Key Takeaways:
- The integration of ESG clauses marks a shift from voluntary commitments to binding agreements.
- ESG clauses should ideally place a lot of emphasis on collaboration and capacity building and thus allow a procurer to be truly “sustainable.”
- While ESG clauses are a powerful tool for embedding sustainability into supply chains, their implementation comes with many legal and ethical challenges.
In our previous article, we highlighted some essential components of ESG clauses. This article delves deeper into ESG clauses and explores their strategic importance in supply chains, and significant considerations for such clauses and challenges.
Contractual Cascading
To address the pressure from society and investors and to account for legal obligations, many companies are embedding ESG clauses into their supply chain contracts. These clauses are intended to function as enforceable tools to ensure that suppliers meet specific obligations, with most emphasis typically on the environmental aspects.
The integration of ESG clauses marks a shift from voluntary commitments to binding agreements. They are particularly impactful when they cascade ESG obligations throughout the supply chain, ensuring that not only the immediate supplier but also lower-tier subcontractors adhere to the same principles and standards. This cascading effect is vital for achieving systemic improvements in sustainability and accountability.
The cascading nature of ESG clauses connects the broader framework of legal and societal demands with operational realities. By mandating that suppliers pass down these obligations to their own subcontractors, companies ensure a ripple effect of sustainable practices across the entire value chain. This approach not only fosters transparency and accountability but also positions companies as proactive leaders in the global push for sustainability.
Dispute Resolution Mechanisms
Dispute resolution mechanisms play a vital role since disputes can arise at any moment. Given the broad application of ESG clauses when they apply throughout supply chains, dispute resolution becomes even more important. In cross-border relationships, the preference must be given to international arbitration in order to ensure enforceability across borders. That being said, an adversarial process such as arbitration is, arguably, not ESG-friendly itself.
Cross-border mediation would certainly be a more appropriate process and may become more of an option with the increasing popularity of the Singapore Convention on Mediation,[1] which allows for the enforcement of cross-border mediated settlement agreements.
Collaboration and Capacity Building
ESG clauses should ideally place a lot of emphasis on collaboration and capacity building and thus allow a procurer to be truly “sustainable.” This may include elements of training and tools to improve a supplier’s ESG performance (e.g. workshop on ethical labour practices), encouraging partnerships (e.g. partnership with Indigenous groups to address deforestation) and offering incentives for improvement (e.g. financial incentives or extended contracts when a supplier exceeds an ESG target).
Challenges in Implementing ESG Clauses
While ESG clauses are a powerful tool for embedding sustainability into supply chains, their implementation comes with many legal and ethical challenges. Companies must navigate a range of legal, operational and in particular practical hurdles to ensure these clauses are both effective and enforceable. Below are some of the most significant challenges with implementing ESG clauses in commercial agreements.
Complexity of Multi-Tier Supply Chains
As already mentioned before, supply chains today are vast and global, often involving numerous tiers of suppliers, subcontractors, and intermediaries. While ESG clauses aim to impose obligations on direct suppliers, ensuring compliance throughout the supply chain is significantly more challenging. Procurers often have limited insight into lower-tier suppliers and the involvement of brokers or agents can obscure the identity of subcontractors, creating additional layers of complexity.
Legal and Cultural Variations
Global supply chains span multiple jurisdictions, each with its own legal and cultural frameworks. Laws governing ESG compliance vary significantly between countries. Further, social and governance expectations differ widely between countries and even states of one country.
In complex supply chains, it is almost impossible to take these differences into account when aiming for enforceable ESG obligations. This poses further challenges.
Measuring/Verifying Compliance and the Risk of Greenwashing
The effectiveness of ESG clauses hinges on measurable and verifiable standards. However, ambiguity in metrics (e.g. what is “fair labour practices”?) and data reliability, which is exacerbated by the fact that some (sub-)suppliers simply lack the means of properly measuring and recording relevant data, pose significant challenges.
This, coupled with the fact that audits are expensive, in particular when conducted across jurisdictions, leads to an increased risk of greenwashing, where companies or suppliers exaggerate or fabricate their sustainability credentials to secure contracts or enhance reputations. Mitigating greenwashing requires diligent monitoring, thorough audits and clear contractual consequences for misrepresentation.
Resistance to Cascading Obligations
Cascading ESG obligations often face resistance from direct suppliers, who may argue that their control over subcontractors is limited. Procurers with strong bargaining power may simply impose cascading obligations. But when a procurer’s bargaining power is weak, as will almost automatically be the case somewhere in the supply chain, strong resistance is a given.
We also observed internal resistance to cascading obligations within procurers because of the additional administrative burden this had within the procurer’s sourcing team.
In line with sustainable practices, it is important for procurers to balance the need for enforcement on the one hand, with opportunities for improvement on the other hand. This ensures a fair but firm approach to ESG compliance.
Learn More: For more insights, check out Harald Sippel’s guest column, ESG Contracts, which his published on a monthly basis through Contract Nerds.
[1] United Nations Convention on International Settlement Agreements Resulting from Mediation. For details, see https://uncitral.un.org/en/texts/mediation/conventions/international_settlement_agreements.
