Managing climate change in supply chain contracts
There is greater emphasis from the global business community to commit to sustainable initiatives such as signing up to the UNFCC Race to Zero and to build COP26 considerations into their 2021 strategic plans. A key component to achieving such aims is to embed environmental and climate change compliance targets throughout an organisation’s supply chain contractual relationships. This not only reinforces environmental and climate change compliance but also mitigates against any financial and reputational risk.
This note explores the typical lifecycle stages of a commercial relationship and the opportunities for an organisation to align its contractual relationships with suppliers with the organisation’s environmental objectives. This is particularly relevant for those organisations who have publicly committed to net zero or environmental targets as well as all organisations seeking to improve their environmental credentials.
Pre-contract
Non-disclosure agreements (NDAs)
Ensuring that climate change and environmental commitments are raised at the early stages of commercial discussions sets the tone of the commercial relationship and aims to create a culture where environmental commitments are at the forefront of the parties’ minds.
Organisations enter into NDAs on a regular basis and are the initial stage in most commercial relationships. NDAs help protect against loss of confidential information, build trust and enable more open conversations amongst parties considering a new commercial opportunity. They also present an early, and often overlooked, opportunity to assess whether the parties’ values in relation to climate change are aligned.
Most NDAs focus on the commercial purpose and key legal protections of confidential information. Considerations such as climate change are often secondary issues, if brought up at all at this stage. Leaving such considerations until a later stage in contract negotiations may lead to a misalignment between the parties which is not uncovered until the contract negotiations have progressed to a stage where it is too late to align those interests.
Standard NDA templates can be amended to align with the organisation’s net zero and wider ESG commitments from the very beginning of commercial discussions and to introduce contractual concepts at an early stage to reduce the risk of misalignment when contractual negotiations are eventually reached.
To ensure that these terms are not overlooked it might be worth considering how to highlight these terms to the supplier by including them as a purpose alongside the commercial purpose, rather than burying them in the legal terms and conditions.
Invitations to Tender (ITTs)
For organisations which engage in the procurement of services through a formal bid process, ITTs present an opportunity for the organisation to state its requirements for environmental targets and commitments from its suppliers at an early stage. These can be included in the specifications for the works, goods or services being procured and in the criteria the organisation will use to evaluate the tenders received. In the public sector, the European Commission has identified the public procurement regime as playing an important role in furthering environmental objectives as part of the European Green Deal1.
Key contractual terms and conditions are usually be included in the ITT documentation and this presents an opportunity to set out the key supplier obligations and rights which the customer will expect the bidders to accept. See below for some examples of the kinds of contractual clauses which might be considered.
Heads of Terms (HoTs)
HoTs are generally used for complex transactions to scope the deal and as a precursor to commencing the drafting of the operative agreements. They set out the key commercial objectives of the parties and sometimes also contain key legal terms which will be incorporated into the binding contracts. HoTs evidence serious intent and, whilst they rarely have legal force (other than, for example, terms relating to confidentiality and costs), they do have powerful force to set the foundations for the ensuing contractual negotiations. As with NDAs, climate change and sustainability issues are often overlooked when preparing HoTs.
Incorporating dedicated clauses in HoTs so that climate change issues become a key consideration for any deal team is a way of ensuring an organisation’s environmental targets are considered by the parties’ deal teams during the contract negotiations. Where a level of due diligence is required as a precursor to a transaction, the HoTs can reference carbon saving opportunities to be explored as part of the due diligence exercise alongside the usual legal, financial and technical due diligence. It will also allow boards to demonstrate how their environmental targets were considered as part of a transaction.
Contract negotiations
Moving on to the actual contract negotiations, there are various options for contractual terms which can be considered and incorporated into the supply agreements depending on the organisation’s requirements. Some can be as simple as allowing the organisation to exit the contract if certain targets are not being met by the supplier (see below “Green Termination”); others can go beyond this, for example requiring a supplier to ensure its own commitments and to demonstrate that its own supply chain meet the customer’s requirements. We have summarised below some of the different approaches.
