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Focus on “G” - ESG Governance

Focus on “G” - ESG Governance

by ESG Business Institute -
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In the continued “mainstreaming” of corporate environmental, social, and governance (ESG) performance, let us focus on “G” as we start the new year. Hong Kong, one of the earliest jurisdictions of listed companies to have introduced ESG reporting and its requirements, has undergone several rounds of updates since the first iteration in 2013. Under the revised ESG Reporting Guide issued in July 2020, one of the key enhancements is a focus on board governance and oversight of ESG issues. The enhanced ESG disclosure framework requires mandatory reporting on the board’s engagement and oversight on ESG matters and “comply or explain” disclosure on four environmental aspects and eight social aspects, with each aspect covering general disclosures on the issuer’s policies and/or compliance with laws and regulations (as applicable), and key performance indicators (“KPIs”).

ESG Practice Disclosure
On 25 November 2022, the Hong Kong Stock Exchange published its 2022 Analysis of ESG Practice Disclosure (“2022 Analysis”). The 2022 Analysis presented significant improvement for disclosures on board oversight and management of ESG issues, from a review of 400 sample ESG reports published for the financial year which ended on 30 June 2021, 31 December 2021, and 31 March 2022. However, issuers were reminded about the requirement to also disclose how the board monitors the progress of ESG-related goals and targets set, and that failure to comply with this requirement would constitute a breach of the Listing Rules.

Issuers are recommended to disclose information on the relevant processes, controls, and procedures used to monitor and manage ESG matters, which may involve elaboration on the following:

  • relevant expertise or skills of the board, or the designated committee or management-level positions, for effective oversight on ESG matters
  • interaction between the board and designated committee or the management-level positions, including the frequency and form of reporting to the board
  • frequency of the board’s discussion on ESG issues
  • internal and external resources and expertise available for the ESG management process
  • alignment of ESG governance with an issuer’s business strategy

On specific environmental or social aspects, the 2022 Analysis emphasized climate disclosures, TCFD -aligned climate reporting and adoption of TCFD recommendations, whereas issuers were recommended to enhance disclosures on supply chain risk management and green procurement practices.

Board Responsibility and Oversight on ESG Issues
As a background, under the enhanced ESG Reporting Guide, all listed issuers are required to include in the annual ESG report a mandatory statement on the board’s oversight of ESG issues, the board’s ESG management approach and strategy, including the process to evaluate, prioritize, and manage material on ESG issues, how the board reviews progress made against ESG-related goals and targets, and how these relate to the issuer’s businesses. The ESG Report must also disclose how the company addresses materiality in ESG factors, describe any stakeholder engagement and the significant stakeholders identified, and the process and results of the issuer’s stakeholder engagement.

As a matter of corporate governance and according to the Listing Rules , the Board of Directors is collectively responsible for the

management and operations of the company. This would include the responsibility to address ESG issues, as well as to discharge the disclosure obligations of the company. A company’s internal governance mechanism to supervise the management of ESG issues may vary and there is no standard practice. However, under the ESG Reporting Guide, a listed company is required to disclose the company’s ESG governance structure to allow investors and stakeholders to assess the company’s commitment and efforts in ESG matters and the quality of its ESG governance.

Furthermore, as elaborated in the “Leadership Role and Accountability in ESG – Guide for Board and Directors” published by HKEX in March 2020, the board of directors of a company should take leadership and accountability in:

  • overseeing the assessment of the company’s environmental and social impacts
  • understanding the potential impact and related risks of ESG issues on the company’s operating model
  • aligning with what investors and regulators expect and require
  • enforcing a materiality assessment and reporting process to ensure actions are well followed through and implemented
  • promoting a top-down culture to ensure ESG considerations are part of the business decision-making process

Pursuant to the most recent corporate governance review and the updated Corporate Governance Code published in December 2021 (“CG Update”), the linkage between corporate governance and ESG and the board’s responsibility for effective governance and oversight of ESG matters were emphasized, with the stated intention to drive effective corporate governance practices and ESG measures beyond a box-ticking exercise. Effective for the financial year commencing on or after 1 January 2022, listed companies are required to publish ESG reports at the same time as the publication of the annual reports.

Stakeholder Engagement and Communication with Shareholders
Another key CG Update relevant to ESG governance is the new mandatory disclosure and annual review of the issuer’s shareholders’ communication policy and stakeholder engagement. This should cover the channels for shareholders to communicate their views on matters affecting the issuer, steps taken to solicit and understand the views of shareholders and stakeholders, and a statement of the issuer’s review of the implementation and effectiveness of the shareholders’ communication policy conducted within the year and including how it concludes. The intention is to introduce effective two-way communication for companies to actively solicit feedback from shareholders and engage with shareholders and other stakeholders (including employees, customers, suppliers, and investors) to achieve long-term success. There is also an upgrade to the Code Provision requiring issuers to establish a whistleblowing policy and system for stakeholders (employees, customers, and suppliers) to raise concerns in confidence and anonymity with the audit committee of the issuer (or any designated committee comprising mostly of independent non-executive directors) about possible improprieties in any matter related to the issuer.

