Two secrets concerning a value chain approach to corporate climate change risk-management

By Roel Nieuwenkamp, Chair of the OECD Working Party on Business and Human Rights (@nieuwenkamp_csr)

This article was originally published by OECD Insights, November 29, 2015

This coming week the world’s leaders will gather in Paris to discuss approaches to addressing climate change, kicking off the 21st annual meeting of countries which want to take action for the climate, otherwise known as COP 21.

A well-hidden secret is that under the OECD Guidelines for Multinational Enterprises (‘the Guidelines’) businesses are expected to do their due diligence on environmental impacts such as climate impacts. This concerns not only their own negative environmental impacts, but also the impacts in their value chain. Another – less well-kept – secret is that the OECD Guidelines include a unique grievance mechanism known as National Contact Points (NCPs) that could also be utilized for climate-related grievances concerning multinational enterprises.

The Guidelines expect companies to behave responsibly through making a positive contribution to economic, environmental and social progress with a view to achieving sustainable development. Besides, the 46 adhering governments expect companies to avoid causing or contributing to negative environmental impacts. In addition the Guidelines expect companies to seek to prevent or mitigate adverse climate impacts directly linked to their operations, products or services by a business relationship. To achieve this, businesses are called upon to carry out due diligence throughout their value chains to identify, prevent, mitigate adverse impacts and account for how they are addressed.

Due diligence, importantly, applies not only to actual impacts but also to risks of impacts. This is particularly relevant in the context of greenhouse emissions as the extent of climate impacts and what they will mean for a company’s bottom line are as of yet not precisely known.

The Guidelines also include a specific chapter on environment which outlines recommendations for responsible business behaviour in this context. For example businesses are encouraged to continually seek to improve corporate environmental performance at the level of the enterprise and, where appropriate, of its supply chain, by encouraging such activities as: development and provision of products or services that reduce greenhouse gas emissions; providing accurate information on greenhouse gas emissions and exploring and assessing ways of improving the environmental performance of the enterprise over the longer term, for instance by developing strategies for emission reduction. Furthermore, the disclosure chapter of the Guidelines also encourages social, environmental and risk reporting, particularly in the case of greenhouse gas emissions, as the scope of their monitoring is expanding to cover direct and indirect, current and future, corporate and product emissions.

These expectations suggest that enterprises should not only be concerned with their direct emissions and impacts on climate change, but that they should also be aware of their carbon footprint throughout their supply chains and that their due diligence efforts should be targeted accordingly. A value chain approach is particularly important in the context of climate change issues as often the majority of emissions will be generated throughout supply chains rather than direct emissions. For example, Kraft Foods, one of the world’s largest food and beverage conglomerates, found that value chain emissions comprise more than 90 percent of the company’s total emissions.

However the supply chain approach has yet to be mainstreamed in the field of corporate emissions management. For example a recent OECD report, Climate change disclosure in G20 countries: Stocktaking of corporate reporting schemes, found that most of the mandatory corporate emissions reporting schemes among G20 countries only require companies to report on direct greenhouse gas emissions produced within national boundaries, whereas significant volumes of emissions are often produced lower down on a company’s supply chain, and often in jurisdictions where that do not have reporting requirements. Likewise a survey conducted by CDP and Accenture in 2013 found that only 36% of 2,868 companies responding report emissions throughout their value chains (known as Scope 3 emissions) and only about 11% set either absolute or intensity Scope 3 targets.

Identifying risks is a primary element of due diligence and therefore the limited amount of supply chain reporting in this context is worrisome and suggests that currently companies are not collecting the information they need to effectively prevent and mitigate risks.

This is problematic not only with respect to the expectations of business to act responsibly but also because increasingly investors are seeing fossil fuel dependence as a systemic risk. For example, the CDP reports that currently 822 institutional investors request climate change disclosure from investee companies. Assets managed by these investors comprise up to a third of all global financial assets. However, this demand had not been reflected in generation of useful information. Research on the top 500 global asset owners found that only 7% of them are able to calculate their emissions, only 1.4% have reduced their carbon intensity since 2014, and none of them has yet calculated its portfolio-wide fossil fuel reserves exposure.

As of yet climate change due diligence has not been considered by the NCP network. However as corporate responsibility to mitigate against climate impacts becomes increasingly prominent, continued industry inaction could lead to a complaint being brought on this subject.

The upcoming two weeks will bring thousands of participants together to brainstorm solutions to perhaps the greatest global crisis facing us today. We hope that the event will prove to be historic and that the implications of corporate value chain approaches and due diligence will be adequately considered.

Useful links

OECD COP21

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Can Companies Really Do Well By Doing Good? The Business Case for Corporate Responsibility

By Prof. Dr. Roel Nieuwenkamp, Chair of the OECD Working Party on Responsible Business Conduct (@nieuwenkamp_csr). This article was original published on OECD Insights, November 2, 2015.

