Four actions for law departments to address supply chain ESG risk

Legal teams are in an ideal position to help strengthen the strategies, policies and processes that govern supply chain relationships. General Counsel and their legal departments can play a key role in helping organizations stay a step ahead of these regulatory changes and reduce potential risks. Legal teams typically have connections across the major functions in the business and have a strong understanding of how various factors will impact the business. They also understand the current and evolving regulatory environment and are experienced in considering the potential future impact of decisions made today. Moreover, they tend to be responsible for or at least carry significant influence over the contracts governing the relationship between an organization and its supply chain.

But meaningful change in the supply chain evolves slowly even as sustainability demands are accelerating, and potential risk is growing. The time for General Counsel to act is now.

The rise of third-party sustainability risk

For many organizations, supply chain redesign and transformation were underway well before the Covid-19 pandemic but it became a more visible priority as lockdowns led to shortages, stockouts and workarounds. Coinciding with this trend is a shift in mindset among consumers, investors and regulators, who are holding organizations accountable for the sustainability practices of their suppliers.

The growing focus on supplier sustainability creates a wide range of risks for corporations. Consumers are demanding that organizations back up their sustainability ambitions with clearly defined actions and greater transparency. Meanwhile, investors are increasing the level of due diligence they perform on organizations’ supply chains to validate the overall sustainability of the organizations they lend to and invest in. Ultimately, consumers and investors are placing pressure on organizations by voting with their wallets, causing both financial and reputational risk.

At the same time, regulators are proposing and enacting new regulations and reporting guidelines that formally extend organizations’ legal obligations to include issues related to their supply chains. A prominent example of the new rules being enacted is the EU’s Green Deal, which proposes to hold companies responsible for human rights or good governance violations and harm to the environment within their supply chains. While some of these rules are being implemented on an EU-wide basis many are being rolled out at a country level. Other jurisdictions, including Germany, France and California have issued their own similar, or more stringent, regulations governing supply chains, adding to the growing complexity of the regulatory environment that organizations must navigate.

The EU Green Deal also proposes measures to discourage “greenwashing” which includes misleading labeling, marketing, public statements or public reporting connected to sustainability. In some jurisdictions where regulations have not yet been enacted on greenwashing, regulators are labeling greenwashing as an unfair commercial practice or similar violation of competition rules to hold organizations accountable. The risk these new regulations pose is significant. Aside from the significant brand damage of being labeled as a “greenwasher” the fines can reach 10% of an organization’s global revenue. For some organizations this could mean billions of US dollars in fines.

The rules being enacted by the EU are inspiring regulators elsewhere. The Securities and Exchange Commission (SEC) is proposing rules that would require businesses to adopt more standardized environmental, social and governance (ESG) reporting for their supply chains. Australia and Japan are also considering greater reporting requirements in this area. These new rules are flooding law departments with new reporting requirements. In the 2022 General Counsel Sustainability Study (Sustainability Study), 55% of General Counsel reported that they believe the volume of internal and external communications, including legally required reporting, on ESG matters will increase over the next three years. This adds yet another layer of complexity and risk that accelerates the need for General Counsel to take action.

Getting started

Nudging your own organization to make progress on sustainability commitments, reporting and compliance can be challenging. But getting third party suppliers in line will be even harder. Moreover, such efforts will take time before results can be realized. For these and related reasons, General Counsel need to act now, starting with these four key actions.

1. Clarify sustainability standards for suppliers and the organization. Suppliers — existing or potential — can have a dramatic impact on group sustainability performance. Suppliers who rank poorly on ESG metrics can be directed to improve or be replaced. Before this can happen, clear rules must be defined. Once suppliers better understand rising expectations, they will be incentivized to begin harnessing their own resources and ingenuity to improve performance against sustainability.

