Managing ESG risk – the New Supply Chain Challenge
As multinationals look to diversify their supply chains to avoid a repetition of the disruption they experienced during the pandemic, they are facing a further set of challenges. Regulators and investors are putting pressure on boards to ensure that new and existing suppliers, often spread across multiple jurisdictions, conform to ESG standards.
Once largely voluntary, compliance is becoming obligatory in many parts of the world – the US and several other countries already have supply chain due diligence legislation in place. America last year passed the Uyghur Forced Labor Prevention Act with the New York State Fashion Sustainability and Social Accountability Act in the pipeline. Other authorities, notably the European Union, are planning such laws. For corporates, the reputational and financial costs of not complying will only mount.
Getting suppliers to sign codes of conduct may have been sufficient in the past. No more. Regulators are requiring multinationals to report on the due diligence they have conducted to ensure that sourcing companies across all tiers of their entire supply chains are sustainable or, at a minimum, taking active steps to being so.
For many boards, this will be a huge undertaking, not least because reporting will have to be carried out on a regular basis, not just at the beginning of a business relationship.
Clearly, the investment required to facilitate continual supply chain monitoring will be substantial, but new compliance technology and, more broadly, a well-thought-out approach to due diligence will secure efficiency savings and limit vulnerability to financial penalties. Moreover, a conscientious multinational will maintain investor confidence and a competitive edge in the marketplace, where sustainability credentials increasingly determine or influence purchasing preferences.
For corporates, maintaining high levels of scrutiny over their supply chains is necessary due to the patchy governance record of many sourcing companies in emerging markets. Multinationals withdrawing partly – or completely – from China post pandemic may reduce the risk of future disruption, yet they take on ESG risks by shifting sourcing operations to some favoured supply chain relocation destinations, such as Vietnam and Mexico.
Both countries are attractive because they are low-cost and politically and economically stable, but their corruption and human rights records are a concern. Without robust due diligence, there’s a danger that the very clear logistical benefits they offer might be undercut by sustainability shortcomings. Equally, wider geopolitical factors may raise questions about the suitability of a country as a supply chain hub. Moscow’s allies, for instance, might face sanctions or receive goods from sanctioned entities in Russia that find their way into products exported to Western firms. Similarly, countries close to China could be drawn into the trade war between Washington and Beijing.
Given the emerging complexity of supply chains, the need to have a high level of visibility over them, coupled with the manpower this requires, means corporates will invariably need to prioritize compliance efforts. This will likely involve the use of technology to identity and target the highest-risk sourcing countries, where due diligence should be focused. The compliance burden will probably be eased by regional and international certification bodies to which multinationals will signal their adherence to ESG standards, with the former then delegating the latter monitoring, auditing recertification tasks.
Moreover, regulators, such as the EU, in the process of finalizing a major new corporate sustainability due diligence directive, will take into consideration the enormous effort required to monitor the length and breadth of supply chain networks. As with similar directives, it will likely urge multinationals to report what they can at the outset, which might amount to just 10 per cent of its suppliers. Critically, though, boards will need to demonstrate progress over time which, in the regulators’ eyes, will be more important than base-level starting points.
In terms of where companies initially concentrate their due diligence efforts, there are two possible options. They might start in low-risk jurisdictions where it is easiest to conduct checks and data is readily available, so that they learn and develop processes that equip them to proceed to more difficult territories. Alternatively, they could begin where compliance is most important, which would be, as I suggested earlier, the highest-risk sourcing countries. There are arguments in favor of either approach, although, I would say, it makes sense to start with the most challenging suppliers or countries.
Of course, should multinationals find weaknesses in suppliers’ ESG adherence, they would be best advised to incentivize – not pressure – them into being more compliant. Ultimately, though, corporates must ask themselves whether they are comfortable about the level of risk they have identified. Reporting for regulators like the EU will not be about declaring there is very low, insignificant risk across your supply chain. Nobody expects that. Nor is that the goal. Rather, it’s about understanding and monitoring risk to decide whether it can be carried, or an alternative supplier needs to be considered.
Increasingly, ESG credentials will become as, if not more important, than cost when corporates select suppliers because of the growing compliance monitoring bill and the possibility of hefty fines for non-compliance. Boards will never be able to eradicate risk in their supply chains, however a strategic approach to mitigating and managing it will enable them to stay on the right side of regulators and investors.
Cvete Koneska is head of advisory services at the geopolitical and security intelligence service Dragonfly.