The ESG challenge
How to prepare a business review
In March this year, with the implementation of the new Companies Ordinance, Hong Kong imposed its first mandatory environmental, social and governance (ESG) reporting requirement. Hong Kong-incorporated companies, unless exempted, will need to comply with the ‘business review’ requirement of the new Companies Ordinance for financial years beginning on, or after, 3 March 2014, inclusive of ESG concerns. This article takes a look at what is required and what guidance is available to help companies with their compliance programmes.
There is an increasing trend for businesses to produce information on the environmental, social and governance (ESG) aspects of their operations. Historically, this disclosure has been made on a voluntary basis, but now an increasing number of jurisdictions, in both developed and emerging markets, have brought in mandatory ESG reporting requirements. Here in Asia there are mandatory ESG disclosure requirements in place in Mainland China, Hong Kong, India, Indonesia, Malaysia and Taiwan. In Australia, ESG reporting is subject to a ‘comply or explain’ enforcement mechanism.
Hong Kong is the latest recruit to this group – it ‘upgraded’ its ESG disclosure requirements in March this year with the implementation of the new Companies Ordinance (Cap 622). Under Section 388 of the new law, companies, unless exempted, need to include a ‘business review’ in the directors’ report section of their corporate reports. The requisite contents of the business review are set out in Schedule 5, and must include a number of ESG areas such as the company’s environmental policies and performance, and the company’s key relationships with its employees, customers and suppliers and others that have a significant impact on the company. Interestingly, this also means that Hong Kong-incorporated listed issuers may have additional compliance requirements over and above those incorporated under other jurisdicitons, as the ESG Reporting Guide under the listing rules is not as yet mandatory.
The ESG challenge
For companies already well versed in ESG reporting the business review requirement will probably not have much impact, but for companies new to ESG reporting the new requirements will be a significant compliance challenge. In particular, among other things, it will require companies to:
- quantify non-financial factors using key performance indicators (KPIs)
- provide context for their corporate reports, and
- report forward-looking information.
These three aspects have historically been major hurdles for companies embarking on ESG reporting. Companies need to acquire the skills to use the metrics for quantifying non-financial factors and there is often a concern that providing contextual and forward-looking information may expose the company to the threat of litigation.
In addition, a recent report by the Global Corporate Governance Forum (GCGF) – Emerging Trends in Environmental, Social and Governance Data and Disclosure: Opportunities and Challenges – points out that ESG reporting often requires more fundamental changes to the way companies are run. Firstly, it requires the adoption of a stakeholder, rather than a shareholder, model of the corporation. ‘This shift effectively implies commitments to strategic investments in employees, customers, suppliers, communities and the environment in ways that produce rewards for stockowners as well as for these stakeholders,’ says the GCGF report.
Secondly, ESG disclosure also means shifting to a long-term focus since it requires companies to monitor matters relating to the future sustainability of the environment and society.
Given the above, the cost of ESG reporting will clearly be an issue, although the business review requirement is targeted at larger companies which are likely to have already embarked on ESG reporting and are generally better positioned to absorb the extra costs involved. Under the new Companies Ordinance, companies which are eligible for simplified reporting are exempted from the business review requirement and the criteria for companies to qualify for simplified reporting have been relaxed.
Guidance on compliance
For companies not exempted from the business review requirement there are a number of guides, both globally and locally, to help with compliance. Probably the best-known international guide is the latest generation – ‘G4’ – of sustainability reporting guidelines produced by the Global Reporting Initiative (GRI).
‘Awareness of the G4, which comprises underlying principles on content and quality of reports as well as standard disclosures, would assist reporting entities under Section 388 of the Companies Ordinance to prepare the business review,’ says the team at SusDev Global, a Hong Kong-based sustainability reporting service provider.
Locally in Hong Kong, the Environmental, Social and Governance Reporting Guide published by Hong Kong Exchanges and Clearing (HKEx) provides an excellent introduction to ESG reporting, but there is now a new guide specifically targeted at helping companies comply with the new business review requirement. Published by the Hong Kong Institute of Certified Public Accountants (HKICPA), the Guidance for the Preparation of a Business Review under the Hong Kong Companies Ordinance Cap 622 (HKICPA Guide) is available in Accounting Bulletin 5 on the HKICPA website: www.hkicpa.org.hk.
The guide, while only in draft form, not only clarifies what disclosures will be required by the new Companies Ordinance, it is also accompanied by an Implementation Guidance which provides highly practical guidance on specific issues companies may encounter in their compliance programmes. For example, the Implementation Guidance has useful advice about the three aspects of ESG disclosure mentioned above – quantifying non-financial factors using KPIs, and providing contextual and forward-looking information.
1. Quantifying non-financial factors using KPIs
The Implementation Guidance provides illustrative examples of the KPIs in nonfinancial areas (such as those relating to water and energy use, waste production, CO2 emission and employee health and safety), which should be disclosed in a business review. A retail company should, for example, be disclosing its waste production due to packaging. This should include the amount of waste arising from packaging (measured, for example, in kilograms of packaging waste per HK$1,000 of products sold). Another example given is that of the KPIs a company in the mining industry should be disclosing relating to ‘lost-time injury frequency rate’ (measured as the number of lost-time injuries per million hours worked).
- The Implementation Guidance emphasises that reporters should:
- explain the calculation methods
- disclose the source of underlying data and, where relevant, explain the assumptions
- highlight where information from the financial statements has been adjusted for the purposes of computing a KPI, and provide a reconciliation
- disclose corresponding amounts for the financial year immediately preceding the current year where available, and/ or
- identify and explain any significant changes to the calculation method used to compute the KPIs compared to previous financial years, including significant changes in the underlying accounting policies adopted in the financial statements.
