This second and final part of the Champion Paper of the most recent Corporate Governance Paper Competition held by The Hong Kong Institute of Chartered Secretaries (the Institute) focuses on the latest environmental, social and governance (ESG) reporting requirements in Hong Kong.

Regulation of ESG reporting serves two important purposes – it sets the minimum disclosure requirements and provides guidelines on best practice. A study conducted by Carrots & Sticks in 2016 revealed that in 400 sampled sustainability reports from 64 selected countries, 65% of the content was mandatory. Notably, mandatory reporting largely applies to state-owned or big businesses only, and usually only targets some parts of sustainability. Many companies are also subject to comply or explain provisions for the remaining areas.

Reporting scrutiny can be divided into three levels:

1. mandatory reporting
2. comply or explain disclosure, and
3. recommended best practices.

In particular, under the comply or explain concept, deviation from the requirements is not always considered non-compliance – companies can provide sufficient and reasonable explanations for any omissions. Hong Kong Exchanges and Clearing Ltd (HKEX) currently adopts a mixture of mandatory and comply or explain disclosure requirements, allowing room for issuers to take their individual circumstances, risk and challenges, operation size and complexity into account.

The compliance requirements in Hong Kong

ESG reporting in Hong Kong is mainly governed by the Environmental, Social and Governance Reporting Guide (ESG Reporting Guide). The guide was published by HKEX in 2012 and has been incorporated into the Listing Rules. It covers four key areas, namely workplace quality, environmental protection, operating practices and community involvement. In 2019, HKEX published its Consultation Paper on Review of the Environmental, Social and Governance Reporting Guide and Related Listing Rules on proposed changes to the ESG reporting requirements. Subsequently, HKEX amended the ESG Reporting Guide and related Listing Rules, and the changes became effective on 1 July 2020. Below is a summary of the amended requirements.

Mandatory disclosure

Governance structure. Before the latest amendments, the ESG Reporting Guide only outlined the overall responsibility of the board of an issuer regarding ESG strategy and reporting, without compelling the board to disclose details of its governance structure or its involvement in the ESG reporting process.

Under the revised ESG Reporting Guide, the board of an issuer is now required to disclose a statement containing the following elements:

• its oversight of ESG issues
• its process used to evaluate, prioritise and manage ESG issues (including risks), and
• its review of progress made against ESG goals and targets, and how they relate to the issuer’s business.

Reporting principles. Even though the reporting principles of materiality, quantitative and consistency were set out in the ESG Reporting Guide before the latest amendments, issuers were not required to disclose or explain the application of such principles in their ESG reports. The revised ESG Reporting Guide now compels issuers to explain how they apply these principles. For example, to satisfy the materiality principle – which is defined as the threshold at which ESG issues are determined by the board to be sufficiently relevant and important to investors and stakeholders – the issuer should disclose:

• what criteria are used to identify material ESG factors and if a stakeholder engagement is conducted, and
• a description of significant stakeholders identified, and the process and results of the engagement.

To uphold the quantitative principle, HKEX requires issuers to disclose the definitions and calculation/measurement methods they have employed to derive data reported.

Issuers were previously not required to disclose the process used to identify which entities or operations were included in the ESG report. This practice was deemed to be misleading by HKEX, as subsidiaries or operations within a group company that performed poorly could be excluded from the ESG report without any explanation, and investors might in turn misunderstand the reported figures as an issuer’s overall performance. The amendments have therefore made it compulsory for issuers to explain the reporting boundary used in their ESG reports.

Comply or explain disclosure

Environmental subject area. Despite HKEX’s policy of upgrading environmental key performance indicators (KPIs) to comply or explain disclosure in 2017, issuers were only required to disclose results achieved from their initiatives to reduce emissions and waste, without describing their targets. Moreover, issuers were compelled to reveal greenhouse gas emissions in total, rather than by types. Under the revised rules, an issuer should disclose a description of targets set concerning emissions, energy use, water efficiency and waste reduction, as well as steps taken to achieve them.

The latest ESG Reporting Guide also introduces a new climate change aspect, which consists of:

• climate-related issues that have impacted or may impact their business, and
• steps taken to manage these climate-related issues.

Social subject area. All social KPIs have now been upgraded from recommended disclosures to comply or explain. Two new KPIs, concerning supply chain management and anti-corruption, have been introduced under the revised rules. Regarding supply chain management KPIs, issuers are required to disclose:

• practices used to identify environmental and social risks along the supply chain, and
• practices used to promote environmentally preferable products and services when selecting suppliers, and how these are implemented and monitored.

In addition, regarding anti-corruption KPIs, issuers are now obliged to reveal any anti-corruption training provided to directors and staff.

The latest ESG Reporting Guide has also revised the requirements for two social KPIs, namely ‘employment types’ and ‘rate of fatalities’. Regarding employment types, issuers were previously recommended to disclose total workforce by gender, employment type, age group and geographical region. They should now include both full-time and part-time staff. Regarding rate of fatalities, issuers were previously recommended to disclose the number and rate of work-related fatalities for the reporting year. Under the revised ESG Reporting Guide, they are now required to disclose the number and rate of work-related fatalities that occurred for each of the past three years, including the reporting year.

Other matters

Shortened time frame for ESG reporting. Issuers are also required to publish their ESG reports within five months after the financial year end, but preferably at the same time as the publication of annual reports.

Independent assurance. Before the amendments, the ESG Reporting Guide provided that an issuer might consider obtaining assurance on its ESG report. However, there was no guidance regarding the benefits of obtaining assurance, nor the information to be disclosed if assurance was obtained. Issuers are now encouraged, but not required, to seek independent assurance to strengthen the credibility of the ESG information disclosed. Where independent assurance is obtained, an issuer should describe clearly the level, scope and processes adopted for assurance in the ESG report.

