Oil giant Royal Dutch Shell was recently ordered by a court in the Netherlands to cut its global carbon emissions by 45 percent compared with 2019 levels by the end of 2030. The ruling highlights the growing need for companies to focus on the environmental and social aspects of environmental, social and governance (ESG) to manage risk and ensure their business models are sustainable.
Companies are facing pressure on a number of fronts to improve their performance in this area, while doing so can also open up new business opportunities and improve their long-term performance.
Loren Tang FCPA (practising), Director at KLC and Chair of the Hong Kong Institute of CPAs’ Best Corporate Governance Awards (BCGA) Organizing Committee and a member of the BCGA Review Panel, says: “We have seen over the years that companies that don’t manage their ESG risks can have financial losses arising from them. We know a lot of investors now include the ESG performance of a company in their investment decision-making.”
Ricky Cheng FCPA, Director – Head of Risk Advisory at BDO and member of the BCGA Organizing Committee and the BCGA Review Panel, points out that companies – particularly those in the manufacturing and industrial sectors that fail to focus on sustainability – run the risk of incurring legal or regulatory action and significant fines. For example, oil company BP paid penalties and claims totalling nearly US$62 billion for the Deepwater Horizon disaster, while Volkswagen’s emissions testing scandal cost it US$33 billion in fines and vehicle refits.
Speakers: (From left) Ricky Cheng FCPA, Director – Head of Risk Advisory at BDO and member of the BCGA Organizing Committee and the BCGA Review Panel; Patrick Rozario, Managing Director, Moore Advisory Services Limited, and member of the BCGA Organizing Committee and Chair of the BCGA Review Panel; Loren Tang FPCA (practising), Director at KLC and Chair of the BCGA Organizing Committee and member of the BCGA Review Panel; Peter Tisman, Director, Advocacy and Practice Development at the Institute; Eddie Ng CPA, Principal, Business Reporting and Sustainability at KPMG and member of the BCGA Review Panel
Alongside the financial penalties, incidents such as these also cause significant reputational damage, magnified by social media. At the same time, there is growing pressure from stakeholders, with both consumers and investors placing an increased emphasis on ESG.
Meanwhile, as many economies strive to achieve net zero carbon emissions within the next 20 to 30 years, companies are having to focus their own strategies on transitioning to low carbon products and services. “Customer preferences change over time, and companies need to respond to market needs to produce more energy-efficient or CO2-saving products, as well as making their fixed assets more resilient to climate change,” Cheng says.
Patrick Rozario, Managing Director, Moore Advisory Services Limited, and a member of the BCGA Organizing Committee and Chair of the BCGA Review Panel, adds that companies must also pay attention to ensure their products do not have a negative social impact. He gives the example of a brokerage firm allowing pensioners to open margin accounts. “They must conduct a risk assessment on the suitability of investors, as the financial risk can be very high with margin accounts.”
ESG is also an increasingly important aspect of risk management. Peter Tisman, Director, Advocacy and Practice Development at the Institute, points out that many of the top risks that companies face are now environmental risks, such as climate change and natural disasters.
Eddie Ng CPA, Principal, Business Reporting and Sustainability at KPMG and a member of the BCGA Review Panel, adds that companies that incorporate environmental and social factors, as well as financial ones, into their enterprise risk management obtain a more holistic picture, enabling them to make better decisions. “There are opportunities, such as catering for changing market demands, which can create a competitive advantage for a company, but it will miss these opportunities if it does not take environmental and social factors into consideration. This is part of the business case for good ESG,” she says.
There is a growing focus from regulators, both in Hong Kong and internationally, on ESG. Tisman points out that the international regulatory body for stock exchanges, the International Organization of Securities Commissions, has spoken about an urgent need for globally consistent, comparable and reliable sustainability disclosure standards to be introduced. In Hong Kong, the Securities and Futures Commission (SFC) has recently conducted a consultation on the management and disclosure of climate-related risks by fund managers, under which fund managers would have to take climate-related risks into consideration in their investment and risk management processes. “There is a movement around the world towards more active investor participation and the issuing of stewardship codes, and this pressure is being felt in Hong Kong as an international financial centre,” he says. Ng points out that the Hong Kong Monetary Authority and the SFC have indicated that they will require listed companies to adopt climate-related disclosures aligned with those set out by the Task Force on Climate-related Financial Disclosures by 2025.
