Integrating Environmental, Social, and Governance (ESG) Factors in Procurement

Two-thirds of the average company’s environmental, social, and governance footprint lies with suppliers. Procurement leaders who take bold action can make a decisive difference in sustainability.

McKinsey Report

Who says a solid environmental, social, and governance (ESG) proposition cannot create value for companies and their shareholders? Not Milton Friedman. “It may well be in the long-run interest of a corporation,” the economist wrote a half-century ago, “to devote resources to providing amenities to [its] community or to improving its government. That may make it easier to attract desirable employees; it may reduce the wage bill … or have other worthwhile effects.”

ESG in procurement refers to considering Environmental, Social, and Governance factors in purchasing decisions.
These guidelines or principles help businesses assess their sustainability and impact, specifically regarding their procurement and sourcing practices.

Understanding ESG

• The E in ESG, environmental criteria, consider the energy your company uses, the waste it discharges, the resources needed, and the impact on living beings. Notably, E includes carbon emissions and climate change. Every company utilizes energy and resources; every company affects and is affected by the environment.
• S, social criteria, focuses on your company’s relationships and reputation with people and institutions in the communities where you operate. S includes labor relations and diversity and inclusion. Every company operates within a broader, diverse society.
• G, governance, refers to the internal practices, controls, and procedures your company employs to govern itself, make effective decisions, comply with the law, and meet external stakeholders’ needs. Every company, a legal creation itself, requires governance.

Just as ESG is an integral part of business operations, its elements are interconnected. For instance, social criteria overlap with environmental criteria and governance when companies strive to comply with environmental laws and broader sustainability concerns.
Usually, the focus is primarily on environmental and social criteria, but governance must be integrated. Excelling in governance requires understanding laws’ letter and spirit—proactively avoiding violations and ensuring transparency and dialogue with regulators instead of merely submitting a report.

Importance of ESG

ESG-oriented investing has seen a significant increase. Global sustainable investment reached $30 trillion in 2019—up 68% since 2014 and tenfold since 2004.

This acceleration has been driven by increased social, governmental, and consumer attention to corporations’ broader impact. Investors and executives recognize that a strong ESG proposition can secure a company’s long-term success. The magnitude of investment flow suggests that ESG is more than a passing trend.

Business performance also supports this. Accumulated research shows that companies attentive to environmental, social, and governance concerns do not experience a drag on value creation—quite the opposite. A strong ESG proposition correlates with higher equity returns and a reduction in downside risk.

Improved focus on ESG enhances equity returns
Integrating ESG considerations into procurement processes can foster sustainability, minimize risks, and increase supply chain transparency. Organizations can use ESG criteria to select suppliers who operate responsibly, reduce their carbon footprint, and adhere to ethical business practices. This approach can reduce the organization’s exposure to reputational, regulatory, and legal risks while promoting sustainability and responsible supply chain practices.

Furthermore, integrating ESG considerations into procurement can align an organization’s values and goals with its purchasing decisions, fostering a positive brand image and competitive advantage.

ESG-optimized procurement not only meets the increasing demands of stakeholders concerned about sustainability and social responsibility but also paves the way for significant growth and success. By incorporating ESG considerations in procurement, organizations can reap multiple benefits, not just for themselves but also for the environment and society at large.

Relation between ESG and procurement

Companies have several reasons to focus on environmental, social, and governance (ESG) issues. They may aim to satisfy consumers, who increasingly prefer brands with strong ESG credentials, even at higher prices. Others seek to stay ahead of stringent regulations, react to pressure from banks and investors, improve employee engagement, or attract and retain talent. For most organizations, the motivation is a combination of these factors, indicating a need to understand and manage environmental impact throughout the business—in real time.

Top ESG performers experience faster growth and higher valuations than their sector counterparts, by a margin of 10-20% in each case. Strong ESG credentials reduce costs by 5-10% as these companies focus on operational efficiency and waste reduction. Additionally, ESG excellence reduces transition risk by helping companies stay ahead of changes in regulation and stakeholder sentiment. These financial benefits, coupled with the positive environmental and social impacts, make ESG integration in procurement a strategic business decision.

ESG leadership begins at home, but it can’t stay there. That’s where procurement’s role becomes so critical. Many companies are already running highly successful initiatives to optimize resource consumption within their operations or engage with their local communities, for example, but the environmental and social footprint of a business extends far beyond its own walls. For most products, 80 to 90 percent of greenhouse-gas emissions are “Scope 3”: indirect emissions that occur across the company’s value chain, such as embedded emissions in purchased goods and services, employee travel and commuting, and the use and end-of-life treatment of sold products. Of these emissions, two-thirds are usually from the upstream supply chain, as per a McKinsey Report. Tier-n suppliers are also more challenging to monitor, increasing the risk that poor environmental or labor practices go unnoticed.

