Key Takeaways:
- Effective ESG clauses are designed to embed enforceable obligations into supply chain contracts.
- While a comprehensive ESG clause covering the E, S and G portions is truly sustainable, it is up to the procurer to determine what metrics it wishes to apply.
- By incorporating clear standards, measurable benchmarks and cascading obligations, these clauses ensure that sustainability principles enter all levels of a supply chain.
In today’s interconnected global economy, businesses are increasingly held accountable both for their own practices as well as for the actions of their supply chain partners. Environmental, Social, and Governance (ESG) principles have emerged as a critical framework for guiding sustainable and ethical business operations.
In Western countries, this process is driven by:
- Societal expectations – consumers place great emphasis on “green products;”
- Investor requirements – many investors are trying to avoid “unsustainable companies” and would rather focus on ESG-friendly companies; as well as
- An increasingly demanding legal framework in Western countries – an increasing number of obligations is imposed by law.[1]
To meet these “ESG requirements,” companies are among others embedding ESG clauses into their supply chain contracts. This allows them to establish enforceable expectations with their suppliers. This approach not only mitigates risks of non-compliance but also positions companies as leaders in responsible and sustainable business practices.
Effective ESG clauses are designed to embed enforceable obligations into supply chain contracts. By incorporating clear standards, measurable benchmarks and cascading obligations, these clauses ensure that sustainability principles enter all levels of a supply chain. Below, we explore the key components that enable ESG clauses to operationalize these cascading obligations and address the diverse challenges of modern supply chains.
Clear Standards and Benchmarks
A robust ESG clause begins with clearly defined standards and measurable benchmarks. These establish the baseline for supplier performance and provide a foundation for enforcing ESG obligations. While the focus is usually on environmental standards, in line with the term ESG, a clause should include:
- Environmental Standards: specific targets such as reducing carbon footprints, adopting renewable energy, or adhering to recognized sustainability frameworks;
- Social Obligations: commitments to fair labour practices, diversity and the prevention of forced or child labour; and
- Governance Requirements: provisions addressing anti-corruption, transparency and ethical business practices.
Measurable Metrics and Baselines
To enable enforceability and comparison, ESG clauses must include measurable metrics. Establishing a baseline allows companies to assess whether suppliers are meeting or exceeding sustainability targets. These metrics could cover:
- Carbon footprint calculations;
- Water usage and waste management; and
- Ethical labour practices and workplace safety metrics;
- Governance-related disclosures, such as anti-bribery compliance
While a comprehensive ESG clause covering the E, S and G portions is truly sustainable, it is up to the procurer to determine what metrics it wishes to apply. In practice, companies often follow internationally recognized standards to ensure consistency and reliability, but even among international standards, there is often a significant discrepancy.
Monitoring, Reporting and Verification
Transparency is a cornerstone of effective ESG clauses. Procurers wanting to ensure compliance throughout their supply chains should therefore insist on including provisions for:
- Regular Reporting: suppliers must provide periodic updates on their ESG performance, ideally on an at least semi-annual basis.
- Third-Party Audits: allowing independent auditors to assess supplier and subcontractor compliance with ESG standards, at least when there are problems.
For cascading obligations, monitoring subcontractors is especially critical. Ideally, the above obligations therefore trickle down throughout the supply chain. This allows the procurer to gain visibility into lower-tier operations, where risks may be hidden.
Cascading Obligations
As a result of the increasing specialisation of companies as well as globalized supply chains, there is hardly any company which only deals with direct suppliers. Rather, for every direct supplier, there is a multitude of indirect suppliers and partners also, all the way to the extraction of raw materials. The cascading nature of ESG clauses ensures that obligations extend beyond direct suppliers to also cover subcontractors and partners of direct suppliers. Key mechanisms of cascading clauses include:
- Flow-Down Clauses: requiring suppliers to replicate ESG commitments in their contracts with subcontractors. This ensures that lower-tier suppliers are also held to the same standards.
- Mandatory Audits and Reporting: suppliers are obligated to provide documentation and allow audits of their subcontractors to verify compliance.
- Accountability Provisions: suppliers are responsible not only for their own actions but also for ensuring that their subcontractors adhere to ESG principles.
Termination and Remedies
Any procurer taking ESG clauses seriously must ensure that they go beyond being toothless paper tigers. This is best done through termination rights and remedial actions in case of breaches of the stipulated obligations. Key elements include:
- Termination for Non-Compliance: companies are allowed to terminate a contract if suppliers or their subcontractors fail to meet ESG standards. This can be provided for in case of breaches, as well as in the form of a Termination for Greener Supplier or Termination for More Sustainable Suppler clause.
- Cure Periods: suppliers should be given an opportunity to address deficiencies before termination, fostering collaboration and improvement.
- Corrective Action Plans: following an ESG-related issue, suppliers should implement measures to resolve identified issues, with timelines and benchmarks for progress.
In line with sustainable practices, 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.
[1] Two laws stand out here: the German Lieferkettensorgfaltspflichtengesetz (Supply Chain Due Diligence Act) requires companies to assess and mitigate human rights and environmental risks within their supply chains. The EU’s Corporate Sustainability Due Diligence Directive (CSDDD), which has still to be transformed into national law by the EU Member States, imposes similar obligations.
