How to achieve sustainable supply chains

To manage these risks, several companies have developed guidelines for supply chain sustainability, but the complexity and geographic dispersion of the supplier network make ensuring compliance a challenge, she said.

“Oftentimes violations happen at a sub tier far away from the buyer, often in countries where social and environmental regulations are loose, and where there is less pressure from the general public,” she said.

One example is the 2014 deadly explosion at the Kunshan Zhongrong Metal Products factory in China. The blast was caused by a buildup of combustible metal dust — a danger workers had long warned about but went ignored, Song said.

Zhongrong, a Tier 2 supplier for General Motors, provided parts to Dicastal, GM’s Tier 1 supplier, to which GM delegated the management of the sustainability standards within Zhongrong, she said.

Ensuring compliance in lower tiers is costly, and developing sustainability standards in remote jurisdictions takes time. Not surprisingly, more than 90% of the buyers choose to delegate, Song said.

Also read: ESG risks can lurk in supply chains, too

How do you minimize the problem: control vs delegation

In a simplified system with a buyer and Tier 1 and Tier 2 suppliers, the buyer may delegate to its direct sub tier (Tier 1) the management of Tier 2, including the supervision of Tier 2’s sustainability standards, Song said. Delegation is cheaper and simpler, she said, but the tier in charge of managing compliance may be affected by ‘moral hazard.’

“Because Tier 1 does not really bear the cost of the violations — a cost which will ultimately fall on the buyer — they may under-invest in sustainability management,” she said.

To mitigate this issue and make the delegation effective, the buyer may judiciously select Tier 1 suppliers who have a sustainability management process in place and/or are located in regions that have tighter regulations on sustainability standards. 

Ideally, it could be more effective for the buyer to assume the management of sustainability directly, because it has more expertise and incentive, Song said. But in practice, this approach is too expensive, so a system of delegation is necessary any time detecting violations in a far tier is complicated, she said.

For such cases, Song studied systems of “guided delegation,” in which the buyer establishes a detailed guidance for their first-tier suppliers, with standards for productivity levels, wages, and hours of work, and a right to pre-approve the suppliers picked by Tier 1.

Additionally, the buyer and Tier 1 can further bolster Tier 2 sustainability efforts by providing extra resources such as training and equipment.

Unfortunately, even guided delegation is not always effective, Song said, as demonstrated by Mattel’s recall of millions of toys in 2007. Their Hong Kong-based manufacturer, having run out of yellow pigment, sourced paint from a supplier outside of the list Mattel had approved. As it turned out, that yellow paint contained lead.

“Mattel was surprised to experience a major supply chain problem despite its longstanding commitment to become a responsible company,” Song said. “The recall ultimately cost Mattel about $110 million and severely damaged the company’s reputation.”

Research from Professor Song found that guided delegation should be combined with a direct auditing system that cannot be delegated to lower tiers.

How to incentivize suppliers to comply with sustainability

A potentially better system involves devising an incentive mechanism that can facilitate a long-term collaboration between a brand and its distant suppliers, Song said.

In new research, Song and colleagues proposed “a sustainability index” to monitor and manage supplier compliance over time. The index was inspired by programs like Starbucks’ C.A.F.E. (Coffee and Farmer Equity), which provides guidelines and metrics aimed at developing a long-term partnership with suppliers often located in “economically underdeveloped regions of the world,” Song said, “where farmers often just get a very tiny share of the supply chain profits.”

The C.A.F.E. program relies on a scorecard and a third-party auditing system. The card sets standards on labor and environmental dimensions and importantly, Song said, it is not a one-time certification; it’s an evaluation system that develops over time and incentivizes the farmers by paying “additional premiums to reward supply chains that show continuous improvement across C.A.F.E. practices,” Starbucks writes.

“So if the score is 60, the supplier becomes a preferred supplier. If it's more than 80, you get a premium. And if you show continuous improvement, you'll get a further premium,” Song said.

At the same time, Starbucks also invests in supplier development, with technical teaching and sharing of best practices, she said.

Song said the essential elements of a successful sustainability program are to have a third party-verifiable index that defines measurable economic targets for each period, and a dynamic payment structure that rewards success and sustainability conditions.

In a crop like coffee, for example, it is important to focus on sustainability conditions such as crop rotations, soil conditions, pest and disease control, Song said.

“It is not one step,” she said. “To achieve the final goal, you do things gradually. You acknowledge the compliance conditions, so that the payment structure is not only based on performance, but also on long-term implications for future performance.”