Tony Wong, Founder, and Regina Tai, Senior Consultant, Alaya Consulting, discuss the findings of Alaya’s latest annual survey of the environmental, social and governance (ESG) standards of Hong Kong’s listed companies.
Seven years after first implementing its ESG Reporting Guide, Hong Kong Exchanges and Clearing Ltd (HKEX) has made a bold, yet much anticipated, step to raise ESG disclosure requirements for issuers in Hong Kong.
In May 2019, HKEX published a consultation paper entitled ‘Review of the Environmental, Social and Governance (ESG) Reporting Guide and Related Listing Rules’. The key focus of the consultation was to emphasise the board’s leadership role and accountability in ESG matters. On 18 December 2019, HKEX published its conclusions to the consultation, announcing that it will implement the new requirements proposed by the consultation, with modifications reflecting comments received, effective for financial years commencing on or after 1 July 2020 (see Hong Kong’s new ESG regime). The new requirements will significantly improve Hong Kong’s regulatory framework for ESG governance and disclosure and position the Hong Kong bourse as a pioneer in driving ESG disclosure in Asia.
While most issuers have upped their game since ESG disclosures became a ‘comply or explain’ requirement of Hong Kong’s listing rules, the name of the game may have been completely changed as a result of the consultation conclusions. Hong Kong is moving on from a stage of mere compliance to a stage where leveraging ESG is at least viewed as a tool for risk management, if not a stage where it is deemed to create value for operations. A successful migration to the new approach to ESG, however, hinges on company boards recognising the role they need to play in the sustainability journey.
The survey findings
According to our latest annual in-house ESG survey, less than half of the 80 listed companies surveyed have established a governance body for overseeing ESG performance and less than two-thirds say there is board oversight of ESG. These findings should not, perhaps, come as a surprise. A large proportion of the issuers we have been working with over the past five years have admitted that their board members do not even read their own ESG reports. Moreover, we have observed many directors more interested in their mobile phones during our ESG presentations. The sad fact is that, despite the efforts of HKEX, ESG has not been high on the agenda of many boards in Hong Kong.
There is good reason, though, to believe that the tide is turning. Starting in 2020, boards can no longer treat ESG as something outside the scope of governance. HKEX has made it mandatory for isszers to publish an annual statement detailing how the board oversees ESG management – in particular identifying ESG risks in operations and reviewing the performance in terms of targets established (see Hong Kong’s new ESG regime).
Briefing the boards of our clients over the past six months about these looming requirements, we have noted a change in attitude among directors. Mobile devices are less in evidence and we have heard comments such as, ‘Looks like we need to start reading our ESG reports’.
The first step towards getting more from the board is to demonstrate that the company’s operations are vulnerable to ESG related risks – and can benefit from ESG opportunities – on a daily basis. An essential part of our work is therefore to identify topics critical to both ESG and the business. For example, a key supplier of a global brand might be busy expanding operations and allocating less resources to labour conditions, waste management and other material environmental and social topics – posing higher risk to not only the supplier but also the global brand. Any evidence of non-compliance from the supplier side could have major ramifications, including reputational damage, short-seller reports, losing contracts and regulatory penalties.
When we advise a board, we have to be very specific about the risks and opportunities that they are or will be facing, as not all ESG topics are of equal importance from an individual industry perspective. Some ESG topics are more ‘material’ in certain industries than in other industries. For example, emissions and waste management is in general more critical in a manufacturing operation than in an office-based environment. That’s how investors look at it and that’s how we have structured our latest in-house ESG study.
Financials lead in adopting TCFD recommendations
Alaya looked at a total of 80 listed companies in Hong Kong from four pillar industries, namely, finance, real estate, transportation and hospitality. We studied the three major risks associated with these industries, including climate change, supply chain management and cybersecurity (see Table 1: Average disclosure performance by industry).
Globally in the past few years one of the top risk issues for multinational corporations has been climate change. Cited as one of the more prevalent global risks that needs to be managed, climate change has also been gaining traction in the investment community. In particular, the recommendations of the investor-backed organisation, the Task Force on Climate-related Financial Disclosure (TCFD), has received increasing attention in the past few years. HKEX has accordingly added a requirement, subject to ‘comply or explain’, for issuers to disclose the significant climate-related issues which have impacted, or which may impact, them. This essentially requests issuers to align their management approach and disclosure practices with the TCFD recommendations.
The TCFD recommendations require companies to establish a governance body to oversee climate-related risks, and to disclose metrics and related targets. Our study shows that half of the companies studied in the financial sector have identified climate change as a material topic and 35% have started aligning with the TCFD recommendations. Most of the companies in other industries are yet to adopt the framework – only less than one-third of them recognise climate change as a material risk. In terms of setting carbon reduction targets, the percentage is around 20% to 35%, led by the transportation industry, among which four companies have established science-based targets with approval from the Science Based Targets initiative.
Supply chain risk remains generally ignored
After a number of high-profile scandals involving unethical practices and mismanagement of subcontractors and suppliers in Hong Kong over the past two years, supply chain risk has become a growing concern for customers, regulators and even the general public. As a substantial part of companies’ environmental and social compliance lies in the supply chain, which is outside of a company’s direct control, identifying and managing these risks is increasingly critical for developing a company’s strategic necessities.
