Brian Ho, Partner, Climate Change and Sustainability Services, EY, discusses how environmental, social and governance disclosure requirements may evolve in Hong Kong and what businesses can do to prepare for the change.
Environmental, social and governance (ESG) issues are not simply a matter of compliance or philanthropy, but of emerging risks. EY’s 2018 global investor survey – Does your nonfinancial reporting tell your value creation story? – found that 97% of institutional investors have already incorporated ESG factors into their investment decisions, either in a structured or informal way. Moreover, at least 87% agree that companies should be reporting on ESG from a risk perspective. As climate-related financial losses become more prominent, for example, there has been an increasing focus on climate change as a corporate risk. The survey found that 48% of investors would not invest in organisations failing to address climate risks, compared to only 8% responding in this way in 2017.
Hong Kong is one of the leading global financial centres, but are our listed issuers disclosing useful information under the new ESG-disclosure regime? EY’s research analysing the ESG reports of over 1,200 Hong Kong listed issuers over two years found that issuers have been in general doing a box-ticking exercise aimed at meeting the conspicuous ‘comply or explain’ provisions of the Hong Kong Exchanges and Clearing Ltd (HKEX) ESG Reporting Guide (Appendix 27 of Main Board Listing Rules). Where HKEX’s original intention was to enhance issuers’ transparency on nonfinancial risks, so as to allow informed investment decisions, EY’s research suggests that many of the ESG reports surveyed were not up to HKEX’s expectations.
ESG analysts representing institutional investors are asking tough questions about organisations’ ESG risk management standards. How are your directors held accountable to ESG risk management? How does your organisation identify emerging ESG risks? Do you have a strategy to manage ESG risks and does that strategy align with your corporate strategy? How are you measuring your ESG performance against your targets?
The ESG Reporting Guide does address these issues but in a less direct way. Moreover, companies tend to observe the ‘comply or explain’ provisions of the guide, for example the ‘General Disclosures’ requirements, but not the Recommended Best Practices. These recommendations, however, often relate to equally important ESG issues and addressing these issues would make companies’ ESG reports more valuable documents to investors. The next round of consultation on revising the ESG Reporting Guide is around the corner and we are expecting HKEX to ask for more detailed disclosures on directors’ responsibilities, the process of materiality assessment and the inclusion of targets for environmental management. In addition the Securities and Futures Commission (SFC), in its Strategic Framework for Green Finance, highlighted the importance of nonfinancial risks – especially climate risks – as key factors in investment and financing. A reform in ESG corporate disclosure standards seems unstoppable.
But for issuers to provide answers to the investor questions above, they will have to create new management systems, policies, metrics and targets. Directors’ involvement is fundamental. EY’s experience tells us, however, that issuers find it difficult to introduce new topics to their organisations’ governance agendas.
How to get directors involved
Bear in mind that boards of directors are responsible for ESG strategy and risk management anyway, so the question is therefore what is the best way for directors to assume such responsibilities. How hands-on should your directors be when governing ESG issues? Are they familiar with the subject? Who in the organisation is responsible for the management of nonfinancial risks and do they report to the board to ensure that directors are aware of current developments? What sort of authority in the organisation is needed to drive ESG risk management? Should the board authorise and endorse effective ESG risk management?
An ESG working group led by a member of the senior management team is a good idea, although the roles of those involved will vary depending on the role directors are playing. The working group could implement ESG policy at an executive and operational level, collect information regarding ESG management performance and report back to the board.
ESG risk identification – rethinking materiality analysis
HKEX is expected to ask for more detailed disclosures of companies’ materiality analysis – which is essentially the ESG risk identification process. Stakeholder engagement is still the core element of materiality analysis. The classic approach is to circulate a survey to stakeholders, asking which ESG topics are more important or impactful to them. However, such surveys may be not as effective as we expect, depending on how they are designed. There is a high chance for a misalignment in how stakeholders conceive your questions and what you intend to ask, so that the survey results may not be very reliable.
As an alternative, it can be more effective to interview representatives of key, vocal stakeholders for deeper insights. Key stakeholders are those who can potentially impact the organisations’ prospects: key customers for a B2B business, suppliers of key raw materials, governments, lawmakers and key personnel. Some stakeholders are more important than the others, but prioritisation is what is often missed.
ESG indices and ratings are widely regarded by investors as important tools reflecting ESG performance and helping them to assess the ESG risk level of listed companies. Therefore, in addition to stakeholder engagement, companies should also refer to these ESG indices and ratings and industry specific research.
Setting targets for your environmental performance
The first challenge when setting a target is to understand where you currently are. Knowing your current performance level is fundamental, but companies sometimes get it wrong because the data they have may not even be correct. Misstatement risk is high for organisations with complex operations that rely on the manual input of ESG data, but digital solutions are available in the market to enhance the accuracy of the metrics used, such as Robotics Process Automation and dedicated sustainability data management software.
Another challenge of target setting is to make sense of the target number you have chosen. A random number without support can be either non-achievable or not sufficiently ambitious. The emerging science-based target initiative may give us a clue to how a justifiable target can be set. A science-based target for carbon reduction, for example, can be based on your organisation’s carbon emission quota, depending on its economic contribution and sector, under the relevant national target to keep the global temperature rise to no more than 1.5°C above pre-industrial levels, as determined by the latest report of the Intergovernmental Panel on Climate Change. Following the same logic, a company in Hong Kong can derive a target for non-hazardous waste reduction, based on the HKSAR Government’s published waste reduction target by 2022 (Hong Kong Blueprint for Sustainable Use of Resources, published by the Environment Bureau, HKSAR Government in 2013).
The proposed target should then be sent to the board for approval, followed by implementation, monitoring and public reporting.
Discussing and managing climate risk
As previously discussed, the capital market is focusing on the climate risks of listed companies. The Task Force on Climate-related Financial Disclosure of the Financial Stability Board has arrived at a number of recommendations relating to climate-related disclosure. These include recommendations to discuss:
- the organisation’s governance around climate-related risks and opportunities
- the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy and financial planning
- the processes used by the organisation to identify, assess and manage climate-related risks, and
- the metrics and targets used to assess and manage relevant climate-related risks and opportunities.
However, climate risk is a rather unfamiliar topic in the Hong Kong market today. Businesses may find it difficult to start even from square one, which is to understand how climate change may affect the organisation. If climate risk disclosure is going to happen, businesses should consider seeking expert opinions on this matter.
Act before you feel the pressure
This article has discussed how ESG disclosure requirements may evolve in Hong Kong and what businesses can do to prepare for the change. This is especially important for larger companies more vulnerable to global institutional investor pressure. To publish ESG reports that are valuable to investors, businesses should:
- ensure your directors understand the relevance of ESG to the business
- assess your ESG risks and climate risks – seeking expert help if necessary
- assess how reliable your current ESG data is, and
- consider smart solutions to enhance data accuracy while reducing reporting costs.
Brian Ho, Partner, Climate Change and Sustainability Services
EY’s 2018 global investor survey – ‘Does your nonfinancial reporting tell your value creation story?’ – is available via the EY website: www.ey.com. The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organisation or its member firms.