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Disclosure Standards Must Cascade Down Supply Chain

The average supply chain remains opaque to investors; experts call for standardisation.

ESG disclosure standards have been pushed to the forefront of investor priorities, with asset owners demanding more transparency on investee companies’ management of ESG risks and opportunities. However, attention now needs to turn to sourcing ESG disclosures across the supply chain, experts argue.

“Investors assessing ESG risks within companies should also be looking to measure their level of engagement with their supply chains on ESG-related issues,” says Sonya Bhonsle, Global Head of Supply Chain at international non-profit disclosure platform CDP.

Customers are showing markedly more interest in tracking and disclosing environmental risks, such as carbon emission levels, with requests for supplier disclosures from members of the CDP Supply Chain group growing by 19% last year, numbering more than 15,000 requests.

“Despite the interruption of Covid-19, the companies we work with are still willing to engage on supply chain disclosures, which tells me they are increasingly understanding how ESG risks from supply chains are becoming a material part of business as usual,” she says.

This month, CDP published its ‘Global Supply Chain 2020’ report, which collated data from over 8,000 companies disclosing through CDP last year. The companies were responding to requests for increased transparency on environmental risks from 154 major buyers, including Walmart, BT and BMW.

The 154 buyers surveyed collectively spend an average of US$4.3 trillion in procurement every year, the report said, and therefore have a duty to “understand and address the environmental impacts and risks of their value chain”.

Next, Bhonsle would like to see more focus on social issues as well. While CDP is very much focused on environmental risks and carbon emissions, other voluntary frameworks do offer different approaches that tackle social issues.

Investors have a big part to play in order to encourage more multinational corporates to demand for transparency on all ESG-related risks – not just environmental – within their supply chains, Bhonsle argues. “It’s the next step in ESG disclosures. Investors can help drive corporates to cascade ESG disclosure standards down the supply chain,” she says.

Emissions lurking within supply chains

Requests for ESG disclosures from supply chains are so far adopting a climate-first approach, according to data from the CDP Supply Chain platform.

As more asset owners and managers pledge to reach net-zero carbon emissions by 2050, transitioning to a low-carbon economy has become a more immediate priority, and not just for heavy carbon-emitting industries such as oil and gas.

However, unless asset owners and asset managers better understand and manage supply chain emissions, these net-zero targets will be more difficult to achieve. Companies’ supply chain emissions are on average 11.4 times higher than operational emissions, according to CDP. Suppliers need to better incorporate supply chain emissions accounting as part of the “new business norm”, the report said.

Without accurate data from their supply chains, organisations will struggle to set out Scope 1, 2 and 3 emissions targets according to demands from regulatory and reporting frameworks, such as the Science Based Targets Initiative (SBTi). So far, adopting science-based targets has helped large corporations reduce their emissions by a collective 25% since 2015, according to the SBTi’s 2020 Progress report.

It is important to note the evidence that suppliers are engaging more with the issue, reducing emissions throughout the value chain. “In aggregate, suppliers undertook activities reducing GHG emissions by 619 million metric tons and saved US$33.7 billion in the process,” CDP noted.

Nonetheless, other areas of environmental risk – such as deforestation and water security – aren’t prioritised as highly.

Last year, CDP released its ‘Zeroing-in on Deforestation’ report, which noted that commitments to net-zero deforestation in the consumer goods sector “are unlikely to be met” unless supply chains better manage deforestation risks. Of the companies studied, just 47% of land managed to cultivate palm oil could claim to meet the Forest Stewardship Council’s (FSC) deforestation standards.

“Forest risk commodities (FRC) supply chains are complex and it is difficult to attribute deforestation to individual commodity producers. By assessing companies’ deforestation risk management, we highlight that the worst performing companies are more likely to be exposed to deforestation within their supply chains,” CDP said.

Supply chain management of water security requires greater attention, Boston Consulting Group (BCG) has warned, as water doesn’t seem to be viewed as a risk beyond how use or misuse of water may threaten the environment. Yet in the World Economic Forum’s 2020 Global Risk Report, water crises were ranked higher than energy price shocks, terrorism and financial crises.

Water security is a huge financial risk, and therefore needs to be managed throughout supply chains, wrote Torsten Kurth, Senior Partner, BCG Berlin, and Adrien Portafaix, Partner, BCG Paris. “Flooding alone led to average annual losses of US$40 billion between 2010 and 2018,” they said.

Put simply, progress is being made in key areas, but investors need to exert their influence to speed up progress and widen ESG-related disclosure coverage. If suppliers aren’t encouraged to engage on environmental action, CDP said companies could face up to US$120 billion in extra cost due to environmental risks in their supply chains within the next five years. That, in turn, will cost the investor.

Lack of visibility on social issues

While environmental issues are beginning to be addressed by supply chains, social issues remain hard to track and comparatively opaque.

“There’s not much visibility on social risks like labour standards and human rights,” says Janne Werning, Head of ESG Capital Markets and Stewardship at Union Investment.

“There is a massive bias towards environmental data in supply chains, and there are big gaps in disclosures on social issues,” agrees Bastian Buck, Chief Standards Officer for the Global Reporting Initiative (GRI).

The further down the supply chain they go, the less control and visibility investors have on social issues like appropriate health and safety measures and employee rights, according a January blog post by Simon Whistler, Senior Specialist of Investment Practices at the UN-backed Principles for Responsible Investment (PRI).

