Environmental, Social Responsibility (ESG): New Age Financial Reporting | Nand L. Dhameja

by Nand L. Dhameja *

March 15, 2022

ESG is the acronym for Environmental, Social and Governance. It is being used in capital markets and by investors to evaluate corporate behaviour and to determine the expected future financial performance of companies. ESG criteria is a subset of non-financial indicators which include sustainable, ethical and corporate governance issues like managing the organisation’s carbon, environmental and social factors; such ESG criteria is attracting greater impact on the development and financing of financial as well as public organisations.

Financial disclosure reports normally emphasise of profits, low risk and higher financial returns; and there is no requirement from the accounting regulating institutions to report of environmental, socio, and governance issues. It is now being realised that such ESG reports will have long term effect on the performance of companies and such matters are being reported as suppliantly information.

Though ESG metrics currently are not a required part of financial reports for publicly traded companies, or organisations; a growing number of companies in India are including these as separate statements namely, initiatives to control pollution, R & D, Corporate Social Responsibility (CSR), (and now also mandatorily required Business Responsibility and Sustainability Report (BRSR)), remuneration policy of employees, and other aspects of interest to stakeholders. These are discussed latter in the following pages. Increasingly there is consensus among many regulators that some form of standardized ESG disclosures would be required of publicly-traded companies on most major global stock exchanges.

ESG criteria though is gaining prominence and has made substantial progress in analysing and assessing the sustainability of social and development projects in developed countries; emerging economies are in the process of making some inroads; and this is presented, in brief, latter.

Despite absence of international consensus regarding ESG disclosures, a number of frameworks and indices have emerged to guide company disclosures and inform investors; and it would not be correct to think that socially responsible investment comes at a cost and would make less money. Some of the leading international frameworks include the Global Reporting Initiative standards, the Sustainability Accounting Standards Board (SASB) standards, the United Nations Principles for Responsible Investment and the United Nations Sustainable Development Goals. Ratings have also proliferated over the last decade. Morgan Stanley Capital International (MSCI) and specialist firms such as Sustainalytics have been joined by traditional credit rating agencies like, Moody’s and S&P Global. As reported by Billy Nauman, a recent estimate suggests that the “global market for ESG ratings is currently worth about $200m and could grow to $500m within five years” [1] The influence of these frameworks and rating agencies is such that they may shape regulation to come.

Investors notably younger generations, in recent years, have shown interest in putting their money, considering substantial environmental, social and governance issues. Brokerage firms and mutual fund companies have started offering exchange traded funds (ETFs) and other financial products that follow ESG criteria.

Nearly 60 percent of respondents to Investopedia and Treehugger survey indicated an increased interest in ESG investments and 19 percent reported incorporating ESG standards into their portfolios.

Similarly, a survey by Morgan Stanley Bank found that nearly 90 percent of millennial investors were interested in pursuing investments that more closely reflect the values they hold.

Annual reports published by financial services companies, like JPMorgan Chase (JPM), Wells Fargo (WFC), and Goldman Sachs (GS) contained an extensive review of the ESG approaches and the bottom-line results; and that ESG-minded business practices are gaining better attraction; and that the investment firms are increasingly tracking their performance

John Elkington, a co-founder of SustainAbility firm, which provides ESG consulting services to companies, is a strong proponent of including non-financial considerations, such as environmental and social factors, in the assessment of stock value.
Before we present analysis of ESG criteria reporting in emerging economies, let us discuss, what does ESG criteria include and how does it work.

ESG: What are Environmental Social and Governance Criteria and what do they include?

As mentioned earlier, three aspects of ESG include Environmental, Social and Governance. Sustainable parameters for the three aspects are illustrated below:

Parameters for the three ESG factors shown above can be supplemented depending upon the nature and size of the enterprise and these are detailed as under:

Environmental Criteria: How does an enterprise perform as a
steward of nature?

