Tobacco major ITC gets a Medium Risk

Sustainalytics, a global leader in ESG and Corporate Governance research and ratings, looks at the businesses of ITC and presents its findings.
By Morningstar |  17-07-20

ESG Impact of Products and Services

  • The management of the inherent characteristics of input materials, and the impacts during use, disposal and recycling (excluding carbon).
  • Severe Risk, considering its high exposure and below average management of E&S Impact of Products and Services. (E&S is the environmental and social risk).

The inherent health impacts of tobacco create risks that are difficult for companies to mitigate. Consumers have filed thousands of lawsuits individually or collectively, many of which result in decades-long cases.

Human Capital

  • The management of risks related to scarcity of skilled labour as well as labour relations, such as non-discrimination, working hours and minimum wages.
  • Low and moderately below subindustry average.

Tobacco manufacturers rely on a diverse set of employees globally, from R&D and marketing professionals to workers in factories and logistics networks. In the long term, poor management practices often result in lower employee motivation and increased turnover rates, which adds HR costs through the need to replace and retrain new employees.

Workforce diversity is also increasing in importance as an HR concern: companies risk shutting out large portions of the talent pool due to outward perceptions of an unwelcome or unaccommodating work environment.

Corporate Governance

  • Represents foundational structures for the management of ESG risks.
  • In consideration of its high exposure and average management, we view the company to have medium unmanaged risk attributable to its corporate governance.

The quality and integrity of the company's board and management, its ownership structure and shareholder rights are identified as the highest weighted governance areas of focus. The company is publicly traded, which leads to heightened scrutiny of its governance practices and increases the importance of governance structures, practices and behaviour. This translates into high exposure to baseline Corporate Governance risk.

The company is noted for showing particular strength in its ownership structure/shareholder rights and its stakeholder governance.

On the other hand, it is noted for weakness in its audit and financial performance systems, its board structure and its remuneration systems.

It has average management of its other governance pillar.

Overall, we rate the company's corporate governance management as average.

Business Ethics

  • The management of ethical considerations applicable to most or all sectors, such as taxation and accounting, anticompetitive practices and intellectual property issues.
  • Considering its medium exposure and average management of Business Ethics, we view the company to be at low risk for the issue.

Tobacco companies experience significant impacts related to business ethics, most of which stem from the unique regulatory scrutiny placed on tobacco companies’ marketing practices, sales and taxation. Governments are trending toward tightened regulations, particularly regarding marketing practices. In addition to mandatory on-package health warning labels, which are now common across the sector, some regulators are requiring on-package graphic depictions of potential health impacts, the removal of all package branding, and/or the removal of all point-of-sale display marketing.

Resource Use

  • How efficiently and effectively a company uses its raw material inputs (excluding energy and petroleum-based products) in production and how it manages related risks.
  • The company's exposure to Resource Use issues is low and moderately below subindustry average.

Tobacco manufacturing is a water-intensive process. It can have a significant impact on water availability where manufacturing facilities are located, given the need to either source water from local suppliers or to extract it from the ground. Water use in tobacco manufacturing occurs mainly through what is called Dry Ice Expanded Tobacco (DIET) treatment, which is used in processing and coating tobacco, tobacco pulp processing and in producing the packaging for products (for instance, inking and dyeing). Any change in the availability or quality of freshwater can have an impact on a company’s operations. In water-stressed areas, in particular, a water shortage can lead to issues in production, higher prices, or even social unrest vis-à-vis local communities.

These risks associated with water scarcity are expected to increase as the affects of climate change continue and more regions experience water shortages. To mitigate related risks, companies should map their operations and identify which sites are particularly exposed to risks related to water stress.

Furthermore, companies should implement comprehensive water management programmes as part of their environmental management systems, and implement initiatives that focus on reducing water use, or on recycling and reusing water where possible.

Resource Use - Supply Chain

  • Focuses on companies' management water scarcity and raw material inputs risks (excluding energy and petroleum based products) within its supply chain.
  • The company's exposure to Resource Use -Supply Chain issues is low and moderately below subindustry average.

