Why ESG Risks Pose a Challenge for Internal Audit

Why ESG Risks Pose a Challenge for Internal Audit

Within the intricate web of global supply chains, we encounter a multitude of risks – reputational, legal and compliance, environmental sustainability, and climate change – all deeply intertwined with business continuity, and all magnified by the pandemic and global conflicts. These elements create a dynamic landscape where supply chain-related ESG risks have the potential to impact organisations on multiple fronts.

With Supply Chain ESG Risks: Harnessing the Potential of Internal Audit, AuditBoard has collaborated with the Chartered IIA to highlight the role of internal audit in aligning supply chain operations with ESG values, targets, and overall business strategies. Download the free guide here.

It’s no longer sufficient for organizations to merely optimise their supply chain operations; they must do so with a keen awareness of their environmental footprint, social responsibility, and ethical governance. To navigate this complex terrain, internal audit can provide insights, guidance, and assurance across three themes: Environmental sustainability, social and governance responsibility, and the effectiveness of ESG risk management programs. Internal audit can support ESG efforts by providing assurance to the board and senior management in identifying, managing, and mitigating ESG-related supply chain risks effectively.

Organisations are under increasing pressure to ensure that their suppliers adhere to labour rights and legislative standards, reduce their carbon footprint to support the road to Net Zero, and eradicate any human rights abuses throughout their supply chain. However, violations of labour rights, such as forced labour, child labour, and modern slavery can be difficult to detect and prevent, particularly in complicated global supply chains, potentially exposing businesses to reputational harm and legal action. The lack of transparency in the supply chain, where numerous suppliers may withhold key information or offer incomplete or misleading data, can make it difficult for supply chain teams to analyse and mitigate ESG risks in their supply chain.

Climate change risks are becoming an increasingly prominent issue for businesses as they seek to reduce their carbon footprint within their supply chain and operate in a more socially responsible manner. Natural disasters exacerbated by accelerating climate change such as hurricanes, floods, and wildfires can also cause major disruption to the supply chain operations by damaging infrastructure, disrupting transportation networks, or causing power outages. Climate change-related risks such as extreme weather events and rising sea levels can also have significant impacts on supply chains, particularly for industries such as agriculture, forestry, and manufacturing. 

In addition to physical risks, transition risks can also have a significant impact on an organisation and are often triggered by changes in legislation, technology, and consumer behaviour. For example, car companies have invested heavily in Electric Vehicle (EV) technologies to reduce the carbon emissions of their vehicles. The EV batteries market is still developing and there is the supply chain risk around shortages of critical materials such as lithium and cobalt used in these batteries. This could lead to production delays for organisations and higher prices for EVs for consumers. In some cases, organisations have faced risks such as higher costs and lower profits in the short term during this transition. Environmental sustainability is increasingly important to businesses from a reputational perspective. Customers are demanding more environmentally sustainable goods and services.

Tesla, an electric car company, has been criticised for its environmental impact. The company has been accused of using child labour within its supply chain to mine cobalt, a key material in its batteries. Tesla has also been criticised for its lithium mining operations, which can have a negative impact on groundwater and ecosystems.

Amazon, the world’s largest online retailer, has been accused of generating a large amount of packaging waste and of having a high carbon footprint throughout its supply chain. Nestlé, a Swiss food and drink company, has been accused of using excessive amounts of water and contributing to deforestation through its third-party supply chain partners.

Supply chains may also be impacted by legislative changes and environmental sustainability policies. For example, ‘The German Supply Chain Act’ is a piece of legislation that mandates businesses to undertake due diligence on their supply chains and make efforts to prevent human rights breaches and environmental issues. 

Although this issue is gaining prominence, supply chain expertise is itself in short supply in both organisations and internal audit functions. This disconnect is worrying as the risk profile is changing and the overall risk posed by supply chain-related risk is increasing, but the time spent by internal auditors on this risk is trending in the other direction. However, for some internal audit functions, the in-house skills to assess these supply chain risks may not be adequate or available at all.

To explore how ESG considerations influence an organisation’s supply chain operations, and internal audit’s role in measuring the effectiveness of ESG due diligence and risk management practices carried out by their organisation, download Supply Chain ESG Risks: Harnessing the Potential of Internal Audit here.