Supply chain risk and resilience

What's the issue  |  Regulation & frameworks  |  Boardroom questions  |  Board actions

Supply chains are subject to – and are creating – more risk than ever. They may rely on suppliers in countries that are politically unstable or under sanctions, or they may be impacted by pandemic-related or other unexpected disruptions, such as the fire at a semiconductor plant in Japan or the blockage of the Suez Canal by the Ever Given. Downstream suppliers may create environmental, social and governance (ESG) risks and additional risks may arise from new regulations.

The COVID-19 pandemic placed pressures on both the supply and demand sides of supply chains. When demand started to rebound quickly after the first lockdowns, it added an additional strain to already disrupted supply flows. There are continued disruptions on the supply-side due to sporadic shutdowns of parts of the supply chain (especially in East and Southeast Asia), shipping container displacement, labor shortages and a decrease in cargo capacity due to reduced commercial travel. Policy interventions have only had a minor impact because the bottlenecks are compounding, mutually reinforcing and are not confined to any one country.

The reduced supply of commodities due to Russia’s invasion of Ukraine adds new pressures. The Ukraine and Russia are major global exporters of agricultural commodities, fertilizer, barley, wheat, corn and critical (often non-substitutable) minerals, such as platinum-group elements, neon, titanium and nickel. A combination of these factors is compounding a general trend of rising inflation, causing shortages and the hoarding of raw materials. In developing countries, and in the absence of an appropriate action plan, this may lead to humanitarian crises and food scarcity, amongst others. Furthermore, sanctions against Russian oil import and the reduction of gas supplies, have dramatically increased energy prices and even generated shortages in energy supply. Some factories have temporarily shut down production due to shortages or too-high energy costs.

Further risks that should be considered include the potential for increased Tier 2 supplier risk (a Tier 2 supplier is a supplier of your direct – i.e. Tier 1 – supplier), due to the lower visibility over them, as well as the 7.6M Tier 2 supplier relationships with Russian entities globally¹. Intertwined global supply chains will also have spillover effects and inflated demand (in an effort to secure goods) will push prices up even further. In addition, the Asia-Europe land (train) route passes through Russia, Ukraine and Belarus. This might bring prohibitively high risks, causing stranded goods and a switch back to sea transport, which in turn impacts already congested ports and record-high freight rates.

At the same time, there’s a rising trend towards ESG considerations in supply chains, to mitigate and prevent ESG problems in the sourcing, manufacturing and transportation of business goods. In finance, environmental risks are increasingly converging with financial ones, with more and more companies disclosing emissions from suppliers. This is enabled by better tracking and evaluation through the use of new technologies. We’re also seeing Net Zero commitments, new regulation and standardization.

Beyond climate, biodiversity is attracting more attention, as over half of global GDP is either moderately or highly dependent on nature². The Taskforce on Nature-related Financial Disclosures (TNFD) was officially launched in June 2021³ to develop and deliver a transparent and practical framework for organizations to report and act on evolving nature-related risks. Water supply will also become a key factor in supply chain security, as concerns grow over drought, flooding and energy access.

In terms of human rights, the International Labor Organization (ILO) created the Declaration on Fundamental Principles and Rights at Work – but voluntary efforts are ineffective, and there’s growing pressure from European citizens to take action. Regulators and companies are feeling this pressure and know they have to take action sooner, rather than later.

Some companies are not yet addressing the underlying supply chain structural issues, and the problem is being kicked down the road. Other companies are undertaking major projects to address supply chain vulnerabilities and improve their resilience and sustainability. In the near-term, a key role for the board will be to ensure that management is rethinking and reviewing their supply chain risk and resilience and that the topic has a place in strategy discussions.

At the same time, boards need to sharpen their focus on the company’s efforts to manage a broad range of ESG risks in its supply chain, which pose not only significant regulatory and compliance risks, but also critical reputational risks for the company.

EU companies and importers will experience significant impact from the following regulation and political action concerning supply chains, during the coming years:

