How can climate-related disclosures assist investors in making investment decisions?

On 14 April 2023, the Stock Exchange of Hong Kong Limited (the "Exchange") published a consultation paper seeking market feedback on proposals to enhance climate-related disclosures under the Environmental, Social and Governance (ESG) framework. The deadline to submit comments on the consultation paper is 14 July 2023. 

The consultation paper proposes to require all issuers to make climate-related disclosures in their ESG reports for financial years commencing on or after 1 January 2024 (i.e. to upgrade the current ‘comply or explain’ requirement), and to introduce new climate disclosure requirements based on the ISSB Climate Standard.

ESG reporting is not new. The Exchange launched the Environmental, Social and Governance Reporting Guide as early as 2013, but at that time ESG was usually associated with corporate social responsibility (CSR). CSR refers to the responsibility of a business to operate ethically and to improve the quality of life of its employees and their families, as well as the local community and society at large. CSR is often driven by a need to protect or enhance the reputation of a business.

On the other hand, business sustainability refers to the use of resources in a way that enables the business to be viable in the long run. It is to ensure that the business can continue to obtain the resources and relationships needed to run the business profitably. 

Both concepts recognise that the environment and communities in which a business operates are integral to its overall success, but corporate social responsibility focuses more on balancing the interests of stakeholders, while business sustainability seeks to maintain its business value. 

Over the past few years, the concept of sustainable business development has been gaining traction as economic activities have grown excessively regardless of resource constraints. In fact, as manifested by megatrends such as climate change and resource scarcity, in order to maintain long-term business capabilities, businesses must proactively manage the risks and opportunities these changes present. 

The core concept of TCFD, ISSB and this consultation paper is based on the perspective of business sustainability and disclosing the risks and opportunities brought by climate change (and other environmental and social related issues) to businesses.

TCFD recommendations and ISSB standards help companies disclose consistent, complete and comparable sustainability-related financial information so that investors can make informed investment decisions. Such decisions include buying, selling or holding equity and debt instruments, providing or selling loans and other forms of credit, exercising voting rights or exerting influence over management actions that affect the business. 

Understanding how investors use climate-related disclosures to make investment decisions can help issuers respond to new climate disclosure requirements in a more targeted manner.

The ISSB Climate Standard is based on the TCFD recommendations and structured around four themes that are the core elements of business operations: governance, strategy, risk management, and metrics and targets. 

Although these four elements are labelled as four contents or pillars, they are not isolated from each other, but are interrelated. For instance, the climate-related risks and opportunities that a company  discloses in their Strategy pillar and the responses they take are the outcomes of the processes described in Risk Management pillar. Therefore, a company's description of its processes for identifying, assessing, and managing climate-related risks can provide investors with confidence that the company is taking a rigorous approach to addressing climate-related risks and factoring such knowledge to strategic and financial planning. Conversely, a company's description of its risk management processes may lead investors to believe that the company does not have appropriate processes in place to address climate-related risks.

Among the four core elements, metrics and targets are the ‘connective tissue’ that connect the various elements and inform, and is informed by, the company’s governance, strategy and risk management processes, creating a feedback loop over time in the same way as other key performance Indicators (KPIs) to inform business management processes as follows:

• Governance: Climate-related metrics enable the board and management to direct and oversee the business more effectively by measuring the impact of climate-related risks and opportunities, and tracking and managing these. Climate-related metrics on remuneration can also demonstrate to investors how directors and managers are incentivised to achieve climate-related goals. 
• Strategy: Climate-related metrics help describe and measure the impact of climate-related risks and opportunities on business, strategy and financial planning, and the resilience of corporate strategies under different climate-related scenarios. 
• Risk management: Climate-related metrics can support the assessment of risk exposure and risk levels. Combined with risk tolerances, risk appetites and risk thresholds, climate-related metrics inform companies of the degree of risk they are prepared to accept and their risk responses (such as accept, avoid, increase, decrease, share/transfer).

The Exchange's ESG consultation paper exceeds 100 pages, and some issuers (especially issuers who have not started to adopt the TCFD recommendations) may struggle to grasp the key content therein. In fact, the gist of the new climate disclosure requirements can be summarised in one keyword - "integration". The new requirements are asking an issuer to disclose the extent to which it has integrated climate-related issues into its corporate structure, business operations, business model, risk management and financial planning. This keyword is particularly evident in the following disclosure requirements:

• Governance: How the board and its committees measure climate-related risks and opportunities when overseeing the issuer's strategy, its decisions on major transactions, and its risk management policies, and whether and how related performance metrics are included in remuneration policies; 
• Strategy: The entire strategy content is to integrate climate-related risks and opportunities into business operations, business model and financial planning 
• Risk management: How the issuer prioritises climate-related risks relative to other types of risks and how this process fits into the issuer's overall risk management process

The ‘integration’ referred to here means that the issuer considers climate-related issues as one of the many factors that companies need to consider in operations and making decisions. For example, when making major acquisition decisions, issuers often refer to the target company’s financial statements and cash flow forecasts, but such financial information does not reflect the additional cost that the target company may incur if and when there are carbon regulations in the future. If the target company is carbon-intensive, the additional cost may exceed the profit reflected from such financial data. The issuer may make wrong acquisition decisions without sufficient information. 

When responding to the new disclosure requirements, issuers may wish to return to this core question and think about the extent to which they have integrated climate-related issues into their business, and whether such integration needs to be strengthened.