In response to the growing focus on ESG among organizations, the Institute is renaming the awards this year to the “Best Corporate Governance and ESG Awards.” “Institutional investors and stakeholders want to understand how organizations address environmental and social matters,” Rozario explains. He adds that the new name also reflects the importance of integrating good governance with environmental and social factors, rather than treating the two areas separately.
The Institute monitors trends in the market to ensure the awards remain relevant. Rozario notes that the awards expanded from being purely corporate governance awards to include sustainability in 2011, given the clear international trend towards increased sustainability reporting, with more Hong Kong listed companies starting to include sustainability or corporate social responsibility sections in their annual reports, or even publishing separate reports. In the following year, the Hong Kong Stock Exchange issued its first guidance on ESG reporting which gave a further push to listed companies.
“In 2011, we introduced one overall award for sustainability and social responsibility reporting. Interest grew very quickly and, in the following few years, we expanded this section of the BCGA,” Tisman says. He explains that the renamed awards will look to identify companies that are doing well at both corporate governance and ESG, and moving towards greater integration of these elements. “At the end of the day, you can’t have good corporate governance without good ESG, and you can’t have good ESG without having a good governance structure above it.” Tang adds: “Over the years we have seen more companies producing very good ESG reports, and we have devoted more resources into looking at up to 500 reports annually as part of the awards. The renaming of the awards also reflects this change.”
“At the end of the day, you can’t have good corporate governance without good ESG, and you can’t have good ESG without having a good governance structure above it.”
Starting from the top
In order for companies to successfully adopt good ESG practices, Tang thinks it is important to have buy-in from the management to drive a top-down approach. “It is very important that you set the tone from the top and identify the factors and risks that have most strategic significance to the company’s survival and integrate them into the corporate strategy, so that the risks are not looked at in silos,” she says.
Ng adds that it is also important that leadership takes ESG seriously and does not simply view it as a box-ticking exercise, which has a cost but does not bring any value. “When you have leadership buy-in, it is easier to implement policies within a company and get buy-in from other stakeholders,” she says.
Tisman agrees, pointing out that if sustainability initiatives are only being looked after by a junior-level team and no one at board level or management level is interested, they are unlikely to get the monitoring they need. “You need to have the right structures in place, the right kind of data and targets,” he says. He adds that companies should focus on the issues that are most material to them and not try to do everything, particularly in the case of small- and medium-sized enterprises. “They need to make it into something that is manageable and understandable, focusing on what is most relevant to their company,” he says.
Tisman gives the example that for a food manufacturer, factors such as product quality and safety, and water stewardship are likely to be important, while for a car manufacturer, fuel efficiency and greenhouse gas emissions are more likely to be priority issues. “Companies need to talk to their stakeholders and conduct an analysis to reach a conclusion on what is really relevant for their own reporting, rather than trying to apply a whole framework of ESG-related aspects in a scattershot way,” he says.
Once companies have identified the issues that are material to them and set their ESG vision, they have to plan how they will achieve it. Rozario points out that they will not be able to achieve everything in one go. They should instead identify the different steps they will need to take, setting attainable goals along the way and backing them with resources.
He thinks putting in place key performance indicators (KPIs) to measure progress and encourage employee buy-in is an important part of achieving long-term goals. “Having attainable KPIs helps everyone work towards one direction,” he says.
Ng stresses that KPIs must not only be relevant, but that companies should also set ones linked to short and medium-term goals, as well as long-term ones, so that they can monitor whether they are on target or need to accelerate their progress. Cheng adds that KPIs should also be aligned to the company’s industry, for example whether environmental goals are linked to CO2 emissions, energy consumption or water use. “Corporates can also make KPIs relevant to them, such as looking at the revenue generated from low carbon products, or cost savings due to energy efficiency, which may be more motivating, especially on the management side,” he says. Cheng adds that management’s remuneration could also be linked to achieving these KPIs.
Tang points out that as well as setting KPIs and monitoring progress towards long-term goals, companies should also report on their progress to show transparency and consistency and win trust from investors and stakeholders. Ng agrees: “We see reports where companies say they have put a lot of policies in place, but without KPIs, we don’t know if they have actually implemented them or what progress they have made.”
“If ESG data is assured by an independent professional, people find it more acceptable and reliable.”
