Winning with Sustainable Supply Chains

Since their adoption in 2016, Sustainable Development Goals (SDGs) have become a beacon for companies and governments to map and evaluate their performance towards sustainability. Action on several SDGs is required for making supply chains sustainable. These include SDG 8 (decent work and economic growth), SDG 9 (Industry, Innovation and Infrastructure), SDG 12 (Responsible Production and Consumption), SDG 14 and 15 ((Life Below Water and Life on Land); and SDG 17 (Partnerships for the Goals). Given the range of SDGs covered, sustainability improvements in supply chains are crucial for the success of SDGs.

Considerable work had started on making supply chains sustainable. COVID-19 has thrown the spotlight back on supply chains and logistics. February 2020 saw a supply shock as supplies from China were disrupted. This was soon followed by a demand shock as most of the countries around the world went into a lockdown. This has exposed the vulnerabilities in production strategies and supply chain processes. The US, India and some other countries are looking at economic nationalism as a solution. Although Brexit had shown a glimpse of these what is to come, the pandemic has exposed the fault lines.

Most of the procurement and supply chain activities are centred around cost savings. This means obtaining supplies at the lowest cost possible. Post COVID-19 this is likely to change with risk of supply being factored into the cost.

Corporate supply chains have been opaque for a long time. This is now changing with greater focus coming on traceability. Coupled with companies becoming more transparent, supply chains are getting the right attention.

So, what is traceability? Traceability is the ability to verify the history and location of products and services in the supply chain. This involves building supply chains that are transparent and providing an easy way to assess where contamination is occurring. Traceability improves product sourcing, reduces costs and ensures a healthy output.

This is not new. For instance, companies have been tracking agricultural commodities and forest products for years. With growth in technology, newer tools and techniques such as sensors and data analytics, are enabling companies to more easily and affordably account for the environmental and social impacts of their materials and products. Thus traceability permeates right from farms, forests and mines to individual factories.

The growth of third-party verification is another factor. Professionals are now readily available to verify the provenance of products and raw materials. This makes it very difficult for companies to escape by feigning ignorance.

Worldwide, many food and beverage companies are partnering with their growers and other agricultural partners to push for sustainable business practices.

An uncertain present, roadmaps to action

The outcome of the Paris Accord (COP21) has extensive ramifications for both manufacturing and supply chains as India needs achieve its nationally determined emission cuts of 33-35% . This has been accentuated by the pandemic. Given the rather low key performance of Indian companies on the supply chain front there is an urgent need for action.

The long term objective would be to develop closed loop supply chains. Closed loop supply chains are designed to and managed to explicitly consider the reverse and forward supply chain activities over the entire life cycle of the product. This involves:

– Product returns management including reverse logistics

– Repair, remanufacture and recycle

– Remaking and reuse

Achieving closed loop systems is not exactly easy. It may take several years to achieve it and some industries may never really manage it .However, some immediate steps could include:

This requires that companies choose the most environmentally responsible suppliers. This also implies that existing suppliers be trained into becoming environmentally responsible.

Many companies engage their suppliers in the greening process. Companies can collaborate with their suppliers to come up with environmental guidelines and innovative approaches to combat environmental challenges.

Shocks come in many forms — climatic catastrophes, hydrologic catastrophes, meteorological events, and, geophysical events. To this biological crisis needs to be added. This will require companies to quickly rejig their supply chain and logistics so that right materials are available at the right time. This involves uncovering and addressing the hidden risks, identifying the vulnerabilities, diversifying the supply base, and holding intermediate or safety stocks.

To maintain their competitive edge and help achieve SDG goals, nationally and globally, companies will have to rethink their approach towards  supply chains.

The World is Changing

COVID-19, the coronavirus pandemic, is seen as an event of the century. Some call it a black swan event. Its impact is felt across all countries and all sectors of business. The pandemic is reshaping the world.

The first impact was felt on supply chains with supplies from China drying up. Slowly bottlenecks from other countries started showing up. Until COVID-19 showed up, most of the procurement activities are centred around cost savings. The mantra appeared to be “buy from wherever the materials are cheapest, subject to quality parameters.” Post COVID-19 this is likely to change with risk of supply disruption being factored into the cost. At the same time, many companies and countries are considering near-sourcing or planning to become self-sufficient. This is likely to have a profound impact on supply chains. This rejigging of supply chains gives companies an opportunity to build green or sustainable supply chains.

