why is ESG related risk management of supply chain crucial?
First, compliance is still the primary reason for ESG related supply chain risk management. In March 2015, the UK passed the Modern Slavery Act, requiring organizations netting over USD37.6m a year to publish the actions they will take to root out forced labor from their supply chains. In February 2016, the US enacted the Trade Facilitation and Trade Enforcement Act, which also includes a section restricting the import of goods produced with forced labor. According to a whitepaper released by EcoVadis, 66% of the surveyed companies cite regulatory compliance as a critically essential aspect of their procurement.
Second, the impact of consumer activism has become louder than ever. A Nielsen’s global survey in 2015 highlighted that consumers’ concerns continuously skew towards climate and ESG issues. Nielsen also believed once an organization breached consumers’ trust, it would pay twice both for the fines and the steep drop in sales. Nowadays, the consumers’ expectation to a company transfers from buying goods at cheapest price to being aware of where it sources raw materials. To monitor and respond to changing consumer preferences is a key ability of companies, especially with the risk of bad publicity and reputation-impairing consumer activism.
Third, investors consider ESG risk management in supply chain as a means of identifying corporate business models. According to Paxworld.com, ESG factors offer portfolio managers added insights into the quality of a company’s management, culture, risk profile, and other characteristics. Therefore, multiple companies develop supply chain management strategies based on the ESG criteria constructed by investors. In return, firms that perform well in supply chain risk management will be able to improve the resiliency of their businesses.
How can firms manage ESG related supply chain risks?
First, follow the supplier code of conduct in relevant industries. Currently, major industries have established their own industry code of conduct, such as the Responsible Business Alliance (RBA) in the global electronical industry. Also, the Sustainable Procurement Standards and the United Nations Global Compact have become formal ESG frameworks. Some of the biggest standard setters have also used guidance to help companies implement ESG risk management into their supply chains. For example, the International Organization for Standardization (ISO) 20400, providing guidance for sustainable procurement, emphasizes the necessity to conduce a due diligence process, pertaining to human rights and climate changes.
Second, improve the ESG risk management mechanism on suppliers. Vendor audit is a useful tool to help build the ESG risk management mechanism, which encourages entities to audit its suppliers’ working conditions, environmental impact, and labor standards. Thus, the entity could not only make sure its suppliers the ESG goals, but also safeguard itself against future risks.
Third, disclose information to the public and accept monitoring by the stakeholders. Supply chain transparency depends on two elements, visibility and disclosure. For visibility, it requires a company to accurately identify ESG related issues and collect data throughout its supply chain. For disclosure, a company should communicate with both internal and external stakeholders on the level and extent of its disclosure details. To be more specific, a company shall start with a materiality assessment, referring to the evaluation of internal and external stakeholder interests, which could also help a company understand the flow of goods, the number of suppliers, and the processes in supply chains.