Putting ESG at the centre of your trade and supply chain strategy can help your business balance dealing with economic challenges right in front of you and sustainability risks on the horizon, writes Rowan Austin, head of trade origination and advisory at NatWest.
Businesses have had to deal with unprecedented levels of disruption in recent years. Brexit – which completely reshaped the regional trade landscape – was enough to contend with. But it was swiftly followed by a global health crisis in the form of the Covid-19 pandemic, whose ever-shifting trade restrictions, border closures and goods shortages, despite fading in public memory, continue to distort markets and resonate throughout global supply chains in various ways.
All of this only to be capped off by a seemingly unending political drama that rattled markets and claimed two prime ministers within a matter of months; a cost-of-living crisis increasingly punctuated by industrial action on a scale not seen in years; rising inflation, and with it, higher interest rates. To say it hasn’t been easy for businesses these last few years would be an understatement, and many have struggled to adapt following each new wave of risks.
But there is a more pernicious consequence of having to firefight one crisis after another. In being forced to become more myopic, businesses risk losing sight of longer-term risks that require careful management. And there are perhaps no greater long-term, all transcending risks than those of an environmental, social, and governance (ESG) nature.
ESG is a useful lens through which to view today’s economic challenges
Business leaders can’t afford to let near-term challenges derail their ESG journeys. In fact, all of what’s been said above underscores the need for businesses to take a deep, cross-value chain approach to sustainability if they are to remain resilient in the face of these risks. Looking at the immediate challenges many businesses face today – rising inflation, interest rates and cost of funding; lower turnover; tight labour markets; exorbitant energy costs – through the lens of ESG can help illustrate why.
Take energy costs. The war in Ukraine has pushed the cost of oil and gas to new heights. But these can be mitigated through lower energy consumption/energy efficiency initiatives, reducing waste, and by increasing reliance on (cheaper) renewable energy sources – accelerating the green energy transition.
What about rising interest rates and cost of funding? A proactive and thoughtful approach to ESG can help here, too. A growing body of research suggests strong ESG propositions correlate with higher equity returns, lower loan and credit default swap spreads, and higher credit ratings. Not to mention the rapidly growing suite of financial products which link borrowing cost to ESG performance, including working capital solutions that enable discounted borrowing in exchange for more regular ESG performance reporting.
Sustainability credibility is also increasingly important for attracting and retaining talent. Of the 13,000 UK job seekers surveyed in January this year by Hays, a large UK-based recruiter, nearly four in five (78%) highlighted that a commitment to sustainability as an important factor in guiding decisions on where they look for employment. Worryingly, that same survey showed just 65% of employers believe these commitments are important to help them attract and retain staff.
All of this is to say: rather than view ESG as something that needs to be balanced against near-term economic and market challenges, see it instead as a valuable lens through which to view those challenges – and a toolkit to help you address them alongside long-term sustainability risks.
Trade plays a crucial role making businesses holistically sustainable
But ESG risks don’t just stop confronting businesses at the office entrance or factory gate. Both climate change and increasing public awareness of environmental and social issues has heightened awareness of supply chains, which create on average up to four times the greenhouse gas (GHG) emissions of a company’s direct operations, with further impact on air, water, biodiversity and resources. At the same time, customers, regulators, investors and the public increasingly expect businesses – and their suppliers – to adhere to social responsibility principles and avoid greenwashing.
If they go unmitigated, ESG risks can have a dramatic effect on a company’s supply chain cost and resilience:
- Policy & legal risk: climate policies to reduce GHG emissions or to halt land degradation can require rigorous measures, to which every trade party will have to comply and act upon or can result in additional costs (including taxes) along the entire supply chain.
- Climate change risks: these can have a huge effect on the resilience, quality and costs of supply chains, impacting the availability of raw material and energy supply to a company and its suppliers, or leading to acute physical risk through extreme weather events.
- Global health risks: it may seem obvious in a post-pandemic world, but global health risks can be hugely disruptive. Lockdowns can force suppliers to cease production, disrupt logistics providers and prompt ad-hoc border closures.
- Market risks: changing customer and investor preferences can result in large shifts in demand for products and/or investment demand. Investors or lenders may start to demand a higher coupon or even turn away from companies if they can’t show that their supply chains are ESG-compliant.
- Reputational risks: these can arise when those you trade with do not comply with a company’s sustainability principles, or when companies don’t ‘practice what they preach’.
Creating and maintaining a sustainable supply chain is essential for mitigating these risks. Successful companies tend to follow a similar four-point process: (1) establish a vision for sustainability and define expectations for suppliers; (2) determine the scope of efforts by identifying the greatest actual and potential risks in the supply chain; (3) work directly with suppliers to improve their sustainability performance, or source new responsible suppliers that fit the bill; and (4) track performance against agreed goals. Perhaps the most important ingredient underpinning all of this is the need for greater supply chain transparency.
Mobilising finance to make trade more sustainable
Financial markets are constantly innovating to help companies align their funding and sustainability objectives.
Supply chain finance has an important role to play here, both in rewarding greater end-to-end sustainability and providing tangible incentives for corporate behaviour change. Structures that offer suppliers financial advantages such as lower pricing, improved access to credit or reduced working capital needs in exchange for prioritising ESG (which can be evidenced through ESG ratings and reporting) could have a significant positive impact on value chains globally, making both buyers and suppliers more resilient to tomorrow’s major shocks – and creating accountability across the entire supply chain.
The role of trade finance, too, is being put to work in much the same way. The global nature of the net-zero transition underscores just how important it is to find new and innovative ways of facilitating cross-border ESG-linked finance and get that funding to regions which shoulder the greatest costs of that transition: emerging markets.
In our view, two important things need to happen before ESG-linked finance can really take off.
The first is standards that are specific to trade finance. Global financial counterparties need a common language for understanding the sustainability characteristics of special ESG-linked products and an accountability framework fit for purpose in trade financing scenarios. Where one bank may view a letter of credit for sustainably farmed palm oil as suitably compliant to ‘count’ as green trade finance, another may not – for example, if the product is then transported to market in the most carbon-intensive ways, or if the farm employs slave labour.
The second is regulatory incentives. Global central banks recognise the need to combat climate change through finance, with many – including the Bank of England – explicitly taking an active role in supporting the transition to a net-zero economy and making the financial system resilient to climate change. And yet, most have only spoken of using the ‘stick’ approach, punishing the financing of carbon-intensive activities, rather than the ‘carrot’ of incentivising higher prioritisation of sustainability through advantageous capital treatment or risk-weighted asset adjustments. We think more of the latter is needed to help push capital in the direction of activities that facilitate the transition to net zero.
Towards a just transition
None of this is to say ESG is a panacea. Nor that it’s easy – or inexpensive – to get right. Everyone knows how vital it is for the world to reduce carbon emissions and live more sustainably, and the cost of that transition (especially for smaller firms) needs to be recognised by global governments and the investment community. But by reflecting on more of our activities through the lens of ESG – especially trade – we can become more resilient to the next crises that await, and more effectively manage the day-to-day challenges directly in front of us.