Holistic supply chain risk management in the age of ESG awareness

The introduction of Environmental, Social, and Governance (ESG) expectations into supply chain management and trade compliance is fundamentally altering the landscape of how businesses operate and interact within their supply chains. ESG considerations encompass a broad range of factors, including environmental sustainability, social responsibility, and corporate governance. As stakeholders increasingly prioritize ESG metrics, businesses are compelled to integrate these considerations into their supply chain strategies.

This global trend has materialized in the form of new and expanded regulatory burdens imposed in the EU, Canada, and the United States, among other places.

• First and foremost, Germany’s LkSG directly connected the issues of supply chain management and ESG prioritization by requiring companies to monitor human rights and environmental risks within their supply chains as a matter of course.
• In the EU, lawmakers continue to iron out the forthcoming Corporate Sustainability Due Diligence Directive, which is similarly intended to make companies responsible for human rights or environmental hazards within their value chains.
• American lawmakers took similar steps with the Uyghur Forced Labor Prevention Act, which requires that companies importing goods from the Xinjiang region of China certify that their cargo was not produced using forced labor.
• Canada’s Bill S-211, passed in 2023, imposed reporting obligations on companies operating in Canada to verify their compliance with laws against forced and child labor within their value chains.

One significant shift is the emphasis on sustainability throughout the entire supply chain. Companies are now scrutinizing their suppliers' environmental practices, seeking partners who adhere to eco-friendly standards and promote responsible resource management. This necessitates greater transparency and traceability, as companies strive to ensure compliance with ESG criteria at every stage of production and distribution.

Moreover, social responsibility has become a crucial aspect of supply chain management. Businesses are expected to uphold labor rights, ensure fair treatment of workers, and support diversity and inclusion initiatives within their supply networks. This involves monitoring labor conditions, addressing issues such as child labor and exploitation, and fostering ethical employment practices across all tiers of the supply chain.

Additionally, governance considerations are shaping supply chain management strategies, as companies are urged to uphold ethical business practices, maintain integrity, and adhere to regulatory requirements. This entails implementing robust governance frameworks, conducting due diligence on business partners, and mitigating risks associated with corruption, bribery, and other unethical behaviors.

Overall, the integration of ESG expectations into supply chain management and trade compliance is driving a paradigm shift towards more sustainable, ethical, and transparent supply chains. Companies that proactively embrace these changes are not only meeting stakeholder demands but also positioning themselves for long-term success in a rapidly evolving business environment.

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Case Study: Volkswagen’s UFLPA Fumble

To illustrate, German automaker Volkswagen recently found itself on the wrong side of the Uyghur Forced Labor Prevention Act (UFLPA) in a mishap that offers insights to compliance teams seeking to harmonize their processes with regulators’ fast-evolving ESG expectations. News stories in mid-February recounted how Volkswagen had, unbeknownst to the company, sourced certain components for thousands of its vehicles from a region of “western China” widely suspected to be the Xinjiang Uyghur Autonomous Region (XUAR). Volkswagen quickly reported the possible violations to Customs and Border Patrol, the agency responsible for administrating the UFLPA. Volkswagen’s compliance team missed this issue due to an ESG gap in their supply chain management protocols. More specifically, Volkswagen failed to take a wholistic assessment of its value chain and all of the actors within it. CBP’s Strategy and Operational Guidance with respect to the UFLPA directs companies to engage in comprehensive “supply chain tracing” in order to assess the risk of human rights violations at various points. Although Volkswagen accounted for its direct suppliers, the company failed to sufficiently review the operations of the indirect suppliers within its value chain.

Under UFLPA, companies must be able to rebut a statutory presumption that their goods originated in the XUAR and/or are the products of forced labor. Practically speaking, this means that importers should be able to: (1) map out their goods’ supply chain, including component parts; (2) describe the role of each entity in the supply chain; (3) provide a list of suppliers associated with each step of the process, with contact information; and (4) furnish affidavits from each entity involved in the production process averring to their compliance with the principles formalized by the XUAR.

Volkswagen was sluggish in modernizing its compliance program to keep up with the changing expectations of regulators relating to ESG concerns. As a consequence, thousands of vehicles are reportedly impounded as Volkswagen navigates the remediation process with CBP. In the age of ESG awareness, one tiny electronic component can cause big compliance headaches for a fleet of Bentleys, Porches and Audis.

Under laws like the UFLPA, lawmakers are demanding more visibility than many companies currently have into their own operations. Such was the case for Volkswagen. This underscores the importance of regular supply chain and regulatory compliance audits to assess how nimbly companies are managing this shifting regulatory landscape. For companies facing circumstances like Volkswagen, it may be prudent to explore alternative suppliers operating in lower-risk regions with better ESG stewardship. At the very least, it is imperative that importers with direct or indirect exposure to high- risk regions undertake supply chain tracing, and be prepared to demonstrate to regulators that their goods are, in fact, compliant with the high labor standards established by laws like UFLPA and its European analogues.

Rethinking Compliance to Meet the Moment

As ESG expectations reshape supply chain management, compliance teams are compelled to reimagine their role within organizations, particularly in how they collaborate with other internal departments such as procurement and trade finance. Traditionally, compliance teams have focused primarily on regulatory adherence and risk mitigation. However, in the context of evolving ESG expectations, their role expands to encompass broader sustainability and ethical considerations.

Compliance teams must now work closely with procurement departments to integrate ESG criteria into supplier selection processes. This involves developing criteria to evaluate suppliers based on their environmental impact, labor practices, and governance standards. By aligning compliance objectives with procurement goals, organizations can ensure that suppliers meet not only regulatory requirements but also ESG expectations.

Similarly, compliance teams must collaborate with trade finance departments to integrate ESG factors into financing decisions. This may involve incorporating sustainability metrics into credit assessments or offering incentives for sustainable business practices. By aligning compliance efforts with trade finance initiatives, organizations can promote responsible investment practices and encourage suppliers to adopt sustainable behaviors.

Moreover, compliance teams play a vital role in fostering a culture of transparency and accountability within organizations. They must educate internal stakeholders about the importance of ESG considerations in supply chain management and facilitate cross-functional collaboration to address ESG-related challenges effectively. By serving as champions of ethical business practices, compliance teams can help organizations navigate the complexities of ESG compliance and drive positive change throughout the supply chain.

In essence, compliance teams must reimagine their role as enablers of sustainable and ethical supply chain management, forging stronger internal partnerships with other teams like procurement and trade finance to integrate ESG considerations into decision-making processes and promote responsible business practices across the organization.

Corporate boards and leadership should proactively push to integrate ESG considerations into supply chain management rather than reactively waiting for regulators to force similar changes. By taking a proactive stance, companies can gain a competitive advantage, enhance brand reputation, and mitigate risks associated with environmental, social, and governance issues. Embracing ESG principles demonstrates a commitment to sustainable and ethical business practices, which can attract environmentally and socially conscious consumers, investors, and partners.

Moreover, integrating ESG considerations fosters innovation and resilience within the supply chain, driving long-term value creation and positioning companies as leaders in their industries. By prioritizing ESG integration, corporate boards and leadership not only fulfill their responsibility to stakeholders but also future-proof their businesses against evolving regulatory landscapes and societal expectations.