Insight letter on Contracting in the New Economy – Contracting to reduce greenhouse gas emissions

Under the Paris Agreement, the 196 parties to the treaty committed to limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels. Everyone knows that while not solving the entire problem, a critical objective of meeting this goal is to drastically reduce emissions of greenhouse gases (GHG). This was emphasized even stronger with the latest report from the Intergovernmental Panel on Climate Change (IPCC), issued on 4 April 2022.

Do the dominant modes and methods of contracting support this objective well? There are reasons to believe that the answer to this question is no.

Are greenhouse gas house emissions even a contractual problem? Indeed, it is. One standard commonly used for tracking and measuring GHG emissions is the Green House Gas protocol. According to this standard, GHG emissions are divided into three scopes:

• Scope 1: emissions generated directly from an organisation’s use of its resources, such as plants, offices etc.
• Scope 2: emissions generated indirectly by the purchase and use of energy.
• Scope 3: all other emissions indirectly generated by an organisation.

A main part of the scope 3 emissions typically comes from the organisation’s supply chain. And – which is crucial – for many organisations, the scope 3 emissions generated by the supply chain constitute the absolute majority of the organisation’s total emission of GHG. Hence, for many organisations, the largest effect on reducing GHG will come from ensuring that the GHG emissions in the supply chain are reduced. To zero, or at least net zero. This makes the issue a contractual problem, since it is mainly through contracts that an organisation can influence the activities of other organisations.

Reducing GHG emissions is only part of the shift towards a sustainable economy and society. It belongs to the ‘E’ in ESG – the acronym used for sustainability in the environmental, social and governance areas. There is today in many medium-sized and large organisations a standard way of contracting for ESG: the use of a code of conduct, which the supplier is contractually obliged to follow. Or, when instead the supplier is the stronger party, imposing the supplier’s code of conduct on its customer.

While being a step in the right direction, only using the ‘code-of-conduct-solution’ will often not be sufficient. Why? Because GHG emissions are typically an integrated part of many organisations’ internal processes, related to for example energy and other resources used in those processes, not least those processes for producing the goods and services purchased by customers. And those supplier processes do not exist independently from the customer processes, but are on the contrary deliberately designed to create value by making the customer processes more efficient or value enhancing. Suppliers of transport solutions, building contractors and manufacturers of components are just a few examples.

Reducing GHG emissions therefore often requires taking an end-to-end approach, involving both the supplier (including its sub-suppliers) and the customer. The GHG emissions reduction then becomes a significant collaborative challenge. The traditional, transactional contract is typically not a good tool to deal with such collaborative challenges. It is a tool for creating relationships at arms-length, with focus on commercial transactions instead of collaborative relationships, aiming to allocate instead of optimizing risks. While being a highly useful tool in many customer-supplier relationships, it will often not provide support for creating the kind of collaborative relationships needed to drastically reduce GHG emissions.

The relational contract provides an alternative. Not least when used in the Vested model, a sourcing model in which the parties build strong partnerships focusing on achieving jointly defined outcomes such as customer satisfaction, lower cost of ownership and – not least – increased sustainability and reduced GHG emissions. A growing number of organisations are using this approach to ensure that their sustainability goals and objectives are met.

Questions for you to think about

• Have your company set corporate sustainability targets, including targets related to reduction of GHG emissions?
• Does your company have a strategy for reducing Scope 3 emissions, involving more than the standard ‘code-of-conduct’-solution?
• Do you have rules in your contracts with important Scope 3 emission suppliers that truly supports GHG emission reductions, end-to-end?