Decarbonization is impossible without sustainable supply chains

Decarbonization is impossible without sustainable supply chains

According to a report by the Governance & Accountability Institute, which tracks the S&P 500 and Russell 1000 Index companies, 96% of S&P 500 and 81% of Russell 1000 companies published a corporate responsibility report in 2021. This represents a significant increase from just 20% of S&P 500 companies publishing such reports in 2011.

Outside of the S&P 500 Index, there is a similar phenomenon around the world. A survey by KPMG found that 78% of the world's largest 250 companies by revenue published a sustainability report in 2022. Even in India, the financial year April 2022 to March 2023 will be the first year ever when the top 1000 listed companies would be disclosing an ESG report in the form of a Business Responsibility and Sustainability Report (BRSR).

This is great news!

The key drivers for these high numbers of ESG reports are a mix of their regulators, investors, customers/consumers and bankers. And due to this, we suspect that over the next few years, ESG data will become as important as financial data. Just like financial data, the whole point of measuring these metrics is to uncover insights into how they can be improved. The end goal of the disclosure exercise is for a company to build a vision of improving its ESG performance over time.

One way of tracking this improvement is setting Sustainability Goals that are relevant to the company’s industry, scale and type of operations and disclosing the progress annually in their ESG reports. But this is easier said than done.

Any company that commits to being sustainable follows a journey which can be broken down into three broad steps:

Step 1: In the first year, they start by creating a baseline ESG report. At this step, the company collects data across the operations, this includes data on greenhouse gas (GHG) emissions, water consumption, waste generation, employee count, policy implementation, employee and worker well-being initiatives etc.

Step 2: Once the baseline ESG data has been established, the company is ready to create its sustainability goals and targets based on that data.

As an example, here are the Sustainability Goals along with the target years created by?Novartis :

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Novartis' Sustainability Report

Step 3: Initiatives must be undertaken to meet these sustainability goals. Taking the example of Novartis’ Net-Zero goal, the following are the initiatives they can undertake:

  • Using renewable energy such as solar and wind to power their own operations
  • Electrification wherever possible
  • Encouraging the adoption of renewable energy among suppliers
  • Energy efficiency practices in manufacturing plants and offices
  • Reducing the waste sent for disposal or to landfills
  • Sustainable procurement means working with suppliers to encourage the adoption of sustainable practices, such as reducing emissions in their operations and increasing the use of renewable energy sources
  • Developing low-carbon products and services

The above journey is summarised on this chart:

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Created by the author

Companies soon realise that to truly move the needle towards meeting their sustainability goals, they cannot ignore their supply chain. Taking the most important goal of decarbonization,?carbon emissions ?associated with a product or service are not limited to the company's own operations (Scopes 1 and 2), but rather extend throughout the entire supply chain (Scope 3). The supply chain includes all the activities and processes involved in the creation and delivery of a product or service, from the extraction of raw materials to the disposal of waste.

In most industries, scope 3 emissions account for a majority of their emissions.

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Source: MSCI. In Scope 3, Category 1 is Purchased Goods and Services, Category 11 is Use of Sold Products and Category 15 is Investments.

To understand the above chart better, let’s compare the biggest hotspots of emissions in some industries:

Utilities:

For Utilities, the scope 1 emissions are the highest as that includes the fuel consumed/burnt to generate power. The higher the usage of fossil fuels like coal for power generation, the higher the scope 1 emission.

Real Estate:

For the real estate industry, the majority of their emissions lie in their scope 2 emissions which are generated by the consumption of grid electricity, heating or cooling, or on-site generated electricity from non-renewable sources.

Information Technology and Communication Services:

Just like real estate, the Information Technology and Communication Services industries also have a majority of their emissions due to their purchased electricity, heating or cooling. These industries are primarily services-led and hence do not produce any GHG-intensive products. Their entire footprint correlates to the number of offices and branches they have.

These industries employ a large number of employees and the fuels consumed in the company-owned vehicles form a major part of their scope 1 emissions.

Financial Institutions:

Financial Institutions have a unique GHG inventory with a majority of their emissions lying in Scope 3 under Investments, also called financed emissions. A recent study by the Carbon Disclosure Project (“CDP”) showed that financed emissions of reporting institutions were ~700 times larger than their operational emissions.

