Evaluating the ESG Framework : The Way Forward

[By Anshika Gubrele & Harsh Khanchandani]

The authors are students of Bharati Vidyapeeth New Law College, Pune and Symbiosis Law School, Pune.

Introduction

Financial considerations have typically dictated investment choices. With the worldwide pandemic, climate change, ongoing depletion of natural resources, and many instances of fraud and scams, investors have become more aware of how environmental, social, and governance (“ESG”) factors of a commercial entity may affect its long-term financial performance. This has led to more investor demand and interest in ESG rating, ESG reporting, and ESG-related products by investors.

It is in this light that the authors in Part I of this article shall attempt to discuss the Indian legal regime along with the international best practices relating to ESG disclosures and reporting standards. In the second part, the authors shall endeavor to discuss the key issues with the ESG reporting in light of the consultation paper issued by the Security Exchange Board of India (“SEBI”).

Indian Framework

While various laws for environmental protection[i], overall well-being of employees, equitable treatment,[ii] and corporate governance have been introduced in India at various times, there is no one consolidated law in India that covers all aspects of Environmental, Social, and Governance standards. Different laws exist for different ESG issues, but none covers all of them.

The Ministry of Corporate Affairs (“MCA“) has been recommending corporations to ensure responsible corporate conduct. It published a set of recommendations known as the National Guidelines on Responsible Business Conduct (“NGRBC“), which included a set of nine responsible business conduct principles. These guidelines also specify the structure for corporate responsibility reporting, which includes the disclosures that must be made for each principle. These disclosures were designed to be used internally by businesses to measure their progress towards sustainable business practices.

In addition to this, in May 2022, the MCA-established Committee on Business Responsibility Reporting (“BRR Committee“) along with SEBI vide Regulation 34(2)(f) of the Listing Regulations introduced Business Responsibility and Sustainability Report (“BRSR“), a more comprehensive reporting framework focusing on all measurable key performance indicators. The Committee has suggested two reporting forms, one comprehensive (for listed and large unlisted firms) and one lite (for smaller enterprises), all of which require disclosures in accordance with the NGRBC standards. While SEBI has issued a circular mandating the top 1,000 listed businesses to submit BRSR, the MCA has yet to provide amendments requiring unlisted entities to file BRSR.

In a similar sense, the Indian Companies Act, 2013 (the “Companies Act”) has codified directors’ responsibility to the community and the environment. In specific, section 166 of the Companies Act[iii] compels a director of the firm to “act in the best interest of the community as well as the environment” and Section 135 of the Companies Act & the guidelines developed thereunder comprises a comprehensive code on every company’s corporate social responsibility. In May 2021, a Sustainable Finance Group (“SFG”) was established by the Reserve Bank of India (“RBI”) to collaborate with other national and international organizations on climate change issues with the intention of coming up with strategies and introducing a legal framework that would require banks and other regulated entities to make appropriate ESG disclosures in order to promote sustainable practices and reduce climate-related risks in the Indian economy.

Finally, the Department of Economic Affairs, in January 2021, established a Task Force on Sustainable Finance to offer a thorough framework for India’s financing of sustainable methods. Additionally, it is tasked with creating a methodology for assessing the risk in the financial sector as well as a draught taxonomy of sustainable operations. Other regulatory measures include the constitution of an advisory committee by SEBI on ESG matters, taxonomy and disclosures for green bonds and a consultation paper proposing disclosure norms for mutual funds launching ESG Schemes.

International Framework

In India, the BRSR framework is being implemented for the purpose of governing ESG reporting. It is noteworthy that compared to systems in other Asian countries, the BRSR framework is commendable. It is important to emphasize that the responsibilities of directors in Indian companies extend beyond the shareholders and encompass other stakeholders as well.[iv] This establishes a robust legal framework for Indian corporations’ ESG reporting and allows for ongoing legislative and regulatory improvement.

The move away from optional ESG reporting and towards mandated disclosures is gathering steam. Like India, which has made BRSR compulsory for its largest listed companies, China, Malaysia, and Indonesia have adopted similar regulations. Other Asian countries, like Hong Kong, have a mixed approach, requiring obligatory disclosures for specific ESG concerns but permitting a ‘compliance or explain‘ approach for climate-change issues. Finally, nations such as Singapore and Japan are attempting to migrate from ‘comply or explain‘ to obligatory reporting.

In terms of disclosure substance and format certain countries including, Vietnam, Philippines, Thailand and Singapore have released ESG guidelines based on the Global Reporting Initiative standards. Japan’s approach to integrated reporting or mandating ESG disclosures in yearly reports is similar to India’s approach to the BRSR. Companies in Hong Kong are obliged to provide ESG disclosures in their annual report. Singapore, on the other hand, mandates ESG disclosures in a separate sustainability report from its listed corporations.