• German supply Chain Due Diligence Act⁴: While this act will not necessarily have a significant impact on Belgian companies, it’s important to note as it is one of the most prominent new regulations in this area and was a trigger for the EU to submit a similar proposal for all EU companies (see below). The act, which is the first in Germany to establish binding standards for companies with regard to human rights and the environment, will take effect on 1 January 2023. It will apply to companies with a head office or branch office in Germany with more than 3,000 employees for the first year, and with more than 1,000 employees as of 2024.
• EU Corporate Sustainability Due Diligence Directive (CSDDD)⁵: On 23 February 2022, the European Commission published its first proposal of this directive. The proposal introduces due diligence guidelines regarding both environmental aspects, as well as human rights in global supply chains. In that way, this directive is very similar to the German supply Chain Due Diligence Act. However, it goes one step further by increasing the liability of companies outside their own operations. Additionally, the proposal aims to empower victims’ access to legal tools against these infringements. Finally, with this directive, the European Commission strives to avoid fragmentation in due diligence requirements within Europe. The directive would apply to large companies, as of 2025, and to medium companies working in high-risk sectors, as of 2027.
• EU Anti-Deforestation Regulation (EUDR)⁶: Announced on 6 December 2022, the EUDR signals that European supply chains of cocoa, coffee, soy, wood, palm oil, rubber, and cattle need to prepare for closer due diligence. The scope covers the above-mentioned commodities, their derivatives and products made using these commodities. Historically, imports to the EU are one of the biggest drivers of global deforestation (36% for crop products, 25% for livestock products between 1990-2008) and the related greenhouse gas (GHG) emissions. The regulation aims to protect the world’s forests and limit deforestation by requiring importers and exporters of these products to prove that they are deforestation-free. This applies to any company, regardless of whether they are EU-based or not, and for legal and illegal sources of deforestation in Europe and overseas.
• EU Emissions Trading System (ETS)⁷: The EU ETS works on the “'cap and trade" principle. A cap is set on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system. The cap is reduced over time so that total emissions fall. Within the cap, installations buy or receive emissions allowances, which they can trade with one another as needed. The limit on the total number of allowances available ensures their value. After each year, an installation must deliver enough allowances to cover fully its emissions, otherwise heavy fines are imposed. If an installation reduces its emissions, it can keep the spare allowances to cover its future needs or sell them to another installation that is short of allowances. The system operates in trading phases and is now in its fourth trading phase (2021-2030), which was revised in 2018 to ensure emissions reductions support the EU's 2030 emissions reduction target (of -40% relative to 1990 levels) and the EU's contribution to the Paris Agreement.
• Carbon Border Adjustment Mechanism (CBAM)⁸: The CBAM is a climate measure that should prevent the risk of carbon leakage and support the EU's increased goal of climate mitigation, while ensuring WTO compatibility. It will mirror the ETS in the sense that the system is based on the purchase of certificates by importers. The price of the certificates will be calculated depending on the weekly average auction price of EU ETS allowances expressed in euro per ton of CO2 emitted. Importers of the goods will have to, either individually or through a representative, register with national authorities where they can buy CBAM certificates. By ensuring importers pay the same carbon price as domestic producers under the EU ETS, CBAM will ensure equal treatment for products made in the EU and imports from elsewhere and avoid carbon leakage.

For a more complete picture, we have also summarized relevant, earlier regulation and political action concerning supply chains, which remain relevant, but where the future impact may be limited. This includes:

• Non-Financial Reporting Directive (NFRD) & Corporate Sustainability Reporting Directive (CSRD)⁹: The NFRD of 2014 requires large public-interest entities to provide specific information on how they operate and address social and environmental challenges. The CSRD is still under development, but will be broader than the NFRD, applying to listed financial and non-public-interest entities as well as those of a certain size. It will include detailed reporting requirements according to mandatory EU sustainability reporting standards on environmental and social matters, the treatment of employees, respect for human rights, anti-corruption and bribery, as well as diversity on company boards.
• EU Global Human Right Sanctions Regime¹⁰: This is the first EU legal framework, introduced on 17 November 2020, that allows the EU to target individuals, entities and bodies (state and non-state), responsible for, involved in or associated with serious human rights violations and abuses worldwide. The framework includes a diverse set of sanctions, such as travel bans and the freezing of funds.
• European Conflict Minerals Act¹¹: The 2017 regulation was applicable as from 1 January 2021, and aims to ensure that EU companies do not import “conflict minerals” – or those mined through forced labor to fund armed conflict – and only import these minerals and metals from responsible sources.

• Do we have visibility on our risk exposure and do we a clear heatmap of our supply risk? To what extent are we exposed to rising energy prices and/or certain commodities supplies, and do we have alternatives to cope with it? Do we need or can we increase our own energy generation and/or create new sources of supply to cope with those risks?
• Are the company’s various supply chain projects being driven by an overarching vision and strategy?
• Who is leading the effort, connecting critical dots and providing accountability?
• Does management have a clear view of the end-to-end supply chain, including the various tiers and sub-tiers?
• How effective is the company’s supply chain risk management framework and processes?
• Do we have the right level of coordination between the company’s compliance, risk and cybersecurity professionals?
• Are there mitigating plans in place for potential disruptions to the supply chain, for example, if you no longer have access to a certain source of energy, a Tier 2 supplier goes bankrupt, or a (lower tier) supplier is accused of unethical practices? Do you have crisis management plans in place?
• How is management monitoring the supply chain, including mapping, visibility and traceability?

• How robust is management’s process to identify the broad range of ESG risk and vulnerabilities across the supply chain?
• What ESG regulations are being proposed/implemented and how do they impact our operations and supply chain? Are we (or how can we be) optimally prepared for them?
• What supplier development protocols do we have in place, for example supplier codes of conduct, supplier training, supplier audits, third-party verification, supplier benchmarking and collaboration?11
• What steps is the company taking to reduce the environmental impacts of its supply chain, for example carbon offsets, environmental technologies, sustainability standards and certifications and third-party collaboration?12
• How robust are the supply chain-related disclosures that are included in the company’s ESG disclosures and sustainability reports?
• How do these disclosures compare to those of our peers?
• Are our external stakeholders satisfied with the level of transparency?

Help ensure that significant supply chain projects being undertaken by management are carried out effectively, such as:

• Updating supply chain risk and vulnerability assessments;
• Diversifying the supplier base;
• Reexamining supply chain structure and footprint;
• Reducing international dependency and developing more local and regional supply chains;
• Deploying technology to improve supply chain visibility and risk management;
• Improving supply chain cybersecurity to reduce the risk of data breaches and high-profile ransomware attacks; and
• Developing plans to address future supply chain disruptions.

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