Vantage Infrastructure on ESG in the supply chain: A costly blind spot

This article is sponsored by Vantage Infrastructure 

In the realm of ESG investing and asset management, achieving full integration and delivering impacts can often feel like a Sisyphean task. With changing regulations, growing disclosures and a rising bar to clear, it is as easy to look back and be motivated by one’s improvements, as it is to look forward and feel discouraged by a moving target. For this reason, we ought to value all steps taken along this sustainability journey, before these can add up to a leap.

In early 2022, the World Economic Forum cited that up to 90 percent of consumer companies’ emissions and environmental impacts are the result of supply chains. Indeed, in our view, tackling sustainability in the supply chain is a challenging step in a manager’s ESG improvement plan. The diversified, multi-layered and transnational structure of most infrastructure companies’ supplier webs can appear such a roadblock that one of two things tend to happen: managers and investments either focus on basic issues for box-ticking purposes, or relegate the entire topic to tomorrow’s to-do list.

However, we have recently observed interest and increased due diligence in this area from sophisticated clients and LPs. This may provide the impetus needed for our industry to shift towards systematic action.

Why is it worth it?

Generally, infrastructure companies have very skilled and knowledgeable procurement teams and their boards recognise supply-chain risk as a critical commercial threat.

However, procurement processes have also tended to place the most weight on price, quality and reliability. We believe that broadening this focus to include ESG management leads to better decision-making and more resilient investments.

Safeguarding reputation. Supply-chain ESG management underpins reputational longevity. As noted by the Harvard Law School Forum on Corporate Governance, businesses are increasingly held to account for ESG issues outside of their direct control. By promoting fair labour conditions, ethical trade and climate change mitigation, infrastructure companies can act as a force for good. Managers and portfolio companies can also improve reputation, protect brand and preserve social licence to operate by limiting exposure to hidden buyer risks, like natural resource depletion, human rights violations and corruption, and avoiding the cost of forced supplier switching.

Avoiding disruptions. It improves an investment’s risk profile. A supply chain in disarray can be costly, as the covid-19 pandemic has demonstrated. Minimising the ESG risks to flow and cost of materials, delivery times and suppliers’ financial resilience can increase a company’s financial performance and reduce both the probability and impact of these risks.

Growing value. The ability to produce value-added disclosures for future investors and show evidence of a resilient supply chain and auditable processes can improve valuations at exit. Moreover, despite the initial investment needed in data gathering and audits, driving ESG performance along the value chain could foster innovation, leading to optimised processes, increased productivity, and cost savings from resource conservation and the circular economy.

While the benefits are evident, the obstacles and prerequisites can appear off-putting. The matrix of relationships in a supply chain involves several degrees of separation between a buyer and the ultimate source of goods and materials, which poses a tracing challenge. Access to information can be hampered by limited contractual leverage and a perceived shortage of alternative sourcing options, along with suppliers’ unwillingness and lack of preparation.

Moreover, in our view a lack of managerial focus is often the biggest challenge. Most infrastructure portfolio companies would worry about their supply chain, but mainly in relation to spare parts or speciality materials, especially in light of recent pandemic/Ukraine conflict/Brexit-related logistics disruption. However, the ESG risks to their supply chain tend to be perceived as limited or already ‘implicitly’ captured. Why is that?

Overconfidence may affect ESG supply-chain risk perception. For instance, cybersecurity risk is likely to be recognised by most audit committees as potentially high to catastrophic and, hence, warranting substantial management and mitigation. Conversely, most companies may not believe to have suffered any reputational or financial damage from ESG risks to procurement, because nothing has gone wrong so far. Therefore, the downside from supply-chain ESG can be perceived as low and this area may lack senior management and board focus.

Building awareness and knowledge

When tackling this difficult and poorly understood topic, a manager’s priority should be creating a solid foundation by building awareness. This involves two primary tasks: understanding the general roadmap and gathering information to assess and improve its risk management over time.

