I. Introduction
In recent years, how a company manages the long-term environmental and social impacts of its business activities (i.e. the environmental, social and governance or ESG concern) has received increasing attention from regulators and the community. This year, international tensions, global environmental issues such as climate change, and regional social issues such as community development have revealed their political sensitivity and strategic significance in economic development.
Accordingly, it is becoming increasingly significant for companies to make ESG disclosures. In China Mainland, under the current ESG disclosure framework and “green finance” policy, some companies listed on Shanghai and Shenzhen Stock Exchanges are required to make ESG disclosures, and enterprises in a particular industry or of a particular nature are also obligated to do so. The ESG performance is gradually becoming one of the factors influencing investment decisions in the capital market. MSCI, Dow Jones Industrial Average, FTSE Russell, and other international indices give China-listed companies ESG ratings based on their ESG disclosures when selecting their A-share components.
In Hong Kong SAR, the Environmental, Social and Governance Reporting Guide (the “ESG Guide”) attached as an Appendix to the Listing Rules of The Stock Exchange of Hong Kong Limited (“HKEx” or the “Exchange”), as amended in December 2019, has taken effect as of 1 July 2020. A company listed or to be listed in Hong Kong SAR (the “issuer”) is required to comply with the ESG Guide for ESG reporting for financial years commencing after 1 July 2020. In brief, the new ESG rules introduce mandatory disclosure requirements. To be specific, the ESG Guide requires disclosure of significant climate-related issues; amends some “Environmental” key performance indicators (KPIs) such as emissions, energy consumption, water efficiency and wastes reduction; upgrades the disclosure obligation of all “Social” KPIs to “comply or explain”; and introduces the “Supply Chain Management” and “Anti-corruption” KPIs.
In response, we introduce this series of articles to review the ESG Guide. The new mandatory requirements, including governance and reporting principles, provide guidance for the “Environmental” and “Social” reporting. In this article, we will first provide a brief introduction and explanatory notes of the mandatory ESG disclosures.
II. Introducing mandatory disclosure requirements with a focus on the process and approach
As stated above, it is the first time for the Exchange to introduce mandatory disclosure requirements in the ESG Guide. A brief review of the history of the ESG Guide: When the ESG Guide was issued initially in 2012, the ESG issues were all “recommended disclosures”; in the first amendment in 2015, some ESG issues were upgraded to “comply or explain”; in this second amendment, in addition to upgrading all ESG issues to “comply or explain”, mandatory disclosures are introduced. At present, the mandatory disclosures are about the ESG-related governance structure, reporting principles and reporting boundary, which mainly reflect the issuer’s governance process and reporting approach on environmental and social issues.
Under the mandatory ESG disclosure requirements, “reporting boundary” identifies which entities or operations are included in the ESG report, which can be selected and explained in regard to specific subject areas and aspects, as is not elaborated herein due to limited space. In this article, we will further explain the “Governance Structure” and “Reporting Principles” below.
(I) Governance structure reflecting “board-level engagement”
The mandatory disclosure of ESG-related governance structure supplements the existing mandatory disclosure requirements under the Corporate Governance Code and Corporate Governance Report attached as an Appendix to the HKEx Listing Rules. In the ESG Guide, the governance structure refers specifically to the board’s governance mechanism for ESG issues, which requires a statement in the name of the board, emphasising the board’s role of leadership and “full responsibility” for the ESG issues. In support of the new disclosure requirements, the Exchange released an updated step-by-step guide to ESG reporting titled “How to Prepare an ESG Report” (the “Guide to ESG Reporting”) and a new guide for board and directors titled “Leadership Role and Accountability in ESG” in March 2020, demonstrating the importance the Exchange attaches to board-level governance.
1. Elements of the statement from the board
Specifically, in an ESG report, a statement from the board contains the following elements:
(i) the board’s oversight of ESG issues, which embraces the strategy and organisational structure of the issuer;
(ii) the board’s ESG management approach and strategy, including the process used to evaluate, prioritise and manage material ESG-related issues (including risks to the issuer’s businesses) and to identify strategic priorities in managing ESG issues for the short and medium-term; and
(iii) how the board reviews progress made against ESG related goals and targets.
2. Form of the statement from the board
The statement from the board on ESG governance may either stand alone or be disclosed across various sections of the ESG report, so long as it is abundantly clear for readers to understand the board’s governance of ESG issues, according to the official response to Query 7 contained in FAQ Series 18 - Questions Relating to Environmental, Social and Governance Reporting. In other words, the ESG governance structure can be presented in a separate section or disclosed in other sections as appropriate, e.g. disclosing the board’s ESG materiality assessment when explaining how the materiality principle is applied; reflecting the board’s governance elements in the disclosure of environmental or social issues; and disclosing the details of the ESG committee in the “Board Committees” section and the board’s management of ESG risks in the “Risk Management and Internal Control” section in the corporate governance report.
