How companies can use their supply chain contracts to lower emissions now

Environmental, Social, and Governance (ESG) encompasses an array of issues so broad that it can seem overwhelming. It includes addressing climate change, eliminating forced labor, preventing exposure to toxic chemicals, and ensuring a wide range of perspectives in the boardroom, to name but a few. In the face of such a broad agenda, one approach would be to push forward on all fronts more or less evenly, treating them as equally important and, to a certain extent, interrelated.

We will examine that approach in future blogs. But this piece offers another approach – the classic triage strategy used by emergency room physicians to save patients suffering from multiple injuries – with a specific focus on how supply chain contracts can play a key role in stopping the hemorrhaging of greenhouse gas (GHG) emissions.

Why prioritize climate change?

Climate change should be our highest priority for the simple reason that it alone presents an existential threat to humanity. To survive (and hopefully thrive), climate change requires that we make historically unprecedented changes in the span of a single generation. In fact, the accelerating pace of global air temperature warming within the past few years has so shocked scientists that they are grasping for words adequate to express their amazement. When staid, cautious scientists are freaking out, you know you have a problem.

To avert the worst scenarios, we must simultaneously clean the electricity supply; decarbonize the manufacturing sector; decarbonize transportation by land, sea, and air; reduce the carbon footprint of the buildings we live and work in; and produce our food and clothing in a more sustainable manner. And we must do all of this on a global scale and during a time of deep political division.

To be sure, forced labor is inexcusable, toxic air pollutants are a serious threat to public health, and myopic corporate decisions lead to all kinds of bad outcomes. But solutions to these problems, as important as they are, will only endure if we save the patient by quickly moving toward net-zero GHG emissions.

Why are supply chains important?

In the face of this enormous challenge, we need the right tools. Tools that reduce GHG emissions in one sector of the economy are good, but tools that can do so across all sectors are much better. Similarly, governmental regulations that require emission reductions are necessary, but tools that can be implemented privately, voluntarily, and internationally can also play a critical role, particularly in the face of regulatory uncertainty.

One such tool has been around for centuries: the corporate supply chain, and specifically the contracts that govern supply chains. Supply chains include "upstream" suppliers of goods and services to a given company, as well as "downstream" customer usage of that company's products. This is sometimes referred to as the "value chain," but let's stick with the traditional term.

Supply chains are the ligaments that hold the world economy together. Consequently, virtually every ton of GHG emissions worldwide is traceable to somebody's supply chain. If you can squeeze the emissions out of supply chains, you've largely eliminated the drivers of climate change.

Take for example a U.S. computer manufacturer that buys chips made in Taiwan, incorporates them into a laptop, and then sells the laptop to an individual who consumes electricity to power the laptop. In that everyday scenario, one can reduce the carbon footprint of the laptop by implementing measures at any or all points along the supply chain—by reducing the amount of energy used to manufacture the chips, by decarbonizing the fuel used by the ship carrying the chips from Taiwan to the computer maker, by decarbonizing the fuel used by the truck carrying the laptop to the customer, and by cleaning up the electricity used by the customer to power the laptop.

The same opportunity exists with respect to the supply chains that provide us with building materials, vehicles, food, and clothing—i.e., almost everything. In that sense, supply chain contracts can serve as an all-purpose, economy-wide GHG tourniquet.

What are regulators doing to reduce supply chain emissions?

Supply chain GHG emissions have attracted lots of attention from regulators, but the actual regulatory framework is still in the early stages of construction and is focused on disclosures rather than mandating reductions. Within the next few months, the Securities and Exchange Commission (SEC) is expected to finalize regulations proposed in 2022 that will require large, publicly-traded corporations to disclose the climate-related risks that their businesses face, as well as their GHG emissions.

The GHG emissions to be disclosed are divided into three categories. "Scope 1" emissions come from sources that the company directly owns or controls, such as gas-powered vehicles and on-site combustion of natural gas for heat. "Scope 2" emissions are those that the company causes indirectly through its energy consumption, such as from fossil fuels generated elsewhere to produce the electricity used in the company's buildings. "Scope 3" emissions include all other emissions indirectly caused by the company, largely consisting of emissions throughout the company's supply chain.

If the SEC's final regulations track the proposed rules, companies will be required to disclose their Scope 3 emissions if they are material or the if company has set a GHG emissions reduction goal that includes Scope 3 emissions. Many companies have included reducing supply chain emissions in their goals, as they recognize that their supply chains are often the main source of their emissions. This would trigger the obligation to disclose, thereby further incentivizing companies to reduce their supply chain emissions.

