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What’s the best way to incentivize supplier sustainability?

A small but growing number of large corporations have been experimenting with something called “sustainable supply chain finance.”

Supplier cash

GreenBiz photocollage, via Shutterstock

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As companies map out how 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, Carbon Trust research shows that Scope 3 or indirect emissions represent between 65 percent and 95 percent of most companies’ carbon impact. So, how does, say, an apparel company make its supply chain more sustainable?

Well, money is one way. In recent years, a small but growing number of large corporations have been experimenting with something called "sustainable supply chain finance." Similar to sustainability-linked loans, these financing programs reward suppliers that meet certain environmental and/or social criteria by offering them a reduced interest rate on a type of credit known as supply chain finance (SCF).

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

A small but growing number of large corporations have been experimenting with something called 'sustainable supply chain finance.'

"As we start to think 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, this 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 norms and the contract between a buyer and seller, purchase orders typically have a payment cycle of anywhere from 30 to 90 days.

For example: Supplier A (a T-shirt manufacturer) has just shipped a large order to Company X (a big clothing brand). Normally, Company X pays its suppliers in 60 days, but Supplier A has expenses it needs covered and could really use the cash immediately. If Company X has a supply-chain finance program with its bank, the bank will "loan" Supplier A the money, so instead of being paid in 60 days, Supplier A has the cash in, say, five days, minus interest.

There’s no credit check or fear of denial because Company X is responsible for paying the bank back. Which brings us to how this type of financing benefits suppliers. The interest rate is based on the credit rating of Company X, a large multinational corporation with a BBB rating, which pays a significantly lower rate than what Supplier A, a midsized manufacturer in Bangladesh, would pay a local lender. In fact, Supplier A may have difficulty accessing capital at all.

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

Apparently, a lot of suppliers need cash, because these sorts of arrangements have become quite common, especially among publicly traded companies that prefer to hang onto the money they owe suppliers for as long as they can as a way to improve their own cash flow, pay down debt and deliver more value to shareholders. Supply chain finance is a $21 biillion market that represents 18 percent of all trade finance transactions, The Economist reports.

Adding ESG to the mix

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

Over the last year, 66 percent of the $2.3 billion in SCF financing the program provided went to suppliers with sustainability-linked pricing, and the organization expects that percentage will continue to grow, an IFC spokesperson said in an email.

IFC isn’t representative of the market overall; however, companies with SCF programs that include a sustainability-linked discount — which have so far been primarily in the apparel industry — still represent a small piece of the pie. HSBC, for example, has only four clients that have added this sort of pricing to their SCF programs. However, banks agree demand is on the rise.

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

On the environmental side, PVH’s program criteria is based on ambition: The supplier must have an energy reduction target and an action plan for how to get there, McConnell said.

Unlike green bonds, sustainable SCF has no restrictions on how suppliers use the proceeds, but the hope is they will be motivated to invest in sustainability-linked improvements, such as equipment or technology that improves efficiency or reduces pollution.

"There’s a lot of interest from our suppliers who don’t currently meet our expectations," McConnell said. "This has enabled really robust conversations around what they need to do in order to improve. It really is acting as an incentive to get better performance from suppliers as well as reward those that are ahead of the game."

The bottom line

So how much does SSCF typically cost suppliers? And how much of a discount does sustainability typically buy them? Well, rates vary and, unsurprisingly, it’s hard to pin folks down on specifics. Neither HSBC nor PVH wanted to talk about rates, even in general terms. The IFC spokesperson declined as well. But here’s some information to help give you an idea.

First, as we’re witnessing, rates can increase due to general market conditions that have nothing to do with Company X or Supplier A.

As of Jan. 1, SCF rates are based on something called the Secured Overnight Financing Rate (SOFR), a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. The SOFR became the benchmark for bank lending after the discontinuation of the London Interbank Offered Rate (LIBOR) at the end of last year.

The SOFR is currently at 1.54 percent, up from .05 percent a year ago.

How much Company X pays in interest is based on the SOFR plus an amount tied to its credit rating. So, if Company X were AAA-rated, 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 variable benchmark and range of credit ratings, the rate for SCF could be under 1 percent or as high as 5 or 6 percent, perhaps even more in some cases. Some lenders have also been known to tack on other fees, although HSBC does not charge its clients’ suppliers additional fees for SCF.

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

Is there a better way?

Given all the variables and unknowns, and the fact the money is owed to the supplier, the perhaps naïve observer without an MBA might ask: If a large corporation really wants to make a dent in its supply-chain impact, couldn’t it incentivize suppliers by simply paying them sooner?

Turns out, it may not be such a naïve question after all.

Purchasing contract terms are seen by some, including many suppliers, as a key hurdle to a more ethical and sustainable fashion industry, and calls to rewrite them are growing louder. For example, the American Bar Association’s Business Law Section published a widely regarded Buyer Code last year, following the widespread cancellation of clothing orders during the pandemic.

"This pandemic, and the behavior of so many brands, showed us that while we are sitting around talking about wastewater treatment, we have a more fundamental problem of not being paid," Miran Ali, vice president of the Bangladesh Garment Manufacturers and Exporters Association, told Vogue.

To address this quite fundamental problem, another organization called the Sustainable Terms of Trade Initiative published a whitepaper in September outlining the practices manufacturers cited as impediments to running a sustainable business. Also included in the paper is a list of manufacturer suggestions for improvement. One of those suggestions: a 60-day maximum payment cycle, although they’d really like a 45-day maximum if they could get it.

Again, perhaps it’s naïve, but doesn’t a 45-day maximum to pay someone what you owe them seem like it should be a given?

Perhaps it would be more effective if corporations that are committed to sustainable supply chains would, first and foremost, commit to some very basic — and frankly fair — practices regarding purchasing and pricing and payment outlined in the whitepaper. Then various types of sustainability incentives, which don’t involve suppliers paying interest on money that’s owed to them, could be put in place on top of those practices.

Seems like more reasonable production schedules, wider profit margins and earlier purchase order payments might go further than a "loan" with interest in creating a more sustainable supply chain.

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