Your most severe ESG impacts will likely be indirect – but you’ll need to report on them nonetheless

In this article, we explore how a significant paradigm shift within corporate sustainability – the evolution from a traditional, own operations-centric view of sustainability to a holistic approach that encompasses the entire value chain – is reflected in new reporting requirements, directly impacting how companies must approach sustainability moving forward.

Your corporate responsibility extends (way) beyond just your own operations

Let us start with a reminder of the arguably biggest and most impactful shift we’re seeing in the corporate sustainability landscape today – value chain accountability.

This shift is already materialising in various pieces of EU regulation, including the European Sustainability Reporting Standards (ESRS) and the upcoming Corporate Sustainability Due Diligence Directive (CSDDD), which both share the overarching purpose of extending the boundaries of corporate responsibility. Firms are now being held accountable not only for their immediate operations, but also for their entire upstream and downstream value chain.

What encompasses a value chain varies widely across organisations and sectors; but to exemplify, for an electronic components manufacturer, it would stretch all the way from the extraction and processing of metals and other raw materials to the disposal or other end-of-life treatment of the final sold product.

EFRAG – one of the main bodies behind the ESRS – further elaborates on this point in their Materiality Assessment Implementation Guidance, stating that a company can be connected with an impact not only by directly causing it (for instance if its workers are exposed to hazardous working conditions without adequate safety equipment), but also by having contributed to it, for example by operating in a heavily industrialised but also populated area, and thereby together with the other companies in this area affecting the local air quality. A company can also be linked to an impact through its business relationships (yes, including beyond first tier), for example by subcontracting a supplier who employs child labourers despite contractual obligations.

Materiality is not determined based on your leverage

A question we frequently encounter is how to assess the materiality of impacts that lie deep within the value chain, far away from the reporting company’s operational control, or relate to a supplier or customer who makes up only a fraction of the reporting company’s total spend or revenue. A typical assumption is that because such impacts are less tangible and the reporting company has less leverage over them, they might not be material. Well, that is a false assumption.

Leverage in this context means the ability to exert influence over another actor, for instance by being a large supplier or customer, or by having influencing power through direct contractual agreements. New guidance from EFRAG makes it clear that leverage does not affect whether impacts that arise in the value chain are material or not. A severe impact remains severe, regardless of where it occurs.

Leverage does however play a significant role when you begin to collect data and manage your impacts. The greater your leverage, the easier it will be to obtain high-quality data and drive meaningful change.

Lastly, note that you in your final reporting should disclose where in the value chain your impacts occur. That way, readers can easily identify where your company faces its most significant sustainability challenges and opportunities.

Let’s not forget about potential impacts

Relating to the above, it should be remembered that both actual and potential impacts matter. Apart from the parameter of likelihood, which only applies to potential impacts, both impact types need to be assessed in the same way in terms of severity (calculated using the parameters of scale, scope, and irremediable character).

We’re seeing that impacts situated further from a company’s direct operational control frequently emerge as potential impacts (and are often also among the most severe). This trend is largely due to the prevailing absence of value chain transparency resulting in less concrete and substantiated links to the reporting company.

However, as the EFRAG guidance also emphasises, any knowledge gaps are to be filled using publicly available industry research and sector average data, with the reasoning that such documentation can uncover less obvious impacts that might present themselves in lesser-known parts of a company’s value chain. For companies dealing with the manufacturing or retail of goods, it is often also these impacts that are the most severe in nature, as upstream material production value chains tend to be i.e. both labour and energy intensive, characterised by hazardous working conditions, and reliant on short-term contractors.

Gotcha. Now, how can I put this information into meaningful action?

You might be asking yourself something like the above. We recommend starting off with the following:

1. Taking the time to really understand your value chain. Examples such as the ones presented above highlight the importance for firms to develop a mature understanding of their value chains, which include not only their activities, products, and services, but also considers affected communities, local contexts, regulatory landscapes, business relationships, as well as any supporting industry and sectoral information to fill current knowledge gaps.
2. Setting up stakeholder engagement systems. Once you’ve identified where in your value chain your environmental and social impact hotspots lie, the next step is to identify the various stakeholder groups potentially impacted by these issues (these could include supply chain workers, local and indigenous communities, or end-users – to only name a few). Subsequently, fostering meaningful dialogue with these stakeholders about the impacts becomes paramount.
3. Setting joint policies, initiatives, and targets. With solid engagement structures in place, you’re equipped to establish tailored initiatives that tackle these impacts at their roots, and set targets to monitor progress effectively. This could be done in collaboration with other actors in your value chain that might have more leverage over the impact, such as your suppliers.

Understanding and acting upon the full spectrum of impacts is now not just a regulatory requirement but a crucial step towards genuine sustainability. By embedding this holistic view into your sustainability strategy, your organisation can not only mitigate risks but also harness opportunities for innovation and leadership in corporate responsibility.