These include,

• energy use, waste, harmful pollutants and chemicals;
• natural resources conservation and environment risk;
• disposal of hazardous waste;
• use of renewal energy
• management of toxic emissions
• non-compliance with government environment regulations

Social Criteria: How does an enterprise manages its relationship with
employees, suppliers, customers, and the community where it operates?
These include:

• policy to protect against sexual misconduct,
• enterprise mission, its social relevance and benefits to society
• activities impacting enterprise’s policies and practices
• activities having adverse impact on investment and society
• encourage employees to perform voluntary work
• working conditions and taking care of employees’ health and safety
• policy to protect against misconduct of employees
• relations with the customers and history of customers protection
• avoid operations in higher risk-areas
• exposure to coal, or hard coal mining, private prisons,
• exposure to tobacco, weapons,
• taking care of animal welfare

Governance Criteria: How does company’s leadership get involved?
These include,
• employees-shareholders-customers satisfaction,
• issues of executive compensation
• accounting practices and transparency and accuracy
• executive pay, audits, internal controls,
• involvement in anti-social and illegal practices
• shareholders rights and their treatment
• transparent choice of members to the Board
• embrace diversity on the Board
• reporting of HRA, Price-Level Changes, and Economic Value Addition

Although ESG metrics are not a required part of financial reports for publicly traded companies, a growing number of companies are including these as separate statements. Increasingly there is consensus among many regulators that some form of standardized ESG disclosures would be required of publicly-traded companies on most major global stock exchanges.

ESG: How does ESG Criteria Work?

ESG criteria has grown out of investment philosophies and has clustered around sustainability and, thereafter, socially responsible investment. Early efforts were to “screening out” companies from portfolios largely due to environmental, social or governance criteria. Efforts are to differentiate between enterprises favouring ESG and are making positive contribution on environmental, social and governance factors. Thus, environmental, social and governance issues are gaining strategic positioning. These ESG favouring criteria may not be additive resulting in a single one figure parameter; or at times may overlap. It emphasises the need to get these criterion factors integrated for purposes of investment analysis and decision making. Investment bankers, brokerage firms, credit rating agencies and financial consultants perform an important role to advise on the suitability and sustainability of investment proposal.

In short, ESG criteria as presented in Figure I would involve ethical criteria to exclude socially adverse industries; environmental criteria screening broadly for environmental, social and governance policies; and to select investments having a direct impact on positive social change.

Figure I

(Source: Market Business News: https://marketbusinessnews.com/financial-glossary/esg-definitio)

As against the above, there is a critic of ESG criteria on the ground that a business enterprise has the sole responsibility to use resources and engage in activities designed to increase profit. According to economist, Milton Friedman, the only responsibility of business is to make money and to distribute it among shareholders; the corporations do not have the skills to know about environment and social factors. They do not know how to alleviate poverty, educate the uneducated, and empower women. Instead, they know how to produce goods and services at the lowest cost possible, and sell them for the highest price possible. In many cases, these very activities are at odds with social cause, such as paying people low wages on temporary contracts with poor long-term benefits.

However, the proponents of ESG criteria have more vigorously proposed with force in favour of ESG and it is gaining strong favours from the investment and financial advising agencies. The Big Four accounting firms EY, PwC, KPMG, and Deloitte unveiled in September 2020 a paper, proposing to harmonize ESG reporting standards, the real data is still awaited. In India SEBI has issued consultation paper for ESG disclosure for various a) Rating providers, and b). Mutual funds offering ESG funds. Further, Ministry of Corporate Affairs came up in 2020 with the guidelines on company reporting under Business Responsibility Report (BRR) and also stipulated Format for the Report. The BRR now has been replaced with the standardised Business Responsibility and Sustainability Report (BRSR); and the BRSR is mandatory for the top 1000 listed companies (by market capitalisation) from the financial year 2022-23.

The sustainable ESG criteria analysed, processed and practiced by companies in India under the relevant regulations, as separate statements are illustrated below:

Environment and Energy Conservation: The Companies Act 2013 and the SEBI Regulations impose various environmental and/or energy conservation-related reporting obligations. Accordingly, companies include in their Annual Reports information regarding any action taken to improve energy conservation, and to describe initiatives taken for an environmental, social and corporate governance perspective.

Remuneration Policy for Corporate Executives: With the objective to introduce the principle of transparency and to have good governance in the remuneration policy, companies are required to disclose in their Annual Reports:

• ratio of the remuneration of senior most functionary to the median remuneration of the employees for the financial year;
• percentage increase in remuneration of senior functionaries during the financial year.
• percentage increase in the median remuneration of employees in the financial year;

Financial information & Financial Statements Presentation: With the objective to recognise and encourage excellence in preparation and presentation of financial information, the Institute of Chartered Accountants of India (ICAI), the accounting regulating professional body, organises annual competition ‘ICAI Awards for Excellence in Financial Reporting’. Recognising that the research contributions in the areas of International and Societal importance encompassing subjects of Accounting, Auditing, Economics, Finance and Taxation, the ICAI instituted ‘ICAI International Research Awards 2020’. It was envisaged that over the period, the research in these areas would provide valuable inputs to address many environmental, social and corporate government issues (ESG) for decision makers towards sustainability. Also, effective financial reporting plays a significant role in accelerating the economic growth of a country as the information provided through annual reports enables the management and other relevant stakeholders in taking various effective business, investment, regulatory decisions.