Procurement’s Role in ESG Footprint

As the primary interface with the upstream supply chain, the procurement function, led by procurement leaders, holds a decisive role in shaping an organization’s ESG footprint. This influence is not just direct through purchase decisions but also indirect by influencing product design.

While it’s clear that chief procurement officers (CPOs) understand the significance of ESG, many companies may need assistance in translating this understanding into a clear vision or sustainability strategy for the procurement function. However, with the right tools, skills, and data, integrating ESG into procurement is not only feasible but also a strategic imperative.

When asked why ESG wasn’t built into their sourcing DNA, most reported a lack of necessary tools, skills, and data. 70% reported that they didn’t understand where their Scope 3 emissions came from. While 90% struggled with identifying the right actions, and 75% didn’t know what ESG targets to set.

While it is accepted that significant work is required in the industry, McKinsey believes that many organizations already have the foundations – especially those with mature procurement capabilities – to create the sustainable procurement that organizations need. Most organizations also have rich upstream value chain data showing how much a company buys, where it comes from, and who makes it. A procurement organization can build on these foundations by taking a holistic approach to the development of new ESG-focused data, processes, and capabilities, says McKinsey.

Integrating ESG into Procurement

Significant work is required to create the sustainable procurement organizations they need. However, many organizations, especially those with mature procurement capabilities, already have robust foundations in place, with rich data on the upstream value chain. They know precisely how much a company buys, where it comes from, and who makes it.
A procurement organization can build on these foundations by taking a holistic approach to the development of new ESG-focused data, processes, and capabilities. Such an approach would involve three basic steps, which together make sustainability (and ESG as a whole) simply part of the way the company does business, starting with what it procures and ending with what it sells and how it supports its customers.

The process of integrating ESG in procurement can be broken down into 3 basic steps:

How Good Can You Be?

You can’t start a journey unless you know where you are, and where you want to go. For procurement organizations, there are several ways to address these fundamental questions. To understand the ESG footprint of the supply base, companies can take an internal approach, asking suppliers to provide detailed information on their own ESG impact, both overall and by category. Alternatively, you can use the external data sources offered by specialist ESG analysis and rating companies. Such analyses will inevitably be incomplete, but a top-down evaluation of the supplier base helps procurement organizations take the lead in identifying the most significant risks and improvement opportunities in the upstream value chain.

Using data and analytics, companies are also building upon and evolving practices already used by high-maturity procurement and product development organizations, employing new approaches to look at the impact of their products and services. For example, procurement experts have long been familiar with cleansheet analysis of component and raw-materials costs. “Resource cleansheets” build on that foundation, creating a granular assessment of both monetary cost and carbon footprint for every component and manufacturing step involved in building a product. Over time, this approach generates a common language that the engineering and sustainability organization can use to quantify and evaluate materials and technology for their cost and emissions trade-offs.

How Do You Get There?

Once procurement leaders understand the ESG footprint of their organization’s value chain, they can begin to implement new practices that seek to address risks and capture value-creation opportunities. Many of these procurement practices can be integrated into the organization’s standard sourcing and supplier-management processes.

Including “sustainability as standard” in procurement processes is an effective way to reduce ESG-related risks and spot opportunities for incremental improvements. It can also help to ensure that procurement teams and their internal customers are aware of the environmental and social impact of purchasing decisions. Where an organization has ambitions to make meaningful changes to its ESG footprint, however, it needs to go beyond the best currently available choices. That requires innovation: sourcing different materials or different manufacturing processes, and collaborating with suppliers in new ways.

Leading procurement organizations are achieving giant leaps in sustainability by focusing time and effort on targeted value-creation initiatives. Often beginning with small pilot projects, these initiatives allow teams to explore all of the available options, develop and test new approaches, find out which ones matter most, and then apply them at scale across the entire enterprise and its supply chain—to lasting impact.

Consider carbon emissions as part of the RFx process, weighing suppliers according to carbon intensity and their impact on the company’s Scope 3 emissions, in addition to criteria such as cost, quality, and delivery performance. More mature companies even apply “internal carbon pricing,” creating a profit-and-loss penalty for business units that source products with high carbon emissions.

Core sustainable-sourcing practices should also include demand-side efforts. Simply making internal customers aware of the carbon emissions generated by products and services can encourage lower-impact behavior in areas such as business travel or indirect purchasing. Requiring business units to measure, report, and reduce their Scope 3 carbon footprint can be even more effective in reducing a company’s ESG footprint from procured materials and services.

