Supply Chains & ESG: How to Use Your Supply Chain to Accomplish Your ESG Goals

In June 2021, Womble Bond Dickinson is offering a comprehensive look at ESG from a variety of viewpoints. The “Doing Well By Doing Good: How Environmental and Social Governance Impact Your Business” campaign continued June 16 with a webinar discussion of supply chain issues and ESG. Participating speakers were Womble Bond Dickinson attorney Greg Chabon and Rob Handfield, Executive Director of the Supply Chain Resource Cooperative and Bank of America University Distinguished Professor of Operations and Supply Chain Management at North Carolina State University. Womble Bond Dickinson attorney Mark Henriques moderated the discussion. Click here to watch the full video of the discussion. What follows are some highlights from this discussion:

For years, efficiency was the focus for global supply chains. Companies had gotten lean, “just in time delivery” operations down to a science, creating tremendous logistical advantages and costs-savings for businesses that did this well.

But the COVID-19 pandemic exposed a soft underbelly to the push for efficiency. Supply chains that run with no margin for error were disrupted by something as immediate and widespread as a global pandemic. And getting them back to full strength has been a challenge—companies have found it is much harder to ramp up distribution than it was to slow it down.

“We’ve had huge shortages and price spikes,” Chabon said. “The supply chain issues are real and important.” 

As a result of the pandemic and resulting shortages, supply chains are under increased scrutiny by companies, consumers, stockholders and governments. And with this scrutiny comes the opportunity to improve supply chains and put them to work for a company’s overall goals. These goals increasingly include ESG—Environmental, Social and Governance. 

So as companies seek to enhance their ESG criteria in response to investor and consumer demands, addressing the supply chain’s impact on ESG is essential. Supply chains also can expose companies to hidden and uncontrollable risk that negatively affects ESG – natural resource depletion, human rights abuses, corruption, etc. Companies are advised to consider and address these potential concerns before they become problems.

Supply Chains Stretched by COVID-19 Pandemic

Handfield described the pandemic-related supply shortages as a “perfect storm.” In the early months of the pandemic, companies scaled back on production significantly, as many consumers were out of work or worried about their employment security and demand for goods and services plummeted. 

But vaccines have put the pandemic under control, and with this has come a wave of pent-up consumer demand. Big-ticket items, such as appliances and home electronics, are so in demand now that they are difficult to find. Raw materials, such as lumber and steel, and critical components such as semiconductors, have seen prices skyrocket in recent months due to demand. Handfield said that some manufacturers actually are declining orders because they don’t have the capacity to meet them.

“With supply chains, when you step on the gas, you don’t accelerate right away,” he said. “Every sector of the economy is being hit with this demand crunch.”

Handfield said that a labor shortage also is a real problem in many sectors and one that is exacerbating the supply chain woes.

Protecting the Supply Chain Through Mapping

So how do companies learn the supply chain lessons from the pandemic? And how do they adapt supply chains to meet ESG goals? 

The first step, Chabon said, is to understand exactly how their supply chains operate. “Everything begins with supply chain mapping,” he said. “Each company has to understand their own supply chains, hopefully at least to the Tier 2 supplier level.  This mapping can help identify where you are vulnerable.”

Supply chain mapping simply is seeking to answer the question of “Who is in our supply chain?” Such mapping typically divides suppliers into Tier 1 (direct suppliers), Tier 2 (suppliers of suppliers) and even Tier 3 (suppliers of suppliers of suppliers). This type of mapping can reveal weak points in a supply chain that may go undetected in a particular audit.

For example, in 2011, General Motors had to temporarily close its truck plant in Louisiana because the plant relied on a component made in Japan, and a tsunami had closed the Japanese plant. 

The interconnected nature of global supply chains means that such risks must be managed, rather than eliminated, in most cases. The Biden Administration recently announced an initiative to bring semiconductor manufacturing to the U.S. in order to protect the nation’s supply of these invaluable products. But Handfield said that such an effort, while laudable, would require bringing the entire supply chain to the U.S., not just the end manufacturing. 

Handfield said companies concerned about supply chain vulnerabilities should work with Tier 2 and 3 suppliers to make sure they have the capital and resources they need to ensure they can meet their role in the supply chain.

Supply Chain ESG Metrics

“There’s a huge demand on the part of consumers” for eco-friendly and ethically sourced products, Handfield said. This demand, by necessity, means that companies must ensure that suppliers meet these desired ESG goals—both in environmental impact as well as in labor/human rights.

