It’s important to monitor two main strands of supply chain environmental risk. The first relates to whether your suppliers are truly committed to sustainability and if they are acting to minimize and ultimately eradicate environmentally unfriendly practices. The second concerns how vulnerable your suppliers are to environmental disaster or climate change.
Whether or not a supplier is committed to environmental targets can directly affect your organization and its reputation. Scope 3 emissions include indirect emissions from a company’s supply chain—so relying on suppliers with inadequate sustainability plans could increase your carbon footprint.

“We’re able to help companies with their responsible-sourcing strategy and sustainable frameworks,” explains Carolina Azar, Senior Director, Product Strategy at Moody’s Analytics. “We can provide an integrated view of all the different kinds of risk organizations face, from financial and credit to climate and environmental. When you’re going into business with an entity, we can give you a clear view of their ESG situation.” This knowledge, she says, means organizations are better equipped to make decisions.

For instance, can you guarantee that your suppliers are sourcing materials sustainably? Requiring environmental certifications can ensure certain standards are reached—signaling your commitment to sustainability and helping to create a stronger future for your company. By finding alternatives to carbon-intensive materials, you are not contributing to the depletion of scarce resources, and your organization will grow in resilience. Assessing your suppliers’ vulnerabilities to natural disaster and climate change is a vital part of mitigating your supply chain ESG risk. “How is that supplier going to react to a negative situation impairment?” asks Bill Hauserman, Head of Financial Crime Due Diligence at Moody’s Analytics. “It could be weather, it could be a tsunami like the one that just hit Tonga.” In 2018, following a drought, parts of the Rhine were at extremely low levels, meaning larger ships could no longer navigate the river. German chemical producer BASF had to halt production because it could not receive the necessary raw materials, and this negatively affected its 2018 earnings.

“The experience of COVID-19 brought into sharp relief the importance of being able to quickly pivot to alternative suppliers,” adds Azar. Diversification strengthens your supply chain and can reveal synergies and innovations.

Read more about making a positive environmental and societal impact.

Reputation is hard to win, and even harder to measure. But we all know when we’ve lost it—and social media is quick to spread the news of any scandal. Today, one key measure of reputation is ESG: your record on environmental and social impact, and on governance. And, in a hyper-connected world, it’s not only your own ESG credentials you need to worry about, but those of everyone you deal with.

EverEdge, an intangible-asset valuation organization, estimates that assets such as reputation account for more than 87% of a business’s value, and a World Economic Forum study reported that reputation alone accounts for 25% of a company’s market value.

Reputational damage can arise from many areas, and ESG risk in the supply chain is one major potential source, with little visibility. Effectively assessing and managing operational risk using ESG metrics helps organizations to become resilient and sustainable, enhancing their reputation and helping them to retain investors, customers, employees—and suppliers.

Monitoring ESG risk in your supply chain makes your organization more attractive. Younger generations are increasingly concerned about corporations’ ethics; according to healthcare provider Bupa, 64% of respondents aged 18–22 say it’s important that employers act on environmental issues. Stakeholders view companies that have strong ESG commitments more favorably, and sustainable investing is rising rapidly in popularity. Assessing your risk exposure also helps you to avoid potentially costly regulatory infringements.

There are challenges in accurately determining your organization’s ESG-related vulnerabilities, but also benefits to adopting a proactive stance. Read on to learn about:

• Why avoiding regulatory infringements is so important.
• The benefits of creating a positive environmental and societal impact.
• How your ESG risk management program can help you retain investors, customers, and employees.
• How monitoring ESG can reduce costs for your organization.

According to the UN, the amount of money laundered worldwide is equivalent to 2–5% of global GDP per year (around $800 billion–$2 trillion). The scale of organized crime is huge, and criminals have quickly adapted to and are thriving in the conditions created by COVID-19, including supply chain upheaval.

Criminals often use legitimate businesses to hide the proceeds of fincrime. In its 'EU Serious and Organised Crime Threat Assessment' for 2021, Europol reported that 80% of criminal networks active in the EU use legal business structures for their illegal operations. A comprehensive compliance program is essential to rooting out such activities in your supply chain.

“Criminal networks are sophisticated,” says Bill Hauserman, Head of Financial Crime Due Diligence at Moody’s Analytics. “It’s critical that companies take the due diligence process seriously, so that they’re not funding terrorism or human trafficking.”

Being unaware of fincrime within your operations can result in hefty penalties. At the end of 2021, a leading bank was fined £64 million by the UK’s Financial Conduct Authority for failures in its automated anti-money laundering system between 2010 and 2018.

“Using technology to monitor for ESG-related risk in the supply chain can bring fairness and transparency to the decision-making process,” says Alex Zuck, Managing Director, Product Strategy for KYC at Moody’s Analytics. According to the latest International Labor Organization data, an estimated 40.3 million people worldwide were in modern slavery in 2016. Even if you believe there are no slaves in the country where your business is headquartered, there could be connections with slavery in your global supply chain. According to the Global Slavery Index produced by human rights group Walk Free, laptops and garments are among the five products most at risk of modern slavery that are imported into the G20. “Human trafficking, human rights and all the other issues that come under ‘social’, such as pay equality, these affect your reputation—and that’s what people remember,” says Hauserman.