3. Requirements for IPO applicants
In addition to issuers already listed in Hong Kong SAR, companies to be listed there are also advised to follow the Guidance Letter HKEX-GL86-16 (the “Guidance Letter”) updated in July 2020. The Guidance Letter highlights that the boards of IPO applicants are required to ensure that the required corporate governance and ESG mechanisms are in place during the IPO process and that additional disclosure is made in the prospectus to promote sustainable development, good corporate governance and diversity. In the E. “Business” section, paragraphs 3.2 and 3.7(a) and (b) specifically provide that the applicants should: i) include a statement on their compliance culture; and ii) put in place mechanisms that enable them to meet the Exchange’s requirements on corporate governance and ESG well in advance. Directors are expected to be involved in the formulation of such mechanisms and related policies. Applicants are therefore recommended to appoint directors (including independent non-executive directors) as early as possible so that directors can engage in the formulation of the necessary mechanisms and policies on corporate governance and ESG.
(II) Application of reporting principles
The ESG Guide sets out four principles of reporting - materiality, quantitative, balance and consistency, and requires a description of the application of the materiality, quantitative and consistency principles in the preparation of the ESG report. The application of the materiality principle imposes substantive requirements on the ESG governance process, as further explained below. Materiality is defined as the threshold at which ESG issues determined by the board are sufficiently important to investors and other stakeholders that they should be reported. An issuer is now required to explain how the materiality principle is complied with and should disclose:
i) the process to identify and the criteria for the selection of material ESG factors; ii) if a stakeholder engagement is conducted, a description of significant stakeholders identified, and the process and results of the issuer’s stakeholder engagement—the stakeholder engagement is intended to seek the views of the stakeholders; and
iii) for the “comply or explain” environmental and social issues under the ESG Guide, if a certain aspect or KPI is not material to the issuer’s business or operations, the issuer may withhold disclosure and explain the non disclosure on the grounds of “immateriality”, stating that the relevant data is not material based on the nature of its own business and operations, rather than deliberately disclosing the irrelevant information, which also reflects the application of the materiality principle.
1. “Materiality assessment” mandatory
At the core of mandatory disclosure is the process of how an issuer identifies material ESG issues, or “materiality assessment”. Systematic materiality assessments, which were once good industry practice, are now considered mandatory. Issuers who have conducted materiality assessments will need to improve the steps, for example, from identifying relevant issues, prioritising identified issues to identifying material issues, and to disclose the details of implementation, while those who have not yet done so will need to put it on the agenda. For the issues to be assessed, issuers can screen out irrelevant issues against all “comply or explain” issues - or, of course, against other more stringent reporting standards and by adopting the usual issues of their peers - and conduct internal and external materiality assessments for each issue. Internal materiality refers to the impact on the business; and external materiality refers to the importance to stakeholders other than investors. Internal materiality is generally assessed by senior managers and/or key employees; and external materiality can be assessed through stakeholder engagement as recommended by the Guide to ESG Reporting.
2. “Stakeholder engagement” recommended
The “stakeholder engagement” for materiality assessment, unlike “board-level engagement”, is not mandatory and is a recommended tool for identifying material issues. In addition, stakeholder engagement may already be part of a company’s day-to-day operations, and many Hong Kong companies have voluntarily disclosed their stakeholder engagements that cover ESG issues in their ESG reports in previous years. The ESG Guide makes it clear that if a stakeholder engagement is conducted, a description of significant stakeholders, and the process and results of the stakeholder engagement should be disclosed. Stakeholders are groups or individuals who are expected to affect or rely on the company, such as shareholders, investors, customers (including potential customers), suppliers, business partners, employees, government and regulators, NGOs and lobby groups, local communities, competitors, peers, and experts and specialists. Of these, those with a high degree of influence and reliance on the company are the key stakeholders and the company may conduct stakeholder engagement only with the key stakeholders.
Effective and feasible forms of stakeholder engagement, or stakeholder consultation, are flexible and diverse. It does not have to be a large on-site event, but can be either an all-employee meeting, a representative meeting or individual interviews, a workshop, a round-table or a panel discussion, or simply a telephone interview, a written consultation, or an online questionnaire. Companies can even collect stakeholder views in their daily contact with customers (including potential customers), suppliers, employees, and other stakeholders.
Conclusion
It is easy to see that the Exchange is pushing for “board level engagement” and “stakeholder engagement” through the mandatory disclosure requirements under the ESG Guide in order to build good corporate governance and market confidence. This motive and movement were already indicated in the Analysis of Environmental, Social and Governance Practice Disclosure in 2018 released by the Exchange at the end of 2019. The ESG disclosure review, besides “comply or explain” issues, paid special attention to the sample issuer’s disclosure in respect of any assessment of materiality and the overall approach to ESG reporting. The focus of the recommendations has been on board-level engagement and materiality assessments. For Mainland companies, their ESG management or reporting generally does not meet the Exchange’s requirement aligning with international best practice. Their ESG reporting is more a matter of public relations, being prepared based on a more casual standard and form that do not comply with the four reporting principles. With regard to mandatory disclosure requirements, it is advisable for the Mainland enterprises listed in Hong Kong SAR, at the beginning of the financial year commencing from 1 July 2020, to start collecting reporting materials early, build the required infrastructure or take the necessary actions to produce an ESG report that meets the requirements in both substance and form.