But how a company should measure suppliers’ ESG performance remains tricky. There is a crucial need for developing and implementing metrics to assess the ESG practices of supplier, contractors, and vendors. However, to date, such efforts have been a jigsaw puzzle of differing metrics, criteria and accuracy. 

“The problem with audits is that is a snapshot in time,” Handfield said. Instead, he said focusing on continuous improvement tells a more accurate story and usually results in better outcomes.

New supply chain analytics research is seeking to consolidate these various criteria and metrics in a unified metric. For example, Handfield is helping lead the development of the Supplier Relationship Maturity Index at N.C. State University’s Supply Chain Resource Cooperative. This ambitious project looked at tens of thousands of data points using a machine-based learning algorithm and graded companies based on their preparedness to weather supply chain risks. The team's work recently was spotlighted in a Wall Street Journal article. 

Researchers graded Fortune 500 companies both on Supply Chain Intelligence (which Handfield defines as “the mechanism by which organizations make as complete analysis as possible of a current or targeted supply base”) and Supplier Relationship Management. Handfield said, “Firms with high scores in Supplier Relationship Management have established the right set of relational structures with suppliers that remain in an optimized supply base.  They are better able to have strong communications, that give them early warning on supply chain disruptions, and can better collaborate with suppliers to seek mitigation strategies.”

The Supplier Relationship Maturity Index also evaluates companies’ progress towards both a) environmentally conscious supplier management, and b) adherence to the UN International Labor Organization guidelines around human and labor rights in the supply chain.  

The latter is particularly important for companies who source in low-cost countries. While many companies rely on labor from these markets as vital links in their supply chain, many organizations haven’t managed ESG risks effectively in these countries.

Chabon and Handfield said that meeting ESG goals doesn’t necessarily result in significant cost increases. One apparel manufacturer reported that paying a fair wage to workers in developing nations added an average of 25 cents to the cost of a t-shirt—an increase most consumers wouldn’t even notice.

“In many cases, the financial offset isn’t nearly as dramatic as some pundits would have you believe,” Chabon said.

Effectively integrating ESG goals into supply chain operations requires strong, frequent communication, Chabon and Handfield said. It is important to set high expectations and track them with measurable metrics. Above all, the supplier/buyer relationship must be built on mutual respect and trust. Such a relationship-centered approach reduces the risks of supply chain disruption.

Many Fortune 500 companies already have strong ESG components in their supply chain management plan. In fact, the Supply Chain Resource Cooperative found considerable overlap between companies scoring high on supply chain innovation and social responsibility. Handfield said the connection makes sense—supply chain managers at well-run companies already have a hand in almost all areas of business, he said. 

“This didn’t happen overnight,” Handfield said. “In some cases, these companies have been doing this for decades.”

Contracts are Key

“The source of problems ultimately comes back to the contract,” Handfield said. But on the positive side, well-written supplier contracts can be key tools in both strengthening the supply chain and meeting ESG targets.

So what if there are problems with a supplier? Chabon said litigation is the last resort, as suing a supplier frequently ends the relationship. Many companies want and need to maintain good relations with their suppliers.  It is far better to work together to repair any problems, he said, and it is better still to anticipate possible problems in advance and account for them in the contract. Chabon said supplier contracts should set clear expectations for both parties and outline how disputes can be resolved with a minimum of disruption.

With this in mind, consolidated and meaningful ESG metrics can be implemented in supply agreements as part of Key Performance Metrics (KPI). KPI data then can be tied to performance incentives and benefits.

Contracts also can spell out ESG-related legal requirements such as:

• Conflict minerals reporting (even if suppliers are not public companies);
• Child labor; and
• Environmental compliance.

It also seems likely that the SEC will require ESG reporting in the future. John Coates, the SEC’s Acting Director of the Division of Corporate Finance, said earlier this year that “the SEC should help lead the creation of an effective ESG disclosure system so companies can provide investors with information they need in a cost effective manner.” Coates said such an ESG disclosure system should address such important questions as:

• What disclosures are most useful?
• What is the right balance between principles and metrics?
• How much standardization can be achieved across industries?
• How and when should standards evolve?
• What is the best way to verify or provide assurance about disclosures?
• Where and how should disclosures be globally comparable?
• Where and how can disclosures be aligned with information companies already use to make decisions?

ESG considerations aren’t going away. Whether driven by federal regulation, or by consumer/stockholder demand, companies will continue to feel increasing pressure to meet environmental, social and governance standards. The most successful companies will integrate such changes throughout their supply chains, working with suppliers to find solutions that meet both business needs and the greater good. An integrated team approach remains the best approach to meeting ESG goals in supply chain management.