The large resource inputs for tobacco cultivation are significant cost drivers for commodity pricing. Poor resource management causes environmental damage and increased scarcity, with resulting economic impacts. Although variable by region, the cultivation of tobacco is water-intensive, requiring approximately three tonnes of water per tonne of tobacco. After harvest and before sale to manufacturers, most tobacco is dried using coal, oil or wood fires, which require large quantities of input fuel. Inefficient use of these resources can negatively impact commodity prices and create long-term procurement difficulties for buyers. As agricultural operations are particularly vulnerable to long-term climate change impacts, crop and process innovation is a significant area of investment.

Some companies have developed improved cultivation methods, which they recommend to suppliers.

Strong management of resource use in the supply chain, through efficient water use or improved soil management techniques, for example, can build resilience to increasing resource scarcity. Strong supply chain management includes strong environmental and social standards embedded into suppliers’ contractual requirements, coupled with regular compliance audits and follow-up reviews. Ongoing supplier engagement and training on best practices are critical to ensuring continuous improvement.

Land Use and Biodiversity – Supply Chain

  • Focuses on how companies manage the impact of their suppliers' operations on land, ecosystems and wildlife.
  • The company's exposure to Land Use and Biodiversity -Supply Chain issues is low and moderately below subindustry average.

Tobacco companies source most, if not all, of their tobacco from third party suppliers. Commercial tobacco farming has shifted towards middle-and low-income countries, such as Brazil, China and India. The deforestation associated with tobacco production contributes to CO2 emissions, climate change as well as habitat fragmentation and a loss in biodiversity, mainly in Latin America, South and South-East Asia and Sub-Saharan Africa.

Tobacco production is also associated with land degradation, a reduction in soil fertility and negative impacts on water cycles. Tobacco is typically grown as a monocrop, associated with the use of chemical pesticides and growth regulators that are a further threat to biodiversity. Large quantities of wood are burned for fuel in the process of tobacco curing, i.e. the drying of tobacco leaf. Wood is also used in producing rolling papers and in product packaging.

Deforestation and a loss of biodiversity in supply chains can negatively impact tobacco companies, due to consumer scrutiny and lead to lower sales, but also to investors potentially disengaging from companies associated with deforestation in their supply chains. Land degradation can lead to disturbances in the supply of tobacco. Companies can mitigate this issue by maintaining strong standards on biodiversity and deforestation for their suppliers and encouraging sustainable agricultural practices.

Human Rights – Supply Chain

  • Focuses on a company’s management of fundamental human rights issues occurring in its supply chain.
  • The company's exposure to Human Rights -Supply Chain issues is low and moderately below subindustry average.

Major publicly traded tobacco companies focus exclusively on manufacturing and marketing rather than growing tobacco and purchase leaves from plantation or merchant suppliers. Multiple ESG-related business decisions and impacts occur before the raw material reaches manufacturers, which can all affect product quality and availability as well as brand reputation.

Tobacco leaves are often hand-picked to maximize product quality and plant yields, and tobacco growers have been found to employ children or undocumented foreign workers to fill the need for inexpensive labour.

Child labour in particular is a systemic issue in the tobacco supply chain, with companies receiving reputational damage from public criticism. This is a notable issue on U.S. plantations, where child labour in the agricultural industry is permitted under federal law. U.S. federal legislation sets minimum ages for agricultural workers at 16 years old for “particularly hazardous” work, 14 for employment without parental permission, 12 with parental permission and no minimum age requirement if the farm is defined as a small business. Regardless, some U.S. companies prohibit under-16 workers in their supply chains. Stakeholder attention on the use of child labour and/or exceptionally poor worker treatment in supply chains will trigger significant negative publicity for the company. For these reasons, companies have stringent supply chain policies and conduct extensive monitoring and auditing programmes.

Best practice includes contractually binding supplier policies which go beyond legislative minimums, supported by regular in-person plantation audits to review site working conditions.

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