Define ESG metrics and policies that can be integrated into the organisations standard supplier selection, procurement, and supply-management processes. As well as select a number of top priority ESG themes and address them with innovation and improvement initiatives.

Organizational Shift

The final step in the development of a sustainable procurement function is a set of actions that embed strong ESG practices into the organization. Procurement teams will need to learn how to evaluate the ESG credentials of potential suppliers, for example, and how to use carbon accounting principles to compare the impact of different supply options. Scaling up flagship sustainability initiatives into company-wide policies may require investment in new technical skills for supplier development teams, which can then engage with suppliers to educate, evangelize, and address specific capability gaps.

The procurement function will need new tools and data sources, too, to enable ESG supply chain teardowns and resource cleansheeting, or to facilitate the identification of suppliers with favorable ESG footprints or novel technologies that could help the organization achieve its sustainability goals.

Finally, companies will need to track sustainability alongside other targets, and adapt their incentive and performance-management systems to ensure the efforts of procurement teams and internal customers are aligned with the organization’s sustainability goals.

Prospective Benefits from Integrating ESG into Procurement

• Top-line growth
  A strong ESG proposition helps companies tap new markets and expand into existing ones.When governing authorities trust corporate actors, they are more likely to award them the access, approvals, and licenses that afford fresh opportunities for growth. For example, in a recent, massive public–private infrastructure project in Long Beach, California, the for-profit companies selected to participate were screened based on their prior performance in sustainability.

ESG can also drive consumer preference. McKinsey research has shown that customers say they are willing to pay to “go green.” When Unilever developed Sunlight, a brand of dishwashing liquid that used much less water than its other brands, sales of Sunlight and Unilever’s other water-saving products proceeded to outpace category growth by more than 20% in a number of water-scarce markets.

• Cost Reductions
  ESG can also reduce costs substantially. Among other advantages, executing ESG effectively can help combat rising operating expenses (such as raw-material costs and the actual cost of water or carbon).

Consider 3M, which has long understood that being proactive about environmental risk can be a source of competitive advantage. The company has saved $2.2 billion since introducing its “pollution prevention pays” (3Ps) program, in 1975, preventing pollution up front by reformulating products, improving manufacturing processes, redesigning equipment, and recycling and reusing waste from production.

• Reduced Regulatory and Legal Interventions
  A stronger external-value proposition can enable companies to achieve greater strategic freedom, easing regulatory pressure. In fact, while the strength of ESG helps reduce companies’ risk of adverse government action, it can also garner government support in many cases.

• Employee Productivity Uplift
  A strong ESG proposition can help companies attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Employee satisfaction is positively correlated with shareholder returns. Recent studies have also shown that positive social impact correlates with higher job satisfaction, and field experiments suggest that when companies “give back,” employees react with enthusiasm.

• Investment and Asset Optimization
  A strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities (for example, renewables, waste reduction, and scrubbers). It can also help companies avoid stranded investments that may not pay off because of longer-term environmental issues (such as massive write-downs in the value of oil tankers).

In China, for example, the imperative to combat air pollution is forecasted to create more than $3 trillion in investment opportunities through 2030, ranging across industries from air-quality monitoring to indoor air purification and even cement mixing.

About Zetwerk

Zetwerk works with original equipment manufacturers in North America and worldwide, fulfilling their manufacturing requirements for customized components and assemblies. We act as a second brain to the OEMs. Our team of experts not just executes the customer’s manufacturing strategy, but adds tangible value at every step of the process, right from vetting designs to finding and managing the suppliers to quality control and logistics. Our customers regard us highly for our transparent and hands-on approach to manufacturing.

Zetwerk executes these projects through its network of partner suppliers spread across USA, India, China, Vietnam, and Mexico. These world-class facilities provide practically unlimited production processes, capacities, materials, part sizes, and weights as well as secondary operations, surface finishing, assembly, and related services. Importantly, we have our teams established in all these countries with a substantial presence in the US.

Zetwerk recently acquired Unimacts, a US-based manufacturing services company, providing further impetus to our commitment to serve North America as a primary market. We have more than 2,000 customers across North America, Asia-Pacific and the Middle East, and a network of more than 10,000 manufacturing partners worldwide. Founded in 2018, we are backed by some of the world’s leading venture capital firms including Sequoia, Kae Capital, Accel Partners, Lightspeed, and GreenOaks. As of 2023, Zetwerk was valued at US$ 2.8 Bn.