“These practices also need to extend further through the supply chain – an inherently more difficult task because of their often complex and opaque nature,” he said.

With little to no visibility of workforces further along the supply chain, it is more challenging for both corporates and investors to evaluate employee pay, working conditions, child labour or maintenance of basic human rights across supply chain workforces.

“We would like to see companies work to improve their visibility on these issues. From our point of view, coordinated action with the investor could help companies better tackle these social problems,” Werning tells ESG Investor.

The hidden costs of supply chain transparency

An industry-wide problem is the ongoing issue of obtaining relevant, accurate and comparable ESG data that allows for more transparency throughout the supply chain. “Supply chain data availability, quality and comparability is poor,” Werning agrees.

Without access to quality ESG data, investors won’t be able to effectively assess risk exposure. Implementing change to tackle this problem won’t be cheap, Buck warns.

“There are costs behind facilitating transparent and standardised information from the supply chain all the way up to headquarter level,” he explains. “By scaling ESG reporting requirements across their supply chains, companies will undoubtedly uncover more ESG issues they need to address, incurring further cost.”

It’s a daunting task. CDP reported that only 37% of suppliers said they were engaging with their own suppliers on ESG issues last year.

While investor pressure can make a difference, supply chain transparency likely requires policymaker intervention, Werning notes. “A lot of suppliers are unlisted, which means they do not have public reporting obligations. Therefore, there’s no transparent and audited data, making assessments of ESG-related risk much more difficult,” he says.

Buck points out that existing standards used by corporates to provide investors with ESG-related disclosures are “fully scalable across the supply chain”. Corporates need to be prepared to meet the costs behind implementing them more broadly, he says.

Standardising ESG disclosure regulation

Supply chains span the globe, operating across regions with differing ESG legislation and reporting requirements, which will make disclosure standardisation difficult without collaboration from policymakers and regulators, experts argue.

“There is absolutely a role for policymakers to get involved in ESG disclosures at a supply chain level,” Bhonsle emphasises. “COP26 would be a great platform from which to begin doing this.”

Asset managers and asset owners can encourage their larger holdings to make ESG disclosures on their supply chains on a case-by-case basis, as they do at Union Investment, Werning points out. However, issuing more mandatory and comprehensive reporting requirements would require regulatory and legislative intervention.

“As investors, we like to see that companies have addressed ESG risks and opportunities in their supply chains, or are in the process of doing so,” Werning adds.

“I would assume that we will see more standardisation of ESG information requests across supply chains in the future, mainly because many multinationals actually share the same suppliers,” Buck says. In the short-term, however, standards-setting bodies like the GRI have plenty on their plate standardising sustainability-related reporting at “the first tier”, he adds.

Corporates and investors are focused on aligning their own ESG disclosures to existing voluntary frameworks and, in some countries like the UK, meeting mandates to report in line with the Task Force on Climate-related Financial Disclosures (TCFD).

Further efforts have been made by ‘the group of five’ to issue a global sustainability standard prototype for climate-related reporting, which they have argued can be applied to all ESG-related issues.

The logical next step is to “go beyond the first tier”, Buck tells ESG Investor.

“So far, industry has looked very narrowly at ESG reporting, beginning at headquarter level, but now we’re extending beyond that by focusing on the concept that you should cover all your business relationships within your reporting – including the suppliers – to better understand what’s happening in those domains,” he says.

“I am seeing investors asking more detailed questions about ESG risks at a supply chain level, but I don’t think it’s their predominant focus right now. They’re still looking at getting headquarter-level reporting right.”

Supply chain ESG disclosures should be “business as normal”

Currently, there is a distinct divide between evaluating ESG risks in supply chains and ESG disclosures from corporates, Bhonsle says, which is inhibiting progress. “Collecting ESG data at a supply chain level needs to be built into business as normal,” she says.

It was the same story with health and safety. When first introduced, health and safety measures were considered ‘nice to have’, but it’s now very much a central part of company policy. ESG risks within supply chains need to be incorporated and prioritised in much the same way, Bhonsle says.

“Investors need to be more hands-on with supply chains by increasing their level of engagement with companies on ESG risks in this arm of their everyday business,” she adds.

Currently, investors simply aren’t exercising the power they have to its capacity. Investors need to now start asking the right questions in order to ensure corporates are endeavouring to find the answers, she says. Are companies engaging with their suppliers on ESG issues? What is the purchasing arm doing to address ESG? Have they fleshed out their supplier engagement to include environment?

“If a company doesn’t know those answers, then that should be a series of red flags to the investor,” Bhonsle emphasises.

This is only the beginning…

Making sure corporates are aligning with the investor’s ESG targets is no longer enough, Buck says. All along the supply chain, there is a plethora of ESG issues that remain unaddressed. Investors are unwittingly contributing to these problems in their everyday investments.

“Investors need to be more conscious of the fact that, by investing in a business, they are also investing in all these prevalent issues that exist within the supply chain of that business, and are therefore contributing to perpetuating these issues,” Buck explains.

There’s still a lot of work to be done to improve investor-level engagement with widespread ESG issues – and the fast-emerging issues surrounding supply chains feels like industry has opened a can of worms.

“We’re only at the beginning of tackling ESG risks in supply chains – investors need to ensure they are part of the solution,” Buck says.

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