The pandemic has also thrown the focus on ESG (environmental, social, and, governance) based investments. Investors are increasingly investing in ESG funds, and the volumes of these funds have skyrocketed. It has been shown that companies that rank high on ESG provide higher returns and tend to have a lower cost of capital. The key factor hampering the growth of ESG investments was the lack of clarity and standardisation of what the ESG factors are. With the EU coming out with the taxonomy for ESG, there will be greater clarity in measuring ESG and ESG investments will get a boost.

The focus on ESG has grown due to two events. Larry Fink, the CEO of BlackRock, wrote a letter to CEOs encouraging them to move towards stakeholder capitalism. The Business Roundtable saw 200 CEOs of the largest companies come together and sign up for their stakeholders. The momentum has grown as customers have become more informed and have started actively looking for sustainable products and companies that treat their stakeholders well.

During the lockdown, people across the world experience clear skies and fresh air – something they had never experienced in their lifetime. With vehicles off the road, pollution levels dropped hugely. This experience is likely to have a profound impact on the way people are going to think about their commuting preferences. This is an opportune moment for a policy shift towards sustainable transportation. There are massive efforts on for cleaner mobility solutions. The trajectory of the shift to sustainable transport will become steeper than what was anticipated earlier. Dealerships are now seeing enquiries for electric vehicles, and the trend is only likely to grow. With the right policy initiatives, fiscal benefits, joint production and R&D efforts by automakers sustainable mobility will take off

The pandemic has exposed chinks in healthcare systems across the world. Even the developed nations have been found wanting in the availability of beds and doctors. At the same time, the focus has shifted to telemedicine and remote healthcare.  This is a positive development for people in remote areas and the poor to access basic healthcare. At the same time, governments and healthcare industry will be spurred to broaden the base of the hospital network. People are also becoming more health-conscious and focussing on remaining fit. Many indigenous immunity boosters (haldi doodh, soonth goli, kabasura kudineer, etc.) have become part of daily ritual furthering the local industry. People are also realising importance of quality fruits and vegetables. Both the growth in immunity boosters and need for high-quality produce is likely to spur sustainable farming — reducing reliance on water usage and pesticides.

Providing quality education has been a massive problem for all developing countries. Large resources are required for providing school infrastructure and training of quality schoolteachers. The pandemic has shown how this can be bridged by online education and remote education through television shows. It is now proven that high-quality education can be provided at scale. Schools and technology providers are finding many configurations through education can be provided.  This will significantly aid in the achievement of SDG of quality education.

Workplaces are also transforming. Work from home has become a reality. While many companies are shutting offices, many like Reed Hastings want their staff back in offices. Among employees, the opinion is divided as well. At the same time, companies are realising the potential gains from digitization and automation. Slated bring significant efficiency to operations it is likely to have an adverse effect on employment with countries with large unemployment levels bearing the brunt.

Sustainable Development Goals (SDGs) set out in 2015 are a call to nations to end poverty, protect the planet and ensure that all people enjoy peace and prosperity by 2030. The 17 goals and integrated and balance environmental, social and economic sustainability.  Changes that we are seeing have a direct bearing on achieving sustainable development goals. Along with Namrata Rana, I study these and several other issues in our study Responsible Business Rankings 2020.

The world is changing, and companies and governments will need to adjust their strategies to cope with the change. Many of these changes seemed distant a few months back. These are now a reality.

The New ESG World: Role of the CFO

Stakeholder capitalism is taking roots. This implies looking at the impact of a company’s actions on all its stakeholders rather than just aiming to maximise shareholder returns. At the same time, there is an increasing focus on environmental, social and governance (ESG) issues. Customers and investors are increasingly looking at a company’s performance on ESG parameters before undertaking purchasing or investing decisions. Both these shifts will necessitate the CFO to operate differently. From having the central responsibility for delivering financial results to shareholders, the CFO will have to co-opt the COO, CMO, CIO, and the CEO to help her figure out the ESG issues that impact financial performance.

