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What is the best way to encourage supplier sustainability?

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As companies strive to reduce their environmental footprint and improve the lives of their employees and communities, one of the biggest challenges they face is their supply chain.

For example, research from the Carbon Trust shows that Litter 3 or indirect emissions account for between 65% and 95% of most companies’ carbon footprint. So how, for example, does a clothing company make its supply chain more sustainable?

Well, money is a way. In recent years, a small but growing number of large companies have experimented with what is known as ‘sustainable supply chain finance’. Similar to sustainability-linked loans, these finance programs reward suppliers who meet certain environmental and/or social criteria with a reduced interest rate on a type of credit known as supply chain finance. procurement (CFS).

HSBC bank and clothing company PVH Corp. announced such a program late last month.

A small but growing number of large companies have experimented with what is called “sustainable supply chain finance”.

“As we start thinking about different kinds of incentives for our suppliers, money matters,” said Mallory McConnell, vice president of corporate responsibility at PVH, which owns brands such as Tommy Hilfiger and Calvin. Klein. “So it was a really great opportunity to do something that was meaningful to them.”

Supply Chain Finance 101

What, exactly, is supply chain finance? And how does it work ?

It starts with a purchase order. Depending on industry standards and the contract between a buyer and seller, purchase orders typically have a payment cycle of 30-90 days.

For example: Supplier A (a t-shirt manufacturer) has just shipped a large order to Company X (a major clothing brand). Normally Company X pays its suppliers in 60 days, but Supplier A has expenses it needs and could really use the money right away. If company X has a supply chain finance program with its bank, the bank will “lend” the money to supplier A, so that instead of being paid in 60 days, supplier A has the money in, say, 5 days, less interest.

There is no credit check or fear of rejection as company X is responsible for reimbursing the bank. Which brings us to how this type of financing benefits providers. The interest rate is based on the credit rating of Company X, a large BBB-rated multinational, which pays a significantly lower rate than Supplier A, a medium-sized manufacturer in Bangladesh, would pay to a local lender. In fact, Supplier A may have difficulty accessing capital.

Of course, this type of financing only works if the buyer has a better credit rating than the supplier. In cases where the opposite is true, which happens, the provider would have no incentive to use the SCF.

Apparently, many suppliers need liquidity, as these types of arrangements have become quite common, especially among publicly traded companies who prefer to hold on to the money they owe suppliers for as long as they can in order to ‘improve their own cash flow, pay down debt and deliver more value to shareholders. Supply chain finance is now a $21 billion market this represents 18% of all trade finance transactions, reports The Economist.

Add ESG to the mix

International Finance Corp. (IFC) launched the first SCF sustainability-related facility in 2014 to Levi Strauss & Co. IFC’s Global Trade Supplier Financing Program provides short-term financing to suppliers through online financing platforms and financial institutions.

Over the past year, 66% 66% of the $2.3 billion in SCF funding provided by the program went to vendors with sustainability-related awards, and the organization expects that percentage continues to grow, an IFC spokesperson said in an email.

IFC is not representative of the market as a whole, however, companies with SCF programs that include a sustainability-related discount – which until now have been primarily in the apparel industry – still represent a small slice of the pie . HSBC, for example, has only four customers who have added this type of pricing to their SCF programs. However, banks accept demand is on the rise.

For its part, PVH starts small and simple with its program criteria. On the social side, the company measures the current performance of its suppliers in terms of human rights and labor practices using the Labor and Social Convergence Program (SLCP). The SLCP acts as a one-stop-shop for data on working conditions at supplier facilities, providing information on compliance with local laws and international standards, among other data points.

Environmentally, PVH’s program criteria are ambition-based: the supplier must have an energy reduction goal and an action plan to achieve it, McConnell said.

Unlike green bonds, the Sustainable SCF has no restrictions on how suppliers use the product, but the hope is that they will be motivated to invest in sustainability-related improvements, such as equipment or technology. that improve efficiency or reduce pollution.

“There is a lot of interest from our suppliers who are currently not meeting our expectations,” McConnell said. “It allowed for some really solid conversations about what they need to do to improve. It really acts as an incentive to get better performance from vendors and reward those who are ahead of the game.”

The bottom line

So how much does SSCF typically cost providers? And how many discounts does sustainability typically buy them? Well, rates vary and, unsurprisingly, it’s hard to pin people down with specifics. Neither HSBC nor PVH wanted to talk about tariffs, even in general terms. The IFC spokesperson also declined. But here is some information to give you an idea.

First, as we are currently seeing, rates can increase due to general market conditions that have nothing to do with Company X or Supplier A.

As of January 1, 2022, SCF rates are based on what is known as the Overnight Guaranteed Funding Rate (SOFR), a large measure of the cost of overnight cash borrowing backed by Treasury securities. The SOFR became the benchmark for bank credit after the removal of the London Interbank Offered Rate (LIBOR) at the end of last year.

SOFR is currently at 1.54%, down from 0.05% a year ago.

The amount of interest Company X pays is based on SOFR plus an amount tied to its credit rating. So, if Company X was rated AAA, Supplier A would pay less for supply chain finance than it does with Company X’s BBB rating. With a lower rating, it would pay more.

Between the floating benchmark and the range of credit ratings, the SCF rate could be less than 1% or as high as 5 or 6%, or even more in some cases. Some lenders have also been known to add other fees, although HSBC does not charge additional fees to its customers’ suppliers for SCF.

As for the sustainability discount, an HSBC banker would only say that it has to be enough to make it worthwhile for the supplier.

Is there a better way?

Given all the variables and unknowns, and the fact that the money is owed to the supplier, the perhaps naïve observer without an MBA might wonder: if a big company really wants to make a dent in its impact on the supply chain? sourcing, could it not incentivize suppliers by simply paying them earlier?

It turns out that might not be such a naive question after all.

Purchasing contract clauses are seen by some, including many suppliers, as a major obstacle to a more ethical and sustainable fashion industry, and there are growing calls to rewrite them. For example, the Business Law Section of the American Bar Association has published a Buyer code last year, following the widespread cancellation of clothing orders during the pandemic.

“This pandemic and the behavior of so many brands has shown us that while we’re talking about wastewater treatment, we have a more fundamental problem of not getting paid,” said Miran Ali, Vice President of the Association of Bangladesh garment manufacturers and exporters. , told Vogue.

To address this very fundamental problem, another organization called the Sustainable Terms of Trade Initiative published a white paper in September outlining practices cited by manufacturers as barriers to running a sustainable business. The document also contains a list of improvement suggestions from the manufacturer. One of these suggestions: a maximum payment cycle of 60 days; although they would really like a maximum of 45 days if they could get it.

Again, this may be naive, but doesn’t a maximum of 45 days to pay someone what you owe them seem like a no-brainer?

It might be more effective if companies that engage in sustainable supply chains first and foremost commit to some very basic – and frankly fair – purchasing, pricing and payment practices outlined in the white paper. Then, various types of sustainability incentives, which do not involve suppliers paying interest on money owed to them, could be put in place in addition to these practices.

It seems that more reasonable production schedules, wider profit margins and earlier order payments could go further than a “loan” in the interest of creating a more sustainable supply chain.