Much has been made of the ability of sustainability-linked finance to drive better environmental, social and governance (ESG) performance throughout supply chains. But tying funding to better practices is only part of the answer. Identifying risks and violations, creating incentives to change, and making sustainability profitable require innovation across every area. Eleanor Wragg reports on some of the market’s recent developments.
The overwhelming weight of accumulated research into corporate sustainability points to a strong correlation between ESG performance and financial returns – at least at the macro level. During 2020, ESG funds, which invest in companies that aim to have a sustainable and societal impact in the world, outperformed the wider market, while a 2018 HSBC study found that 84% of companies who are looking to make ethically or environmentally sustainable changes do so in order to improve their revenues and financial performance.
On an individual supplier level, though, the link between ESG and profitability is often a harder sell. Paying workers better wages, reducing pesticide use or offsetting carbon emissions all cost money, and there is not always an immediate payback for these investments. And with poor sustainability practices often hidden deep in supply chains, away from the prying eyes of NGOs and regulators, there is little enticement to disclose what’s truly going on.
One of the most attractive characteristics of sustainable supply chain finance is that it creates an artificial – yet solid – financial reason to do better: suppliers are afforded cheaper working capital if they meet ESG metrics. But the extent to which the structure represents a long-term, viable solution is under question.
“The problem with sustainable supply chain finance, or any type of sustainability-linked lending at the moment is that it is entirely about subsidies from the banks because there is no differentiated beneficial capital treatment for better ESG performance, and it will likely be years before there is,” says Shona Tatchell, CEO and founder of Halotrade.
“We need to get to a point where banks should not profit out of somebody’s poor ESG performance with penalties, nor have to subsidise good performance,” she adds.
The fintech firm, which uses smart contracts to convert supply chain sustainability data into automated access to trade finance, has developed a system to bring the information recorded to banks’ financing programmes and unlock access to faster and cheaper financing for responsible and sustainable sourcing.
“By creating a really rich picture of the product, it becomes essentially a de-commoditised commodity that has a unique identity. Our technology allows buyers to know when the contract itself has actually been fulfilled, and therefore you can not only do a different type of financing, but you can inject more efficient financing at different points in the supply chain,” she says.
A pilot project carried out in 2019, which tracked tea from farmers in Malawi being sold to Unilever and financed by BNP Paribas, proved the feasibility of a sustainability ‘data-for-benefits’ swap in opening up access to finance at no additional cost.
“In the Trado project, Unilever were able to know everything that they could possibly want to know about that tea,” explains Tatchell. “We managed to design a methodology whereby we could have pre-shipment non-recourse invoice discounting, which was able to be priced at Unilever’s cost of finance. The differential between the cost of finance for the supplier and the cost of finance for the ultimate buyer is substantial, meaning there is potentially a lot of financial reward to play with.”
Halotrade is now working on a similar project in India, sponsored by the Asian Development Bank (ADB), which will focus on the garment supply chain.
“It’s about conditionality and reward,” Tatchell adds. “This is not a top-down approach and a way of saying ‘you must do this’ and ‘you must do that’. It’s about system efficiencies enabling injection of incentives, without it having to cost anyone any money.”
Cleaning up transition industries
The metals and mining sector presents an interesting contradiction. While it is a notorious carbon emitter and one of the world’s most energy-intensive industries – accounting for as much as a tenth of total global energy consumption – it is also a vital player in the energy transition from fossil-based fuels to renewable energy.
Demand for copper, lithium and rare earths has skyrocketed as carmakers move towards electric vehicles, and solar and wind power installations increase. But as miners rush to bring new projects into production in ever more remote and difficult locations, the environmental impact risks negating the gains brought to bear by any increase in clean energy capacity.
Addressing climate risk in mining, therefore, has become of paramount importance. However, getting visibility along mineral supply chains is challenging at best: a 2016 report by Washington-based NGO The Enough Project revealed “a common practice of moving minerals from non-validated mines to validated ‘green’ mines for tagging, and a black market for tags, which are smuggled and attached to noncertified minerals”.
“For many mining companies, particularly those that are going above and beyond expectations in the ESG field and wish to differentiate themselves and their products based on it, this is very frustrating,” says Arnoud Star Busmann, CEO of MineHub,
a blockchain-based platform for digital trade in metals and mining. “It’s also very difficult for investors, traders and financiers to determine which producers are truly performing at a higher level or at least improving against their baselines.”
The company, which started life as a platform to digitalise paper-based post-trade operations, financing and logistics, is now using its technology to help the sector measure and manage its carbon emissions.
“A lot of companies are trying to figure out what this means and how to do it, because is not necessarily simple or straightforward – particularly when it comes to scope 3 emissions, because they have lots of customers, lots of suppliers, lots of transactions and a lot of material,” says Star Busmann.
“We are capturing the fabric of supply chains. We know the buyers and the sellers, we know what moves from what to where, where it comes from, where it goes to, how long it takes, and who is moving it. With that, we can transport ESG-related attributes along the value chain.”
This can enable mining companies to link data on their own scope 1 and 2 emissions to that from downstream operations like steel mills and smelters. As a growing number of banks begin to call time on financing carbon-intensive industries, initiatives such as this can then pave the way to better access to funding for the mineral trade, as transactions can be proven to be green.