This means the proportion of the GHG emissions that a financial institution has exposure to through lending, investment, or underwriting activities to each client.

Why is calculating Scope 3 emissions hard?

Amongst the three, Scope 3 emissions are the hardest to calculate because this data lies with the suppliers that companies have zero or low ownership of over.

A pharmaceutical company may have set a goal to reduce its greenhouse gas emissions by a certain percentage over the next few years. However, the company's supply chain includes the production of active pharmaceutical ingredients (APIs), often sourced from suppliers in countries such as China and India. These suppliers may use energy sources that are more carbon-intensive than those used in the company's own operations. To address this, the pharmaceutical company could work with its suppliers to encourage the adoption of clean energy sources, such as solar or wind, in the production of APIs, or explore opportunities to source from suppliers that have implemented sustainable practices. The company could also consider optimizing its transportation and logistics practices to reduce emissions associated with the transportation of materials and finished products.

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Scope 3 categories for the pharmaceutical industry linked with their total emissions

But scope 3 decarbonization and, in turn, supply chain sustainability is not easy. A lot of moving parts have to work together.

Key challenges faced by companies implementing supply chain sustainability:

  1. Lack of data and transparency

It is difficult for companies to obtain accurate and complete data on the emissions associated with their supply chains. Suppliers may not have the necessary data collection and reporting processes or the technical know-how in place, which can make it challenging for companies to identify the sources of emissions and track progress over time.

2. Complexity and diversity of supply chains

Supply chains can be complex and involve numerous suppliers and stakeholders, each with its own processes and practices. A company as large as Novartis can have more than 20,000 suppliers. This can make it difficult for companies to identify the most significant sources of emissions and to implement solutions that are effective across the entire supply chain. In addition to that, the calculation methodology may differ depending on the type of supplier. A supplier providing raw materials has to adopt a different GHG emission calculation methodology than a logistics and transportation supplier.

3. Cost and resource constraints

Decarbonizing a supply chain often requires significant investments in technology, infrastructure, and expertise, which can be costly and resource-intensive. Smaller companies may lack the resources to make these investments, while larger companies may face pressure to balance the costs of decarbonization with other priorities, such as profitability and growth.

4. Resistance from suppliers

Suppliers may be resistant to making changes to their processes and practices, especially if they perceive the changes to be costly or disruptive to their operations. Companies may need to work closely with suppliers to build trust and collaboration and to demonstrate the business case for decarbonization.

5. Regulatory and policy uncertainties

Companies may face uncertainty around future regulations and policies related to carbon emissions, which can make it challenging to plan and implement long-term decarbonization strategies. Companies may need to closely monitor regulatory developments and engage with policymakers to ensure that their supply chain decarbonization efforts align with evolving regulatory requirements.

What does the on-ground reality look like?

Implementing supply chain sustainability can be a decade-long exercise for which companies tend to start with their first-tier suppliers. They expect these suppliers to in turn require sustainability compliance from their first-tier suppliers and so on. Companies cannot levy sustainability compliances with suppliers they don’t have a direct contractual relationship with.

These suppliers have to disclose not only their emissions numbers but also data on employee and worker health and safety practices, complaints and practices against sexual harassment, bribery/corruption, hazardous working conditions, overtime demands etc. But the challenge still remains around the traceability and transparency of this data.

As all countries around the world strengthen their ESG disclosure requirements, we should expect the implementation of supply chain sustainability to become more manageable. Based on all the reading I have done, I found?Apple’s Supply Chain practices ?the most impressive. They don’t only rely on their suppliers filling out their sustainability assessments but also interview their workers to verify the data received (539,000+ interviews in 2022).

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Apple’s Supply Chain Sustainability Progress Report

While this post was focused on decarbonization, the meaning of sustainable supply chains is a lot broader than that. In a future post, I will discuss how to implement supply chain sustainability.


Stuff I enjoyed this week:

  1. UNEP released?The 2023 Climate Risk Landscape ?- I plan on writing a post on Climate Risks in the coming weeks
  2. Bill Gates’ blog on?The state of the energy transition
  3. A book I’m reading and would highly recommend:?Radical Candor by Kim Scott

Thank you for reading!





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