To promote better management of supply chain risk, HKEX has introduced two new KPIs in the Supply Chain Management Aspect and raised these KPIs, among other social KPIs, from ‘recommended disclosure’ to ‘comply or explain’. The new supply chain KPIs require disclosure of:
- practices followed in identifying environmental and social risks along the supply chain, and
- promoting environmentally preferable products and services.
On one hand, the majority of the companies surveyed are far from ready for reporting their supply chain risks. Among the 24% of companies that mentioned supply chain risks, vague and general statements are commonly found in their reports, without disclosure of the specific risks identified, how the company is impacted by those risks and the related management approach. On the other hand, sourcing environmentally friendly products has been gradually integrating into procurement practices. 43% of the companies surveyed have implemented relevant policies on this. Two of them reported that they even conduct reviews of product life cycles when considering suppliers’ selection.
Engaging with sub-tier suppliers has always been an important yet challenging task for companies with complex multi-tier supply chain networks, as companies do not have direct relationships with them. Companies need to identify and focus on particular products and services that have significant impact on their respective operations, or certain types of supplier with high ESG risks – this might involve suppliers who have access to conflict minerals or who have labour-intensive or heavily polluting manufacturing processes. There have been a couple of short-seller reports in recent years that have built their cases on non-compliant operating practices along the supply chain.
The nature and magnitude of supply chain risks vary in different industries. Companies should consider the entire supply chain in their risk assessments so as to include the high-risk sub-tier suppliers in the scope of supply chain management. For example, hotel groups may identify types of food or products with high environmental or safety risks and introduce controls to monitor their suppliers and raw material providers. Property developers may prioritise safety management conditions of subcontracted workers in their health hazard mitigation plans.
Only 18% of the companies surveyed have a suppliers’ code of conduct stipulating ESG requirements. Such requirements act as the basis of evaluation and monitoring, as well as disclosure of appropriate KPIs, such as subcontractor injury rate and percentage of green products procured. Supply chain risk cannot be managed without collective efforts within the industry. Let sustainability be part of the dialogue not only with suppliers, but also with peers and industry actors. Acting together through committing to industry or international sustainability standards can help foster more effective change both internally and externally.
Cybersecurity is out of the spotlight
Cybersecurity risks are acknowledged in the financial industry, with a relatively higher level of disclosure of risk management approaches to these risks. The majority of companies in the other three industries surveyed, however, simply ignore the entire topic in their ESG and annual reports, let alone disclosing any board oversight of the issue, or related risk management strategies and policies.
While some recent cyber attacks have resulted in data leakage from banks and airlines, they are not the only industries that are vulnerable to cyber threats. The rise of smart living and hospitality services has triggered a wave of informationalisation of business operations. Hotel groups and real estates companies will soon find themselves managing complex computer systems and handling large volumes of data that are prone to various types of attack such as malware and denial-of-service (DoS) attacks.
Cyber attacks are diverse, unstructured and mostly unpredictable. Moreover, the impacts of cyber attacks are not limited to data loss, but can also lead to suspension of operations and loss of digital and physical assets. A single breach may have inestimable consequences for a company’s operations. This is not a mere IT issue and cannot be solved simply by hardware upgrades or firewalls. Companies need to raise their overall preparedness, from short, mid- and long-term strategies to employee awareness.
Disclosure should include whether simulation exercises are conducted with cyber attack scenarios, whether awareness-building campaigns are held and whether international standards are being followed when communicating with investors and other stakeholders. All this information is currently lacking in the majority of the companies surveyed, except a few leading financial services groups.
Our latest annual ESG survey confirms that, in general, larger companies tend to be better prepared for ESG risks and consequentially take earlier action to measure and manage these risks – that is one of the the reasons that they are able to maintain their competitive advantages. The hope is that these lessons will be learned more widely in the market. Hong Kong listed companies need to recognise that ESG is no longer about compliance, it is an approach to management thinking that helps companies stay ahead of their peers, creating a strategic ‘differentiator’ and bringing sustainable returns to stakeholders.
Tony Wong, Founder, and Regina Tai, Senior Consultant
Alaya Consulting is a Hong Kong-based firm that advises companies on non-financial reporting and sustainability process improvement. For the full research report discussed in this article, please contact Regina Tai: firstname.lastname@example.org.
SIDEBAR: Hong Kong’s new ESG regime
The consultation conclusions published by Hong Kong Exchanges and Clearing Ltd (HKEX) on 18 December 2019 contain a number of significant improvements to Hong Kong’s regulatory framework for ESG governance and disclosure.
- Introducing mandatory disclosure requirements to include:
- a board statement setting out the board’s consideration of ESG matters
- the application of the reporting principles ‘materiality’, ‘quantitative’ and ‘consistency’, and
- an explanation of the reporting boundaries used by ESG reports.
- Requiring disclosure of significant climate-related issues which have impacted, and may impact, the issuer.
- Amending the Environmental key performance indicators (KPIs) to require disclosure of relevant targets.
- Upgrading the disclosure obligation of all Social KPIs to ‘comply or explain’.
- Shortening the deadline for publication of ESG reports to within five months after the financial year-end.
The above requirements will be effective for financial years commencing on or after 1 July 2020. More information on the latest HKEX requirements is available on: www.hkex.com.