The HKICPA Guide emphasises that KPIs and other information in the business review should be prepared and presented consistently from one year to the next. Where consistency is maintained, it suggests that directors should include a statement to this effect, such as: ‘no changes have been made to the source of data or calculation methods used over the periods shown’.
Finally, reporters should bear in mind that the ultimate purpose of including these KPIs is to take the first step towards improving performance in the relevant areas. The HKICPA Guide recommends, therefore, that reporters should set and communicate its performance targets and measure whether they are achieving them.
2. Providing context
One of the principles emphasised by the HKICPA Guide is that the business review should both complement and supplement the financial statements in order to enhance the quality of disclosure. ‘In complementing the financial statements, the business review provides useful financial and nonfinancial information about the business and its performance that is not reported in financial statements but which, in the directors’ judgement, may be relevant to the members’ evaluation of past results and assessment of future prospects,’ the HKICPA Guide states.
This might include commenting on the events that have impacted the reporting entity over the reporting period. It might also include changes in market conditions which have had a significant impact on the development and performance of the reporting entity during the period. ‘Every company is affected by its external environment. Depending on the nature of the business, the business review should include discussion of matters such as the reporting entity’s major markets and competitive position within those markets and the significant features of the legal, regulatory, macro-economic and social environment that influence the business,’ the HKICPA Guide states.
3. Reporting forward-looking information
The HKICPA Guide also stresses the need for the business review to report on the main trends and factors that directors consider likely to impact the future prospects of the reporting entity. This advice is supported by SusDev Global. ‘Financial reporting has conventionally focused on presentation and analysis of historical data. In contrast, sustainability reporting frameworks, such as the GRI sustainability reporting guidelines, are designed to assist stakeholders to evaluate how the long-term profitability of any organisation can go hand-in-hand with social justice and protection of the environment,’ says the team at SusDev Global.
As mentioned above, many reporters are reluctant to give forward-looking information for fear that this may expose the company to the threat of litigation. The HKICPA Guide therefore advises directors to include a caveat in their business review advising readers that such disclosures are made in good faith but should be treated with caution given the uncertainties involved and the difficulty of getting objective verification.
The significance of the business review requirement
The new business review requirement is a significant escalation of Hong Kong’s ESG disclosure requirements, not so much in terms of the specific requirements – these reflect standard ESG disclosure best practice – but because it is the first time such requirements have been made mandatory in Hong Kong.
We will have to wait until next year (2015) to assess the quality of disclosures in the first batch of business reviews included in annual reports, but that quality will not only depend on what is disclosed, but also on how the disclosures are made. Will the business reviews be written in a clear and readily understandable style? Will they provide readers with focused and relevant information?
The SusDev Global team points out that the G4 guidelines offer helpful guidance here. Materiality is a key concept in G4 and the guidelines recommend that reporters document the process for defining report content. ‘Inevitably the process for defining report content requires subjective judgements but the organisation is expected to be transparent about its judgements. Accurate records enable the organisation to explain its chosen approach to reporting on some sustainability impacts rather than others, importantly it also facilitates independent assurance of the process for defining report content,’ the G4 guidelines state.
SusDev Global is concerned that companies may have an ‘opt out’ from disclosing material issues since Schedule 5 of the new Companies Ordinance specifically exempts companies from disclosing ‘impending developments or matters in the course of negotiation if the disclosure would be seriously prejudicial to the company’s interest’. They suggest that the HKICPA Guide could encourage reporters to adopt the approach taken by the GRI guidelines to any such omissions. ‘In exceptional circumstances, if it is not possible to disclose certain required information, the report should clearly identify the information that has been omitted and explain the reasons why the information has been omitted,’ SusDev Global says. The GRI guidelines add that, where the omission is due to the unavailability of data, the organisation should disclose the steps being taken to obtain the data and the expected timeframe for doing so.
With the implementation of the new Companies Ordinance in March this year, Hong Kong entered the era of mandatory ESG reporting requirements. Robin Bishop, Director of Corporate Responsibility, Community Business, emphasises however that there are huge gains to be made by companies prepared to go beyond the mandated requirements.
‘There is a solid business case for companies to go beyond compliance when it comes to ESG reporting. Organisations increasingly find that their profit and loss statements are influenced by parameters that do not feature on the balance sheet. These external parameters are ESG or “sustainability” issues that could be economic, environmental or social in nature. Sustainability reporting gives organisations a framework to identify these sustainability issues, and to understand their impacts on its business. There are also direct benefits which include enhanced brand value or reputation, greater success at attracting and retaining talent, operational efficiency, mitigation and/ or reduction of risk, financial impact as well as the opportunity for organisational growth,’ she says.
Kieran Colvert, Editor, CSj
The HKICS submission to the ‘Guidance for the Preparation of a Business Review under the Hong Kong Companies Ordinance Cap 622’, is available in the ‘Submissions’ section of the HKICS website: www.hkics.org.hk.
Enquiries should be directed to Mohan Datwani, Director, Technical and Research – by email: firstname.lastname@example.org; or by phone: 2881 6177.
- The Guidance for the Preparation of a Business Review under the Hong Kong Companies Ordinance Cap 622, published by the Hong Kong Institute of Certified Public Accountants (HKICPA), is available in Accounting Bulletin 5 on the HKICPA website: www.hkicpa.org.hk.
- The Environmental, Social and Governance Reporting Guide, published by Hong Kong Exchanges and Clearing (HKEx), is available on the HKEx website: www.hkex.com.hk.
- The G4 generation of Global Reporting Initiative (GRI) guidelines can be found on the GRI website: www.globalreporting.org, or directly at: https://g4.globalreporting.org.
- The BEC Handbook: Understanding Materiality for Environmental, Social and Governance Reporting, published by the Business Environment Council (BEC), is available on the BEC website: www.bec.org.hk.