Corporate Social Responsibility: As part of Corporate Social Responsibility (CSR), companies are required to contribute towards social cause. Such contributions though voluntary in western countries, is mandatory for companies in India. As per the law enacted in April 2014, every company with a net worth of Rs. 500 crore or more, or turnover of Rs. 1,000 crore or more, or net profit of Rs. 5 crore or more in a financial year is required to contribute 2 percent of the average profit of the last three years towards CSR in various areas clubbed under 11 broad activities; and about Rs. 20,000 crore is the annual contribution under CSR. In addition, top 1000 listed companies (by market capitalisation) are required to provide ESG disclosure.

For CSR reporting, companies constitute a Corporate Social Responsibility Committee (CSR Committee) to have symbiotic relationship between the various stakeholders to strengthen communities, and also to recognize the long-term benefits of such relation.

ESG among Emerging Markets: Analysis [2]

Similarly, ESG analysis in Emerging Markets (EM) provides investors with an information set uncorrelated with traditional financial metrics. The quantity of ESG data has grown exponentially in EM over the last five years; and more dynamic and fast-growing industries having strong ESG practices have competitive advantage. ESG issues are receiving greater attention from consumers, corporations, and regulators across EM. ESG analysis provides investors with a set of information that is uncorrelated with traditional financial metrics; it lends additional insights into a company’s management quality, strategic positioning, rational, efficiency, and potential risk exposures.

Active shareowner engagement is a critical source to gain insights and to catalyse positive change with improving ESG practices. These additional sources of insight are ESG “improvers” have outperformed bottom quintile “decliners” in the US, Europe, and Asia by 1.0%, 1.4%, and 5.1% respectively, annualised since 2018 on a sector-neutral basis. This represents a promising opportunity for active investors who can identify ESG improvement before it is recognized by the market.

Emerging Markets have long been viewed as laggards on ESG disclosure compared to developed economies. Regulators in EM have been increasingly adopting ESG disclosure requirements. Recently, the Chinese regulator has mandated new environmental disclosure for its more than 3,000 publicly listed companies. The 2018 Sustainable Stock Exchanges (SSE) progress report highlights several key EM Stock Exchanges at the forefront of ESG regulations. For example, the likes of Brazil, Hong Kong, India, Indonesia, Malaysia, Mexico, South Africa, and Thailand are currently mandating ESG disclosure as a listing rule. A brief of the SSE’s findings is presented in Figure II:

Figure II

Sustainable Stock Exchanges Progress Report

Bloomberg ESG Disclosure Score: US, European Companies and Emerging Markets
Increasingly, EM companies are embracing ESG reporting and disclosure. Analysis of the proprietary Bloomberg Disclosure Score measures the amount of ESG data a company reports publicly, it reveals strong progress relative to US and European companies. It is presented in Figure III

Figure III

Bloomberg ESG Disclosure Score among US, Europe and Emerging Markets over the years [3]

Way Ahead

How the ESG and its parameters can be operationalised?

ESG criteria are qualitative as well as quantitative. These are to be adopted for commercial enterprises and also enterprises in the social sector i.e., non-commercial enterprises. To start with, ESG to be sustainable, should be with non-commercial enterprises and attempt should to workout quantitative parameters for each of the aspects.

To iterate, big four accounting firms EY, PWC, KPMG, and Delolitte have worked out a paper proposing harmonised ESG reporting standards; and the Business Responsibility and Sustainability Report (BRSR) in India is mandatory for top 1000 listed companies for the year 2022-23. Institutes like ISB, ICAI have a challenging task to develop ESG reporting standards, or indices, as reported for developed and emerging economies, for different category of enterprises – services enterprises, manufacturing units, commercial and social projects. These would be guiding force for analysing and proposing investment proposals considering various social, commercial, governance and environmental factors to bring in added value to the nation or the enterprise concerned.

* (Author: Dr. Nand L. Dhameja, Professor Emeritus, FMS Manav Rachna International Institute of Research & Studies, Faridabad; and Manish Dhameja, Senior Banker having Experience in Africa, South Asia and UAE)

Views expressed are of the authors and not the organisations to which they belong
Authors express their gratitude to the anonymous Reviewer for his comments on the earlier draft