Non-financial Disclosures – Rise to Fame

Posted On - 10 April, 2023 • By - Souvik Ganguly

Globally, there is a rise in the regulation of corporate behaviour based on non-financial factors such as sustainability and environmental, social and governance (ESG) impact. In 2022, about 65 countries have enacted 100 new policies and regulatory measures related to sustainable finance and ESG norms (Green Finance Platform, December 2022). This includes countries across the European Union (EU), Unites States of America (US) and Asia.

This may be attributed to the increase in green finance flows by 100 times over the last decade (Reuters, 2022). Sustainable assets in the US amounted to about USD 8.4 trillion in 2022, representing 12.6% of total assets under professional management (US Forum for Sustainable and Responsible Investment, December 2022). International financial institutions such as the World Bank have also reported deployment of USD 31.7 billion in green and sustainable finance (World Bank, September 2022).

The rise in sustainable finance has also led to exaggerated and misleading claims by financial firms regarding their ESG credentials, due to a lack of standards tailored to ESG investing (known as ‘greenwashing’). To tackle greenwashing, disclosure norms have been enacted by the law makers across jurisdictions. In this article, we touch upon the emergence of sustainable finance, measures introduced in the US, EU and India and share our thoughts on the disclosure norms for sustainable financing.

Genesis of the conversation

The United Nations Conference on Environment and Development in 1992 (Earth Summit) resulted in the adoption of United Nations Framework on Climate Change (UNFCC). The UNFCC became the first internationally recognized document which considered the change in the Earth’s climate and its economic impact. In 2006, ESG factors were first mentioned by the United Nations in the Principles for Responsible Investment formed by a group of some of the world’s largest international institutional investors.

In 2015, the international community adopted the Paris Agreement, 2015 (Paris Agreement) which is one of the most significant treaties on climate change. The Paris Agreement universally obliged the signatories to commit to reduce their greenhouse gas (GHG) emissions to mitigate the effects of climate change. It also required countries to make their finance flows consistent with international commitments.

Green finance

This meant that ESG factors came into the limelight. The ‘E’ in ESG related to climate change, GHG emissions and other forms of pollutions; the ‘S’ related to human rights, labour welfare; and the ‘G’ referred to the governance structures of the companies. As per a report published by OECD in 2020, the reason for the focus on ESG may be due to at least 3 factors: (i) similar returns as that from mainstream financial investments; (ii) societal values influencing investor decisions; and (iii) a shift towards long-term sustainable investment performance. The investments made after an ESG assessment are generally termed ‘sustainable finance’.

Green finance investments may be understood as a subset of sustainable finance as it only considers the environmental aspects of a project, while sustainable finance extends to all aspects of ESG. It is different from business-as-usual investment in so much that green finance internalises the environmental costs of an activity and promotes environmentally positive outcomes. The financial products or services used for green finance include green bonds, green mortgage, green commercial building loans, vehicle loans and green debit and credit cards.

Approach in the EU, US and India

§  European Union

The EU has developed an overall framework for non-financial disclosures which are applicable to companies, investors as well as other financial market participants including financial advisors (Oxford Academic, February 2023).

For large companies and listed small and medium enterprises, the EU has introduced non-financial disclosure norms by enacting the Corporate Sustainability Reporting Directive. The directive requires the companies to publish non-financial disclosures in accordance with the upcoming European Sustainability Disclosure Standards which is currently in the draft stage. It requires the companies to include the company’s impact, performance and position on sustainability matters in its management report (European Commission).

With respect to financial market participants and financial advisers, the EU has implemented sustainability‐related disclosures which require the financial market participants and financial advisors acting as agents for investors to make pre‐contractual and periodic disclosures in relation to sustainability risks in investment decisions; and the extent of completion of the sustainability objectives (European Union)

The various disclosures are supported by the EU Taxonomy which provides technical screening criteria for determining whether an economic activity can be considered as ‘environmentally sustainable’ to both companies and investors (European Commission).

§  United States

In March 2022, the US Securities and Exchange Commission (SEC) proposed the disclosure of climate related risks and metrics in financial activities (SEC). The proposal broadly requires public companies to provide detailed disclosures of the oversight and governance of climate-related risks by the board and management; material impact of climate risk on the business; scope of greenhouse-gas emissions; and climate related target plans. Further, these disclosures only relate to climate related risks and not the other areas of ESG (Brookings, June 2022).

There is also the emergence of an opposing school of thought in the US which advocates for investment decisions solely for maximising profits without accounting for the non-financial factors. This anti-ESG school of thought emerged when the big banks stopped lending money to oil companies in 2020 citing ESG concerns. This has since been driven by political agencies (New York Times, February 2023). Off late, some of the banks and financial firms have modified their strategies to navigate this political discord (Bloomberg, March 2023).

