CEP Magazine - April 2022

The right to audit…extensively

Vendor contracts must allow you the right to audit and inspect, physically and through documentation, those articles and procedures that ensure products are being built in conditions that we ourselves would be comfortable working in, and to ensure that the components of products are delivered as promised by the supplier (example: no unauthorized part substitutions). The contract rights also need to extend the right to inspect as far back in the supply chain as needed to obtain assurances that the entire supply chain contributing to the build of a given product is free from unethical environmental conditions and to ensure that component and material substitutions are aligned with agreed-upon materials.

Without a right to audit this extensively, it is impossible to declare ourselves compliant with public commitments and to stand up with credibility to authorities who may challenge any claims made as to the integrity of the product under ESG mandates.

Having the rights isn’t enough. Companies can no longer rely on the fact that their contracts state they have the right to audit without demonstrating that they have exercised that right. Auditing must be done routinely and as frequently as necessary. Audit findings must be adequately remediated and documented in a timely fashion, and Plan B suppliers need to be identified and ready to step in if needed. Companies need to be prepared to pivot if remediations don’t work. Plan B and Plan C suppliers are all now affected by more than just part availability.

Product design and supply chain sourcing

Many small to mid-sized companies have approached the issue of supply chain in terms of costs, velocity, quality, and volume. This has always been the best and right way to do it as a small business. There are generally no other choices for a small business making decisions affecting the company’s survival and growth opportunity. But larger companies must consider the investment of a higher-priced part valued for its more ethical sourcing and ecologically safer componentry, and see that as part of their value as a credible enterprise. The value of the higher-priced parts is now playing a significant part in a company’s publicly traded investor valuation. ESG as individual initiatives have always been “nice to have.” They have been implemented out of a desire to do good, but not necessarily at the expense of profitability. As the years have passed and ESG activities haven’t matured out of the “but for the profits” approach, investors are requiring much, much more.

To what extent this is going to succeed without hurting businesses’ bottom lines is yet to be seen under the pressure of investor and regulatory mandates, but activists on all fronts of ESG opine on the long-term profitability of those investments today. Their research has shown that investment here makes for happier, more productive employees who are committed with purpose rather than simply staying for pay.^[1] Proponents have proven the mid- to long-term profitability of those companies with happier, purpose-driven employees. But all of this investment starts with an investment in upskilling product design engineers and exposing them to matters beyond the blueprinting of their products to understanding componentry beyond function and legislative mandates affecting the product’s design. It also means that engineers and supply chain managers alike need to know what advanced technology exists in the ethers of our common marketplace, and they need to know a lot about their forecasting needs and their return on investment relative to higher-cost, slower-to-market parts. In effect, the economy and industrial marketplace is facing the precipice of environmentally sound products tipping to more affordable and accessible parts of the grander supply chain. How quickly companies shift to comply with ESG mandates will be the true accelerant of niche environmentally conscious integration within the broader supply chain ecosystem.

Documentation with archival architecture

It will be more critical than ever to have a reliable, credible, and secure method of obtaining, retaining, and analyzing the documentation required to be submitted by vendors in the supply chain, attesting to their labor standards, their environmental impacts, and those of their suppliers. There are already numerous regulations around the world obligating companies to attest and report to authorities, labeling products as compliant with sensitive chemical usage, and other conflict-mined minerals usage.

Depending on the size and footprint of the company, this may or may not be news. But in the ESG space, these regulations are the world’s first attempts to advance the credibility obligations of impending ESG reporting regulations. Look first to the European Union and its mandates around the Restriction of Hazardous Substances (RoHS); Registration, Evaluation, Authorisation and Restriction of Chemicals (REACH);^[2] Substances of Concern In Products;^[3] and Waste from Electric and Electronic Equipment regulations.^[4] Then turn to other jurisdictions in the United States and elsewhere to see implications of regulations like Prop 65.^[5] Australia and the European Union and many other jurisdictions have published regulations surrounding the use of indentured labor, and there are labor regulations in absolutely every jurisdiction a company might choose to do business. All of these regulations and the need to be able to begin auditing from a singular point of commitment means that as companies that care about the credibility of the supply chain and being able to stand up to the regulations and commitments regarding ESG, we must have access to this documentation from all suppliers in the supply chain.

A document repository that is secure and reliable is needed with processes for obtaining those documents (secured by language in contracts) and refreshing those documents with any changes in the supply chain. Vendor contracts have never been more integral to the effectiveness of compliance as they are today. Extending well beyond global supply chain disruptions and the security of committed inventory, the inventory that has been committed must still meet high and rigorous standards of environmental and labor benefits as well as quality.

Formalized procurement protocols

To satisfy the ESG requirements for support of diverse businesses in the supply chain, we will need to really understand the demographics of vendor organization ownerships. Similar to how we already monitor for sanctions conflicts, this needs to be documented when we solidify supply chains.

We also need to document why larger, nondiverse organizations are more suitable for our operation than small, diverse businesses. At a minimum for US federal contractors and for many state contractors, the US government’s Federal Acquisition Regulation obligates its direct contractors to ensure that comparisons are made between potential vendors and that adequate documentation exists to justify when a small, diverse business has been downselected.^[6] What this means is that for companies operating without formal procurement procedures, it is impossible to comply with mandates essential for both complying with the Federal Acquisition Regulation and ESG mandates. Companies need to be profitable, but when a diverse business can provide the same or greater profitability, it should be given the opportunity to deliver against a contract just as well as a larger company with more throughput capacity. Sometimes this won’t be the case, and this is of course going to be a completely reasonable business decision to make, but not having the appropriate documentation to satisfy the fact that small, diverse businesses were offered an opportunity to bid on the business—and without adequate documentation to demonstrate a lack of ability to meet all procurement requirements—the optics work against the ESG mandate.

Standards dependency

The notion that this kind of robust vendor management and procurement system is achievable and easily streamlined would be an absolute fallacy. What is important to understand is that there are open standards that enable companies to rely on objective third-party certifications to represent the simplest way for vendors to comply with the greatest portion of our expectations—and which simplify our own ability to verify. For example, it is much easier for a company to seek out partners who publish their RoHS and REACH certifications, as well as provide access to their own environmental certifications, International Organization for Standardization certifications, and independent audits like Responsible Business Alliance certification results. Having a compilation of the most important standards and compliance certifications relevant to your business and its ESG objectives alleviates the intensity with which company auditors need to invest their own energy to validate.

Meeting the rising ESG standards head-on

There is a lot to digest about supply chains in a time when supply chain disruptions have almost crippled a global economy. They are complex mechanisms that have evolved to be even more complex despite what we all do to streamline and simplify solutions for a consumer-obsessed marketplace. The need to have a tight governance model over procurement practices and vendor management procedures has never been greater, irrespective of the impacts that impending ESG reporting regulations bring into view. The ability to formalize and manage the auditing obligations for the supply chain through process and tight controls simplifies tier one companies’ ability to comply with the most rigid ESG reporting mandates we can envision.

Takeaways

• Environmental, social, and governance obligations cannot be accomplished without having a contractual right to audit and exercising that right.

• Product design teams must upskill to understand the ecological impact of the product and understand who in the supply chain can provide greener parts.

• Vendor management programs must be much more robust and exhaustively governed than they were in the past.

• Formalized procurement programs are no longer optional.

• Governance can be simplified through top-tier suppliers self-commissioning independent audits against industry-recognized standards.