Professor Simon SM Ho, President, The Hang Seng University of Hong Kong, and Anthony Tyen, Director, Provident Governance Services Ltd, propose a revised conceptual framework for ESG with greater emphasis on ethics, stakeholder value and sustainability.
Many companies spend considerable resources on improving their ESG performance and reporting, and this is a trend to which the capital market has been paying close attention. Improved ESG practices not only have potential environmental and societal benefits (helping to tackle climate change and social inequalities, or improving labour rights for example), but they also enable a more efficient resource allocation and lead to better risk management and more sustainable corporate growth.
Some nine years ago, in 2013, Hong Kong Exchanges and Clearing Ltd (HKEX) released for the first time its ESG Reporting Guide, which sets out certain reporting approaches and principles that serve as minimum parameters for listed companies’ ESG reporting. Since then, HKEX has issued a number of updates to the Reporting Guide.
Nevertheless, while there has been a general acceptance of the importance of ESG performance and reporting, this area of corporate practice still lacks a robust conceptual framework. ESG is arguably a loose and convenient buzzword that lacks clarity regarding its purpose, assumptions, elements and limitations. In particular, many ESG reports focus on environmental issues and on investors’ information needs, and demonstrate little concern for business ethics or the company’s responsibilities to each of its different stakeholders.
Moreover, there has rarely been any serious discussion in either the market or the literature regarding why the three domains of ESG have been put together, why in this particular order and how they interrelate with one another. The current ESG disclosure requirements in Hong Kong do not specify whether governance aspects should be disclosed together with environmental and social aspects in a single report, or in what order. Rather, to many companies, it is only some additional regulatory requirement to comply with.
Lacking an integrated conceptual framework, the major problem with existing ESG reporting is that it is not based on a company’s purpose and responsibilities. Different concepts or terms such as responsible management, business ethics, Corporate Social Responsibility (CSR), sustainability, responsibilities to stakeholders and corporate governance cannot easily be linked together.
As many of the inherent concerns regarding ESG reporting have not been addressed, it is doubtful to what extent piecemeal revisions of the HKEX requirements or other regulatory bodies can significantly improve the cost effectiveness and value of ESG reporting, especially in achieving social and environmental progress.
In March 2022, the International Sustainability Standards Board (ISSB) of the IFRS Foundation issued two IFRS sustainability disclosure standard exposure drafts on Sustainability-related Financial Information (IFRS S1) and Climate-related Disclosures (IFRS S2). While acknowledging the timely address by ISSB on the desperate concern of the effect of climate change on corporate sustainability, as evidenced by a report of the World Economic Forum of 2020, the two exposure drafts however focus only on environmental sustainability and climate change reporting. We do hope that the IFRS Foundation continues to make efforts to tie up the other loose ends inherited from the current ESG legacy.
Ethics, stakeholder value and sustainability
To address the shortcomings discussed above, the first step in developing a revised ESG model is to identify a sound and comprehensive conceptual framework. We believe that corporations are important social institutions that have the capacity to benefit various stakeholders and society. In recent years, some business and academic leaders have suggested redefining the purpose of corporations from the perspective of social contracting. That is, since companies enjoy privileges such as limited liability, unlimited life and independent legal person status, management should implicitly agree to bear responsibilities to various interdependent stakeholders, and make a positive impact on today’s pressing challenges such as climate change and social concerns. Thus, corporate leaders should not concentrate solely on shareholders’ interests, but rather should optimise value for all stakeholders upon whom the company depends for its existence. In other words, corporations need to balance the interests of all major stakeholders and aim for sustainable corporate growth.
While corporate governance provides a framework within which boards make decisions, such frameworks should be based on the fundamentals of the decision-making process by responsible management, which we believe is the single common denominator for corporate governance. We therefore propose an enhanced ESG model based on the Integrated Conceptual Framework of Responsible Management developed by one of the authors of this article, Simon Ho, in 2020. This framework stems from the umbrella concept of social contracting and examines the purpose and the core values of responsible management.
In this integrated framework (see ‘Our enhanced ESG model’), three core domains are identified: ethics, stakeholder value and sustainability. On top of these three domains comes the existing governance domain, which provides the overall corporate direction and leadership for responsible management.
The existing ESG model pays little attention to ethics, which is the foundation of responsible management. Ethical decision-making not only shapes sustainable businesses but also facilitates the creation of long-term value to stakeholders more effectively. In the field of corporate governance, moral integrity is generally recognised as one of the major pillars. Management awareness of ethical issues is therefore a fundamental attribute which ensures that managers avoid abusing their power or undertaking improper actions that could result in questionable behaviours and practices within organisations.
