Why payment terms shouldn’t be used as green incentives

Offering suppliers preferential payment terms as an incentive for them to adopt greener practices can backfire on a company if its carrot is viewed as a thinly disguised stick
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As the year rolls on, the UN’s forthcoming conference on climate change in Glasgow looms like Christmas on the business calendar, with eco-conscious companies increasingly in the market for something special to show how much they care. They are shopping for sustainability.

One potential storehouse is the supply chain, the source of most of their greenhouse gas emissions. When the UK’s largest retailer announced in April that it would start using its payment terms to incentivise suppliers to reduce their carbon footprints, it did not expect a backlash. Several observers interpreted Tesco’s intention to reward stronger sustainability performance with earlier settlements as being more a way to legitimise late payments.

Improved terms could be used as an incentive, but we should not treat payment on time as a pat on the head

A carrot not a con

In theory, incentives are useful tools for encouraging change. If fair payment terms are made better by the desired action, that seems like a win-win situation. But any such arrangement must still be designed with care, warns Mark Chadwick, MD of sustainability solutions at Engie Impact in the UK & Ireland. 

“It’s a matter of having the correct measurements and controls. Offering any incentive poses risks, so we must structure them appropriately, mindful of any potentially corrupting influence,” he explains.

Trust and credibility are key in any client-supplier relationship, so waving a big compliance stick, only thinly disguised as a carrot, is not the answer. 

“To be a genuine carrot, an incentive must offer an improvement on business as usual,” Chadwick stresses. “It is not enough to ask for sustainable action to forestall a downgrade in terms and conditions.”

The right to receive on time

Not all sectors are the same, of course, when it comes to their traditions of supply-chain management. Incentives play differently depending on the prevailing culture.

The construction industry, for instance, became notorious for perpetuating an adversarial approach in which deliberate late payment, or even non-payment, was common practice.

Although construction may be modernising its approach, there remains some way to go to normalise the basics of responsible bought-ledger management. As a result, any prospect of dangling carrots in front of SME suppliers and subcontractors here still seems remote.

Moreover, the idea of incentivising these micro-businesses in such a way is wrong in principle, argues Shaun McCarthy, chair of the Supply Chain Sustainability School. 

“Payment to terms is a fundamental right,” he says. “If the contract states that the client should pay in 30 days, this should happen. This frequently doesn’t happen in the construction sector – and the biggest players tend to be the worst offenders.”

The school measures its own success in terms of the extent to which it can encourage the whole supply chain to engage with the green agenda. But it would never approve of the use of sustainability as a bargaining chip for cash flow assurance, McCarthy stresses.

Any attempt to nudge lesser players in the supply chain simply by honouring existing payment promises appears more patronising than encouraging, he adds. “Improved terms could be used as an incentive, but we should not treat payment on time as a pat on the head. It’s a contractual entitlement.”

Good rewards for better data

One way of adding an extra dimension to the value exchange might be to introduce a ‘sustainability data for benefits’ swap between supplier and buyer.

Convened by the University of Cambridge Institute for Sustainability Leadership (CISL) in 2017, Project Trado was an experiment to test whether sustainability data could be transferred from the start of a supply chain – in this case, tea farmers in Malawi – to large consumer goods companies at the other end, including Sainsbury’s and Unilever. Powered by blockchain technology and supported by Barclays, BNP Paribas, Rabobank and Standard Chartered, the project also explored whether benefits via trade finance terms could incentivise small primary suppliers to adopt greener practices. 

For the 225 farmers involved, sharing information about the social and ecological issues they were dealing with unlocked more favourable pre-shipment finance terms with potential long-term benefits. Contributing more than £57m a year to the country’s trade figures, tea is big business in Malawi, representing the country’s second-largest export commodity. The evidence from the project proved both that data transfer is possible and that banks can incentive small farmers.

The project’s organisers hope that the Trado model will serve as a blueprint that can be applied in other settings to deliver social and environmental improvements. But, when it comes to applying the approach more widely, supplier size needs to be a key consideration, as Thomas Verhagen, senior programme manager at CISL, explains. 

“These mechanisms can work if they adhere to a specific system of proportionality with regard to rewards and penalties. The smaller the supplier, the larger the rewards for compliance – and the smaller the penalties for non-compliance – should be. Smallholder farmers in particular should face no penalties,” he argues.

Trado is not only initiative that’s been exploring potential for linking data and finance. The International Chamber of Commerce has also developed standards for the transfer of sustainability information alongside commercial banking payments. These have now been adopted by Swift, an inter-bank system for sending payment orders.

What these initiatives have in common is that they are striving to monetise the value of sustainability deep in the supply chain. They are trying to make it pay, for everyone, including consumers and shareholders.

Given the undeniable currency of climate action right now, this green is the new gold.