Supply chain must lead the shift from risk mitigation to competitive advantage

The is the final article in a four-part series on creating a balance between meeting the evolving needs of customers and making progress toward meeting ESG goals. You can read part one here, part two here, and part three here.

Every company is on a tightrope between balancing business growth, supply chain resiliency and ESG risks and performance. Balancing ESG issues and the needs of the new customer makes the balancing act even more difficult. The supply chain function is the link between the internal functional silos and the critical suppliers. The challenge is to add enough controls so you can survive falling off the tightrope.

As part of integrating ESG and compliance into operations, many companies are trying to push the supplier compliance and ESG risk management responsibility to their business units. As a result, the supply chain function gets visits from the information security team stressing that suppliers must have sufficient data protection controls in place. The sustainability managers want suppliers to meet labor and environmental regulations and standards. The legal department pushes for suppliers to have sufficient anti-corruption systems in place to meet contractual obligations and legal requirements. Of course, every department thinks their risk area is the most important. Given that the number of companies in a supply chain can run into the tens of thousands, it is a daunting job. Companies must evaluate and prioritize high-risk suppliers and selected risk topics to effectively manage compliance and risk.

Inherent versus residual risk

Forward-thinking companies realize they need to go beyond assessing the inherent risk of suppliers to finding scalable ways to assess the residual risk suppliers pose after factoring in their systems and controls. Inherent risk factors such as location, type of business or level of interaction with the government can’t be easily changed. But every supplier does have the ability to reduce their residual risk by improving the maturity of their management systems. This is true for every compliance and ESG topic. By focusing on residual risk, you can make sure you and your suppliers have added enough controls to reduce the damage from falling off the tightrope.

According to a 2022 study by Deloitte and Manufacturer’s Alliance, companies that prioritize supplier risk management and assess the residual risk of suppliers can achieve a 20% reduction in supply chain disruptions and a 14% decrease in compliance-related issues.

Supply chain management needs to prioritize where to focus their attention by starting to holistically risk-rank suppliers based on the residual risk they pose, and match this against the ESG topics that are most critical to their corporate strategy, ESG goals and stakeholder interests.

There are many tools and sources available to assess the inherent risk a supplier poses. In the case of corruption, you can look at the country and the level of government interaction. For data privacy you can look at the jurisdiction and the data being collected. For labor, you can look at the prevalence of forced labor or use of sub-contractors in that country and industry. The bigger challenge, and an ultimately more effective method, is to review and define the acceptable level of residual risk across the range of ESG topics.

Different risks for different pillars

What is your risk tolerance in the E, S and G pillars and what is your risk tolerance on the topics within each pillar? For example, a technology company may demand suppliers have very low residual risk in information security, whereas an outdoor apparel company may require suppliers to have a very low residual risk in environmental practices.

To do this you must look at the maturity of systems and controls the supplier has in place to manage their inherent risk. A mature compliance program can effectively offset a high inherent risk thus creating a lower residual risk. One multinational company, for example, found that a long-term supplier in China had a lower residual risk than a newly contracted supplier in Norway.

As we discussed in the previous articles, the transition to new business models and the evolving demands of the new customer will require companies to partner with suppliers in new ways to create Constellations of Value. Changes in regulations and public opinion may make certain ESG issues more relevant and important. This will require you to change how you assess and risk-rank suppliers. A supplier that has a mature environmental compliance program may be in the infancy of developing a data privacy program. What did not matter before may suddenly become a critical area of concern.

Related:

Read part 1: Supply chain: The intersection of ESG and the new customer

Read part 2: The supply chain is the hub for creating new constellations of value

Read part 3: Unlocking competitive advantage through strategic data sharing

Given the demands the new customer, the sweeping range of ESG topics and the complexity of supply chains, every company must prioritize. Every company needs to make a conscious decision about which topics are most important in the E, S and G pillar to their corporate strategy. This will help companies determine where to excel to gain a competitive advantage and where to be content with effective risk mitigation. This is only possible if supply chain leaders evolve to using more effective and scalable ways to assess the residual risk of suppliers and work with critical suppliers to reduce the residual risk to a mutually acceptable level. This will require trusted relationships with key suppliers where strategic data sharing takes place and applies to every type of company involved in producing and delivering your products and services.

Balancing ESG pillars

The other critical component in turning ESG into a competitive advantage is selecting the right topics for your company to focus on in the E, S and G pillars. ESG is not one big thing. It is a number of discreet but linked issues under the ESG umbrella.

In the E pillar, there is currently a groundswell around carbon reduction. Similarly, in the S pillar, DEI is grabbing a great deal of attention. These are both clearly important topics that need attention. However, some credit card and smartphone companies are promoting data privacy as a core product benefit. Some outdoor apparel companies are promoting responsible supply chain practices around environment and human rights.

Supply chain must be an essential partner in shaping and meeting ESG goals and gaining a competitive advantage for the firm. New customers – both B2C and B2B – are increasingly integrating ESG considerations into their purchasing decisions. But be aware that not all customers care to the same degree. You need to make decisions that balance the traditional supply chain concerns of having the right product at the right place at the right time with the new ESG considerations. There may be trade-offs between product cost and labor conditions or between delivery speed and carbon emissions. The intersection of business models to meet the needs of the new customer and the increased focus on ESG requires the supply chain function to be at the center of cross-functional teams and at the hub of external Constellations of Value. Supply chain leaders must play a critical role in setting the right ESG goals for your organization and in engaging suppliers to share strategic data and commit to collaborative improvements. It’s not easy, but those that excel will turn ESG into a competitive advantage and become sustainable industry leaders.

About the authors:

Craig Moss is executive vice president of Ethisphere and director of the Digital Supply Chain Institute David Kurz is senior fellow at the Digital Supply Chain Institute and associate clinical professor at Drexel University

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