With new and evolving regulatory demands and increasing pressure from stakeholders, the importance of environmental, social, and governance (ESG) consideration is growing. Companies are now reporting on relevant topics and taking actions to improve their performance on associated metrics.
As they set targets and develop strategies, companies often need to look beyond their own operations and assess the impacts within their value chains. For companies who don’t integrate ESG, some may have to start considering ESG factors as pressure from their value chain increases.
Engaging with the value chain becomes essential for understanding key ESG topics and recognizing the upstream and downstream effects of their operations. This engagement also helps clarify the role companies play in achieving established goals and targets. To meet their objectives, companies may need to collaborate with value chain partners, encouraging them to set their own targets and implement improvement strategies.
Businesses that extend their focus beyond their own operations and actively engage with the broader value chain will be better positioned to achieve their ESG goals and targets.
The first step in connecting a company’s value chain with its ESG endeavors is to define the value chain and understand the influence on the company. The value chain is comprised of important stakeholders that have an impact on the company’s success and ability to meet their goals. The value chain can be broken down into three stages – upstream, downstream, and own operations.
The upstream stage covers a company’s suppliers, or the businesses that provide the necessary materials and services for a company to operate effectively. This stage would also include the suppliers of suppliers, resulting in a long and complex value chain.
The next part of the value chain is a company’s own operations. This includes all activities performed for a company, regardless of whether they are revenue generating or not. When setting ESG goals, companies often must identify where their operations are having the most significant impact.
The third stage is downstream, which is everything involved in the delivery, use, and disposal of a company’s products and services. It includes all their customers and for products, the transport, use, and end of life treatment of the product. Some products may just be a component in another product, making the value chain more complex.
Considering ESG factors can be a way for companies to find innovative ways to improve their business and reduce impacts on the environment and society. For some, ESG consideration is limited to reporting, whether for regulatory purposes or from investor and stakeholder pressure. Other companies are more ambitious with their ESG considerations and set goals on relevant ESG topics and develop strategies to meet them. In doing this, they may aim to reduce risks to their business or find cost saving efforts. By considering ESG factors, company management can improve their business proposition and become more resilient to changing factors.
Companies that integrate ESG into their business strategy may be able to become more competitive in the market. Having good ESG practices, by developing a strategy, reporting on topics, and tracking company performance, can attract both customers and capital, and put companies in a position to be preferred suppliers. To meet changing market demands, companies that can be adaptive and innovative with their products and service offerings are more likely to succeed.
Other advantages of considering ESG factors are cost savings and risk mitigation. Companies that can improve processes to reduce resources and waste can save on expenses associated with resource and utility purchases and waste disposal costs. By identifying potential risks that could negatively impact the company, businesses can adapt and implement mitigation strategies to prevent or lessen the financial impacts, which is crucial for the longevity of the organization.
ESG integration will become increasingly important as new compliance requirements are issued, climate risks materialize, and stakeholder pressure increases.
As companies track performance against material ESG topics and strive to improve, they often will have to look beyond their own operations. The value chain becomes a crucial component for impactful actions. Due to the complexity of value chains, the ESG goals and initiatives of some value chain players can put pressure on and influence the ESG actions of other players.
For companies aiming to reduce the impact their products have on the environment, they will often have to look at the materials used in its production, the use of the product, and the afterlife treatment, all of which are part of the value chain.
Due to the complexity of supply chains, making informed decisions on who to source materials and supplies from becomes an important aspect for company management. Within supply chains, there can be human rights violations, overexploitation of resources, and compliance issues that negatively affect the environment and communities.
For example, if a company is using raw materials to manufacture a product and purchasing from a supplier who is illegally sourcing the raw materials, it can be detrimental for company reputation. Even though the manufacturer is not directly involved in the illegal sourcing, by purchasing the material, they are enabling the activity. Supply chain transparency can expose this type of behavior and highlight that the manufacturer is not responsibly sourcing materials for their products. Consumer demand for their products can decrease as they exercise their purchasing power to align with their own values.
Companies with due diligence procedures in place will screen their suppliers to avoid purchasing from suppliers that don’t adhere to their standards for operating. Many companies develop a set of responsible procurement policies and procedures used to evaluate potential suppliers. They may evaluate a supplier’s adherence to human rights guidelines/principles, instances of environmental noncompliance, management of environmental and social impacts, including targets in place, and risk management.
