Harvard University

By Zeng Han Jun

Development of ESG criteria

Governments are increasingly incorporating Environment, Social and Governance (ESG) criteria into mandatory financial disclosures as part of their efforts to achieve net zero carbon and contribute to the United Nations’ Sustainable Development Goals (SDGs). What does this mean for businesses, though?

Over 20 years ago, ESG principles were established, primarily to support selective investment and as criteria for reporting sustainability credentials. ESG disclosures were previously voluntary. Companies used them to differentiate themselves and add value to their businesses for investors and the general public.

Following the Paris Agreement (2015), governments have implemented policies to reduce carbon emissions and contribute to the SDGs. Among these regulations is the requirement for companies to make ESG disclosures.

ESG policy to drive the nett zero transition

For example, the European Commission has published or revised regulations aimed at incorporating sustainability into its financial policy framework. Regulation 2019/2088 on sustainability related disclosures requires banks and its financial advisers to disclose ESG information to their customers, and Regulation 2019/2089 (also known as the Low Carbon Benchmarks Regulation) aims to improve transparency and consistency in low carbon indicators.

The EU Taxonomy Regulation, enacted in 2020, contributed to the establishment of an EU classification system for sustainable activities. Furthermore, Directive 2014/95 requires large public interest companies to publish reports on their environmental protection, social responsibility and employee treatment, respect for human rights, poor corporate governance and diversity on company boards.

In 2017, the Task Force on Climate-related Financial Disclosures (TCFD) issued its final recommendations on reporting on climate impacts and action. It established a framework for businesses to create more effective climate-related financial disclosures using existing reporting processes, allowing for more reliable cross-market comparison.

New Zealand was one of the first countries in 2020, to commit to mandatory climate risk disclosures that are aligned with the TCFD recommendations for publicly traded companies, large insurers, banks, and investment managers.

The 2019 Streamlined Energy and Carbon Reporting Regulation (SECR) in the United Kingdom also introduced mandatory disclosures related to energy consumption, greenhouse gas (GHG) emissions, and energy efficiency actions for selected companies as part of their annual reporting.

Singapore also published its sustainability reporting framework in 2021, with climate disclosures playing an important role in transforming finance for a greener future. Singapore has been building the green bond market for years, including under a “Sustainable Bond Grant Scheme” from 2017 that has propelled the issuance of almost USD$8.3 billion in green, social, and sustainability bonds. That included a $1.1 billion set of green bonds issued in 2020 by Star Energy Geothermal Group, used in part to finance geothermal energy generation facilities in West Java, Indonesia.

The impact of mandatory ESG disclosures on businesses

Companies will face increased scrutiny regarding the sustainability of their activities in the future, as well as due diligence, with ESG criteria serving as a key requirement for investment decisions. Companies must measure and manage their environmental and social impacts, as well as have in place a governance structure to support this, in order to comply with mandatory ESG disclosures.

Although this may be overwhelming for some businesses that have not yet embarked on the sustainability journey, focusing on these aspects now can help businesses mitigate future compliance and climate risks. Companies should view incorporating ESG criteria as an opportunity to improve their businesses, create positive impacts in their value chains, and improve investor relations, not just any desktop exercise.

Companies should evaluate their businesses and create a roadmap for incorporating ESG criteria into their operations. While this will almost certainly necessitate short-term investments, it would almost certainly provide long-term value. Some research have showed that companies that have incorporated ESG into their operations consistently outperform their peers and may even benefit from lower-cost financing. Investors, for example, are becoming more aware of the risks that climate change can impose on traditional financial assets, and they may be willing to accept a lower return on investments linked to more sustainable activities.

What comes next?

Businesses should begin to think how they should embark on their ESG journey and gradually adapt and prepare for the more stringent disclosure regulations. They must also anticipate the higher level of rigor that investors and financiers will emphasis during due diligence. Integrating sustainability into corporate practices and reporting today would ultimately increase business value and allow businesses to contribute to a more sustainable future.

Copyright © 2021 Zeng Han-Jun. All Rights Reserved.