How can your supplier and contractor agreements improve your ESG Performance?

At its core, Environmental, Social and Governance (ESG) matters refer to the risks and opportunities that could impact a company’s ability to create value over the long term – and how the company is managing those risks and taking advantage of those opportunities to ensure its long-term economic sustainability.

The starting point for many companies is to develop an ESG Policy setting out the key ESG principles to which the company subscribes. These objectives are refined into key targets and objectives against which the company’s ESG performance is assessed. The most common of these targets is achieving net zero emissions by 2050 but also include objectives and targets covering matters such as resource management, safety incidents and recycling. While companies will seek to meet these targets to their own operations, the overall impact of the product they produce may not meet ESG best practice if their suppliers are not implementing similar ESG measures. It can be particularly frustrating for companies locked into long-term supplier contracts with suppliers that have poor ESG credentials and no incentive to improve.

Often ESG considerations are not key components driving procurement practices, with price and quality being the primary considerations. This results in supplier agreements that do not provide customers with much opportunity to impose ESG standards on the suppliers or contractors or change to suppliers and contractors that comply with a higher ESG standard that is important to the customer. To ensure that your suppliers and contractors meet the ESG considerations that are important to your business, the following principles and practices should be explored prior to and during contract negotiations:

• Term Sheets: Ensure that ESG issues are set out in terms sheets negotiated with suppliers / contractors. The term sheet should set out the standards that the supplier or contractor must meet, the time frame within which the standards must be met and the consequences if the specified targets and objectives are not met.
• Objective and auditable targets: Any targets that are selected with which the supplier or contractor must comply must be possible and measurable. That is, the parties must be able to objectively assess the supplier / contractor’s compliance with agreed targets.
• Reviewing and Reporting: Agreements should include obligations on the supplier / contractors to report on their compliance with the agreed targets at specified intervals. The reports need to include sufficient information so that compliance can be assessed.
• Termination Rights: Agreements should include termination rights that are linked to (i) a failure by the supplier / contractor to comply with the ESG targets; (ii) circumstances where a competitor can provide similar products or services with a better ESG pedigree (and the supplier / contractor cannot match the competitor’s ESG performance); and/or (iii) circumstances where the supplier or contractor is found to be “ESG-washing”.
• Termination penalties: Some agreements contain break fees if the agreement is terminated. These clauses may lock companies into long-term agreements with suppliers or contractors that do not adopt ESG best practices or fail to innovate to improve the ESG pedigree of their goods or services. Break fees should not apply in respect of ESG-performance related agreement termination.
• Liquidated damages: Innovative alternative remedies can be adopted rather than terminating the agreement where a supplier or contractor fails to meet the ESG targets. These may include monetary payments or could even include purchasing carbon credits, contributing to ESG-related charities or planting trees.
• Legacy clauses: Where the company has significant bargaining power, it may consider imposing legacy ESG clauses into its agreements with suppliers and contractors. These clauses require that the supplier and contractors impose similar ESG obligations imposed on its suppliers and contractors.
• Preferential trading terms: Not all conditions in the agreement need to be sanctions. It is possible for companies to offer preferential trading terms (such as better interest rates, increased use of their goods or services or better payment terms) to those suppliers / contractors that meet and exceed the ESG standards.
• Risk-sharing options: During the COVID-19 pandemic, parties relied on force majeure clauses to preserve cash flows to the detriment of the parties with whom they contracted. Parties may seek to exclude certain events from force majeure provisions in favour of an even-handed or “risk-sharing” contractual position. These provisions have positive ESG benefits in that it could help suppliers / contractors stay in business and employees retain their jobs.
• Warranties and indemnities: In some instances, it may be appropriate for suppliers or contractors to warrant a particular situation when it comes to its ESG performance. Failing to comply with the warranty would allow the company to claim damages under the agreement.

The above options can help companies improve their ESG performance and the ESG performance of their supply chain. Excitingly, the above list is not a closed list and there are various ways companies can improve their ESG credentials through their contractual arrangements with suppliers and contractors.

If you would like to explore some of these options in your business, contact Matthew at matt@burnellattorneys.com.