International Quarterly — Issue 35

Environmental, Social and Governance (ESG) and supply chain risk management

By Ben Smith, Senior Associate, Oliver Weisemann and Tajwinder Atwal, Trainees, Fenwick Elliott

Introduction 

It is uncontroversial that ESG is a boardroom level issue for many businesses, and this is unlikely to change in the near future. ESG is pervasive and cuts across many different aspects of a what a business does or areas with which it may be involved. With new and pending legislation, a Court of Appeal judgment, as well as a UK Supreme Court judgment, ESG and risk management, particularly in relation to supply chains, is fundamentally important for every company to prioritise. 

Key considerations:

  • Increasing demand for transparency and accountability by the public and non-governmental stakeholders.
  • Introduction of legislation that increases businesses’ reporting requirements.
  • Expansion of legal responsibility to cover actions of the supply chain. 
  • How do you manage the risk?

Increasing demand for transparency and accountability

There is increasing pressure on companies to adopt “best practice”. A survey by PWC in 2021 found that 83% of consumers think companies should be actively shaping ESG best practices and 86% of employees prefer to support or work for companies that care about the same issues they do. These are striking figures. Companies can also find themselves named and shamed where they fail to meet the standards expected of them.

Legislation

EU Legislation

The European Union and its member states have been particularly active in developing new legislation related to ESG. 

In 2014, the EU took the first major step towards a new ESG framework by implementing the Non-Financial Reporting Directive (“NFRD”), which introduced reporting requirements for large companies, including listed companies, banks and insurance companies. Under the NFRD, these companies are under an obligation to publish information related to environmental matters, social matters, human rights, anti-corruption and bribery, and diversity of company boards.1

In 2019, the EU implemented the Sustainable Finance Disclosure Regulation (“SFDR”), which imposes mandatory ESG disclosure obligations and introduces rules for reporting on sustainability and ESG factors. For example, it states investments must not “do no significant harm”. This means that if an economic activity contributes to an environmental or social objective, then it should also not significantly harm any other social or environmental objectives. 

This is being taken further with the implementation of the Corporate Sustainability Reporting Directive2 (“CSRD”) in January 2023 (set to be implemented by EU member states in July 2024) which will affect EU companies but also those with large EU-based subsidiaries.3 Currently, the reporting standards under the CSRD remain undefined, although it seems likely that these will be even more onerous than the requirements already in place and may align with EFRAG’s Draft European Sustainability Reporting Standards issued in November 20224, which include disclosures expected of companies in respect of its own workforce, workers in the supply chain and affected communities and end-users.

UK Legislation

At the time of writing, the EU standards above remain applicable in the UK. However, given the withdrawal from the European Union in 2020, the UK government is under no obligation to give effect to the CSRD. Even though the CSRD isn’t likely to be implemented into UK law in the immediate future, it is likely to affect UK-based companies nonetheless, as any UK company that has a large EU-based subsidiary, or a subsidiary that is an SME listed in the EU, will need to make disclosures under the CSRD.

The UK has also independently made its own advances in ESG legislation. While generally concerned with environmental governance of water, nature and biodiversity, the Environment Act 2021 (“the Environment Act”) enables secondary legislation to be made, including regulations requiring payment towards the disposal of products and materials. In the context of a construction site, employers and contractors need to be mindful of disposing of materials correctly and the associated costs. This can be done by fixing the price of disposing materials during the tender process and embedding this in the contract. 

The Environment Act also enables the creation of new extended producer responsibility schemes, whereby the government can make anyone who produces, sells or supplies packaging responsible for the full net costs of managing clients’ products and packaging. These schemes are extensive and include the power to order the payment of waste management fees and other charges. 

DEFRA also held a consultation between March and June of 2022 to determine environmental targets in the context of the Environment Act. Notably, one of the core issues in this consultation was the government’s target of eliminating avoidable waste of all kinds by 2050.5

The construction industry is the second largest consumer of plastic packaging in the UK behind the packaging industry itself6, and it is estimated that an average 34% of a construction site’s waste (by volume) is packaging waste.7 Therefore, it seems likely that the Environment Act and future legislation will impact producers of construction products and other stakeholders further down in the construction supply chain.

Expansion of legal responsibility to cover actions of the supply chain 

Recent case law has also opened up the prospect of liability for the actions of one’s supply chain. 

In Begum v Maran (UK) Ltd,8 the Court of Appeal unanimously held that a duty of care owed by a UK company could extend to actions of international third parties in its supply chain. This followed the landmark ruling in Vedanta Resources PLC v Lungowe9 whereby parent companies in the UK could be liable to communities affected by the actions of their non-UK subsidiaries. 

Furthermore, the ruling in Okpabi v Royal Dutch Shell10 concerning pollution caused by oil exploration saw a successful cross-border environmental litigation in the UK Supreme Court. In this dispute, the Court allowed Nigerian citizens’ environmental damage claim to proceed against the UK parent company of the local subsidiary, Royal Dutch Shell. 

These cases serve as a timely reminder that, in the current climate, UK companies need to be more aware than ever of the actions of the third parties they incorporate into their supply chains as well as their non-UK subsidiaries. This area, in particular, will be of some concern to companies in the construction industry as construction supply chains can be long, complex and multinational, potentially making it difficult and expensive to exercise sufficient oversight to eliminate the risk of litigation. 

How do you manage the risk?

As is clear from the above, the due diligence burden and the potential liability of contractors, suppliers and manufacturers within the construction industry has increased in the last few years. This is not simply a negative development, as the new standards that firms are now required to comply with serve as signposts of where one needs to go to become a more ethical and sustainable business. 

However, the implication is that companies now need to consider whether the typical existing due diligence structures, contractual obligations, audits, etc., are still sufficient to discharge one’s duties and protect against liability and whether further steps should be taken. For example:

  • Is it possible to consolidate the supply chain to take greater control and oversight of these risks?
  • Consider enforcing standards more rigorously, which will require a greater degree of transparency from the supplier, which may itself need to be enforced by way of audit, monitoring and spot checks. 
  • It may not even be enough to enforce these changes on one’s direct suppliers; it may also be necessary to ensure they do so with their own suppliers in turn. 

Conclusion

The rise of ESG as a novel supply chain pressure comes at an inauspicious time for many in the construction industry. The necessity to be in a position to report on your supply chains and to have complete oversight is an onerous obligation in any event, and will undoubtedly require additional resourcing and the establishment of robust procedures to comply with.

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Ben Smith

Tel: +44 (0)20 7421 1986
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