Where this becomes important for companies, is that if they are not operating in a responsible manner, they may lose out on business opportunities. While a supplier company may not have their own procedures for responsible sourcing or any consideration of ESG, the pressure from their customers within the value chain can influence management decisions. To stay competitive, they may need to start integrating ESG and responsible procurement, which may influence other upstream value chain organizations.
Company goals also have the ability to influence other companies in their value chain to integrate ESG or set goals of their own. Oftentimes when a company sets goals or targets, the ability to meet them extends beyond their own operations. Initiatives may impact procedures and relationships with both upstream and downstream value chain companies.
In the case of decarbonization, many companies have made commitments to reduce emissions or to become net zero or carbon neutral. Most of a company’s GHG emissions are from their value chain (scope 3), so in order to achieve their commitments, their strategy must also focus on reducing their scope 3 emissions. This can include choosing suppliers who produce fewer emissions or that have their own decarbonization targets. In some instances, companies will only work with suppliers who have set targets. This puts suppliers without targets at risk of losing customers and shows how dependencies within the supply chain can lead to meaningful climate action.
Targets related to reduced resource consumption and waste production pushes companies to find operational efficiencies and refine their processes. Companies may also aim to reduce the amount of hazardous, critical, or high-impact materials that are used in products. These reductions in amounts and types of materials can lead to market shits. Companies who have integrated ESG and have evaluated risks stemming from changing market demands will likely already have a transition plan in place and be better able to adapt to these changing trends.
With the dependence of each organization on multiple others, demands from one company or industry can have prominent impacts throughout the value chain.
Some of the newly implemented ESG regulations require companies to evaluate and engage with their value chain. These regulations have broader implications as companies who may not be subject to compliance may still have to participate in specific regulatory tasks.
The EU’s Corporate Sustainability Reporting Directive (CSRD) requires in scope companies to conduct a double materiality assessment to determine which ESG topics they need to report on. The double materiality assessment evaluates both the impact their company has on people and the environment (impact materiality) and how ESG factors affect the financials of the company (financial materiality).
In completing this exercise, companies must identify and engage with their stakeholders to understand the issues most important to them. During this exercise, companies must map their value chain, identify stakeholders such as customers, suppliers, investors, employees, regulators, and industry organizations, prioritize them, and determine the best method of engagement. Engagement may conclude sending out surveys, conducting interviews, or desk top research. For each relevant topic, companies are then reporting on their governance, strategy, risk management, and metrics and targets. As this information is publicly available, the increased transparency may influence companies to improve on specific topics which may put pressure on their value chain as that aim to meet targets and implement strategies.
The Corporate Sustainability Due Diligence Directive (CSDDD), also implemented by the EU, requires in scope companies to establish due diligence procedures that evaluate potential and actual human rights and environmental impacts within their own operations and value chain. For the negative impacts identified, companies must also establish mitigation efforts to prevent or minimize these impacts. Like with CSRD, companies must also engage stakeholders within their value chain to identify impacts. Companies now have a responsibility to reduce the harmful effects to people and the environment that occur within their value chain and are obligated to take action to mitigate it. Companies not in scope of CSDDD, but have customers that are, will still be required to engage and identify potential issues. Depending on findings, it may lead to improvements within their own operations and the establishment of their own value chain due diligence.
While complexity of value chains can amplify negative impacts, it can also expand positive ESG efforts. Within a business, their own operations are a small part of everything it takes to make their business successful. They would not be able to operate without their upstream and downstream value chain partners which makes the value chain and their impacts that much more important.
One company, especially larger and influential companies, can influence others. By integrating ESG into their business strategy and setting goals, they can influence other stakeholders to do the same. This, along with regulatory pressure, companies are going to need to consider ESG factors to stay competitive in the market with their customers, regardless of whether they are in scope of regulations or not. The interconnectedness in the value chain contributes to shifts in the market that prioritize ESG integration.
Increased transparency in various industries and markets also makes the case to prioritize ESG. An increased number of companies are providing publicly available information on their supply chain. Companies will be less likely to work with companies with known human rights and environmental violations because of the negative impacts it could have on their brand and reputation.
Transparency also helps expose companies who do violate human rights guidelines or environmental regulations. Companies that work with suppliers in good standing and provide transparency on such show their commitment to responsible procurement, help protect their reputation and can make them more competitive to their customers who also focus on responsible sourcing.
The integration of ESG is increasing for many industries. The need for companies to engage and rely on their value chain to understand their own impacts and meet their own goals will further make the case of the importance for companies to consider ESG factors.