Optimising your contracts as part of your ESG agenda 7 min read
Organisations can no longer only pay lip service to environmental, social and governance (ESG) matters, as stakeholders increasingly demand a higher bar for responsible business practices and require ESG considerations to be a core part of every organisation's corporate strategy.
Suppliers and service providers are a critical input into an organisation's ESG footprint, with supply chain contracts offering a key opportunity for businesses to realise their ESG goals.
Below are our top tips on how businesses can optimise their supply chain contracts to meet ESG objectives.
Ensure access to supply chain data
There is an increasing expectation from regulators and investors that companies will publicly report on environmental matters. For example, the International Sustainability Standards Board (the ISSB) recently published its draft sustainability disclosure standards, which would require companies to disclose information about significant sustainability and climate-related risks and opportunities to which they are exposed. It is yet to be seen whether governments will support the adoption of the ISSB's standards, and the Australian Accounting Standards Board (the AASB) is currently consulting on the suitability of those standards for adoption in Australia.
Similarly, climate-related disclosures may soon become mandatory in the United States, under the U.S. Securities and Exchange Commission's recent climate disclosure proposal.
Regulatory change is not the sole driver of ESG reporting, and we are seeing a vast appetite for voluntary action too. Almost half of the world's assets under management, worth $43 trillion, are now linked to net zero emissions goals under the Net Zero Asset Manager's Initiative (meaning that achievement of these goals is a critical criteria of the relevant investment).
Access to supply chain data is key to enabling such reporting, and will become even more critical as reporting obligations increase.
Consider IoT technologies and blockchain when it comes to capturing supply chain data
IoT technologies such as sensors and smart meters are increasingly being used to capture operational data (eg energy use) in real time.
The most sophisticated organisations are ensuring the data collected through their IoT devices is also the information required for their ESG reports, so that the entire ESG reporting process can be automated from sensor through to report.
Blockchain is also being touted as a solution for tracking and validating supply chain data from an ESG perspective, given the core competencies of blockchain technology – transparency, reliability and automation – can be leveraged to drive improvements in the accuracy of and access to ESG data. Take Heineken as a recent example – it used blockchain to trace five hops varieties through their sourcing origins, and captured the water and fuel consumption of each. Heineken then demonstrated to its consumers the environmental journey of the product, through a QR code on the beer bottle.
Top tip
Assess whether the reporting obligations and/or audit rights under your existing contracts can be used to obtain access to ESG data from suppliers. Organisations often have reporting rights in their contracts that are underutilised during the contract lifecycle. This is where good contract management can assist.
Expand adoption of 'soft-law' modern slavery obligations
Non-binding so-called 'soft law' standards (such as the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises) are being widely adopted by companies. Such soft law standards are setting the bar for stakeholder expectations on how companies should be operating regarding human rights issues.
Most human rights soft law frameworks (such as the UNGPs and the OECD Guidelines) expect companies to use their leverage to cascade human rights standards and expectations throughout their supply chain
Not doing so could expose entities that have committed publicly to those frameworks to claims of misalignment with their commitments, and even accusations of misleading or deceptive conduct (especially where they may be on notice of actual or potential adverse human rights impacts).
Top tip
Expand your existing obligations beyond compliance with strict legal requirements, to capture a broader set of commitments. For example, warranties that a supplier will not engage in conduct inconsistent with statutory requirements relating to modern slavery can be easily adapted to apply to soft law standards. Equally, a requirement that a supplier develop and maintain policies consistent with the customer's policies can be adapted to apply to that customer's sustainable business practices generally.
Use standards to address subcontractor performance
As stakeholder expectations and the geopolitical landscape change, many organisations are increasingly concerned about the entirety of their supply chain (including their suppliers' own subcontractors).
One way in which companies are ensuring appropriate handling of ESG matters throughout their supply chain is by imposing minimum standards (particularly environmental and social standards) that suppliers' subcontractors must comply with.
Contractual mechanisms are also being used to enable visibility and control over subcontractor appointments (including the appointment of contractors that are a few steps up or down the supply chain).
In addition, there is a growing trend to include targeted drafting around subcontractor management arrangements for ESG purposes – eg through a requirement that subcontractors be trained and audited on ESG issues or required to report on compliance with ESG matters.
The recent public boycotts of organisations whose supply chains involved operations in Russia and Myanmar demonstrate that legal liability should not be the only consideration in circumstances where reputational risk may also be extremely high
Imposing minimum standards that apply to the entirety of an organisation's supply chain (and not just those entities the organisation has a direct contractual relationship with), and maintaining a degree of control over and visibility as to the appointment of subcontractors, is increasingly important.
Top tip
Look to implement a change management procedure and change in law clause that affords flexibility in long-term contracts. Given how quickly ESG regulation and expectations are shifting, these mechanisms can be used to ensure that supplier commitments can be uplifted to account for changes in ESG requirements (and that the cost of this uplift is not necessarily borne by the customer).
Leverage contractual remedies for ESG compliance
Certain 'traditional' contractual remedies are being leveraged in new ways, to incentivise ESG compliance and deter a supplier's misalignment with an organisation's ESG strategy. For example, benchmarking rights, continuous improvement obligations and termination triggers are all traditional contractual provisions that are being reframed and broadened to provide mechanisms through which an organisation can require suppliers to help deliver on its ESG commitments.
The Chancery Lane Project recently launched its Climate Clause Selector tool, which allows users to search and download precedent climate clauses to use in commercial agreements
Examples of such contractual mechanisms include an ability for a party to terminate the agreement in favour of a greener supplier, continuous improvement requirements focused on environmental matters, and inclusion of a climate remediation fee. The Chancery Lane Project publishes its Climate Control Playbook, which is free to download and contains precedent clauses to use in commercial agreements.
Top tip
Scrutinise the impact of the use of alternative dispute resolution mechanisms, such as arbitration, as a means of resolving ESG-related contractual claims. While parties may prefer alternative dispute resolution processes as they allow for greater confidentiality about disputes, the use of these mechanisms has the potential to generate reputational issues if seen to be an attempt to hide an organisation's failures in sustainable procurement or ethical practices.
Undertake supply chain due diligence
Finally, it is not just the contractual provisions included in an executed agreement that are important. Conducting due diligence on suppliers before they are engaged remains a critically important step in ensuring ESG standards are upheld in an organisation's procurement process.
In Australia, organisations wanting to undertake ESG-related due diligence on prospective suppliers have done so on a voluntary basis, without being able to point to mandatory due diligence legislation as exists in certain other jurisdictions. This means maintaining competitive tension in the request for proposal (RFP) process is critical to ensuring that due diligence access is provided. We are also seeing scoring methodologies in RFP assessments as another way organisations can successfully emphasise the importance of ESG matters in their procurement processes.
Europe has taken the lead on mandating supply chain due diligence and this is a space to watch
There is a global trend of countries introducing mandatory supply chain due diligence in the 'E' and 'S' spaces. The US, Canada, EU, Germany and Japan, to give a few examples, have all recently proposed legislation that would require companies to perform diligence on their supply chains for adverse impacts, including, in some instances, proposing civil and criminal fines, or other sanctions, for non-compliance with the requirements.
Top tip
Involve your legal team with the preparation of procurement documentation, and ensure ESG requirements are brought to the fore in the supplier assessment process. This may include preparing RFPs and response frameworks that prioritise ESG criteria, and ensuring bidder responses are evaluated on their ability to meet such ESG requirements. Similarly, through their involvement in the preparation of board packs or contract approval processes, legal teams can ensure ESG objectives remain front of mind during the procurement process.