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Delivering sustainability through supply contracts
June 8, 2022 – This is the fourth and final article in this series. In earlier articles, we described rapidly emerging environmental, social and governance (ESG) legal and regulatory requirements. In this article, we describe ways for buyers to meet those requirements in their supply chains.
Doing so will be challenging. Supply chains are already optimized for least cost, including as to the manner of production. ESG change increasingly requires changing the manner of production. Buyers generally have limited data on the manner of production or its cost. For suppliers, changes to the manner of production may increase cost, violate other agreements, or create other risks.
There are, however, opportunities. Technology is increasingly making it easier for technical, operational, user and business stakeholders to collaborate across companies to develop new solutions. The analytical power of scorecard methodologies, which assess performance against a range of metrics, is helping to allow goals, such as ESG, to be part of a balanced analysis. Board-level and C-level support for ESG are facilitating the necessary collaboration across traditional silos. Supply chain contracts are steadily more adaptive, flexible and nuanced, allowing broad change.
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A first approach is to use accepted standards from laws and standard-setting bodies. Accepted standards are more credible and thus more likely to be adopted "as is" instead of being negotiated. Conforming to accepted standards is less costly and complex for suppliers than working with diverging standards from various buyers. Certifications may be available from reliable third-party audit or certification firms, avoiding the need for each buyer to do its own audit.
Accepted standards can be implemented using long-established contracting concepts. Supply contracts have long included clauses requiring suppliers to comply with designated standards, train their people in line with those standards, obtain third-party certification of compliance, and allow audits by buyers. Anti-corruption compliance is an early example of success at that approach in the supply chain, and privacy compliance is a more recent example.
However, accepted standards only take a buyer so far. They often are framed at the enterprise level, not the specific supply chain for a specific buyer as performed by a specific supplier. That may not satisfy regulatory or company requirements for the buyer because those requirements generally apply to the buyer’s supply chain specifically, not merely to the companies in the buyer’s supply chain. Also, audits at the supplier enterprise level may be unreasonably costly or intrusive and, in any event, it may be unreasonable for a single buyer to ask a supplier to modify its entire enterprise for that buyer.
As a result, buyers may seek to include contract terms beyond those typical in a supply contract. Typically, the negotiable topics are product, price, delivery time and delivery location. The manner of production – how the supplier will deliver – is generally left to the supplier.
In collaborative contracting, the parties negotiate about far more topics. In those negotiations, buyers may make operational, technical and financial commitments beyond paying the agreed prices. For example, the buyer might agree to fund investment by the supplier in changing its manner of working and the ongoing costs, or to change its product requirements to reduce adverse ESG impact for the supplier.
Collaborative contracting often requires a substantial investment. Done right, it requires considerable time for the operational, technical, user, business and legal terms to be negotiated and agreed. There may be new, and more complex, terms on commitment, contribution, control and sharing of risks and rewards. In the context of ESG specifically, those obligations may be designed to allow the suppliers to profitably produce on a more sustainable basis. Also, it likely produces contracts that are inconsistent across suppliers, which may cause difficulties in integrating the resulting goods and services.
In managerial contracting, buyers manage supplier operations through contracts. Buyers obtain contractual commitments to compliance with detailed process requirements and use boots-on-the-ground inspections to ensure those commitments are satisfied. They control critical decisions, such as subcontracting work and sub-component sourcing. They use scorecards, incentives, meetings, reports and other managerial tools like those that they would have used if the buyer and the supplier were a single enterprise. This allows buyer to control, to some extent, the manner of production.
Managerial contracting was developed for quality assurance, particularly for goods where quality is difficult to measure at delivery and thus engineered into the product. For example, cooling a component slowly and evenly may allow it to last 10 instead of five years. So, the buyer focuses on cooling speed instead of waiting five years to see what breaks.
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