Do’s and Don’ts of ESG Clauses From Both Sides

You may be thinking to yourself, “ESG Clause. What is that?” But Environmental, Social, and Governance (ESG) clauses are starting to pop up in template agreements. And there is a good reason for it.

Public and multi-national companies are under increasing scrutiny on their ESG practices from regulators, investors, activists, and customers. In many cases, companies are also held accountable for the environmental and social practices of their suppliers. As a result, they want contractual guarantees of good ESG practices.

So how can we manage ESG risk better? Here are some do’s and don’ts for suppliers and customers.

As a supplier:   

Don’t over-commit.  

Your company may have excellent environmental and social practices. It may be tempting to assume these comply with international guidelines, accept the provision, and move on. Here’s the rub – even if you comply already, documenting your compliance with multiple schemes is time-consuming and expensive. If you are required to do this on demand for a client, it will disrupt the business. And when your client realizes you are not prepared, you will lose credibility.

Do ask the client what they are really concerned about.  

The clients may be asking for this representation because they are concerned about carbon footprint, human rights violations, or any number of other issues. Once you understand your client’s concerns, you can propose language that addresses those concerns in a manageable way. The advantage to clients is that a more narrowly tailored provision will strengthen their ability to request targeted documentation and call a breach if necessary. The advantage to you is that you can focus your ESG actions on what matters to your clients.

Do create a proactive ESG or sustainability program and documentation.

If your clients are concerned about ESG, your company should find a way to address those concerns proactively. You can do this by participating in GRI reporting, creating an annual sustainability report, committing to the UN Global Compact, and many other ways. Having documentation of your practices will make clients who are concerned about ESG much more likely to want to work with your company and help steer off difficult contract negotiations around ESG.

As a customer:

Do your supplier due diligence.

A lot of ESG risk can be managed through due diligence. Ask suppliers to provide information on their ESG practices as part of the RFP process. Leverage a third-party ESG rater like Ecovadis or create your own diligence questionnaire. If a supplier does not meet your ESG standards, not contracting with them at all is much better protection than you will be able to achieve through an ESG clause.

Don’t ask for the moon.

It can be tempting to just add a laundry list of standards into a template and call it good. This would be a mistake. Engaging with voluntary guidelines, reporting, and ratings requires significant investment on the part of your suppliers. If you require multiple forms of reporting and ratings, you will end up limiting yourself to very large suppliers. Or suppliers who are willing to sign any contract representation, regardless of whether it is true.

Do develop a tailored ESG template clause.

Start by identifying the purpose of your ESG clause. What environmental or social risks are likely to come from your supply chain? What issues are your investors and customers most concerned about? What information from your supply chain are you legally required to report on? Use the answers to these questions to write a clause that states clear and measurable requirements. Once you have this, it will be easier to stick to the clause in negotiations and enforce it where necessary.

This is new territory for many contract drafters. Here is an example (though not necessarily recommended) ESG clause:

A more tailored provision could look like this:

Contractor represents that it is in full compliance with international and national laws with respect (i) human rights, (ii) embargoes, arms and drug trafficking and terrorism, (iii) the health and safety of employees and third parties; (v) environmental protection; (vii) corruption and bribery, fraud, influence peddling; and (viii) anti-money laundering measures.

There aren’t a ton of precedents. So often the result is an extremely broad provision that requires suppliers to follow multiple sets of voluntary international guidelines. I have seen provisions that require suppliers to follow OECD Guidelines, the UN Global Compact, International Environmental Regulation, and more. Many of these guidelines are just that – guidelines. They don’t provide a clear standard that could be used to measure breach.

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The corporate paradigm has changed. Businesses can no longer confine themselves to watching the bottom line. We are expected to do better. We must be good corporate citizens and contribute to solving complex global challenges. ESG clauses are yet another sign that corporate behavior matters. The legal profession has a unique opportunity to set the new standard. Let’s work together and get this right.

For more advice on how to improve your company’s ESG performance, follow me on LinkedIn where I frequently post advice on this subject for legal counsel.

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