Targets and reporting obligations
In order to achieve its net zero or sustainability targets, an organisation needs a way to enforce its supply chain’s sustainability performance. Currently, the environmental impact of goods or services are rarely captured in supply agreements and therefore there is little incentive on a supplier to improve its environmental performance and no recourse for the customer if the supplier fails to improve its performance, or even fails to adhere to the targets it promised during the sales process. This can result in an organisation missing its sustainability targets.
A solution to this issue is to include contractual obligations that ensure the supplier is adhering to certain environmental standards in much the same way it might be required to adhere to technical service standards, including:
- environmental warranties, including warranties that the supplier has undertaken an assessment of its carbon footprint;
- environmental targets for performance and on-going performance improvement obligations, such as reducing a supplier’s waste and pollution in providing its products or services by x% per year;
- a mechanism for environmental remediation fees or damages for breaches of environmental performance targets; and
- environmental information reporting obligations and audit rights so that the supplier is held accountable for its environmental performance.
Incorporating such clauses into commercial contracts will ensure that an organisation has control over its environmental performance targets and provides transparency as to the organisation’s overall environmental impact not only internally but throughout its supply chain.
It may be possible to develop some general targets or obligations which can be applicable to all suppliers but to be most effective and for larger and more critical supply contracts it will be advisable to ensure that obligations are tailored to meet the organisation’s published targets and are relevant to the particular category of supply using SMART objectives, i.e. specific, measurable, attainable, realistic/relevant and time bound so that contractual remedies are effective.
Climate risk sharing
Unlike other categories of business interruption events for which an organisation or its suppliers may be able to procure insurance, in respect of climate change risks, insurance may not be available. Leaving the onus and cost of managing climate change with the supplier alone may lead to undesirable outcomes from an environmental and social perspective. An alternative is to consider a concept of climate risk sharing. Climate risk sharing clauses can ensure that in the event of a climate change event, the parties co-operate in good faith to ensure no adverse climate consequences such as an increase in greenhouse gas emissions or dumping of stock. Specific clauses which relate to climate risk sharing can ensure there is a contractual risk assessment based on balancing financial and commercial obligations and the environmental and social impacts.
Ending a contract
Many organisations become locked into contracts without the ability to require the supplier to improve its sustainability credentials or terminate the agreement in favour of a "greener" supplier. Where termination rights are available, organisations may be deterred from exercising termination rights due to early termination fees.
A solution to this issue is to include a clause that allows a right of termination for a customer so that they can contract with an alternative supplier in order to meet its sustainability and other environmental objectives. A contractual right to switch to a greener supplier if the existing supplier cannot match the alternative offer encourages “green competition” between existing and prospective suppliers and provides a strong incentive for appointed suppliers to continuously improve their sustainability performance. Such clauses can ensure that the customer does not incur any exit-related liability (such as cancellation or early termination fees) unless the existing supplier is able to at least match the green improvements represented by the alternative supplier’s offer.
Alternatively, a customer could incentivise a supplier by committing to a renewal for a further term provided that certain targets have been met.
To avoid challenges at the negotiation stages it is advisable to consider introducing such a right at an early stage (for example in the HoTs or ITT).
Breach of green targets or other climate change obligations
Depending on the bargaining position of the customer, a number of sustainability related "material breach" termination triggers can also be included in the contract linked to the supplier’s obligations to adhere to the targets and reporting obligations. In practice it may more difficult to measure actual compliance with environmental targets and the damage caused by a failure to meet those targets may be remote or difficult to quantify, but other provisions may be more measurable, for example reporting, information and remediation obligations.
Again, to avoid challenges at the negotiation stages it will be advisable to include these key termination rights at the HoTs or ITT stage.
Macfarlanes has contributed to the Chancery Lane Project’s Contract Playbook which includes a set of template climate change related provisions that can be included in commercial contracts. The Chancery Lane Project encourages a collaborative effort of lawyers from around the world to develop new contracts and model laws to help fight climate change.
1 https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en