The rise of non-financial reporting
The increased focus of investors and stakeholders on ESG factors is driving demand for companies to publish non-financial information, according to Tang. “Non-financial reporting is key for them to assess whether the company’s performance is on track and whether it can be sustained and is resilient to upcoming risks. This information is really key to their decision-making,” she says. Ng adds, “Financial and non-financial reporting should not be looked at in silos. Investors need information on how a company operates from both angles.”
Cheng agrees that there is increasing interdependence between financial and non-financial information. “Investors want to look at how ESG factors are affecting the financial statements, such as what provisions companies have made to make their properties resilient to climate change, how they are spending on research and development (R&D) for new products, how ESG factors may impact a company’s business model and how they could impact its value.”
Tang sums up that without both sound financial and non-financial reporting, investors are unlikely to have confidence that companies have the right strategies, policies and business models in place for the long-term. “If it is done well, this combination is indicative of a company that is likely to sustain its value over the longer term,” she says.
Currently, there are a number of frameworks to help companies report on ESG matters, such as the Global Reporting Initiative, the United Nations Sustainable Development Goals, and, in the United States, the Sustainability Accounting Standards Board, as well as organizations focusing more specifically on climate-related reporting. All of this can be confusing. However, there are also moves to make financial and non-financial reporting more integrated, e.g. through the framework developed by the International Integrated Reporting Council and, more recently, announcements that a number of these bodies intend to work more closely together.
Tisman says: “The Trustees of the IFRS Foundation are now talking about changing their remit to set up an International Sustainability Standards Board modelled on the International Accounting Standards Board under the foundation. If it goes ahead, this could help to harmonize ESG reporting standards.”
“We see reports where companies say they have put a lot of policies in place, but without KPIs, we don’t know if they have actually implemented them or what progress they have made.”
The role of accountants
Accountants have a key role to play in many areas of helping companies improve their sustainability, including assisting with the collection, analysis and reporting of data. “Ensuring the completeness and accuracy of data is something that accountants always do,” Rozario says. Ng adds that accountants are also good at communicating business value and insight to corporates, which can help them see the value of having sound ESG policies in place.
Tang says: “In addition to being adept at applying standards, accountants generally have a good knowledge of areas like risk management and internal control, and internal audit – skill sets that will be increasingly important in ensuring the integrity of ESG data gathering and analysis reporting. I think accountants are well set to play a leading role in this area in the future.” But, Tisman adds, they also need to collaborate with other professionals who have a background in specific areas where data collection is important, such as those in emissions and other relevant aspects of ESG.
Cheng thinks accountants can also play a role in the materiality assessment of ESG factors and risks for companies. “They can also make use of their financial knowledge to assess the return on investment for R&D projects for the development of new products and services,” he says.
Accountants also have an important role to play in assurance. Tang says: “If ESG data is assured by an independent professional, people find it more acceptable and reliable.” Ng agrees, adding that accountants are used to exercising professional judgement and professional scepticism.
Tisman points out that as there is currently no single standard for recording and reporting ESG data, concerns about the quality of this data may be deterring accountants from doing more assurance. To assist practitioners, the Institute recently issued Auditing and Assurance Technical Bulletin 5 Environmental, Social and Governance (ESG) Assurance Reporting, which details how to apply Hong Kong Standard on Assurance Engagements (HKSAE) 3000 (Revised) Assurance Engagements Other than Audits or Reviews of Historical Financial Information. “The Institute’s guidance is one of the first of its type,” he says.
Ng points out that ESG and sustainability frameworks are less developed than the accounting frameworks, which can be a challenge to auditors. As a result, the Institute is planning on targeting areas that are challenging to the profession and offering guidance to enhance the consistent application of HKSAE 3000. In the long run, greater comparability in the approach to assuring ESG reporting will also be important for investors and other stakeholders.
While implementing ESG policies and reporting on non-financial information may be challenging, Ng thinks it is something companies cannot afford to ignore, as environmental and sustainability risks and opportunities will affect companies’ operations and long-term value creation. Tisman agrees: “A lot of things have happened over the last decade or more that has caused civil society and the public to lose trust in business but, by giving serious attention to ESG, companies can regain some of that trust and show that they are collaborators in helping to ensure a long-term sustainable future for the planet.”
In response to the growing focus on environmental, social and governance (ESG) issues among organizations, the Institute is renaming the awards this year to the “Best Corporate Governance and ESG Awards.”