ESG, what is it?
ESG is shorthand for Environmental, Social and Governance and relates to the standards used to measure an organisation's social and environmental impact arising from its operations as well as the organisation's corporate governance. ESG considerations are becoming increasingly important in relation to supply chains as organisations seek to reduce their social and environmental impact. This is being driven by a diverse set of legislation and governmental regulation across the globe. Which has meant that organisations have increased ESG responsibilities and reporting obligations, which in turn has resulted in organisations setting out their own ESG policies. In addition, investors and financial institutions are increasingly scrutinising an organisation's ESG credentials and in some instances pricing investments and other financial products based on an organisation's ESG policies and performances.
How do ESG policies play along a supply chain?
Take palm oil. It is an important component of many every day products consumed around the World from food stuffs, cosmetics and pharmaceutical products. Yet the chain from tree to consumer can be a complex one involving many organisaitions which may include processing, transport, manufacture, distribution and retail before reaching the eventual consumer.
The supply chain will very often transcend different geographical areas and different organisations within the supply chain may be subject to different requirements dependent upon the jurisdiction they are in. It is generally organisations over a certain size that fall under the statutory regimes and by the nature of things they will normally be at the top of the supply chain. But it does not end there, because a processes or transport company further along the supply chain may fall within one or more jurisdiction's ESG regulations.
Even though an organisation may not be caught by any ESG regulation as such, because of its size or location, but there is an increasing trend for ESG obligations to be passed up and down the supply chain to the smaller supply chain links, thus imposing serious contractual ESG obligations on every organisation in the chain.
The organisations who are subject to ESG reporting requirements have little choice. They have to demonstrate that they are ESG regulation compliant and that includes understanding its supply chain and where the components in the supply chain are in terms of ESG regulation. The larger organisations will develop policies that they will want to ensure are followed up and down the supply chain. Some of these could be conflicting policies. An organisation which reports under scope 3 of the Carbon Disclosure Project (CDP), will be concerned that the compliance policies it is required to work to are followed at each stage of the supply chain.
The UK's Sustainability Disclosure Requirements (SDR) came into force in May 2024 under the ESG Framework .
Taking the palm oil scenario again by way of an example: A large cosmetics company needs a large supply of palm oil for the manufacture of its lipsticks. It contracts with an importer, who in turn, sources the oil from a distributor in say Porto de Santos. The distributor contracts with a shipping company to ship the oil to the UK under the shipping company's standard terms and at the same time has a contract with a processing plant, which in turn has a contract from a plantation for the supply of the raw material for processing. That is the downstream of the supply stream.
On the upstream side, the cosmetics company has contacts with various suppliers, a contract with a logistics company for the delivery of its products and contracts with various retail stores. The cosmetics company has institutional investors and financiers all of whom are subject to the UK's ESG reporting regime and the investors and the financiers require the cosmetics company to abide by their ESG policies. The financiers offer favourable financing rates to organisations with very good ESG credentials. The cosmetics company is concerned about ensuring that it can demonstrate to its investors, financiers, and other stakeholders that it is ESG compliant.
The contractual conundrum
The conundrum is that supply chains are global, whereas ESG laws, standards and regulations and guidelines are territorial and vary from one jurisdiction to another and are one component in determining the framework for ESG obligations, the other component being the companies own ESG policy. Some of the differences in national rules may be capable of being overcome if the entity at the top of the supply chain is able to enforce one set of ESG terms and conditions down the supply chain requiring all parties in the chain to adhere to the same ESG requirements. There will however be limitations to such an approach, as not all contracts downstream will be implemented perfectly over time. While contracts are one technique parties can use to limit their risks arising from imposed ESG obligations, it is a technique that has its limitations and other risk management techniques will need to be implemented to further minimize risks.
The following steps can be taken to implement an ESG compliant contractual network:
- Check the ESG requirements are clear, defined terms, are correctly used and substantive obligations are clearly set out. Drivers for specific ESG contract clauses include: - Soft law standards such as OECD: guidelines for Multinational Enterprises on Responsible Business conducts; The EU corporate sustainability Directive; and specific clauses that can be adopted from The Chancery Lane Project library of specific clauses; and those in the American Bar Association database of ESG clauses.
- Assess the consequences of noncompliance and if the contractual remedies are appropriate.
- Identify if the supplier is already legally obliged to meet requirements or will be obliged to comply with future requirements.
- Ascertain if the supplier voluntarily complies with requirements.
- Consider industry and market practice.
Data requirements for ESG compliance.
Imposing a contractual regime for ESG compliance by a practice of "Spatter and Hope" will be ineffective without due diligence on all the supply chain and access to quality data objectively obtained independently without just relying on declarations of others. While the collection of such data may start with public registries and datasets, that will all need to be plotted onto a supply chain map plotting geometric locations of suppliers cross checked with image analysis and active due diligence investigations. The objective of ESG compliance is to ensure a compliant procurement system is created, not just to use contracts to shift risks to unwitting third parties lower down the supply chain.
Disputes and International Arbitration
You will have seen from the preceding section that the cosmetics company has included in its contracts a requirement to abide by its ESG policies and to provide data to the cosmetics company which demonstrates compliance.
We are seeing reported an increasing number of ESG related disputes.
So, what if something goes wrong? Let's say it transpires that the plantation was recently established after a large swathe of rain forest was cleared and the people who work on the plantation are unregistered, paid very poorly and are made to work in the sun for 8 hours a day or say that the carbon data provided by the shipping company was inaccurate. With the tendency to pass ESG obligations along the supply chain someone mid-chain may find themselves liable for failings downstream to them in the supply chain. The cosmetics company may then have a problem with its investors, shareholders and financiers or even face a class action lawsuit and would want to pass any such liability to its own suppliers and which would be passed down the chain as far as it might go.
Arbitration is the favoured dispute resolution in the majority of cross-border contracts and will be the forum for such disputes in the vast majority of cases.
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