The CFO of tomorrow will need to have an integrated view of the company. Thus, she will have to look at performance across the company’s operations, talent, and, supply chains. Integrated thinking will ensure that not only the company sees gaps in all areas of the organisation on both ESG and functional parameters but starts taking steps to improve performance. Beyond identifying, improving and measuring performance, the CFO will have to rethink reporting. Integrated reporting (IR) that puts together strategic, financial and ESG performance of the company will become more commonplace. CFOs will have to relearn how they measure and report performance.

CFOs will also gradually realise that focus on share price, and EPS are not enough. The financial statements need to be retooled. The balance sheet and profit and loss statements need to capture economic, social and governance (ESG) elements. Take the case of emissions. Although difficult to measure the potential harm due to emissions can be captured on the balance sheet as an expense. Similarly, estimates of lack of diversity will appear on the income statement as an expense. These measurements are like those used for valuing externalities. Essentially, there is a need for a framework that generates an “ESG” EPS.

There is a slew of new financing mechanisms that are now available to help CFO raise funds for her company’s ESG actions. Green bonds, sustainability linked bonds, impact bonds, sustainable development bonds etc. dot the financing skyline. These financing sources will help the CFO transform the company from brown to green.

The CFO has traditionally relied on her in-depth knowledge of accounting standards. Newer standards are regulations have come up – TCFD (Taskforce on Climate-related Financial Disclosures), SASB (Sustainability Accounting Standards Board), Integrated reporting, Business Responsibility Reporting, GRI reporting, etc. Keeping track and building knowledge on these standards and guidelines will be a daunting task for the CFO.

At the end of the day, the CFO will need to ask herself:

  • How can my leadership and I build a perspective and shared understanding of the fundamental purpose of the business beyond profits?
  • How do I evaluate projects and proposal beyond maximising value and incorporating ESG concerns?
  • How do I rank and evaluate investments that provide long-term value with responsibility?
  • How do I keep abreast with ESG rankings and frameworks? How do I choose the one that works best for my company and me?
  • How do I communicate my approach to stakeholders through communication and engagement?
  • What internal and external reporting practices do I develop that ties up both finance and purpose?
  • Like everyone on else what new skills and abilities do I develop to function in the ESG centric world?

Photo credit: Photo by JESHOOTS.COM on Unsplash

THE NUTS AND BOLTS OF SOCIAL RETURN ON INVESTMENT

The concept of Social Return on Investment (SROI) emerged from the work done by the Roberts Enterprise Development Foundation (REDF). Originally intended for large social enterprises, over time it has been fine-tuned to meet the requirements of various types of organisations. SROI is an outcomes-based measurement tool that helps organisations to understand and quantify the social, environmental and economic value they are creating. In effect, SROI captures the triple bottom-line of people, profits and planet.

Every business needs to periodically measure its performance. One of the ways of measuring the company’s performance is the accounting rate of return.  This is simply the profits that the company has earned divided by the investment that it made in the business. Companies are also impacted by externalities – things that take place outside its factories. These externalities are not captured in the accounting rate of return.

Externalities are best understood by examples. For example, if the factory’s chimney releases smoke it has harmful consequences on the people and farms nearby. This is beneficial and is called negative externality. On the other hand, if the company builds a road to its factory then it makes it easier for people in nearby areas to commute. This is positive externality.  Every social and sustainability action of a company will have an impact in terms of externalities. To measure the performance of a company’s social and sustainable actions we use the metric – social return on investment or SROI as it is popularly called.

In practice, there are two ways of calculating SROI depending on the level of measurement. When the measurement is undertaken at the company’s level, it is based on both social and economic benefits and considers economic as well as social investments. On the other hand, when the measurement is undertaken at the project level it is simpler to look at only social costs and benefits and relate them to social investments.

Thus, the company level measurement is defined as:

where social profit is social benefits less social costs.

And, the project level measurement is defined as:

THE PRINCIPLES OF SROI

There are seven principles of SROI that support the application of SROI. These are:

Involve stakeholders: Stakeholders are the ones who are most impacted by the change being brought about. They should be informed and identified and involved during the entire process.

Understand what changes: There are two types of outcomes of any change process—intended outcomes and unintended outcomes. It is necessary to have sufficient proof of the changes that have been brought about.

Value the things that matter: Value all things that matter. Where direct measures are unavailable, suitable proxies should be used.

Only include what is material: Materiality requires an assessment of the criticality of that piece of information to the decision at hand. If this is information is excluded would the decision-maker make a different decision? 