Of course, unethical working practices can still take place in richer nations. In 2020, headlines abounded about a UK-based fast-fashion retailer regarding employment practices in some of its factories in the north of the country. The news had significant reputational and financial consequences for the company, with £1 billion wiped off its value in the immediate aftermath of the reports. In November 2021, its share price had fallen 44.3% since January of the same year.

“Companies can take action against modern slavery, but first they need to find out where in their supply chains slavery risk is highest,” explains Dr Alexander Trautrims, Associate Professor in Supply Chain and Operations Management at the University of Nottingham Rights Lab. Different solutions are appropriate in different situations, he says. “You might want to change the way you place orders, or instead of spot buying decide to develop longer-term relationships. You have to go in, see where risks are and engage with the situation.”

Read more about fincrime in the supply chain.

Stakeholders and the public are increasingly interested in ESG measures and an organization’s commitment to them, and want to see tangible goals and progress. Regulators are also paying attention: recent developments include Germany passing its Supply Chain Due Diligence Act, and the IFRS Foundation launching its International Sustainability Standards Board.

But a one-size-fits-all solution isn’t the answer—or likely even possible. “The approach has to be sophisticated—one that fits company, context and industry,” says Ioannis Ioannou, Associate Professor of Strategy and Entrepreneurship at London Business School. And as more organizations innovate to create the programs that best suit them, stakeholders look set to gain through rising standards. ESG risk management is by its nature primarily a long-term exercise, so measuring against transparent goals shows that your organization is prepared to be held accountable by stakeholders.

“The main risk that our members face is the difficulty of gathering the right data,” says Julia Jasinska, Senior Policy Adviser, Sustainable Finance at UK business organization CBI. “If you work with SMEs and mid-tiers, it might be hard to get the right data to help you assess ESG risk to the extent that you would like to.”

It is therefore important to work with a provider that can generate accurate proxy scores for companies for which you may have little data, allowing you to assess as much of your supply chain as possible. A comprehensive ESG risk management program can also articulate to your stakeholders and investors how you’re able to leverage your supply chain to improve sustainable outcomes. “If you offer financial support, you might link it to ESG improvements, and then you can offer support on the ESG front as well,” says Jasinska. “You then become more attractive than your competitors—there’s a huge altruistic case, but also the business case to engage.” Finally, monitoring the reputational risks around the organizations and individuals in your supply chain demonstrates to investors that you have comprehensive oversight—and prevents operational disruption.

The presence of politically exposed persons, bad actors, or sanctioned individuals can turn reputational damage into financial damage in the form of sanctions and fines. “If you overlook something in your due diligence and it then turns out that a person who is in your supply chain is a slum lord, or a drug lord, or a human trafficker, that’s what gets onto the front page,” says Bill Hauserman, Head of Financial Crime Due Diligence at Moody’s Analytics. “Reputation is in the eye of the beholder, which means that the quantity of data that needs to be distilled into insights is much bigger than it was before. And that kind of information tends to be unstructured, such as media.”

Learn more about sustainable supply chain management.

Good ESG risk management across your supply chain brings financial and reputational benefits. “There’s the idea that companies that manage their ESG issues are becoming fundamentally better companies,” says Ioannis Ioannou, Associate Professor of Strategy and Entrepreneurship at London Business School. “Therefore it’s thought that not only will they minimize risk, they’re also likely to survive and outperform their competitors.”

“Double materiality” is an important concept in this respect, and must be considered alongside credit and financial risk. It means considering not only how ESG risk might affect your organization, but also how your organization might affect the environment and society. Applying a double materiality lens to your supply chain now will benefit both your company and wider society in the long run.

Assessing the ESG risk of your potential and current suppliers means you can create a more diversified, agile and resilient supply chain. Choosing the optimal suppliers both reduces the risk of supplier churn and increases the likelihood of avoiding reputationally harmful incidents. Less time spent on supplier research and onboarding means lower costs. And, without any scandals associated with your company name, costly damage-control methods are not necessary.

However, even the most prepared company might still encounter problems. Christopher S Tang, Faculty Director of UCLA Center for Global Management, points to the recent example of Dyson. Discovering that a supplier in Malaysia was in violation of labor laws, the company terminated its contract. “When you’re proactive you boost customer and investor confidence,” he says. “Dyson disclosed and took immediate action.” What are the next steps for ESG risk management? Cyber risk is a critical area. Insurer Hiscox has reported that the average cost of a cyberattack on a business is $200,000. The ability to accurately assess suppliers’ vulnerabilities to cyber criminals is becoming more sophisticated, helping to further reduce your risk exposure.

In a fast-moving world, transparency is key. A comprehensive ESG risk management program offers opportunities: by innovating and adapting at speed, your organization will maneuver itself to the head of the pack.

“When disruption happens, especially for established businesses, what are the options?” asks Ioannou. “Companies that fail to navigate destruction end up in the corporate graveyard. It’s either adapt or perish.”

Read more about the benefits of data and automation for supply chain monitoring.