Creating a Sustainable Supply Chain with ESG Integration

ESG Integration can be defined as the evaluation of a company’s environmental, social, and governance practices, their impacts, and the company’s progress against benchmarks. Investment managers may rely on information about a company’s ESG efforts, including ESG ratings and ESG scores, to assess a company’s performance and to integrate ESG in the key functions like portfolio construction, risk management, and compliance processes.

Companies are increasingly incorporating ESG thinking into their strategic planning, reporting, and communications decisions, and leveraging ESG performance as a strategy to access into new markets, as ESG has gained popularity among investors.

Integrating ESG is likely to become more important in the coming years as concerns around the long-term sustainability of economic activity, the impact of climate change, and human survival are soaring. Though inflows in ESG funds continue to grow, “Greenwashing” is still the top concern for the regulators.

A recent study by a shareholder advocacy group found that 60 of 94 ESG funds failed to adhere closely to the principles of ESG investing

The critical part of ESG Investing is to know how exposed and how well your portfolio companies manage their industry-specific material ESG risks and ESG performance indicators. While various aspects of ESG may be important to a company’s long-term success, the process of identifying these areas and tracking and reporting on these issues varies greatly from one company to the other and is only now beginning to be standardized across industry groups and markets.

Companies that implement effective ESG practices are less likely to face ESG controversies and are better able to respond when ESG incidents do occur. And those incidents can be costly. The table below shows some examples of ESG related fines.

Examples of Fines and Settlements Related to ESG issues

Supply chain

The increasing action on ESG highlights the growing need to integrate ESG into the investment process and decision-making, as it becomes critical to identify those companies that are well positioned for the future and to avoid those likely to underperform or fail. Stakeholders focus on environmental, social and governance, or ESG, while issues encountered in the process is compelling companies to increase transparency and accountability within their supply chains. ESG topics relevant to a company’s supply chain are varied, and may include human rights, forced labor, greenhouse gas emissions and biodiversity loss.

According to a report by McKinsey & Company, as much as 90% of greenhouse gas emissions and other environmental impacts are the result of consumer companies’ supply chains

The International Labor Organization estimates that nearly 40.3 million people are in modern slavery – 5.4 victims for every 1,000 people

As such, the supply chain has significant potential for achieving major advancements in sustainability performance. But how a company is supposed to measure suppliers’ ESG performance remains tricky. There is a crucial need for developing and implementing metrics to assess the ESG practices of suppliers, contractors, and vendors. However, to date, such efforts have been a jigsaw puzzle of differing metrics, criteria, and accuracy.

To see what kind of issues the investment managers and the investee companies face, let’s take an example of human rights violation within the supply chain of the companies.

The ‘S’ in ESG

Considering social concerns when investing, especially as part of a comprehensive ESG integration strategy, can protect investments. Only a few countries currently regulate the disclosure of supply chain impacts on the environment and society, but some high-profile claims of human rights violations have spurred legislators throughout the globe to act.

In 2020, a human rights violation claim was filed against the world’s largest tech companies by Congolese families who said their children were killed or maimed while mining for cobalt used to power smartphones, laptops, and electric cars.

According to the lawsuit, the firms assisted and encouraged mining enterprises that profited from the labor of minors who were forced to work in hazardous conditions, which resulted in death and significant injury. Some of the youngsters were killed in tunnel collapses, while others were disabled or experienced life-changing disabilities because of mishaps, according to the families.

Majority of the world’s cobalt resources are found in the Democratic Republic of Congo, which also produces more than 70% of the world’s current cobalt.

Notwithstanding, mining in the Democratic Republic of Congo is dangerous because of the prevalence of artisanal small-scale mining. More than two million Congolese miners rely on this largely unregulated and labor-intensive activity for their livelihood. And this mining practice comes with major human rights risks such as child labor and dangerous working conditions.

Organizations that ignore such risks run into trouble with the government regulators, and the people in general. This can cause both regulatory sanctions and significant reputational risks.

There is a growing public sentiment that inexpensive supply chains cannot supersede human rights. In the past few years, numerous companies in a wide range of industries have faced severe backlash for missing to identify and/or address such incidents taking place within their value chains. These systemic ESG risks are also relevant to financial institutions and other members of the investment community, who should take care to ensure that the companies in which they invest are cognizant of the human rights risks associated with their value chains.

Challenges while Integrating Social Factors

Variable data – Investors find it difficult to include social concerns into their investing procedures, despite the evident correlation between bad social practices and firm risk. While there is an upsurge in the quantity of indicators for how firms are evaluated, due to variable data, assessing a company’s social behavior is still more difficult than assessing its environmental policies.

Data quality – Data quality is crucial in environmental, social and governance (ESG) investing, where lack of mandatory and consistent reporting of non-financial information by companies makes it challenging for investors to make decisions based on that information. Consider SFDR for example, most of the data vendors don’t have hundred percent coverage for the mandatory indicators. There are structural obstacles to using non-financial information. Much of it is presented in either narrative or an unstructured form.

Hard to quantify – Recognizing that social issues are essentially more qualitative, investors often find it challenging to incorporate them as they are not as easy to quantify. As a result, it can lead to complications for investors to showcase the financial impact social issues have on risks and impacts for long-term investments.

Lack of standardization – There are now gaps and inconsistencies in how social variables are measured, as well as a lack of established practices and global standards for reporting by firms. Furthermore, there is no consensus on how much importance these social issues should be given.

Lack of understanding – The problem for investors extends beyond data. One of the most difficult aspects of adding social elements into an investment portfolio is that different investors interpret social characteristics differently.

Dependence on multiple factors – Social factors don’t just depend on how consumers will judge a company’s behavior. Geopolitical events also fall under the social category in ESG investing and conflicts like these can prevent companies from producing or distributing their products.

Addressing the Social Indicator challenges

Investment managers have to rely on multiple data vendors to source ESG data. Sourcing data from multiple vendors creates another problem of mapping the data to the standards and taxonomies. There is a need of an ESG Integration tool which can help in mapping the data with the material issues based on the taxonomies and standards.

With a robust tool, these ESG risk factors can be linked to the global ESG standards and framework like SASB, GRI, etc. and further be used to better position the portfolios by eliminating the laggards. The tool can help in integrating ESG, by systematic and explicit inclusion of ESG risks and opportunities in all key aspects of an investment process. It can onboard current and future structured and unstructured ESG content from data providers, so users can focus efforts on the meaning held within the data.

Hexaware ESG Integration Solution

Hexaware’s ESG integration services are powered by Amaze^® for Capital Markets platform. Our core objective is to enable our clients to better manage ESG risks, integrate ESG in investing decisions across the enterprise, comply to regulatory requirements like SFDR, and fulfill the Net Zero and other climate action commitments.

Amaze^® for Capital Markets is a cloud native NextGen data management platform that leverages intelligent automation technologies to deliver self-service capabilities, superior end-user experience and operational efficiencies.