Sustainable Financing

Challenges and benefits of ESG reporting for companies

Dr S.S. Garg, General Manager and Head, Environmental and Social Safeguards Management Unit, IIFCL

The growth of sustainable infrastructure finance, including the increasing array of financial products, has att­ra­cted the at­­tention of various stakeholders given its po­tential to deliver financial re­­­tu­r­ns, align wi­th societal values, and co­ntri­bute towar­ds sustainability and climate-related objectives.

Today, environmental, social and governance (ESG) investing has become a leading form of sustainable finance. ESG in­ve­s­ting takes into consideration ESG factors when making investment decisions. ESG ratings, which are applied to companies representing 75-80 per cent of market capitalisation in 2020, have evolved in re­cent years to incorporate long-term fin­an­cial ris­ks and opportunities in investment de­ci­si­on-making processes. Meanwhile, the en­vironmental “E” pillar score of ESG rating is being increasingly used as a tool to align investments with low-carbon transition. A range of financial market products and me­asurement approaches have de­ve­loped to help investors align portfolios with specific climate objectives and strategies in line with the Paris Agreement.

Despite noteworthy progress, there are co­n­­siderable challenges that hinder the po­t­ential of these approaches to support long-term value and climate-related internat­ional objectives, notably with respect to ESG investing. These include the promulgation of different approaches, data inconsistencies, and lack of comparability of ESG criteria and rating methodologies, as well as lack of clarity on how ESG integration af­f­e­cts asset allocation. Ultimately, these challenges could constrain the pace and scale of capital allocation needed to ac­hieve tangible progress to support long-term value and a transition to low-carbon economies. Therefore, policies should be framed to fo­ster global interoperability and comparability of ESG approaches, as well as to stren­gthen the tools and methodologies that underpin disclosure, valuations and scena­rio analysis in financial markets associated with a low-carbon transition. This has be­co­­me more important in the Indian scena­rio as Prime Minister Narendra Modi anno­unced at COP26 that India will achieve net zero carbon emissions by year 2070. The role of the industry to combat climate chan­ge is now paramount. To im­press this segment with socially consci­ous investors, it is necessary to maintain a high ESG rating by co­nsciously conducting business operations, and not just focus on how much mo­ney the business is making.

Fundamentals of ESG

Companies are feeling increasingly pressured to report their ESG data from custo­mers, investors and regulators.

Environmental: The environmental criterion covers how companies use energy and manage their environmental impa­ct. It pertains to how a company uses re­sources across the board – Scope 1 to Scope 3. The key factors considered are energy efficiency, climate change, ca­rb­on emissions, biodiversity, air and wa­­ter quality, deforestation and waste manag­e­ment. Companies that do not consider th­e­se environmental risks may face un­foreseen financial risks and in­vestor scrutiny.

Social: The social criterion examines how a company fosters its people and cu­l­ture, and how that has ripple effects on the broader community. The factors considered are inclusivity, gender and di­versity, employee engagement, customer satisfaction, data protection, priv­acy, community relations, human rights, and labour standards.

Governance: Governance considers a company’s internal system of controls, pr­actices and procedures, how an or­ganisation stays ahead of violations. It en­sures transparency and adoption of industry best practices. It also includes dialogue with regulators. The key factors considered are the company’s leadership, board composition, executive compensation, audit committee structure, in­ternal controls, and shareholder rights, bri­bery and corruption, lobbying, political co­ntributions, and whistleblower programmes.

Explaining Scopes 1, 2 and 3

To help delineate direct and indirect emission sources, improve transparency and pr­o­vide utility for different types of organisations and different types of climate policies and business goals, three “scopes” (Scope 1, Scope 2 and Scope 3) are de­fin­ed for greenhouse gas (GHG) accounting and reporting purposes. Scope 1 and 2 are carefully defined in this standard to ensure that two or more companies will not acco­unt for emissions in the same scope. This makes the scopes amenable for use in GHG programmes where double counting matters. Companies will accou­nt separa­tely for and report on Scopes 1 and 2.

