- When all fall in line will Sri Lanka be in a better position to attract sizable FDIs and achieve its sustainability goals.
- ESG that resembles the consciousness of a business to accomplish positive climate action in building a more sustainable and resilient future for our Society.
- Businesses must realize that only through relevancy and entirety of disclosures could business, help its potential investors and rest other stakeholders gauge whether the business is a “good corporate citizen” and a “worthy investment”.
Sri Lanka is taking up sustainability and ESG (environmental, social and corporate Governance) issues on its top priority. Numerous strategic initiatives proposed by the country leadership reinstating the government focus to supporting and promoting of the United Nations Sustainability Development Goals (SDGs) to achieve transformation towards a sustainable and resilient society which includes commitment to carbon neutrality by 2050, half nitrogen waste by 2030 through the Colombo Declaration on Sustainable Nitrogen Management, to limit the overuse of artificial fertilizers – to help address health concerns, to increase the contribution of renewable energy sources to 70% of national energy needs by 2030. To achieve these laudable objectives, the support of technology, skills development, investment, and financing must follow through.
“Sri Lanka would be in a better position to be able to attract sizable Foreign Direct Investments (FDIs) as well as achieve its sustainability goals when all fall in line and see through the very same strategic lens for defining how value is created, delivered and measured across all verticals” says Buwanesh Wijesuriya, Partner, Transaction Advisory Services, Ernst & Young based in Colombo.
The increasing focus for a framework built on ESG helps organizations to be more conscious toward accomplishing positive climate action, building a more sustainable, resilient future based on these nonfinancial factors that are generally not covered under mandatory reporting.
Generally, environmental factors address topics or concerns such as waste management, emissions impact, energy efficiency, air and water pollution, environmental protection, and biodiversity loss and restoration. Social factors take into consideration human rights, labor rights, working conditions, health and safety, employee relations, employment equity, gender diversity and pay inequity, anti-corruption, and impact on local communities. Governance factors comprise issues on ownership and structural transparency, shareholder rights, board of directors’ independence and oversight, diversity, data transparency, business ethics, and executive compensation fairness.
In summary, an ESG framework offers another way of assessing a company without solely looking at its profitability and balance sheet but paying attention to how the performance impacts the broader society at large. Simply, an ESG framework helps stakeholders, especially potential investors, to gauge whether the business is a “good corporate citizen” and a “worthy investment”.
Findings of a survey conducted by EY Global
2020 EY Climate Change and Sustainability Services (CCaSS) Institutional Investor survey shows that “Investors are stepping up the game when it comes to assessing the performance of companies using non-financial factors. Overall, 98% of investors surveyed evaluate non-financial performance based on corporate disclosures, with 72% saying they conduct a structured, methodical evaluation. This is a major leap forward from the 32% who said they used a structured approach in 2018.”
At present, numerous ESG frameworks are used by organizations. Among these, the one widely used in Sri Lanka is the Global Reporting Initiative (GRI). This framework is recognized as one of the most holistic approaches available to determine how an organization affects the world in terms of its existence and operations. The United Nations Sustainability Development Goals (SDGs) and Sustainability Accounting Standards Board (SASB) are a few other frameworks used by organizations internationally. Regardless of the framework used, the quality of the ESG reporting is only good as the execution of the policies, the data collected and the governance surrounding the monitoring and reporting.
In the US, the Securities and Exchange Commission (SEC) requires public companies to disclose certain ESG information, such as a description of human capital resources and any measures or objectives which the management perceives as material to understand the performance and direction of the business. In addition, the SEC issued guidelines in 2010 with directions on US securities laws and regulations requiring disclosures such as climate-related information, depending on a company’s circumstances.
In EU, a proposal in April 2021 was presented to replace reporting requirements under the Non-Financial Reporting Directive (NFRD), requiring large public-interest companies with more than 500 employees to disclose environmental, social, and employee-related matters, such as anti-bribery, corruption, and human rights performance. The proposed Corporate Sustainability Reporting Directive (CSRD) will extend the scope to include large companies and all companies listed on EU-regulated markets in the EU (except listed micro-enterprises). The CSRD brings sustainability reporting closer to financial reporting by requiring “limited assurance” of sustainability information by a company’s auditor or an independent assurance services provider. Later, there will be the option of moving forward to “reasonable assurance”.
Where do the frameworks fall short?
