In recent years, businesses have scrambled to secure their supply chains amid COVID-19 disruptions, the global impact of the war in Ukraine, and the growing prevalence of record-breaking extreme weather. For many, the addition of enhanced emissions reporting obligations will stretch their resilience to the limit as they face the need to account for emissions taking place outside of their direct area of operations.
Scope 3 emissions span 15 categories: purchased goods and services, capital goods, fuel and energy, upstream transport, waste, business travel, employee commuting, upstream leased assets, downstream transport, processing of sold products, use of sold products, end-of-life treatment of sold products, downstream leased assets, franchises, and investments. Estimates suggest that, in total, these emissions can account for 80-95% of the total value chain of an organization’s footprint.
Until recently, reporting of Scope 3 impacts has been voluntary, but the mood is changing fast. Established in November 2021, the International Financial Reporting Standards (IFRS) Foundation’s International Sustainability Standards Board (ISSB) introduced its IFRS S1 and IFRS S2 standards, which include requirements for reporting Scope 3 GHG emissions.
The EU Corporate Sustainability Reporting Directive (CSRD) took effect in January 2023, with EU Member States required to incorporate its provisions into law by July 2024. The CSRD significantly expands the range of activities that affected companies must report, demanding oversight of both direct and indirect business relationships across the entire value chain. Under the Directive, all large and listed companies will now be asked to undertake detailed sustainability reporting. Approximately 50,000 companies will fall within its remit, up from 11,000 previously.
Another initiative, the Carbon Border Adjustment Mechanism, launched in October 2023, was set up to address the problem of companies relocating carbon-intensive operations to avoid reporting on them. Meanwhile, the EU Corporate Sustainability Due Diligence Directive (CSDDD), which was agreed in December 2023 and is expected to take effect this year, represents significant strides in targeting both climate-related and human rights violations by companies.
Policy in the US still lags Europe in its Scope 3 requirements, with recent updates to the Securities and Exchange Commission rules for Climate-Related Risks only requiring disclosure of Scope 1 and 2 emissions. However, it is expected that the US will follow the EU example in time, as investors increasingly expect clarity on risks across listed companies’ entire operations.
As part of the current much-needed trend towards increasing transparency and accountability in supply chains, there is a tendency to view intermediaries as the problem, as they create barriers in the value chain and divert money that could be better spent paying the farmers fairly. However, it is important to acknowledge that intermediaries add value and that without them, in many cases, the product would not exist, and the supply chain would not work.
The crucial role played by intermediaries in supply chains is evident in the problems a large medicines provider encountered during an initiative to deliver free malaria treatments in African countries. The manufacturer, a well-known European company, provided the drugs for free, but they did not arrive. On further investigation, it seemed that the lack of economic incentives for the intermediaries meant the delivery of the drugs did not take place.
In response to the reporting challenges and inefficiencies presented by traditional supply chains, some companies are taking control of various roles previously held by intermediaries. This includes establishing their own farms and directly employing people in certain roles. The aim is to drastically reduce the number of steps in the value chain, which in turn will help simplify Scope 3 disclosure. But how likely is vertical integration to lead to more sustainable businesses?
In the face of unprecedented challenges, from global crises to regulatory shifts, integrating vertically offers a strategic pathway to resilience and sustainability.
Multinational company Henkel, which owns several popular consumer brands, is cooperating with intermediaries across its supply chain in what could be regarded as a ‘vertical partnership’ approach to tackle the problems associated with accounting for Scope 3 emissions.
As is the case with many large organizations, the vast majority of Henkel’s CO2 emissions related to its products are not produced by the company itself but by its consumers and suppliers. Of these, 66% are generated by consumers – using the company’s cleaning products in their washing machines, for example – and 27% arise from the raw materials in its supply chain. The pressing challenge for the company is how to monitor and manage these external emissions over which they have historically had no control.
Henkel has committed to what it calls a vertically integrated global footprint based on strategic partnerships to advance sustainability throughout the supply chain. The company works with multi-stakeholder initiatives to foster these partnerships in all areas of operations and activities, including the purchase of raw materials and packaging materials, production, logistics, use of its products by consumers, and reuse in material cycles.
Vertical integration can also work for individual companies with complex supply chains. In the food sector, most emissions happen at the farm level. Tracking these emissions is close to impossible because many farmers are suppliers of suppliers in chains that can include 10-14 different intermediaries.
The Toks restaurant group, which has 192 sites in Mexico, decided to attempt vertical integration for the coffee it serves in its branches to simplify its coffee supply chain. Hoping to address the difficulties inherent in managing the chain, which comprised 10 different intermediaries (encompassing all aspects of coffee production and procurement, from growing, processing, and milling to roasting and distribution), the company focused on steps it could take to ensure the coffee its customers were drinking was fairly distributed.
“In a world of interconnected risks, vertical integration offers a promising avenue for companies to fortify their supply chains and uphold sustainability standards.”
In the first stage of this process, Toks provided technical assistance (including basic training in financial management) to the farmers who grew its coffee, resulting in a sixfold increase in revenue for the farmers. The company also bought a milling facility, reducing the 10 steps in its coffee supply chain to three. The impact on the farmers in this example was profound, with benefits affecting the next generation. Previously, they had to operate within a system in which every actor in the chain had an incentive to buy at the lowest price and sell at the highest price, with no coordination to guarantee the farmers a sustainable wage. By improving the financial viability of coffee farming, the company enhanced the likelihood that coffee would continue to be grown on these farms as the children of farmers would be less likely to leave for opportunities in the cities.
Dispersed and disintegrated supply chains make sense in a stable economy, where the products people need are reliably available. However, the combination of post-pandemic financial impacts, geodemographic factors such as the Russia-Ukraine conflict, and extreme weather such as more frequent and severe droughts, floods, and wildfires, means that companies can no longer rely on these supply chains to function as expected.
While large and multinational companies may be concerned about the impact on profits of increasingly unstable conditions in their markets, their smaller intermediaries – from producers to suppliers and traders – may already be at risk of losing their livelihoods to failed crops, blockaded ports, and other crises. Sustainable vertical integration strategies can help keep these smaller stakeholders in business, boosting efficiency and productivity throughout supply chains.
From a sustainability perspective, the trend towards greater vertical integration could have positive impacts by reducing waste in supply chains. During times of abundance, waste occurs throughout the chain and is not viewed as problematic. Now, as companies look at how to gain control of their supply chains for regulatory compliance purposes, they can seize opportunities to reduce waste and other environmental impacts through partnerships, consolidation, and other innovative approaches.
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