ESG reporting: preparing for the new regime
CSj takes a look at Hong Kong Exchanges and Clearing’s proposed ‘upgrade’ of its Environmental, Social and Governance Reporting Guide.
Mandatory requirements for companies to report on their environmental and social impacts have become a standard part of most regulatory regimes around the world, and, while it has been a little longer coming to Hong Kong, such requirements have now taken their rightful place in the HKSAR. The new Companies Ordinance, implemented in March 2014, requires all Hong Kong incorporated companies (unless exempted) to include a ‘business review’ in their annual reports discussing their environmental policies and performance, and giving an account of their key relationships with stakeholders such as employees, customers and suppliers.
To avoid the scenario whereby Hong Kong-incorporated companies would be subject to tougher disclosure requirements than those incorporated in other jurisdictions, in May this year broadly similar disclosure requirements were added to the ‘Disclosure of Financial Information’ section (Appendix 16) of the listing rules. Following these legislative and regulatory reforms, from the financial year ending on or after 31 December 2015 onwards, it will now be mandatory for listed issuers to report on their environmental and social impacts.
Prior to these developments, Hong Kong had adopted a voluntary approach to environmental, social and governance (ESG) reporting. In 2012, Hong Kong Exchanges and Clearing (the Exchange) launched voluntary guidelines on the disclosure of ESG information, designed to help listed companies get started in ESG reporting.
Judging from the level of environmental and social disclosure in Hong Kong, the Exchange’s ESG Reporting Guide (which came into effect in the 2013 reporting year) was badly needed. Unfortunately, however, the guide did not lead to a significant increase in the number of listed companies adopting ESG reporting. A survey of ESG reporting carried out by the Exchange in June this year met with a low response rate (21%), and approximately two-thirds of the companies that did respond indicated they were not reporting on ESG issues.
Based on a survey conducted by Bloomberg in April this year, the Exchange estimates that about half of companies listed on the Exchange are currently reporting on ESG matters. The survey indicates, as you might expect, that the level of ESG reporting varies according to market capitalisation – with a lower uptake rate among small cap and a higher uptake among large cap companies.
The fact that the guide did not result in a significantly wider adoption of ESG reporting does not reflect on the quality of the guide itself. The guide gives a useful and user-friendly introduction to ESG reporting, which complements the more complex international guidelines available, such as those produced by the Global Reporting Initiative. Its one ‘flaw’ is the level of compliance it requires – the market needs a stronger nudge to start on the ESG journey. Indeed, recent market feedback received by the Exchange indicates that many issuers are waiting for the recommended disclosures of the guide to be upgraded to ‘comply or explain’ before they begin to report. As a result, the Exchange is now proposing to do just that.
The proposed revisions to the guide
In July this year, the Exchange published a consultation paper seeking views on proposed amendments to its ESG guide which would see many of the recommended disclosures of the guide being upgraded to ‘comply or explain’. The consultation (Review of the Environmental, Social and Governance Reporting Guide, available on the Exchange’s website: www.hkex.com.hk) also proposes to revise the guide in a number of other ways to update and improve it. The main proposed changes are highlighted below.
1. Reorganising the guide
Currently, the Exchange’s ESG guide is organised into four subject areas (workplace quality, environmental protection, operating practices and community involvement). The Exchange proposes to rearrange the guide into two subject areas (environmental and social) since these two areas are the major components of ESG reporting (regarding the ‘governance’ component of ESG, see ‘Where is the governance?’ on page 24).
The reorganisation of the guide would also involve a revision to the ‘aspects’ listed under these two subject areas. Under subject area A (the ‘environment’), there would be three aspects:
- emissions (current aspect B1, renumbered aspect A1)
- use of resources (current aspect B2, renumbered aspect A2), and
- the environment and natural resources (current aspect B3, renumbered aspect A3).
Subject area B (‘social’) would comprise eight aspects: employment, health and safety, development and training, labour standards, supply chain management, product, anti-corruption and community investment.
2. Upgrading the compliance level
The reordering mentioned above foregrounds the environmental aspects of ESG disclosure and this is also reflected in the fact that the Exchange proposes to upgrade both the ‘general disclosures’ and the ‘key performance indicators’ (KPIs) under this subject area to comply or explain, while only the general disclosures under the social subject area would be upgraded to comply or explain – the KPIs under this subject area would remain voluntary recommendations (see ‘The proposed new ESG Guide’ on page 26).
3. Requiring compliance disclosure
The focus of the Exchange’s consultation is on upgrading issuers’ reporting obligations. In addition to its proposed revisions to the guide, it has also proposed an amendment to listing rule 13.91 introducing a new obligation for issuers to state in their annual reports or ESG reports whether they have complied with the ‘comply or explain’ provisions set out in the ESG guide for the relevant financial year. Where an issuer deviates from the ‘comply or explain’ provisions, it must give considered reasons in its ESG report.
4. Promoting gender diversity
The proposed ‘upgrade’ of the ESG guide would also be accompanied by some textual revisions. These revisions would be designed to ensure consistency with the ESG disclosure requirements of the new Companies Ordinance and Appendix 16 of the listing rules, and to incorporate disclosure of gender diversity in the guide.
