For investors assessing ESG risks in their portfolios, practices in the supply chains of investee companies have sometimes seemed like a secondary consideration. But no longer. Regulators across various jurisdictions are increasingly demanding that corporates disclose data on their supply-chain emissions, as well as report on human rights risks among their suppliers.
German legislation on supply-chain due diligence entered into force in January, and a directive that would require similar measures across the EU is moving towards completion. Meanwhile, the EU’s Corporate Sustainability Reporting Directive will require companies to report on Scope 3 emissions from their supply chains, and in the US, the Securities and Exchange Commission has also proposed a rule on Scope 3 emissions.
The need for accurate data on ESG factors in supply chains is therefore growing rapidly. But this brings a host of challenges. Collecting data on practices in companies’ own operations can be hard enough; insisting that companies report data on their supply chains, which are often long and extremely complex, is inherently more difficult.
“While ESG aspects regarding supply chains have always been considered a reputational and thereby business risk, these are increasingly a potential source of governmental sanctions and private litigation,” says Julia Grothaus, partner at law firm Linklaters.
“This shift of focus coincides with the trend of more and more hard law when it comes to the role of companies in protecting human rights and environmental interests.”
Legislation on supply-chain reporting often produces heated debate, particularly among business groups that bemoan its costly and time-consuming nature. But investors that seek to improve ESG practices are eager for enhanced regulations that result in more data being disclosed.
With more information available to investors, “reporting requirements will thus facilitate screening investments for supply-chain risk during pre-due diligence, as well as the due diligence itself”, says Grothaus. “Once the investment has been made, the information will help to develop and implement strategies and tools for monitoring and supporting portfolio companies as they work to transform their sourcing programmes.”
Last August, a group of 39 investors signed a letter calling for human rights and environmental due diligence legislation in the UK. Months earlier, dozens of investors also signed a letter protesting the delay in the EU’s supply-chain due diligence measures.
Tulia Machado-Helland is head of human rights at Storebrand Asset Management, which was among the signatories of both letters. She tells Responsible Investor that voluntary guidelines, such as the UN Guiding Principles on Business and Human Rights and the OECD’s Due Diligence Guidance for Responsible Business Conduct, need to be supplemented with compulsory requirements. “Regulation with teeth” is needed, she says, to force companies to act on supply-chain concerns.
Machado-Helland notes that, at present, investors face severe challenges in collecting reliable and comprehensive information on ESG practices in a company’s supply chain. A basic problem – and a reality that is often overlooked – is that large companies, particularly in certain sectors, have only a limited idea of what their own supply chains look like.
“I’m so often surprised that you ask companies [about their supply chains], and they don’t even know. They know their first tier, the direct suppliers, but beyond the second tier they don’t know that much,” says Machado-Helland.
Ignorance can also be convenient for corporates. When facing difficult questions from investors, corporates can often hide behind the difficulty in tracing their supply chain. “It’s really easy for them to just brush you off,” warns Machado-Helland, who says investors need to work with other stakeholders to force corporates to take their concerns seriously.
In the absence of company disclosures on human rights practices in their supply chains, investors need to scrape together information from a variety of sources, including data providers, the media and NGOs. “We know that we’re getting the tip of the iceberg,” says Machado-Helland.
She adds that there is much room for improvement in how data providers operate. “Data providers are weighting the financial risk, or the economic loss for the company, more than the actual impact on stakeholders. When they are doing this, they are not in alignment with the UN Guiding Principles or the OECD Guidelines.”
Scope 3 challenges
Alongside human rights, the other major supply-chain concern for investors is on the reporting of Scope 3 emissions data.
“For investors, Scope 3 data from investee companies is crucial for understanding the full impact of their portfolios,” says Claire Elsdon, global director for capital markets at global non-profit CDP. “High-quality Scope 3 data from investee companies is likely to be crucial in responding to growing regulatory pressures and also in meeting investors’ own net-zero commitments.”
However, estimating Scope 3 data has long proven challenging even for larger companies. Elsdon says that only 41 percent of companies that disclosed through CDP last year reported emissions for at least one Scope 3 category.
The SEC published proposed rules for climate disclosure in March 2022 that would require companies to report Scope 3 emissions from the upstream and downstream activities in their value chains. The proposed rule contains some exemptions for smaller companies, and Scope 3 requirements would be phased in over a longer period than for Scope 1 and 2. Nevertheless, the proposals have produced a major political controversy.
Kristina Wyatt, chief sustainability officer at climate data software company Persefoni, says that much of the criticism is the result of a “broad-based misperception on what it takes to calculate Scope 3 emissions”.
“There’s this notion that all of these small suppliers that are in a company’s Scope 3 value chain will have to expend a lot of time and energy to calculate their emissions, and that this is going to be terrible for the economy.”
However, Wyatt points out that the SEC in fact does not require Scope 3 estimates to be based on primary data. Instead, companies can base estimates on factors such as industry averages and spend-based methods. “The burden on companies in reporting those Scope 3 emissions really isn’t as significant as the opponents would make out.”
Sonya Bhonsle, global head of supply chain at CDP, says a spend-based method is the “minimum requirement for high-level reporting”. But she cautions that “in using this approach, a company’s only opportunity to reduce their impact is to change what they buy or to buy less of it, which is not always an option.”
Bhonsle says the CDP has observed a “gradual transition to [companies] using more data collected from their suppliers in their Scope 3 approaches over time”. This means, she says, companies can use supplier data to “prioritise high-impact interventions, such as encouraging their suppliers to purchase renewable electricity, which in turn reduces the emissions associated with the goods and services they purchase”.
Tech to the rescue?
Credible Scope 3 estimates certainly depend on access to both technical expertise and huge quantities of data. As a result, Wyatt argues that technology has a vital role to play. “Technology’s going to help companies to report and make their calculations more accurate, transparent, auditable and reliable – and bring down the cost of reporting,” she says, noting that software platforms can help companies to understand where their emissions are concentrated and how they can be reduced.
“The technology helps companies not just do the initial calculations, but also to find the levers that can help with cost-effectively decarbonising and to show how they’re progressing on their path towards decarbonisation.”
Amid the debates around disclosure requirements and calculation methodologies, the simple fact is that supply-chain emissions cannot be ignored if the investor community is serious about reaching net-zero targets.
Indeed, the vast majority of a company’s carbon footprint comes from its supply chain; Scope 3 emissions are on average 11.4 times greater than operational emissions, according to CDP data. Finding ways to not only collect data, but to act on it, needs to be an urgent priority on the road to net zero.
Follow the money
EU mulls including financial services in due diligence regime
The proposed EU Corporate Sustainability Due Diligence Directive will undoubtedly have major consequences for asset managers, given the effect on their investee companies. But European policymakers continue to debate whether to impose specific requirements on financial services companies themselves.
In a deal agreed at the end of last year, EU member states opted against requiring financial services firms to take action if their clients failed to prevent adverse human rights and environmental impacts. However, the European Parliament is set to approve a text that would require asset managers and institutional investors to “induce their investee” to prevent or mitigate adverse impacts.
The disagreement on the requirements for financial services is now set to be one of the most contentious issues that will need to be resolved before the directive can take effect.