Further, in the existing ESG model, the social domain is arguably too broad and hence confusing, as it consists of a number of loose reporting elements such as human rights, training (which is not well-defined in the ESG Reporting Guide), equal opportunities and diversity, corruption prevention, occupational health and safety, consumer rights, community engagement and so on, which do not necessarily relate to each other. The expectations and information needs of different stakeholders are not systematically addressed. Considering this, we propose that the enhanced ESG model should be based on the four domains of ethics, stakeholder value, sustainability’ and governance.
The various existing and additional reporting requirements or key performance indicators (KPIs) should then be classified according to each of the four redefined domains of ESG listed above. To illustrate, here are some examples of new KPIs in our refined ESG model. For ethics, KPIs would include investment in ‘sin stocks’ that would currently be an aspect of governance. Excessive work hours and any monopolistic behaviour would go under stakeholder value. Other examples would include interactions/engagement with investors. For sustainability, examples of KPIs would be the proportion of renewable energy consumed and management salary multiples over operational staff wages, as well as innovation and knowledge creation, and long-term risk management.
Towards a stakeholder-based and sustainable economy
Apart from advocating for the enhanced ESG model, we have also identified the following suggestions for improvements to current ESG reporting practices, subject to materiality considerations.
Establish an ESG committee
A fundamental principle of corporate governance is to ensure accountability. It is observed though that the boards of some companies do not sign off the ESG report. Emulating the approval process of financial statements by the company’s audit committee, it is proposed that companies should establish an ESG committee, consisting mainly of independent non-executive directors (INEDs), which will monitor the issuer’s ESG-related matters and be responsible for endorsing the ESG report.
Currently, ESG disclosures are commonly done on a group basis only. This may mask poor ESG performance in subsidiaries since their KPIs may be ‘offset’ by better performance elsewhere in the group. This may not only lead to under-investment in environment correction activities, but also impose the threat of greenwashing where the public would be misguided in the belief that the company is ‘greener’ than it actually is. In such cases, reporting at the subsidiary level would facilitate comparability among companies of different segments locally and abroad.
Improve the integration of Hong Kong and Mainland ESG requirements
With the more intensive integration of the Hong Kong and Mainland economies, as well as dual listings, Hong Kong’s present ESG reporting model does not take adequate consideration of recent ESG developments in the Mainland. Our ESG proposal will require more collaboration between Hong Kong and Mainland authorities.
Policies, plans and action executed should be disclosed separately, and the proper implementation of such policies and plans should be monitored. Such disclosures also manifest accountability of responsible management, which is a major principle of corporate governance, vital in establishing confidence among stakeholders and shareholders.
It is evident that across the globe, the current ESG reporting model has fallen short of the expectations of society at large. Different stakeholders are desperately waiting for new thinking on this matter. This article has laid out an enhanced version of the existing ESG model. Our enhanced ESG model offers a structure which aligns with the principles of good corporate governance and will help to measure true corporate performance and facilitate meaningful comparison between companies, industries and specific topics.
Although our enhanced ESG reporting model represents only a modification of the current prevailing ESG reporting model, it nonetheless provides a robust framework that seeks to address some shortcomings of the present model. It is time to recalibrate.
Professor Simon SM Ho, President
The Hang Seng University of Hong Kong
Anthony Tyen, Director
Provident Governance Services Ltd
This article represents the authors’ personal views. CGj’s Viewpoint column provides a forum for readers to share their views and expertise on issues relevant to the work of governance professionals. Please contact CGj Editor, Kieran Colvert, by email: firstname.lastname@example.org, if you would like to submit an article for publication in this column.
SIDEBAR: Our enhanced ESG model
The four domains, outlined below, of our revised ESG model are complementary, mutually reinforcing but distinct, each with its own core concepts and execution.
E is for ethics. This represents the moral principles or conscience that govern a company’s behaviour. Companies are obliged to implement ethical business policies and practices with regard to diverse issues, some of which are not currently subject to legal requirements.
S is for stakeholder value. Companies need to disclose the value they create for each of their stakeholder groups, including investors at large, employees, customers, suppliers, creditors, community, regulators and the government.
S is for sustainability. Companies need to meet the needs of this generation while not compromising those of future generations. This domain is centred on the core concept of the triple bottom line, that is the goals of ‘people, planet and profit’ (the 3Ps) and encourages organisations to take a longer-term perspective, and thus evaluate the future consequences of their activities and decisions.
G is for governance. This domain focuses on the mechanisms and processes by which companies are directed and controlled. In this context, governance essentially involves balancing the interests of the company’s many stakeholders, especially among shareholders, the board of directors and senior management, and thus calls for appropriate incentives, control and risk management measures.