Do not over-claim: Only that portion of benefits should be claimed that the organisation is responsible for creating.

Be transparent: All inputs and outcomes must be documented and made available to the stakeholders.

Verify the result: The results of SROI should be vetted by an independent assurance agency for it to be credible.

THE SROI MEASUREMENT PROCESS

Unless one follows a systematic process to arrive at SROI, the outcome is unlikely to be credible and reliable. The following steps are recommended for arriving at a credible and reliable SROI.

Step 1 – Map the stakeholders: It is important to establish the boundaries of the SROI measurement. First, one needs to figure out the outcomes of social intervention. Second to figure out who the stakeholders of the social project are. It may be worthwhile to list the stakeholders. Finally, one needs to understand how to involve the stakeholders in the project.

This is undertaken by means of impact maps. To understand an impact map, let us take the example of a company constructing a farm pond. The farm pond provides benefits to agriculture, humans, and animals. For agriculture, benefits may be in terms of increased yields and/or more crops in a year. For humans, more water is available for drinking. bathing and cooking. Milch animals may yield more milk. Although there may be lots of benefits, most of them will add little value to the impact. These need not be considered. As the accountants will tell you these fail the materiality test. Once the benefits are identified these need to be converted to monetary terms.

One of the interesting things about outcomes is that they often depend on circumstances. For example, a water project in an arid area is more valuable than one where water is relatively easily available.

Step 3 – Evidencing the outcomes and giving them a value: Step 2 provided a qualitative measure of the outcome of the social project. However, it is also important to put a monetary value to the outcome. This involves (i) developing outcome indicators; (ii) collecting outcomes data; (iii) establishing how long outcomes last; and (iv) putting a value on the outcome.

Step 4: – Establishing the impact: The outcomes that we measure should be auditable. Hence it is essential that outcomes are not over claimed. Also, we need to figure out how much of the impact is because of one’s own activity and how much of it would have taken place anyway or how much of the outcome would have occurred without our intervention and how long will the benefits last. This requires measurement of three key metrics:

Deadweight is a measure of the amount of outcome that would have happened even if the activity had not taken place. It is calculated as a percentage.

Attribution is an assessment of how much of the outcome was caused by the contribution of other organisation’s or people.

Drop-off is used to account for how the outcomes, in future, are likely to be less than current measurements. It is only calculated for outcomes that last more than one year

Step 5 – Calculating the return: Now all the inputs and outputs have been measured, SROI can be calculated using formula listed in the section Social Return on Investment.

Step 6 – Conducting a sensitivity analysis: Relying on a single SROI number can be dangerous. Many assumptions are made while computing SROI. Hence it makes sense to test the robustness of SROI to these assumptions.

ADVANTAGES AND DISADVANTAGES OF SROI

Like any measurement SROI also has its advantages and disadvantages. All the advantages and disadvantages of economic ROI apply to SROI as well and some more.

Advantages

  1. It is simple and easy to calculate. Requires only two pieces of information—profits and investment—numbers that are already available in financial statements.
  2. It measures profitability by scaling social profits to the investment made. Thus, companies are comparable on SROI.

Disadvantages

  1. SROI measurement is impacted by the point of time when the measurement is undertaken. Thus, in a multi-year project, SROI could be different in each of the years. This causes confusion.
  2. Profit (the numerator) is impacted by accounting choices. Different depreciation policies could lead to different profit numbers even though there is no change in the underlying business.
  3. Measuring social costs and benefits often requires measuring shadow prices—making it complicated to apply in practice. For example, where water is conserved in a water-scarce area, the value of water conservation depends upon the extent of water scarcity. Higher the water scarcity, higher would be the value of water.
  4. Measurement of deadweight, attribution and drop off poses significant challenges as there are no direct measures. Estimates must be made based on prevailing local conditions. Such measurement errors could have a significant impact on SROI.

References

SROI Network, ‘A Guide to Social Return on Investment’, London: Cabinet Office, 2012

Photo Credit: Photo by Leon Dewiwje on Unsplash

The Future of Sustainable Finance

Sustainability is about leaving the earth for our children in the same way as we got it from our parents. Not only have we not retained the earth as we got it, we’ve made it worse. Hence, a lot of work needs to be done to turn the clock back. 

