The importance of sustainability has risen up the corporate agenda over the last couple of years. While this trend has been driven by mounting pressure from investors, customers and regulators in the face of the climate crisis, it also reflects the heightened sensitivity in societies on the importance of public health and social welfare as a result of the ongoing COVID-19 pandemic. As part of these developments, the social (S) and governance (G) elements of ESG in addition to the environmental (E) have come to the fore too.

Supply chains are of particular importance when it comes to transitioning towards a net zero economy given the fact that up to 90% of an organisation’s environmental impact lies in its value chain – either upstream (in the supply chain) or downstream (e.g. the product use phase).¹ To this end, banks have been working hard to embed sustainability-linked targets into the traditional supply chain finance (SCF) instruments that facilitate global trade – a move that is supporting corporates in not only making their own operations more sustainable, but also incentivising their suppliers to adopt more sustainable and responsible behaviours.

Yet, while great strides forward are being made, the SCF business must get better in promoting sustainability. Why is this the case?

The link between financing and sustainability was not always as well-established as it is today. The idea that private finance might be one of the keys to achieving sustainable development on a global scale was first identified at the Earth Summit in Rio de Janeiro in 1992.² In the years since, support for sustainable finance among businesses and the public – as well as the volume of sustainable financing solutions – has accelerated rapidly. The potential to include ESG performance indicators into financing tools is now widely acknowledged – and its popularity among banks, corporates and consumers reflects this. Between 2016 and 2020, the sustainable finance market has grown significantly, with estimates indicating that ESG assets rose by nearly one third to USD 35trn, which accounts for around 36% of all professionally managed assets.³

Despite the boom, the market is still very much in its infancy – particularly when it comes to harmonisation. As the market has developed, so too have the frameworks that seek to govern it. In recent years, a host of initiatives, in the form of voluntary (and increasingly mandatory) principles, standards, definitions, taxonomies and reporting tools, have been introduced.⁴ While these sustainable frameworks will be key to ensuring all market participants are on the same page, the sheer number available today is having the opposite effect. What one ESG framework might deem sustainable, another might not – and this is creating a fragmented and somewhat confusing landscape.

With this in mind, it is perhaps unsurprising that the calls for convergence and alignment are getting louder, and the industry is responding through attempts at harmonisation. For example, in November 2021, the International Platform on Sustainable Finance (IPSF) launched its guidance for a Common Ground Taxonomy package, which provides a comprehensive assessment of the existing taxonomies used in the European Union and China, identifying the commonalities and differences in their respective approaches.⁵ The World Bank and the Organisation for Economic Co-operation and Development (OECD) are also working to provide guidance on the development and international alignment of taxonomies.⁶

In addition to aligning taxonomies, there is a growing trend among policy makers to mandate sustainability disclosure for large corporates – deemed a necessary step if key climate goals, such as the United Nation’s Sustainable Development Goals and the Paris Agreement, are to be met. Most notably, publicly listed companies in Europe with more than 500 employees have, as of 2021, been required to disclose how much of their revenues, capital expenditure and operating expenses will be eligible for the EU Taxonomy.⁷

The growing pressure on corporates to comply with new frameworks and regulations means that sustainability is beginning to touch all parts of a business’s financing – from raising funds in the capital market to fostering sustainability across supply chains. And corporates are certainly taking note of these efforts, with a recent Economist Impact survey finding that the rapidly growing ESG requirement is the top trend impacting the treasury function.⁸

However, given that supply chains often involve a large network of companies with vastly different demographics operating across multiple geographies, the task has not been without its challenges.

Regulatory action, however, is helping push things forward. In March 2021, for example, the European Union announced its Supply Chain Due Diligence Directive, which holds businesses responsible for the environmental impacts and governance of their entire global supply chain.⁹ Elsewhere, the Sustainability Accounting Board and the EU’s Sustainable Finance Disclosure Regulation (SFDR) are working to impose greater transparency obligations and periodic reporting on sustainability information for firms and products.¹⁰

Outside of regulatory compliance, there are, of course, several other motivations driving the push towards sustainable supply chain finance (SSCF). First and foremost, many corporates see this as a moral imperative.

For example, the UN environment programme recently warned that greenhouse gas (GHG) emissions need to be halved by 2030 to stand a chance of limiting global warming to 1.5°C.¹¹ The various processes involved in a corporate’s value chain will generally lead to the production of a significant volume of GHGs, which can be generated in three ways: directly by the company’s operations (defined as Scope 1 emissions), indirectly from sources that are purchased (Scope 2) or not controlled in its value chain (Scope 3), with Scope 3 emissions accounting for around 70% or more of a company’s carbon footprint.¹² As a result, it is emerging as a corporate’s duty to not only get their own houses in order, but also to take up a leadership position and engage their entire supply chains in reducing emissions. This ultimately goes beyond climate change to other areas, such as securing adequate working conditions for all employees along the supply chain.