Corporate Purpose, Values, and Strategy for Long-Term Sustainability
Emphasizing the link between corporate governance and ESG, the CG Update stipulates that:

  • corporate governance provides the framework within which the board forms their decisions and builds their business
  • the entire board should be focused on creating long-term sustainable growth for shareholders and delivering long-term values to all stakeholders
  • an effective corporate governance structure allows issuers to have a better understanding to evaluate and manage risks and opportunities (including environmental and social risks and opportunities)

Remarkably, the CG Update introduced a new Code Provision on corporate strategy, business model, and culture. This new code requires the board to align the company’s culture with its purpose, values, and strategy, to instil and continually reinforce the organization’s values of acting lawfully, ethically, and responsibly. Culture is explained as intertwined with the company’s purpose which it seeks to achieve and the strategy to deliver long-term success, and when aligned with strategy and leadership, results in a shared purpose and long-term sustainability.

Board directors of listed companies are therefore expected to establish and take into account corporate purpose, values, strategy, and culture as part of corporate governance and oversight of ESG risks and opportunities. In this regard, addressing climate-related risks are the policy’s priority and is considered urgent. This should be regarded as one part of an issuer’s overall corporate governance and management of ESG issues, along with other environmental or social aspects that are material to the issuer’s businesses.

On risk management and internal control, the CG Update also highlights that the board is responsible for evaluating risks which include material ESG risks in achieving the issuer’s strategic objectives, and ensuring appropriate and effective risk management and internal control systems are in place. In addition, the board is also responsible for the annual review of the issuer’s ESG performance and report.

Directors’ Duties
With such clear expectations on the board’s responsibility on ESG issues, directors of listed companies should be mindful of the discharge of directors’ duties in this regard.

Under the Hong Kong Companies Ordinance (Cap. 622) which has codified the directors’ statutory duty of care, a director must exercise reasonable care, skill, and diligence, specifically about the general knowledge, skills, and experience that may reasonably be expected of a person carrying out the functions concerning the company, and the general knowledge, skills, and experience that the director must have.

The Hong Kong Companies Registry (“CR”) has published “A Guide on Directors’ Duties” which outlines the general principles of directors’ duties based on case law and statute. All directors of Hong Kong companies are advised to read the Guide which is made accessible from the CR, the Hong Kong Exchanges and Clearing Limited (“HKEx”), the Securities & Futures Commission (“SFC”), the Official Receiver’s Office, and the Hong Kong Monetary Authority (“HKMA”).

Among the principles covered in the said guide, ‘Principle 1’ states the duty to act in good faith for the benefit of the company as a whole, while ‘Principle 2’ refers to the duty to use powers for a proper purpose for the benefit of the members as a whole. These are elaborated to require a director of a company to act in good faith in the best interests of the company, meaning that a director must uphold a duty to act in the interests of all its shareholders, present and future. Furthermore, in carrying out this duty, a director must, as much as possible, regard the need to achieve outcomes that are fair between its members, and that the primary and substantial purpose of the exercise of a director’s powers must be for the benefit of the company.

As noted above, the updated Corporate Governance Code emphasizes the responsibility of the board for effective governance and oversight of ESG matters and further states that the entire board should focus on creating long-term sustainable growth for shareholders and delivering long-term values to all stakeholders. The board should also work on developing an effective corporate governance structure that allows issuers to have a better understanding to evaluate and manage risks and opportunities including environmental and social risks and opportunities.

Other than the listed companies, the Companies Ordinance mandates all registered companies in Hong Kong (unless exempted) to prepare an annual directors’ report which, among other requirements, “must contain particulars of any other matter that is material for the members’ appreciation of the state of the company’s affairs and the disclosure of which will not, in the directors’ opinion, be harmful to the business of the company”. The directors’ report should contain a business review section which includes a description of the company’s principal risks and uncertainties, details of important events affecting the company that has occurred within the financial year, and an indication of likely future development in the company’s business. Furthermore, the business review must include, to the extent necessary for an understanding of the development, performance, or position of the company’s business, including:

  • an analysis using financial key performance indicators (defined to mean “factors by reference to which the development performance or position of the company’s business can be measured effectively”)
  • a discussion on the company’s environmental policies and performance, and the company’s compliance with the relevant laws and regulations that have a significant impact on the company
  • an account of the company’s key relationships with its employees, customers and suppliers, and others that have significant impacts on the company and on which the company’s success depends

While companies that meet certain specified criteria may qualify for simplified reporting and be exempted from the said requirement for business review (for example, private companies with revenue or assets below certain thresholds), the requirements are generally applicable to public companies. In any case, such requirements of the Companies Ordinance provide a solid reference for directors of Hong Kong companies in considering appropriate management approaches to address business risks including environmental and social factors in corporate business activities. For smaller companies, it is perhaps never too early to establish a solid governance structure as a foundation for growth and organizational purpose, values, and strategy.