In relation to the roadmap, there is useful guidance from several reputable sources, most notably the UNPRI, the UN Global Compact and the GRI, so no proverbial wheel needs to be recreated. At Vantage, we have captured a roadmap in six sequential stages of ESG integration in a portfolio company’s supply chain, as shown in the diagram. The initial level of integration starts from mapping suppliers against ESG risk factors to identify hotspots and assess materiality. By progressing through the subsequent stages, a portfolio company can achieve the ultimate objective of aligning suppliers’ performance with its own risk appetite.

We have noticed that, at the start of a manager’s deep dive, portfolio companies can rarely be charted against a single stage of a roadmap. This is because companies may lack a holistic strategy to address ESG supply-chain risk. Often, no sequential steps are being taken and there is no clear rhyme or reason to the issues chosen for due diligence. To build awareness, the manager should start precisely from sharing a best practice roadmap with management teams and set this as a common context.

The second task involves fact gathering. This can be a challenging step for a manager to implement, as the ground to cover is substantial; companies may have differing ESG risks because of their business, location and stage of maturity, and resourcing may be limited. Furthermore, even active managers cannot be in charge of procurement in their day-to-day. We can drive strategy and assist. Therefore, any due diligence conducted by a manager as part of ongoing stewardship needs to be focused and strike a balance between the bigger picture and the detail.

The UNPRI has published useful guidance on how to engage with companies on ESG supply-chain risk, focusing on the “four Ps”: process, people, policy and performance. We have drawn inspiration from that guidance and other sources to create a bespoke questionnaire for our equity infrastructure investments. This has allowed us to collect data on the underlying supply-chain risk factors and benchmark the activities undertaken by each company against our roadmap and relative to each other. Thus, we can better assess the stage of integration maturity, analyse gaps and prepare action plans.

Overall, ignoring ESG risks in value chains can be a costly blind spot for managers, whereas addressing this area systematically should prove a worthwhile investment in the long run.

Practical due diligence suggestions

From our experience of introducing a programme of engagement and ongoing stewardship of ESG supply-chain risk, we have drawn a short list of tips in relation to the questionnaire itself.

Set the tone. To have constructive engagement, explain the long-term benefits of managing ESG supply-chain risks upfront, provide a roadmap and set out how answers will be assessed. This improves the quality of responses.

Make it manageable. Judge carefully the breadth of data collection. An initial questionnaire should be comprehensive but not too long, to secure maximum cooperation. The answers will provide you with scope for follow-up questions.

Include a self-assessment. Ask management teams to rank their stage of ESG integration maturity. This offers interesting insight into their level of awareness (against the factual results of the questionnaire) and any potential behavioural bias.

Beware of virtue-signalling. Companies may truly believe that doing something good in procurement from an ESG viewpoint equates to good risk management. However, your questionnaire may evidence that, amid several positive actions, ESG supply-chain risks are not mapped, sized or mitigated systematically.

Go beyond the basics. Most companies will have elements of a sustainable procurement process, along with policies to meet legal requirements on modern slavery, bribery and corruption or health and safety.
Meeting legal or regulatory requirements is just the starting point. Explore the less scrutinised areas, such as companies’ efforts to understand or influence suppliers’ diversity and climate impacts.

Focus on ongoing stewardship. Probe how ‘static’ processes are applied through time. A policy or code of conduct can be introduced once, to tick a box. Collecting data proactively and undertaking periodic supplier audits requires ongoing engagement and verification. In addition to constituting better risk management, these provide scope to drive improvements.

Investigate the challenges in tackling the last P (performance). Ask management teams about the challenges they see to full ESG integration. These may include lack of supplier co-operation, no management time outside core business priorities, small size of suppliers, unsophistication, lack of leverage or choice. Understanding these perceived challenges will help construct a plan and set realistic supplier KPIs.

Benchmark carefully. Benchmark results but make allowances for key differences. A highly visible, regulated infrastructure company is subject to prescriptive standards and runs sizeable public procurement processes. While it cannot be compared with a niche, mid-market company with industrial customers, it can provide useful templates and insights to close some gaps.