ESG Risks in Procurement — A Guide on ESG Risk Management

ESG risks in procurement are becoming more important today for many investors and companies advocating for sustainable business practices. However, these ESG risks appear in various forms, which can overwhelm many procurement professionals when managing this type of risk.

In this article, I will discuss what ESG risks are and how procurement can help promote sustainable business practices. Additionally, I will be sharing with you some ways to mitigate ESG risks in your business operations. 

With my years of experience as a procurement manager, I have shared these tips with many procurement professionals, helping them avoid ESG risks in their procurement practices successfully.

After reading this article, you will be able to implement the strategies I shared to streamline your procurement processes and achieve sustainability in your operations while avoiding ESG risks that could hinder your progress.

What is ESG?

Did you know that globally, humans are using resources at a rate 1.6 times the planet’s capacity? According to the International Labor Organization, there are 27.6 million people in forced labor worldwide, including 3.3 million children. Additionally, 45% of U.S. workers encounter misconduct and unethical behavior at their jobs, which affects around 62 million people. 

These facts highlight significant issues across three major areas of global concern: environmental sustainability, social justice, and governance practices.

Due to these issues, the United Nations has outlined 17 sustainable development goals by 2030, encompassing 169 projects and tasks for collective action. 

Of course, governments should not be the only ones responsible for solving this problem. Companies are also expected to align with these goals, incorporate them into their business practices, and assess risks relevant to each goal for their specific operations.

This is where ESG (Environmental, Social, and Governance) comes in. ESG is a framework that helps organizations assess how they manage risks and opportunities related to environmental, social, and governance factors. 

What Are ESG Risks?

While many companies have an ESG framework, it cannot guarantee the avoidance of ESG risks, especially with a weak framework.

ESG risks are issues that can negatively impact a company’s financial, operational, and reputational performance due to problems that are related to environmental, social, and governance factors.

Let me give you an example for each pillar:

1. Environmental risk

For example, a large energy company operates its power plants in an area prone to flooding. As climate change progresses, the area experiences more frequent flooding that caused the energy plants to shut down. 

The company incurs significant financial losses due to halted production and the costs of repairs. Also, investors have begun to question the long-term effects of this, resulting in them pulling out their money from the company.

2. Social risk

Imagine a huge global fashion company that sources its materials from various countries. After information had leaked that one of its suppliers was involved in sweatshops, the company received massive backlash from the public. 

The leakage has resulted in a public outcry and many people have voiced out that they will boycott the brand, leading to a significant drop in sales. 

3. Governance risk

For example, a fashion company where all their top executives are involved in unethical practices such as manipulating financial reports just to inflate the company’s performance. 

When these are uncovered, the company’s stock price plummets due to the loss of investors’ trust. The fallout escalates as media coverage exposes the unethical behavior, leading to customer distrust, regulatory fines, and lasting damage to the company’s reputation.

How Procurement Contributes to Sustainability

Procurement can contribute to sustainability developments by selecting the right suppliers and implementing sustainable category strategies. Examples include recyclable packaging, eco-transport, and regenerative energy resources.

Implementing sustainable practices is commendable. However, it’s important to take note of the risks associated with your suppliers or their suppliers in the Environmental, Social, and Governance (ESG) areas. 

A supplier might restrict its employees’ right to freedom of association, violating fundamental human rights. Alternatively, the supplier could improperly manage hazardous waste, resulting in severe environmental damage.

Furthermore, not partnering with ethical suppliers committed to sustainable practices can hinder your company’s ability to establish strong sustainability standards, ultimately exposing your organization to various risks.

Steps to Minimize ESG Risks

Here are some simple steps that you can take to minimize these ESG risks:

1. Assess ESG Policies

ESG policies are documents that define the guidelines and requirements for each element at the organizational level. During supplier screening, make sure to check the availability of such policies, supported by management systems and processes that address ESG. 

For example, many companies adopt non-binding ‘soft law’ standards such as the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises. These soft law standards are raising the bar for stakeholder expectations on how companies should address human rights issues. Check if your suppliers integrate these standards into their policies.

2. ESG Due Diligence

Conducting due diligence on suppliers before talking with them is important to uphold ESG standards in your procurement process. Best practices include integrating a set of questions during the pre-tender stage, such as in the Request for Information (RFI). 

Additionally, it’s worthwhile to incorporate ESG factors as part of the evaluation criteria for supplier selection. With this, you can ensure that you are dealing with sustainable suppliers. 

3. Integrating ESG Into Your Contracts

Integrating ESG into your contract clauses can help you mitigate risks better. Traditional contractual remedies are being used in innovative ways by many companies to incentivize ESG compliance and discourage supplier misalignment with an organization’s ESG strategy.

For example, benchmarking rights, continuous improvement obligations, and termination triggers are all conventional contractual provisions that companies can utilize to ensure suppliers meet ESG commitments.

One example of these contractual mechanisms is including a clause that allows you to switch to a more eco-friendly supplier if needed. It’s also important to set clear subcontractor requirements and keep track of who they are to make sure they meet ESG standards.

4. Reporting And Performance

New legislation requires visibility into ESG practices across supply chains and reporting progress on set goals. This means having access to supplier data on ESG goals is essential and legally required. 

Moreover, you should define and agree on ESG KPIs with your suppliers and track their performance. Make sure to include access to KPI data in your contracts.

5. Proper ESG Governance

To keep up with regulatory changes, it’s important to establish strong ESG governance with your suppliers. Try collaborating with them to define best practices and agree on how often and what to discuss regarding ESG. 

This could be part of regular performance reviews or separate meetings for specific projects. Make sure these discussions are practical and relevant. By doing this, you not only reduce ESG risks for your organization but also contribute to global sustainability goals.

Conclusion

Managing ESG risks is important for businesses aiming to ensure sustainable practices within their operations. With this, procurement professionals play a huge role in mitigating these risks by selecting the right suppliers. You may ask why this task alone can mitigate a lot of risk, right? 

This is because suppliers can carry lots of risks, particularly those who fail to comply with regulatory standards and industry laws. A single non-compliant supplier can disrupt the entire process, leading to customer dissatisfaction and financial losses. Ensuring that suppliers align with ESG standards is essential to protect your business and maintain operational integrity.

Furthermore, the strategies in this article will guide you in managing ESG risks effectively and enhancing your procurement practices. These recommendations have been successfully applied by many organizations, including the procurement professionals I’ve taught, resulting in improved sustainability and reduced risk.