KEY CHALLENGES WITH THE ESG REPORTING

  1. Methodological Data issues – There are major problems with the data that is being generated by corporations today,  including lack of verification, differences in the manner in which data is collected by corporations and then subsequently, reported. Generally, it creates a lack of faith by investors in quality of that data therefore, it becomes difficult to make investment decisions. The methodological quality of data is still a fundamental challenge.
  2. Lack of standardization – As a norm, companies assess environmental and social information in order to put it into Financial Year (FY) audit reports. To move data into financial reports specifically into financial statements of a report has legal, financial implications. There is relatively less reference to a standard for reporting, disclosure and materiality outside of sustainability reports. In sustainability reports, we observe reference to primarily the Global Reporting Initiative standard but in financial reports, no standards are referenced because only few standards are recognized by the financial community in the ESG space.
  3. Constantly evolving reporting requirements – Due to the constant changes in political landscape, reporting framework continues to evolve. With the changes in legislations, it becomes difficult for companies to cope up with the changing reporting requirements.

ESG REGULATIONS: THE NEED OF THE HOUR

The ESG rating providers (ERPs) evaluate the performance of the companies on the basis of few parameters/criterion. Then, against every criterion, it gives a rating. The ERPs do not appear to use a uniform way of evaluation and ratings presented also differs internally in it. The matrix used is objective in nature and it cannot be conclusive of any company’s actual efforts towards ESG.

In January 2022, the watchdog of securities market, SEBI, issued a consultation paper that proposes a regulatory framework for ERPs that rate listed companies. The consultation paper listed out several reasons due to which regulation of ERPs is highly needed. Some of the reasons mentioned include, lack of transparency in rating, conflicting interests among ERPs etc.

The consultation paper proposes for introduction of a regulatory framework by suggesting following:-

It proposed that ERPs need to have accreditation in India by suggesting for certain eligibility requirements such as adequate capital, skilled manpower and requisite infrastructure. The Consultation Paper has proposed SEBI registered credit rating agencies and research analysts to act as ERPs, provided it fulfills the eligibility requirements.

Although SEBI has not proposed standardized rating matrix but currently, it has recommended that the accredited ERPs should compulsorily disclose the type of rating they assign and further disclose the methodology adopted while assigning such ratings. Therefore, a proper rating assessment must be ensured. In order to make this entire process more effective and uniform, the SEBI suggested that ERP’s must conduct proper research before giving a specific rating. It is recommended that ERPs must have a committee consisting of skilled professionals for assigning ratings and this committee would undertake the responsibility for developing and changing the methodologies as it deems fit.

Subsequently after the issuance, the SEBI referred the subject of ERP regulation to an advisory committee formulated in May 2022. The proposed regulatory framework is indeed an appreciating move by SEBI as it will increase the transparency of ERP and balance the need of all stakeholders.

CONCLUDING REMARKS

The requirement ESG considerations is rapidly increasing and investment organizations are increasingly prioritizing sustainable investing models.  SEBI has released a consultation paper outlining a regulatory framework for ESG reporting, however, despite these efforts, the detection of fraud and issues such as “greenwashing” will remain a challenge. This is due to the fact that ESG ratings are primarily based on self-reported and unaudited disclosures made by the rated companies. In order to make a significant impact towards sustainability and effectively address the challenges posed by ESG, a collaborative effort between the government and regulators is crucial. Individual efforts alone may not yield the desired results in promoting responsible and sustainable investing practices. In this regard, a comprehensive regulatory framework that incorporates stringent standards, robust mechanisms for monitoring and enforcement, and measures to prevent fraudulent activities will be necessary. Additionally, educational programs and initiatives aimed at raising public awareness about ESG issues will play a critical role in promoting sustainable investment practices.

 

[i] Environment (Protection) Act, 1986; Water (Prevention and Control of Pollution) Act, 1974; Air (Prevention and Control of Pollution) Act, 1981; Wildlife (Protection) Act, 1972; Forest (Conservation) Act, 1980 Biological Diversity Act, 2002.

[ii] Factories Act, 1948; Payment of Wages Act, 1936; Minimum Wages Act, 1948; Equal Remuneration Act, 1976; Contract Labour (Regulation and Abolition) Act, 1970; Child and Adolescent Labour (Prohibition and Regulation) Act, 1986; Trade Unions Act, 1926; Employees State Insurance Act, 1948; Employees Provident Fund; Miscellaneous Provision Act, 1952; Payment of Gratuity Act, 1972 and Maternity Benefit Act, 1961.

[iii] M.K Ranjitsinh vs Union of India (Writ Petition (Civil) No. 838 of 2019); dated 19 April 2021.

[iv] Section 166 (2) of the Companies Act, 2013.

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