ESG-related supply chain issues

Covid-19 has disrupted global supply chains and tested the operational resilience of most businesses. Evidence is starting to build that companies with high ESG (environmental, social and governance) ratings outperform others during the Covid-19 crisis. ESG is starting to be seen as a component of, and proxy for, resilience. One reason suggested for this is that those companies have stronger governance, robust supply chain management and better relationships with suppliers. Some companies have strengthened their resilience through analysing their tier 2 and tier 3 supply chains and reinforcing areas that they have identified as potential vulnerabilities.

At the same time, the Covid-19 pandemic has shone a light on inequalities and harmful practices in certain supply chains. As we have seen this month, these issues can have a swift and significant impact on businesses, both financially and reputationally.

The recent fall out

It is striking that, although allegations often relate to a specific supplier, the impact is felt most strongly by companies selling the end products, their investors and business partners.

Those impacts can be wide-reaching - and have included plummeting share price, cancellation of commercial contracts, and major investors deciding to disinvest. Companies may experience significant negative consequences before any investigation has found evidence of wrongdoing, indicating that perception of serious ESG-related supply chain problems is a serious risk to businesses. Investors, particularly sustainability-linked funds, may come under fire for investing in such businesses, even where impacted companies have been given high ESG ratings by index providers.

In the past month, there has been a surge of high-profile media coverage of supply chain issues. In the UK, the clothing manufacturing industry in Leicester has been subject to allegations that some factories are paying workers unlawfully low wages and operating with poor conditions which breach Covid-19 health and safety guidance. In the UK and elsewhere, similar concerns have been raised around working conditions in agriculture and meatpacking businesses following localised outbreaks of Covid-19.

Who could be impacted?

ESG issues can arise in any supply chain. For all companies, it is critical to ensure that there is a robust process to identify and manage issues of this type and to have active governance, risk management and remedial processes in place. Increasingly, transparency about risks inherent in certain types of supply is important because it recognizes the issue and the magnitude of the challenge that a buyer faces.

At particular risk are larger companies, public or private, which often have multiple, complex and global supply chains. Also at higher risk are fast growth companies, which might have outgrown the safeguarding governance and compliance mechanisms they put in place in simpler times, if indeed they have set them up yet.

However, others are also at risk. PE houses have portfolio companies with often complex supply chains. Asset managers have investments in companies with supply chains. Institutional investors, such as pension funds, invest in the PE houses and the asset managers. Ratings agencies and ESG analytics companies may struggle to source information on this type of risk. Real estate companies do business with tenant companies who occupy factories/warehouses on their land. The evolving legal landscape and stakeholder expectations mean that all businesses should consider the indirect risks arising from their business relationships and how these can best be addressed.

The changing landscape

Companies and their investors are finding that they can no longer divorce themselves from their supply chains or investments for ESG purposes.

Firstly

, the commercial view has changed. This is no longer all about NGOs, though they certainly play a big role, and articles in left leaning newspapers. Commercial and investor expectations are changing. Stakeholders are increasingly holding businesses accountable in relation to the policy commitments and sustainability-related statements they have made publicly. Ethical sourcing and supplier compliance with human rights standards are rapidly attracting greater scrutiny from a range of commercial stakeholders.

This has pushed some companies to build out from the traditional methods of supply chain management, which focused on the commercial aspects of procurement such as favourable supply terms and business continuity. The Covid-19 crisis has accelerated the scrutiny of companies’ response to, and management of, social issues. In addition to the focus on working conditions during Covid-19, this has included some companies immediately changing payment terms to ensure suppliers received rapid payment. It has also led to considerable negative press for those businesses who made late, without payment, cancellations - leaving suppliers’ workers vulnerable to being uncompensated for labour already carried out.

Secondlyhere), and in France the 2017 ‘Devoir de Vigilance’ law goes further and requires substantive action by companies to investigate their own activities and supply relationships for corruption, human rights abuse and sustainability. Riding the wave of related proposals in over 10 member states, the EU has announced plans to introduce mandatory human rights due diligence (see here). Different EU rules, adopted in the last year, will soon require institutional investors to disclose how they factor ESG into investment decisions (see here).

, the legal and regulatory landscape is changing too. In the UK, the Modern Slavery Act 2015 imposes reporting obligations (see

What can businesses do?

None of this is easy, but let’s start with the art of the possible.

The urgent challenge for leadership teams is to ensure they have governance, information gathering and escalation structures in place to provide the opportunity to prevent or remedy issues. This is not a topic for which painting-by-numbers solutions are going to be sufficient, but they are a necessary start.

Businesses can start by asking themselves some simple questions, such as:

• How well do you know your supply chain, or those of your investment/portfolio companies? Can you go beyond “Tier 1”? Have you mapped your exposures further down the chain?
• What governance framework do you have in place in relation to your supply chain? Are all the right business functions represented as part of that framework?
• Do you have a proper Supplier Code of Conduct and do you enforce it? This is one of the things ESG ratings and analytics companies look for. They are likely to look more closely now at content, implementation and verification.
• Are you comfortable that you have a credible articulation of your supply chain management - what you consider the salient risks and your approach to addressing these?
• Have you looked at what you say publicly about supply chain and ESG? If it hasn't been verified recently, check whether it is accurate. Public reporting can sometimes get out of sync with practice.
• Are there opportunities to support good ESG performance down the supply chain? A number of retail facing corporations have initiated supplier financing arrangements with ESG performance requirements.
• Are you confident that potential problems are being escalated to you, so that these are picked up early and addressed efficiently? And do you have the people to engage? Are your Speak Up systems open to, and well advertised to, supply chain workers?
• Are you comfortable on an ongoing basis with the Covid-19 risk assessments and implementation of safety measures in the work place? Do you revisit these to adapt them, so that as facts and understanding changes about Covid-19 your approach is able to reflect this?

This is challenging territory for corporates and investors. It is impossible to avoid supply chain issues. However, companies that proceed thoughtfully - taking account of the ESG risks and opportunities as an integral part of supply chain management - are likely to be more resilient and better able to manage issues if and when these arise.

The stakes are high financially, reputationally and legally. Strong leadership teams will be continually challenging themselves in this space.