Key ESG reporting issues in Hong Kong

The cost of compliance

During the public consultation period in mid-2019, there was much debate as to whether HKEX should raise the compliance level for some aspects of ESG reporting to mandatory disclosure. Some respondents expressed concerns about the cost implications and urged the government to provide subsidies, especially for small and medium-sized enterprises (SMEs). Notwithstanding the time and financial cost associated with ESG report preparation, listed and non-listed SMEs will likely find ESG disclosure helpful to enhance competitiveness and attract investors, particularly given the global trend towards responsible investing. Arguably, the new ESG regime in Hong Kong remains flexible and issuers still have the option to explain why certain KPIs are deemed immaterial, which in turn drives the cost of complying down.

Opposition in previous consultations also argued that the cost burden would deter future listings in Hong Kong and therefore diminish its value as a financial hub. However, as various jurisdictions and stock exchanges have implemented similar measures, the argument for stringent ESG disclosure requirements creating a ‘non-tariff’ trade barrier no longer stands. Instead, HKEX needs to act quickly and enact relevant regulation to stimulate the market to adapt, and thereby create more cost-efficient ways of compliance through innovation.

Materiality of mandatory KPIs

Consultation respondents had diverse views on whether certain KPIs should be made mandatory. Opponents contested that mandatory quantitative KPI disclosure is not industry-specific and may disadvantage certain sectors. However, the beauty of the new regime is that HKEX recognises that while corporate governance structure disclosure needs to be made mandatory, other environmental and social KPIs are indeed industry-specific. The comply and explain approach and materiality matrix allows different sectors to tailor their ESG report to standards and aspects which they view most appropriate to them, regarding the environmental and social KPIs.

Different reporting standards

At the global level, five of the most well-known ESG reporting standards are the Global Reporting Initiative (GRI) Standards, Integrated Reporting Framework, Sustainability Accounting Standards Board, Dow Jones Sustainability Index and the United Nations Sustainable Development Goals. Each of these frameworks have similarities and differences regarding their focus, scoring scale, users and reporting period.

As for Hong Kong, Alaya Consulting reported that prior to HKEX introducing more stringent ESG disclosure requirements, the GRI Standards, or GRI G4, continued to be the most popular framework, in addition to HKEX’s ESG Reporting Guide, which aligns with international practice. It was also reported that more than half of the sample companies adopted guidelines from other stock exchanges (such as Shanghai Stock Exchange and Shenzhen Stock Exchange), or industry-specific guidelines issued by Mainland authorities (such as China Securities Regulatory Commission and Oil and Gas Industry Guidance on Voluntary Sustainability).

With the new KPIs and quantitative principle embedded into the new reporting regime, HKEX unified the standards and KPIs used, to a certain extent, which makes it easier for companies to benchmark their performance against one another. This is the case especially for governance, where disclosure of frameworks and standards are now mandatory. It is expected that greater uniformity of reporting will allow more consistent disclosure, and investors can more efficiently and effectively arrive at investment decisions.

Quality assurance

Another contested issue is the verification of reported data. External confirmation can ensure that the reported information and calculation methods truly and fairly disclose a company’s ESG performance. Alaya Consulting in 2018 surveyed the ESG reports of the largest 200 Hong Kong–listed companies by market capitalisation and revealed that only 23.5% (47 out of 200) of companies had some degree of third-party assurance for ESG reports. Among the 47 assured reports, only six had the entire report assured. Therefore, it can be inferred that external auditing is not regarded as material and only a small portion of companies are willing to invest in assurance at this stage.

HKEX also expressed in its 2015 Consultation Conclusions that because mandatory ESG disclosure was still relatively new for many companies, it would be unnecessarily burdensome and costly to require companies to obtain external auditing for their ESG reports at that stage. Furthermore, because of the flexible comply or explain enforcement mechanism, and the inherent complexity of diverse KPIs, it would be difficult for external parties to verify such information independently without introducing some bias into the measuring process. Notably, while some law firms, consultancy services and compliance companies do offer ESG report writing and verification services, unlike the GRI, there is currently no dedicated regulation framework or certified training programme governing these third-party service providers.

We are convinced, however, that the absence of a mechanism to check figures and the reporting issued by companies or their third-party agents undermines the effectiveness of ESG reporting. The better view is therefore for HKEX to implement a monitoring process, whereby spot checks of figures can be conducted and companies would have to account for any inaccuracies. Notably, having a system in place that requires disclosure of some ESG performance does not mean that the disclosing companies and respective investors can reap all the strategic and operational value of ESG. This is because compliance does not necessarily translate to active ESG risk management. For example, months before the 2016 Volkswagen (VW) emission cheating scandal was revealed, some rating agencies (for example MSCI and Sustainalytics) already had provided poor ratings for VW’s governance for its lack of board independence. Nevertheless, due to VW’s false emissions ratings, its environmental record continued to look positive. Therefore, with limited external auditing, it remains difficult to evaluate the credibility and reliability of an ESG report.

Ngan Sum Long, Bachelor of Business Administration (Law); and Kwong Lok Lam, Bachelor of Laws

The University of Hong Kong

The Institute holds its annual Corporate Governance Paper Competition and Presentation Awards to promote awareness of corporate governance among local undergraduates. This article is a summary of the 2020 Champion Paper – Does Investment in ESG Values Generate Investment Value? A Cost-benefit Analysis of ESG Reporting in Hong Kong. More information is available on the Studentship section of the Institute‘s website: www.hkics.org.hk.