Hiranthi Fonseka, Partner, Financial Accounting Advisory Services of Ernst & Young, Sri Lanka explained that the frameworks do a reasonably good job in terms of streamlining disclosures when one chooses to disclose on a particular criterion. Ms. Fonseka said “The frameworks alone would not facilitate a comparison between different companies. What matters is whether the reporting organization has a robust process in place to help determine what is material and relevant to their stakeholders and achieve entirety of disclosures”.
The GRI framework brings in a lot of subjectivity when attempts are made to carry out a comparison between companies. This is due to diverse views around what is more relevant to the reporting organization based on its sector, industry, or organization values and other focus areas. So, some level of uniformity must be introduced to facilitate the need for comparisons.
For example, a company’s business focus may be around environmental factors, while for others, it could be on social or governance factors. Many people in a room can give rise to various opinions as to what they perceive as more relevant. Yet, determining and reporting on what is material and relevant to the respective reporting organizations' stakeholders is nessasy to cater to the investor and stakeholder relations and recemble the progression the company would achieve through its proccesses, policies and action.
The flip-sided Investor perspective
EY survey on Climate Change and Sustainability Services (CCaSS) reveals an increasing investor preference for formal framework to be in place when communicating sustainability initiatives. The results indicated that 83% respondents are likely to see a new formal approach to measuring and communicating an entity’s intangible value as necessary in assessing long-term value, with only 2% investors indicating otherwise.
In the past several years, the dynamics of the sustainability debate has dramatically changed, with mainstream investors noting that sustainability issues impact the risk, return and value of companies in the long term. This has resulted in investors increasingly demanding comparable, consistent, and reliable information about a company’s sustainability performance. This change is considerably influencing securities regulators to be involved and, likewise, corporate boards to seriously think about and react to sustainability issues. Financial institutions show an increase in trends to use ESG factors to enhance a company’s valuation, lower investment risk and protect reputation.
Understanding the ESG metrics prior to investing?
Explaining on ESG metrics, Buwanesh Wijesuriya highlighted that, an investor may want to define for themselves what’s important to them because some organizations have very specific strategies on ESG, while others may have a varying focus on the three pillars of ESG. Irrespective of what point the organization is at, as far as the subject matter concerned, from a potential investor point of view, the organization must enforce such initiatives within the organization that would create value to the business and minimizing business risks.
For example, assuming that two agriculture farming organizations have the same level of ESG reporting. In current context, there is a shift in government policy towards the usage of biological fertilizer in the agriculture farming sector. Should one organization already made initiatives to shift part of their production towards using biological fertilizer, the organization should find this transition easier than the other organization that has yet to do so.
From an investor point of view, the latter should be attributed with a higher business risk as the effort for it to move towards this transition will be relatively challenging. The former would have already secured its supply chain to acquire biological fertilizer, its market branding and its business returns would have already reflected the impact from such initiatives. Given the same level of ESG reporting in both organizations, a smart investor should have been able to gauge the business risk and return concerning the government policy shift.
Understanding investor interpretations on disclosed ESG data
The quality of the ESG data reported by an organization largely depends on the robustness of the process in place to capture the data It also depends on how relevant, and material are the criterion reported to stakeholders. Majority of the organizations in Sri Lanka uses GRI framework. There is a high amount of subjectivity that can come into play in interpreting the reported data specially when comparing between organizations, as well as in the application of the concept of reevance and materiality.
In the current outlook, the way forward would be for the investors to interpret data based on the industry the reporting organization is functioning in. For example, a tire manufacturing company could ideally report more data on the environment pillar as opposed to an IT service organization. However, it does not mean that they should have a lackluster approach in terms of reporting on the other two pillars. Probably, a tire manufacturing company will be more susceptible to issues associated with the disposal of waste and usage of energy than an IT company. Hence, the environmental factors would relatively be more prominent than the social and governance factors. This can easily leave room for overrating and underrating on the remaining pillars; hence, this is a pitfall to avoid. An investor making an investment decision should interpret the presented ESG data in this context.
The ESG data will give insights into the qualitative factors of an organization. Insights such as how does an organization handle its waste resources, how it looks after customers, does it stay out of trouble with the regulators, does it have a decent management structure that encourages accountability. Investors will attribute lower risk premiums to organizations having good frameworks in place whereby attributing higher capital market valuations. Considering the above, these organizations will also be able to attract relatively cheaper funding than those who do not have such frameworks in place. Invariably investors will steer away from companies that are badly run and that may end up having serious scandals in the press that can harm the reputation and corporate image.
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