The Exchange’s consultation points out that including gender disclosure in the guide would bring it in line with international standards of ESG reporting and with Hong Kong’s Corporate Governance Code. The Code provides that issuers should have a policy concerning diversity of board members and disclose that policy in their corporate governance reports. While the Code does not define diversity, it states that it involves a number of factors, including but not limited to, gender, age, cultural and educational background, and professional experience.
‘We consider that it is appropriate to include gender disclosure in the ESG guide, as it will give companies the opportunity to provide a fuller picture of the diversity within their entire work force,’ the consultation states. The Exchange hopes that highlighting the need to report on gender diversity at every level of employment will help to create a pipeline for women to move up the corporate ladder to more senior positions.
What will be the impact of the proposed changes?
The proposed changes to the ESG guide have been in the pipeline for some time and are unlikely to take the market by surprise. Moreover, these changes will be ancillary to the ESG disclosure requirements of the new Companies Ordinance and Appendix 16 of the listing rules. Technically speaking, the new proposals do not amount to mandatory ESG reporting. After all, if any particular disclosure called upon by the ESG guide is not relevant to an issuer, it can opt to ‘explain’ its non-compliance rather than ‘comply’ with the disclosure requirement.
That said, the proposed changes do represent an ‘upgrade’ for Hong Kong’s ESG reporting requirements. The Exchange points out in its consultation that the comply-or-explain approach is an effective tool to encourage ESG reporting since it enables listed companies to take an ‘evolutionary’ approach to building their competencies and devising their own ESG strategies.
The revised guide still allows for flexibility in the way companies comply. The Exchange is not proposing, for example, to simply make compliance with the entire guide subject to comply or explain. ‘We do not propose to upgrade all the recommended disclosures in the ESG guide at this stage, as we consider that setting the reporting bar too high prematurely may have an adverse effect on the overall quality of the ESG reporting amongst our issuers. For instance, it may encourage box-ticking or treating non-compliance as a norm,’ the consultation states.
The compliance burden has also been minimised by maintaining an approach that allows for multiple reporting formats – the ESG disclosures may be presented as information in the issuer’s annual report, in a separate report, or on the issuer’s website. Furthermore, disclosures may be provided at the group level, rather than by each subsidiary within a group. Issuers are also permitted to make their disclosures (up to three months after the publication of their annual reports.
The Exchange intends to implement the new guide and listing rule changes, subject to responses to the consultation, for financial years commencing on or after 1 January 2016. This means that companies without an ESG data collection and analysis capacity will need to establish one immediately since it takes at least a year for such a system to start yielding the necessary data. Companies should bear in mind that the proposal to upgrade the KPIs under the ‘environment’ subject area to comply or explain will mean that companies will need to disclose hard data on all of the environmental aspects listed in the guide (such as emissions and use of resources).
ESG reporting is a long-term commitment. The Exchange’s ESG consultation points out that there are many long-term benefits to getting this right – including cost savings and increased profit margins, talent retention, improved access to capital, better supply chain management and an improved reputation. The benefits of staying ahead of the new ESG disclosure requirements of the Companies Ordinance and the listing rules, as well as the proposed new requirements of the ESG guide, are not therefore limited to regulatory compliance. ‘The process of reporting acts as a catalyst that prompts issuers to assess the environmental and social risks that may impact their businesses and vice versa. What follows as a result is that companies are better prepared to manage these risks,’ the consultation states.
The ‘Review of the Environmental, Social and Governance Reporting Guide’ consultation paper is available on the Exchange’s website: www.hkex.com.hk.
SIDEBAR: Where is the governance?
The Exchange’s Environmental, Social and Governance Reporting Guide does not have much to say about ‘governance’. The guide points out that governance is dealt with separately in the Corporate Governance Code (Appendix 14 of the main board listing rules). Is the governance component of the acronym therefore redundant? Far from it. The term ‘ESG’ has become shorthand for the key components of non-financial reporting. It just so happens that in Hong Kong the environmental and social components have taken longer than the governance component to enter the regulatory spotlight – hence the fact that the Corporate Governance Code predates the ESG guide by seven years.
Nevertheless, the three components of ESG reporting are very much linked – after all, the ultimate goal of good corporate governance is to ensure that an organisation is run in an efficient and sustainable manner. This requires a functioning board and management that can monitor and manage the risks the organisation is facing and may face in the years ahead. Clearly, this task will require the organisation to be collecting, analysing and disclosing ESG information such as its energy consumption, its water consumption, and the amount of pollutants or packaging materials it produces.
The environmental, social and governance components of ESG are therefore all linked under risk management. The Exchange’s consultation points out that an organisation’s impacts on the environment and society can no longer be regarded as ‘someone else’s problem’ – in the current environment, these impacts represent potentially serious risks to the organisation’s continued existence. The consultation cites a 2012 study by KPMG (see details below) which identifies 10 global sustainability ‘megaforces’ (climate change, energy and fuel, material resource scarcity, water scarcity, population growth, wealth, urbanisation, food security, ecosystem decline and deforestation) which will affect the future of every business over the next two decades. The consultation points out that ‘companies with ESG practices embedded in their corporate culture will likely be much better placed to respond to the impacts of these megaforces’.
The 2012 KPMG study (‘Expect the Unexpected: building business value in a changing world’) is available online at: http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/building-business-value.pdf.