Working with the business to define clear standards to be communicated to suppliers is a critical step toward this goal. Setting expectations for suppliers is clearly on the minds of many law departments as 90% of respondents in the Sustainability Study said they plan to help establish ESG standards for their organization’s suppliers over the next three years. With the changing regulatory environment, timely execution on these intentions is important.

But before this can happen, businesses themselves need to understand their own sustainability goals and the ways suppliers can have an impact. Standards for carbon emissions, resource use and similar issues need to be clearly delineated. Also, companies need to consider sustainability standards around employee safety, diversity, equity inclusion and other labor practices. General Counsel are ideally positioned to assist with these efforts.

2. Develop contracting processes and templates to reduce risk and support monitoring. Once standards are in place, organizations need to take steps to implement those standards with current and future suppliers. Visibility into the agreed terms for each supplier will be necessary to help support ongoing efforts to monitor and hold suppliers accountable.

This will require legal teams to develop new contract templates and processes that require the use of pre-approved standard and fallback clauses that align with the organization’s sustainability guidelines for its suppliers. Such efforts will help promote consistency across the organization and reduce potential risk from deviations, as teams revisit and repaper existing contracts or enter into new supplier relationships.

Currently, 67% of law departments say they are regularly involved in developing contract terms and policies to ensure supplier contracts support the company’s sustainability goals. Meanwhile, 89% plan to focus on reviewing and amending existing supplier contracts align with their organization’s sustainability standards.

However, overarching contracting challenges reported by many law departments may undermine this work. Notably, in the 2021 EY Law Survey, 69% of law departments reported that they do not prohibit the use of non-standard contracts, risking deviations from standard terms.

Complicating matters, 90% of contracting professionals say they face challenges merely locating contracts. Further, 55% of these executives say their organizations do not have the tools to analyze contracts at scale. This suggests most companies have no efficient way to understand which contracts are or are not compliant with current regulations or internal policies. Taking steps to develop new processes and invest in more robust technology to help extract and store contract data is a critical step. Doing so will give law departments and their organizations the visibility they need to mitigate potential risks as regulations continue to evolve.

3. Increase focus on pre-execution due diligence. Revamping, updating and even re-negotiating existing supplier contracts to factor in sustainability terms will require significant resources. But to truly head off potential risks, it is key for the organization to conduct sustainability focused pre-execution due diligence on all new relationships.

General Counsel clearly see room for improvement in this area as 92% plan to increase due diligence on suppliers’ environmental practices while 80% plan to increase due diligence on suppliers’ employment practices over the next three years.

A critical first step for General Counsel is to work with the organization to define guidelines for due diligence processes.  Creating and memorializing guidelines will clarify internal expectations and help the business hold itself accountable for execution.  Guidelines will also help address any compliance questions from regulators.

4. Monitor and maintain ongoing supplier compliance. As business conditions change, suppliers’ ability or willingness to comply with sustainability guidelines may evolve. Transparency into supplier practices is key to identifying potential compliance issues and reducing risk. In the Sustainability Study, 69% of General Counsel report challenges in gaining the required transparency into supplier impact on environmental sustainability and 51% on working conditions. Also, only 55% of General Counsel plan to increase post-execution monitoring of suppliers over the next three years, placing many organizations at risk.

To help ensure the necessary transparency, General Counsel should first develop and require use of supplier contracts that include clear terms around obligations for providing relevant access and data. As noted above, tracking these obligations is an important part of the compliance process.

However, the business should also be accountable for conducting monitoring to validate that suppliers are actually complying with the terms of their agreements. To facilitate this activity, General Counsel should work with the business to develop processes and guidelines that establish how and when the business will conduct monitoring activities so the expectations are clear and defensible. Taking the critical step to monitor suppliers will give the organization an important opportunity to identify and address potential problems before they become public.

Timing is critical

The spotlight is no longer on companies alone, but also on those with whom they do business. And the potential time required to establish and execute the necessary standards, guidelines and processes is not likely to be short. Yet, the potential risk is growing every day, so time is of the essence as law departments consider their next steps.