  • Scope 1 – Direct GHG emissions: These GHG emissions are generated from sources that are owned or controlled by the company. For example, emissions from combustion in owned or controlled boilers, furnaces, vehicles, etc.; and em­i­ssions from chemical production in ow­ned or controlled process equipment. Direct CO2 emissions from the combustion of biomass shall not be included in Scope 1, but reported separately. GHG emissions not covered by the Kyoto Pro­tocol such as CFCs and NOX will not be included in Scope 1, but may be reported separately.
  • Scope 2 – Electricity indirect GHG emissions: Scope 2 accounts for GHG emissions from electricity purchased by a company for consumption. The electri­city is purchased or otherwise brought into the organisational boundary of the company. Scope 2 emissions physically oc­cur at the facility where electricity is generated.
  • Scope 3 – Other indirect GHG emissions: This is an optional reporting category that allows for the treatment of all other indirect emissions. Scope 3 emissions are a consequence of the activities of the company, but occur from sources not owned or controlled by the company. So­me examples of Scope 3 activities are extraction and production of purchased materials; transportation of purchased fuels; and use of products and services.

The ESG criteria are used by socially conscious investors and shareholders to screen investments and assess a com­pany’s impact on the world. They affect how your company will gather and retain funding from investment funds that have a socially responsible investment strategy.

The three pillars: Environmental, social, governance

The ESG criteria are divided into three main categories – environmental, social and gov­er­nance. The environmental criterion covers how a company performs as a st­eward of nature. This includes action on climate change, greenhouse gas emissions and reductions, and water usage.

The social criterion examines how it manages relationships with employees, suppliers, customers and communities where it operates. The key themes include labour standards, health and safety performance, community and employee welfare and the way a company treats clients and custo­mers. The governance criterion deals with a company’s leadership, executive pay, audits, internal controls and shareholder rights. This includes anti-corruption measures, tax transparency, biodiversity policy, responsible business policy and decision-making across the executive board.

Why is ESG important?

There are a number of financial benefits for companies that pursue a high ESG performance. What is more important is that in­vestment is made with responsiveness to­w­ards sustainable infrastructure financing.

  • More attractive to investors: Green investment funds and socially responsible investors are more likely to fund companies with good ESG scores.
  • Better performance: A study by a leading asset manager Amundi showed that between 2014 and 2017, its portfolios with high ESG scores outperformed competing investments.
  • Better financial indicators: MSCI reports that high-ESG companies experience lower cost of capital, less volatile earnings and lower market risk compared to low-ESG companies.

There are proven business benefits of sustainability reporting. The active disclosure and communication of a company’s ESG impacts is key to future-proofing its success. Furthermore, reporting ESG data allows stakeholders and investors to gain an insight into the business and maximise its positive impact. It helps manage risks stemming from ESG issues, obtain real value and better terms from the financial sector, build reputation and trust among customers and business partners, incre­a­se employee retention and motivation, id­entify strengths and weaknesses, and create a competitive advantage.

What is ESG reporting?

ESG reporting refers to the disclosure of data covering an organisation’s operations in three areas – environmental, social and governance. It provides a snapshot of the impact of a business on the three areas for investors. The analysis of performance across these ESG factors includes quantitative as well as qualitative disclosures and helps screen the in­ve­stments. ESG reporting helps investors av­oid companies that might pose a greater fin­ancial risk due to their environmental performance or other social or governmental practices.

Outlook

The Axis ESG Equity Fund, HSBC Global Equity Climate Change Fund of Fund and Invesco India ESG Equity Fund are some ex­amples of ESG funds. According to re­search by Edelweiss Securities Limited, as of June 2021, there are 10 domestic ESG funds in India. Interestingly, out of th­ese funds, eight were launched in the past one year. Meanwhile, Mahindra & Mahi­ndra, ITC Limited, Future Retail, Infosys, Mind­Tree, Tata Steel, and Tata Chemicals are included in the list of ESG companies.

While the demand and practice of ESG reporting have increased, there still lies a considerable knowledge gap between ESG information and supply. This gap is driven by several factors like varying ESG reporting standards and frameworks, non-mandatory reporting regimes, and steep costs of data collection and reporting. Th­ese can hamper the efforts to offer hi­gh­er quality data to investors to help them make informed decisions. Fortuna­tely, companies can work with experts to develop and incorporate ESG-balanced strategies into their overall performance. The main challenges in ESG reporting are defining ESG metrics and materiality, internal and external ESG data collection, sharing data with rating agencies, data validation and third-party assurance, and unactionable data insights.

An ESG data environment requires data integrity built on reliable, trustable and se­cure data in all aspects. There is a need to assess what systems are currently in place and where data is stored. Gi­ven the volume of ESG data, it is crucial that the right technology is implemented to quickly extract and swallow the desired data. To ensure that the ESG data is trus­table, a system that prioritises data in­tegrity is essential.

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