Will ESG demands mean that due diligence in the value chain changes radically?
A combination of forthcoming legislation, increasing investor demands and societal pressure means that a business’s value chain is coming under closer scrutiny. GoodCorporation’s latest Business Ethics Debate at the House of Lords sought to explore the approaches businesses are taking when conducting due diligence across their value chains.
Hosted by Baroness Neville-Jones, the debate was attended by senior representatives from across the corporate sector.
Giles Bolton, former Group lead of sustainability at Tesco and author of an acclaimed activist book on how to improve aid and development outcomes, Aid and Other Dirty Business, opened the debate by providing the following key insights into how ESG demands might impact the way due diligence in the value chain is conducted by businesses:
Giles began by reminding us that we are living in a rapidly evolving, existential period and need to act fast to address the timelines that might make our sustainability targets unachievable. As a society, we face a real and genuine need to ensure our methods of production become more sustainable. Currently however, the average investment cycle looks to gain value over a two-year period; governments tend to operate on a policy arch designed to serve the 4/5-year election cycle. This creates structural timelines that are not geared to address the long-term sustainability issues society faces.
Giles’ also outlined an inherent ‘culture’ problem linked to unsustainable growth. The market mechanism, coupled with entrenched consumer purchasing habits and weak regulation combine to drive consumption beyond what might be considered sustainable, and the roadmap to change this is yet to evolve.
However, Giles was adamant that change is possible if all stakeholders address the issue head on. The emphasis on ESG matters is starting to shift the focus, giving businesses a key role to play in creating a more sustainable world. Taking greater responsibility for the value chain is a key part of this, making due diligence a critical tool in delivering greater sustainability.
The debate discussion
Companies were asked for their view on whether they felt current and future ESG demands would mean that due diligence in the value chain will change radically. Those who agreed put forward the following arguments:
Key points in favour of the premiss that due diligence will change radically in the value
chain due to current and future ESG demands:
- ‘Radical’ change is already occurring in the ways in which due diligence is being conducted in value chains, as companies have already started to adjust to emerging requirements to report on a growing number of ESG issues. Legislation, such as the EU Corporate Sustainability Reporting Directive (CSRD) and the forthcoming Corporate Sustainability Due Diligence Directive (CSDDD) will require companies to publicly report, often for the first time, on a number of key ESG indicators, Including the provenance of products, working conditions, child labour and greenhouse gas emissions.
- The shift in emphasis from pure financial reporting to reporting on ESG issues is in itself a radical change, placing a new obligation on companies to manage their value chains very differently.
- Pressure is also coming from investors and consumer groups for businesses to be more accountable for activities within the value chain. This will require due diligence to be conducted throughout the value chain, if companies are to limit their exposure to reputational risk, and this represents a radical change to the way most businesses currently conduct due diligence in their supply chain.
- In particular, value chain due diligence across tier two and tier three suppliers is a more stringent expectation: recent anti-bribery and human rights legislation has required companies to conduct supply chain due diligence. This has mainly been done on tier one of their supply chain. However, the requirement to report on the ESG impact of goods and services produced across the entire product lifecycle, including in tier two and tier three suppliers, makes emerging due diligence requirements significantly more demanding, requiring radical change.
- Value chain due diligence is becoming a key factor in enabling companies to retain employees: employees, particularly Gen Z, do not want to feel they are contributing to the degradation of the environment or to adverse social impacts through the work they do. As such, they want to see how the companies they work for or may wish to work for report on these ESG issues.
- External geo-political factors may cause ‘radical’ changes to how companies conduct due diligence on their value chain: some suggested that the current global geopolitical situation coupled with the onset of increased due diligence due to more stringent ESG demands is leading many companies to examine the global spread of their value chains, in some cases looking to relocate some of their suppliers closer to home. This is a radical shift and such disruption to supply chains will require businesses to conduct increased due diligence as they switch to new suppliers and service providers.
Key points against due diligence changing radically in the value chain
- A number of guests felt the change would not be radical: many companies are already conducting due diligence in order to locate and mitigate risks in their value chain. Any due diligence that is expected of companies, following the onset of forthcoming legislation, is likely to be more of the same and will not require a major change in practice.
- Many companies have already shown they can respond to due diligence requirements – the emerging ESG demands are no different and due diligence will be conducted in much the same manner, albeit across the value chain, as it was previously: companies have had to embed strong compliance programmes in response to international anti-bribery and corruption legislation, such as the U.K. Bribery Act, and the new due diligence demands resulting from forthcoming legislation will mirror this process which has already been successfully embedded.
- Radical change may not occur as conducting due diligence across the value chain will be expensive and companies will not be able to pass on the extra cost to consumers: with customers either unwilling or unable to bear the additional cost, it will simply be too expensive for some businesses, as such, many businesses may simply ignore any requirements for more widespread, rigorous due diligence.
- The response by companies to ESG demands has not been unified and this may limit the numbers adopting value chain due diligence: each company believes that their response to increased ESG demands is ‘right’. This may result in companies having their own approach to how due diligence should be conducted across the value chain, thus increasing the burden on the supplier and limiting both the scope and impact of and wider due diligence.
- Tier two and tier three suppliers are usually very small entities and are not ready for the scrutiny of radically changed due diligence: multiple due diligence questionnaires sent to tier two and tier three suppliers could cause confusion. There is also a danger that ESG demands might exceed the disposable resources of such suppliers with the result that reporting obligations will not be met and the desired shift in transparency and standards not achieved.
- How businesses react to the outcome of any value chain due diligence is key to whether the due diligence itself has been effective: the amount of data collected by companies during value chain due diligence is likely to increase as a result of emerging ESG demands. Companies must be able to act on this large amount of data to enact real change in the businesses practices of those suppliers they engage in their value chain. If this becomes too burdensome it will fail to deliver the primary objective of raising standards across value chains.
The GoodCorporation view
Our experience shows that companies are increasingly looking at their value chains to meet more stringent investor, regulator and consumer demands. The critical part to getting this right is taking a proportional and risk-based approach. For many, getting a good understanding of the real risks in their value chain will be key to effective value chain due diligence. Forthcoming legislation is driving businesses to report on the steps they are taking to manage their value chains and best-practice will take this beyond a tick-box exercise. The best companies will increasingly view value chain due diligence as a key component of their corporate governance and risk management efforts, as greater scrutiny of the value chain will help limit exposure to a variety of risks, including those related to corruption, human rights and misconduct which can seriously damage reputations.
Nevertheless, an effective due diligence process will recognise that suppliers and businesses alike need tailored and resource-efficient due diligence solutions which are sector-specific and relevant for the size of the supplier in question. Suppliers do not want to complete due diligence questionnaires which are onerous and burdensome and businesses do not want to be inundated with data that is unable to provide visibility over their most salient risks. As increased ESG and legislative demands force companies to increase the amount of due diligence they are conducting, the required scale may be achieved via digital solutions which provide businesses the opportunity to identify and benchmark the relevant data that they receive during the due diligence process so they can respond accordingly. GoodCorporation has developed a bespoke digital compliance solution to meet these challenges, as a complement to our traditional consultancy work. It provides a fast and easy means of testing the effectiveness of procedures in suppliers and other third parties, identifying red flags, producing benchmark data and, if required, an analysis of the information received from the entities being assessed. Contact our head of Digital Ranica Kozhipatt to find out more.