ESG investing: How to ensure your portfolio company makes the grade

New and tightening regulations across the U.S. and EU are beginning to require investors to assess the Environmental, Social, and Governance (ESG) risks of their portfolio companies’ business activities and supply chains.

The current draft of the EU Corporate Sustainability Due Diligence Directive (EU CSDDD), which is going through discussions between the EU Council, EU Parliament, and the European Commission, enforces mandatory human rights and environmental due diligence requirements on institutional investors and asset managers. The scope of the Directive may eventually extend to other financial players as well.

The reputational risk that a company suffers when its name makes the headlines can result in a hit to its valuation or impact its customers’ purchasing habits. Moreover, forced labor bans, such as the ones we see in the US, Canada, and Mexico, may lead to profitability risk resulting from detained shipments at Customs. Increasingly, we are also witnessing the possibility of hefty fines (at least 5% of net worldwide turnover for some companies in the European Union) for non-compliance. When viewed collectively, these risks can be hugely disruptive to company leadership and boards who must prioritize managing these crises/issues over executing on day-to-day business strategy.

The supply chain due diligence landscape has shifted from a “nice to have” – with reporting/disclosure previously the main priority – to now requiring a due diligence or compliance plan to be in place. Investors should invest in companies that not only meet legal and regulatory requirements but who actively seek to improve their responsible sourcing programs.
 

How can investors work with their portfolio companies pre- and post-investment to ensure that high ESG standards are met?

Pre-investment due diligence
Conduct a high-level assessment to identify potential ESG risks in your target company’s supply chain.

1. Conduct interviews with company management and review management policies to ensure they are able to identify, manage and mitigate supply chain risk.
2. Identify the company’s exposure to environmental and social risks in the supply chain based on key sourcing products or industries and countries, as well as issues related to specific critical suppliers.
3. Conduct a stress test to evaluate whether the company would be able to provide mandatory disclosures or evidence of its responsible sourcing practices.

Ongoing due diligence during asset management
Undertake a deep dive analysis of a company’s supply chain with a third party and benchmark against industry peers.

Through an in-depth assessment, investors can look out for:

1. More insight and visibility into the portfolio company’s supply chain
   Engage with portfolio companies to better understand who and where they are sourcing from, directly and indirectly. As an example, suppliers in the U.S. may inadvertently be sourcing from high-risk suppliers (through subcontracting or otherwise), such as in the recent child labor findings at 13 meat processing facilities in eight states. Companies who source a large percentage of their products from traditionally high-risk markets will need to have robust programs in order to manage risk accordingly. Investors should note that high-risk markets can include developed markets, such as the U.S., which is now considered a high-risk sourcing country alongside emerging markets (see ELEVATE’s 2023 Supply Chain ESG Risk Ratings Report for more details).

2. Maturity of the responsible sourcing program
   Understand whether the portfolio company has a robust monitoring and assessment program to identify issues in specific factories or farms and support suppliers to improve their management systems. Strong programs should take a data-driven approach to prioritize suppliers based on the inherent risk of a given commodity and geography alongside an analysis of leverage that the companies have with them. Depending on the level of risk, the portfolio company should deploy a range of tools including on-the-ground third-party audits, annual self-assessment questionnaires, anonymous worker voice surveys, grievance mechanisms, etc.

3. Identification of high-risk suppliers
   Identify whether any of the suppliers are potentially linked to sanctions or other controversies relating to labor, health and safety, environment, business ethics, and management systems. It is also critical to understand whether portfolio companies source high-risk components/materials, such as conflict minerals, cotton, aluminum or polysilicon and if so, how this risk is being managed.

4. Proactive supplier engagement
   Investors should assess whether portfolio companies are actively engaging with their most high-risk suppliers to manage risk and support capacity development on social and environmental issues. This can take the form of, for example, digital learnings on forced labor or trainings on workplace discrimination, and environmental waste and pollution, etc. Financial incentives for suppliers that meet or exceed certain sustainability standards should also be considered.

Ongoing engagement with portfolio companies
It is important to continue engaging with management to encourage them to improve their ESG practices. This can include dialogue with the company’s board and management team, as well as participation in shareholder meetings and voting on ESG-related proposals. Investors can also use their influence to encourage companies to adopt more sustainable practices such as eliminating child labor, ensuring acceptable working hours, or reducing deforestation.

By ensuring portfolio companies have robust responsible sourcing policies and programs, supplier partnerships, and insights into emerging and existing risks, investors can manage their own risk exposure and support performance improvement.