There are five gigatrends that are defining the world today:

Climate crisis: Or weather cycles are changing. We have experienced hotter summers, colder winters, heavier rains in parts and droughts in others. There have also been unusual fires and hurricanes. 

Circular economy: The circular economy is premised on returning to the earth what we take from it. It also aims to reduce the amount of waste that is generated. Corporations around the world have taken initiatives to become circular.

Sustainable transport: Transportation is a major source of pollution. It also uses fossil fuels extensively. To mitigate both concerns sustainable transportation which can be either mechanical (bicycles) or operated with renewable energy (electric vehicles) have become prominent. 

Plastic waste: Plastic was once seen as a wonder material. However, plastic does not degenerate easily and, so, lies in our landfills and oceans causing enormous harm to communities and aquatic life. 

Renewable energy: Fossil fuel supplies are finite and likely to last only a few more generations. They are also polluting. Hence, the world is shifting to renewable energy.

For each of these governments and corporations require large sums of money. So, where does this money come from?

Sustainable finance developed to bridge the gap in funding. Investors who are sustainability conscious and have surplus funds need to reach governments and corporations that are short of funds. Sustainable finance comes in many shapes.

On the financing side are the green bonds that are tied to sustainable actions by companies. Thus, if a company needs to invest in a effluent treatment plant it will fund the financing need by issuing green bonds.

Then there is sustainability linked bonds that pay interest based on performance achieved. Thus, a company that aims to reduce its CO2 emission will set up annual targets that need to be achieved and the interest on the loan will be tied to the achievement of these goals.

Transition bonds help companies move from “brown” to “green.” A coal-based or gas-based power plant shifting to solar power can utilise the transition bonds.

Social impact bonds are raised for social causes and like sustainability linked bonds are a pay-for-performance security. Thus, if a government or an NGO is trying to reduce maternal mortality rates in a particular region, then they can utilise these funds and interest is charged based on targets of maternal mortality declines.

On the investing side, the most popular approach is exclusionary screening. Here banks and fund houses stop investing in companies that are involved businesses like oil, tobacco, and, gambling. This is the most common approach to investing.

Then there is active ownership. Here investors are actively involved in a company’s actions through shareholder activism. This involves attending board and shareholder meetings to ensure that companies act sustainably. 

Finally, we have ESG integration where ESG factors are closely looked at before a decision to invest is made. Thus, a bank may rate a company on the environmental, social and governance parameters and based on the outcome make investment decisions.

Sustainable finance has been on the rise in the recent past with ESG investing being at centre stage.

Covid-19 has led to a change in thinking about sustainability. Many see this as a black swan event a term popularised by Nassim Nicholas Taleb. A black swan event is typically seen as having negative consequences for the economy. John Elkington, on the other hand, sees this as a green swan event. He believes that this is likely to bring about exponential progress in the form of economic, social, and environmental wealth creation.

Currently, economies are in disorder and fragile. The Post-Covid economy will be more than resilient. It is, in fact, likely to antifragile. A resilient system is unaffected by disorder whereas an antifragile system benefits from disorder.

Another key trend is that businesses will be closely looking at stakeholder capitalism. The recent pronouncements of Larry Fink and the announcement of top 200 CEOs through Business Roundtable have helped create a momentum for stakeholder capitalism.

So, what holds for sustainable finance?

  1. Transition finance will help shape the economic recovery. 
  2. Industries are increasingly championing sustainability. Sustainable finance will have to meet the significant scale up in investments by companies to meet their sustainability needs.
  3. Companies are increasingly creating zero-carbon roadmaps for themselves leading to spurt in demand for sustainable finance.
  4. Stakeholder capitalism will become more dominant and there will be increased scrutiny of a company’s actions.
  5. With the development of European union’s taxonomy for ESG investing, ESG investing is likely to get a leg up.

At the same time there will be several roadblocks too. 

Banks will be increasingly risk averse leading to significant focus on exclusionary screening. They will also worry about stranded assets and the ability of companies to repay their debts. 

Large companies tend do well on ESG as they have relatively easy access to funding. Mid- and small-tier companies will need significant support to be ESG focussed.

While measuring ESG, environmental actions of companies easily measured. Measuring social and governance actions, on the other hand, are difficult and complex. This is marred by the fact that there is a multiplicity of reporting documents that, at times, conflict with each other.

The world of sustainable finance is at an important junction and its trajectory is likely to be steep.