Clearly, improving sustainability does not have to be a purely altruistic stance by corporates; it also makes sense from a business perspective. Consumers are becoming increasingly selective in what companies they transact with – and having strong ESG credentials can help secure buy-in to a company brand. In addition, a commitment to improving ESG behaviour can help secure buy-in from investors, who are increasingly aware that ESG factors represent material risk.¹³

Finally, COVID-19 has highlighted the fragility of many supply chains, and has pushed the need for resilience-focused practices to the fore. ESG principles dovetail with this goal and corporates are increasingly looking to shorten, localise or diversify their supply chains in an effort to drive greater resilience and foster long-term success.¹⁴

The interplay of these three factors – the growing regulatory pressure, the genuine desire to become sustainable from a moral and business perspective, and the need to bolster supply chain resilience – has led large corporates to ask their banks for support. As a result, the tool of SCF is being adapted and updated to incorporate a growing range of sustainability metrics.

With the popularity of SSCF on the rise, how exactly are banks meeting this demand? The first step towards setting up a supply chain finance programme that embeds sustainability metrics is taken by a corporate’s procurement department. Sustainability-linked KPIs of the procurement department will manifest themselves in the contractual arrangements with suppliers. An external agency is typically mandated to rate all the suppliers from an ESG standpoint. The ratings would ideally take into account all three ESG dimensions, with a rating in each sub-category and a total weighted-average rating.

The SCF provider is tasked to set up a pricing model that follows the lead of the sustainability KPIs set by the corporate’s procurement department. In its simplest form, an SSCF programme will provide preferential pricing to suppliers with a better ESG rating, hence incentivising suppliers to strive to improve their rating. Ratings would be renewed at fixed intervals (usually annually), and pricing is reviewed accordingly. The sub-category ratings are relevant as they provide transparency – corporates and banks have a no-tolerance policy towards human rights violations and will take remedial steps in case a supplier receives a sub-par rating on this aspect.

This works well for corporates looking to onboard to their first SCF programme, or those looking for additional support. However, large corporates will likely already have several existing SCF programmes in place. To recreate these agreements entirely from scratch can prove to be difficult, not least because of the number of parties involved.

Fortunately, there is another option. Rather than reinventing the wheel each time a corporate wants to onboard to an SSCF programme, banks, including Deutsche Bank, are exploring new ways of adapting existing SCF programmes to incorporate sustainability-linked goals. This solution would be more bespoke, to create processes that blend into the functioning of the existing SCF programme.

If done well, the SSCF programme should work in much the same way as if it was created from scratch, but with the added benefit of not requiring renewed buy-in from the long tail of suppliers. They will initially be offered the standard discount and, depending on their ability to meet the sustainability-linked KPIs, the discount could increase or decrease. Hence, an SSCF programme will ultimately have a carrot-and-stick approach that matches the procurement strategy of the buyer.

While standards for providing sustainability ratings to suppliers and for the structure of SSCF programmes will take time to establish, certain best practices have emerged. Transparency, neutrality and independence of the ratings methodology are in our view the minimum requirements for a robust SSCF programme that would stand the test of a “greenwashing” challenge in the future as market standards are established.

Can ESG ratings provided by the buyer or the bank be considered as independent as those provided by a third-party ESG ratings agency? Are voluntary commitments to certain behaviour or memberships to alliances sufficient? These are questions that wil need to be answered as the number of SSCF programmes grow.

For all the talk of regulations, frameworks, taxonomies and solutions, exactly how far along its sustainable journey is the SCF industry? In a survey conducted by the International Chamber of Commerce, 66% of banks stated that they already had a trade and SCF sustainability strategy in place.¹⁵

Despite this, the sheer scale of the task at hand means that there is still a long way to go. To put it in perspective, the average original equipment manufacturer has more than 5,000 suppliers worldwide. To be seen as credible, large corporates are going to have to tackle the ESG standing of a large part of that portfolio – a time-intensive process that is logistically complex.

But that is not the only obstacle – there is also the issue of securing buy-in from all stakeholders. Small or medium-sized suppliers – especially those operating in emerging markets – may have other more immediate issues to deal with and may not see the value in the ESG target they have been set.

As such, while innovative solutions, such as those that allow banks to embed ESG components into an existing programme, as well as regulations and increasingly harmonised standards, are clearing a path forward for banks, education remains an important component. The key, therefore, is to set achievable, yet impactful, ESG standards for suppliers to meet – and, at the same time, help those who fall below requirements to improve.

Though challenges certainly remain, making sustainable supply chains the norm is an urgent and important mission, and one that will pay off in terms of greater security, credibility and prosperity for all involved

This article was first published in BCR’s World Supply Chain Finance Yearbook 2022 (April 2022)

Sources

¹ See https://bit.ly/3lf8vav at carbontrust.com
² See https://bit.ly/3NkKuL4 at unepfi.org
³ See https://bit.ly/3sHDZdD at bis.org
⁴ See Sustainability In Export Finance Whitepaper, International Chamber of Commerce, September 2021.
⁵ See https://bit.ly/3MCyDs9 at regulationtomorrow.com
⁶ See https://bit.ly/3aa7zCd at greenfinanceplatform.org
⁷ See https://bit.ly/3lfZr54 at assets.kpmg
⁸ See Treasurers are facing key ESG challenges
⁹ See https://bit.ly/3wkQuxL at cbi.eu
¹⁰ See https://bit.ly/3wzyM8Q at tradefinanceglobal.com
¹¹ See https://bit.ly/3Np51yp at unep.org
¹² See Financial World, November 2021
¹³ See Sustainability and supply chains
¹⁴ See Sustainability and supply chains
¹⁵ See https://bit.ly/3lj74YI at tradefinanceglobal.com