“Mining companies want information so they can manage their portfolio and bring down the scope 3 footprint of their business. With greater visibility, they can make better choices about the equipment suppliers or explosives they use, and even which carriers ship their products. We sense urgency with many companies to get a handle on this, and are getting interest from all sides of the market,” says Star Busmann.
With the visibility issue all but solved, the company now plans to add in carbon offsetting capabilities, which will eventually enable mining companies to deliver fully carbon neutral products to the end customer.
Weeding out human trafficking
According to the UN, the fashion industry is responsible for a devastating environmental impact, producing more wastewater and carbon emissions than all the world’s international flights and maritime shipping put together.
Then there is the human cost: in recent years, the reputations of major fashion brands have been tarnished by the discovery of appalling labour conditions in garment factories in developing countries. More concerning still, new evidence indicates that forced labour is being used to pick cotton in Xinjiang – home to approximately 20% of the world’s supply of the fibre – leading to international outcry and a toughening of regulatory requirements on the sector.
A new law on human rights in supply chains adopted by Germany will mean large companies could be fined as much as 2% of annual revenue for human rights breaches. Meanwhile, a recent parliamentary inquiry has urged the Australian government to empower border authorities to detain shipments under a scheme similar to the US’ withhold release orders, which apply to designated products imported from a country or region. If an importer is unable to prove the absence of forced labour from the product’s supply chain, it must re-export the goods.
“This is far-reaching,” says Vivek Ramachandran, CEO at Serai. “Proving that there is no human trafficking in your supply chain is not easy, because you have to know and provide evidence of who exactly is in it.”
While fashion brands may have visibility into the first couple of tiers of suppliers, from then on things become more complicated, he says.
“They know the manufacturers of the garments, they nominate many of the fabric mills, but they don’t really know the facilities where the fabric is manufactured. Beyond that, long staple cotton typically gets used up very quickly. But it can be up to two years before commodity cotton makes it into a garment. You have many different bales from many different farms that are mixed together, so how do you prove where the cotton has come from?”
Serai originally started life as a tech-based solution for B2B trade in the garment industry, making it easier for buyers and sellers to connect with each other. But as the imperative to tackle exploitation in the sector has grown, the platform has shifted its focus to traceability.
“At the end of last year, one of our large clients requested that we repurpose what we had built to create permissioned data sharing so that they could get credentials on who is in their supply chain,” says Ramachandran.
Serai has now been retooled to enable suppliers to input information about their raw materials or intermediate goods, such as provenance or ESG performance, and share this with multiple parties, essentially creating visibility from the farm all the way to the finished item of clothing.
Ramachandran adds that Serai is now seeing “exponential” uptake. “When we went live in the first quarter of 2020, we had 250 companies on the platform. We now have 9,000. Cotton traceability is one use case. Tomorrow, it might be carbon emissions or water use. The industry will evolve.”
Defining the business case
The long-term business case for improving sustainability performance is both obvious and compelling: a liveable planet is a clear prerequisite to any kind of future activity – economic or otherwise.
In the shorter term, however, demonstrating the benefits of ESG efforts along supply chains remains a challenge, and one that must be overcome to get more companies to engage with the issue.
“There are still those in the market who feel they haven’t been shown convincing enough numbers,” says Alexander Malaket, founding partner of ESG Validation, which provides banks and investors with independent, consistent and evidence-based assessment of ESG performance, and validation of claims in the ESG profiles of companies. “There is a business case, but we just haven’t necessarily developed it as strongly as we can yet.”
Although major investment firms such as BlackRock are beginning to use their ownership stake to pressure companies to improve disclosures, not everyone is on board. “Some asset managers will say, ‘I have a fiduciary obligation to my investors to maximise returns, and if I have to go and invest in a tobacco company, a mining business or a gun manufacturer to maximise returns, that is what I will do’,” says Malaket.
One problem is defining what ESG in supply chains actually is, and where the greatest impacts lie. There are currently as many as 400 different assessment techniques and measurements, and as well as this proliferation of competing metrics, there aren’t yet adequate tools for gathering, auditing and reporting sustainability information.
“We think we’ve done the ‘E’ of ESG but we really haven’t. We’ve got climate on the radar, but we’re only just starting to think about things like biodiversity and why it’s relevant for businesses. I’m also not sure that we quite understand ‘S’ as broadly as we should,” says Malaket. “On the ‘G’ piece, it could be argued that sustainability is a governance concept to begin with. If we’d honed in on governance first, we would have got the rest of it right.”
He adds that there are also difficulties balancing different aspects of sustainability.
“Anyone who ignores the transition part of this question is missing a huge trick. Industries will not change overnight. Companies in the fossil fuels sector cannot suddenly become fully renewable energy focused, but we can’t ignore them. Fossil fuels are a huge part of economic value creation, and in an emerging market in Africa or South Asia, you can’t ignore the fact that burning coal is a matter of life and death for people.”
He calls for the conversation around supply chain sustainability to be flipped on its head, and that rather than a focus on risks – be those environmental or reputational – it is time to start looking at the potential benefits of improving ESG performance.
“The UN Sustainable Development Goals (SDGs) are probably the most comprehensive and detailed forecast of opportunities that has ever been put together for companies to look at,” he says. “If we can quantify these, the commercial and financial business case becomes much more compelling. We already have the reputational piece; this is how we solve for the incentive question.”