A recent study involving a survey of over 1000 CEOs found that 93% of them believe that sustainability will be important for the future success of their business. These views may be based on strong evidence from studies that have contributed to strengthening the link between company performance and “doing the right thing”. However it should not be forgotten that a moral, and in some cases legal expectation towards business to do the right thing exists independently of financial incentives.

Cost and risk reduction

These days the consequences of irresponsible business behaviour can be significant. For example BP’s bill for settlements of state and federal claims for environmental damages and damages to impacted communities for the Deep Water Horizon spill reached nearly USD 54 billion this June. The Volkswagen scandal involving emissions rigging of vehicles contributed to their stock plummeting a third of its value in less than a week and estimated costs associated with recalls as well as penalties that will have to be paid are being reported at USD 35 billion.

A recent study by Vigeo showed that corporate social responsibility (CSR) related sanctions for companies are also quite common. Nearly 20% of companies in a sample of over 2,500 were found to be subject to such sanctions between 2012 and 2013, amounting to penalties upwards of EUR 95.5 billion

Beyond actual legal liabilities poor business conduct can also result in delays and opportunity costs for companies. For example where companies do not adequately communicate and engage with stakeholders it frequently leads to delays in operations, misapplication of staff time, and lost opportunities in instances where companies want to expand operations, renew contracts or otherwise. A study by Harvard found that the costs attributed to delays arising from community conflict can cost a mining project with capital expenditure between USD 3 million and USD 5 billion on average, or USD 20 million per week in NPV (Net Present Value) due to delayed production.

Additionally, reputational costs stemming from poor business conduct increasingly can hurt the bottom line and scare off investors. Today divestment campaigns from companies with poor environmental and social records are a common tool to encourage better behaviour.

Competitive advantage, reputation and legitimacy.

Responsible business practices, in addition to avoiding costs, can help to build a positive corporate culture and image. This in turn can influence the retention of employees, help increase productivity as well as boost brand appeal and thus increase market strength.

In a study of the ‘’100 Best Companies to Work for in America’’, Prof. Edmans of the London School of Business found that those companies generated 2.3-3.8% higher stock returns per year than their peers over a period of 27 years.

More broadly, a cross-sector Harvard Business School study by Prof. Serafeim and others tracked performance of companies over 18 years, found that “high sustainability” companies, those with strong environmental, social and governance (ESG) systems and practices in place, outperformed “low sustainability” companies as measured by stock performance and in real accounting terms. (High sustainability include companies which include a substantial number of environmental and social policies that have been adopted since the early to mid-1990s; Low-Sustainability Companies include comparable firms that have adopted almost none of these policies.)

ESG

Firms with better sustainability performance were also shown to face significantly lower capital constraints. A study by Babson College and IO Sustainability found that CSR practices have the potential to reduce the cost of debt for companies by 40% or more and increase revenue by up to 20%. Likewise a recent meta study by the University of Oxford found that 90% of the studies on cost of capital show that sound sustainability standards lower the cost of capital of companies. Furthermore the study found that 88% of research showed that solid responsible business practices result in better operational performance. And 80% of the studies show that stock price performance is positively influenced by good sustainability practices.

Shared value creation

In a Harvard Business School article Professors Porter and Kramer coined the term ‘’shared value creation,’’ defining it as generation of economic value in a way that also produces value for society by addressing its challenges. A shared value approach reconnects company success with social progress. Firms can create shared value in three ways: (1) by reconceiving products and markets; (2) redefining productivity in the value chain; and (3) building supportive industry clusters at the company’s locations.

Porter & Kramer describe the societal and business benefits of providing products to meet societal needs and serve disadvantaged communities and developing countries. For example, a service developed by Thomson Reuters providing weather and crop pricing information for farmers earning under $2,000 reached subscription by an estimated 2 million farmers and contributed to increasing income in more than 60% of them. In another example Nespresso created shared value by investing in their suppliers, resulting in higher incomes and fewer environmental impacts among coffee growers, while increasing Nespresso’s supply of reliable quality coffee beans.

Delayed recognition of the business case for RBC

While a significant and growing body of empirical evidence is pointing to the fact that responsible business makes good business sense this understanding has yet to be internalized in the mainstream. In the first place information challenges continue to exist because certain benefits of RBC such as strong corporate culture or good will are difficult to isolate and quantify. However there is reason to believe that these data gaps will be overcome as increased information regarding RBC is collected.

Another reason is that intangible assets, whether they be related to RBC or other intangibles in general, are not usually immediately reflected by financial markets as their value is only realized in the long term. In order to make sure these values are recognized in financial markets, and thus adequately prioritized at the level of companies themselves, organizational changes will have to be made.

There is growing evidence that responsible business conduct pays off for business which affirmatively answers the question that companies can indeed do well by doing good. However in order to ensure that responsibility is embedded within corporate DNA, a move towards organizational and incentive structures prioritizing long term growth over short term gains will have to be made.