But the Scope 3 portion of the SEC's proposed rule is in significant legal jeopardy due to the U.S. Supreme Court's 2022 decision in West Virginia v. EPA. There, the six conservative justices struck down the Obama EPA's Clean Power Plan (CPP), which would have created a GHG emissions cap and trade system to help decarbonize the electric generating sector. As described in an earlier DWT blog, the Court ruled that the CPP exceeded EPA's authority under the Clean Air Act. The Court did so by relying on the controversial "major questions doctrine," which says that regulations addressing matters of "vast economic and political significance" can only survive if clearly authorized by Congress. Opponents of the SEC's proposed rule have warned that they will similarly argue that Congress has not given the SEC clear enough authority to require disclosure of Scope 3 emissions.

In the meantime, California has stepped into the breach by enacting legislation (analyzed by our colleague Vid Prabhakaran) requiring companies doing business in California that have annual revenue over $1 billion to disclose their Scope 1 and 2 emissions starting in 2026 and their Scope 3 emissions starting in 2027. It is not clear how much overlap exists between SEC-jurisdictional companies and companies subject to the new California legislation, but it is likely to be substantial. Importantly, the clarity and specificity of the California legislation should immunize California regulators from attacks under anything resembling the major questions doctrine, but the law will undoubtedly be litigated on other grounds.

Adding to the complexity of reporting requirements, Scope 1, 2, and 3 emissions must also be reported under the European Union's Corporate Sustainability Reporting Directive, which became effective in January 2023. The requirement applies to EU and non-EU entities operating in the EU through franchises with annual net turnover of more than €150 million in the EU. SEC Chairman Gensler recently noted that if the SEC rule is overturned in the courts, a significant number of U.S. companies will still have to comply with the EU and/or California requirements.

What can companies do on their own to reduce supply chain emissions?

Rather than waiting for the regulatory dust to settle, companies that want to decarbonize can employ a tool that they largely control: their contracts with their supply chain partners. This approach allows companies to tailor the requirements placed on their suppliers to meet their own environmental goals. It also allows tailoring requirements to a specific industry, and even to the idiosyncrasies of a specific product or service.

The best-known example of this contracting approach is Salesforce's Sustainability Exhibit, which it appends to contracts with its suppliers. The exhibit requires suppliers to publicly disclose their Scope 1, 2, and 3 emissions, thereby circumventing whatever the Supreme Court may decide.

But the exhibit goes much further by also requiring the supplier to set a science-based target through the Science Based Targets initiative ("SBTi") that aligns with limiting global warming to 1.5 degrees Celsius (i.e., the "stretch" goal set by the 2015 Paris Climate Agreement), and then to make good-faith efforts to actually achieve that target. For added incentive, the exhibit allows Salesforce to terminate the contract if, in Salesforce's reasonable discretion, the supplier's environmental practices could have a material negative impact on Salesforce's reputation by conflicting with Salesforce's published sustainability, carbon reduction, and renewable energy targets.

This is just the beginning. The Chancery Lane Project, a DWT pro bono client, has created a cafeteria of model contract provisions aimed at aligning with net-zero emissions. It includes over 30 provisions relating to supply chain contracts, including ones that: (a) require suppliers to quantify their progress toward meeting certain sustainability requirements; (b) require the supplier to procure 100% of the electricity it uses from renewable generation sources; (c) allow the purchaser to switch suppliers if the existing supplier is unable to match a "greener" offer from an alternative supplier; and (d) require disclosure of a supplier's climate-related lobbying, financing, and climate leadership activities.

Finally, a recent ABA publication notes that contracts add rigor and discipline to the GHG reduction process because they are typically drafted and enforced by lawyers specifically tasked with managing the company's procurement processes. Consequently, when the CEO or board wants to know exactly what is being done at the operational level to reduce the company's supply chain emissions, the general counsel and sustainability managers are well-positioned to share the relevant language and the processes used to enforce it. This documentation will also reduce the risk of adverse outcomes in the context of "green claims," a topic recently addressed by several of our DWT colleagues.

Conclusion: a huge opportunity

Supply chain contracts offer a key tool that companies can use to reduce GHG emissions, thereby bending the warming curve in a direction more tolerable for our children and grandchildren. Legislators and regulators are making progress on the disclosure front, but it will be years before the law becomes relatively clear, and years thereafter before actual supply chain emission reductions are mandated. In the meantime, companies have a huge opportunity to chart their own course on both fronts via contract, limited only by their ambitions and creativity.

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