§  India

The Indian securities market regulator, Securities and Exchange Board of India (SEBI) has recently mandated ESG disclosures called the Business Responsibility and Sustainability Report (BRSR). The BRSR obligation is applicable to the top 1000 listed companies by market capitalization. To enhance the creditability of the disclosures, SEBI has also recently mandated that the top 1000 listed companies by market capitalization will be required to provide disclosure and verification on selected ESG indicators. These key indicators include change in GHG, water or environmental footprint; investment in recycling; enhancing employee wellbeing and safety; and enabling gender diversity and inclusive development.

Further, SEBI has also acknowledged the risk of greenwashing in absence of accepted standards across the market (SEBI Consultation Paper, August 2022). To tackle the risk of greenwashing in the green bonds market, SEBI has issued a consultation paper on green bonds in August 2022. This consultation paper proposes changes to the current SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021. SEBI has referred to the principles framed by the International Capital Market Association (Principles) for the purpose of this consultation paper and has suggested that the issuers of securities make the following disclosures:

(a)   Categorisation as green projects: disclosure of certifications, taxonomies or standards followed, if any, in classifying the project as green project;

(b)   Use of proceeds: disclosure regarding temporary placement of unutilized proceeds; separate disclosure of utilization of proceeds of each bond in case of multiple issuance of bonds; and in case of refinancing of other projects using green bond proceeds, disclosure of details of projects proposed to be refinanced, percent share of financing and refinancing of proceeds and look-back period for identifying projects that may be refinanced; and

(c)    Environmental impact: disclosure of environmental impact of the projects in the offer document or as a continuous disclosure; and disclosure of external reviewers of projects, if appointed at pre-issue or post-issue stages, on stock exchanges where bonds are listed or proposed to be listed in addition to the offer documents.

Other global developments

In addition to above mentioned country specific measures, the Task Force on Climate related Financial Disclosures (TFCFD, June 2017) which is an international organization with members from various countries including the EU, US, UK and India, recommends the following disclosures:

(a)   Governance: management and board oversight assessing and managing climate risk;

(b)   Strategy: company’s strategy on climate risk and impact of climate risks and opportunities on the company’s businesses, and financial planning;

(c)    Risk management: company’s processes for identifying, assessing and managing climate risks and  the process of integration of the climate risks identified by the company in the overall risk management of the company; and

(d)   Metrics: metrics used to assess and manage the climate risks and opportunities.

Our thoughts

From the measures taken to implement non-financial accountability, EU appears to be leading the world in the regulatory framework on ESG and green finance with more comprehensive ESG parameters, covering public as well as private companies. The US is currently focusing only on the climate related aspect of the disclosures and extending it only to public listed companies. Importantly, it has been noted that as the EU regulations become applicable on private companies as well, non-EU entities having their businesses in EU may also be required to align their disclosures with the EU regime.

India has taken a blended approach with the regulatory mandates focusing on all ESG parameters while making them applicable to the top listed companies. However, the framework for green finance and ESG disclosures in India is still rudimentary. The only disclosures that investors may rely on is the ESG disclosures under BRSR, which are voluntary for private companies. Further, there is no supervisory body or mechanism to verify these voluntary disclosures resulting in investors having to employ their own diligence. Considering that most Indian businesses are micro, medium and small enterprises, adherence to global standards of ESG disclosures may be challenging for such companies and may increase costs. Keeping in view India’s industrialisation and growth requirements, the ESG focus may not benefit India unless the growth and development reaches a certain stage. Accordingly, India may not be ready for EU style regulations to implement ESG as it may adversely affect India’s growth opportunities. It is relevant to strike a fine balance in India to increase growth by industrialisation without adversely affecting India’s committed position of achieving net zero emission norms by the year 2070 (Mint, January 2022).

We have already started to witness a change in this regard as the government has sanctioned various policies and initiatives for reducing emissions, incentivising alternative fuel mixes and encouraging development of alternative energy sources on one hand (Ministry of New and Renewable Energy, July 2022) and increase India’s potential as a manufacturing hub under the ‘Make in India’ initiative on the other. Global companies, such as Apple, have already made India a hub to manufacture and increase exports from India. Further, stringent EU regulations are also incentivising companies to look at India as a manufacturing hub (Daikin – Business Standard, March 2023). Accordingly, it will be this fine balancing act that will be required from time to time over the next few decades, through policies and actions, to ensure that the development potential of the country is realised together with systematically entrenching the culture and practices to achieve sustainable growth for the long term. The journey is arduous and time consuming, however, it is critical to achieve the potential of India balanced with seeding, protecting and enhancing the principles inherent in the concept of ESG.

Authors: Souvik Ganguly, Akhil Ramesh and Shrishti Mishra

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