Although some natural resources like the sunrays are infinite, other major parts of the environment are not renewable and cannot be used recklessly without any negative consequences. Companies also fail on the social and governance aspects. So, for any kind of business, existence of environmental, social and governance (ESG) risks are inevitable. These cannot be avoided but the preparedness of a business to face them is what gives them an edge over the others. Hence the importance of collection, managing and reporting of ESG data. Businesses will therefore incur some cost in this regard. They must take all these risks into account while making business decisions. In addition, an ESG audit will help evaluate the environmental, social and governance risks of a company’s operations, as also its products or services. Such audit can identify the potential risks so that the same can be addressed adequately before they go out of control.
What is ESG Audit?
ESG audit is an assessment of the risks a business faces in environmental, social and governance areas. It has nothing to do with the financial, secretarial or cost audit and the process is also entirely different. In such audit an organisation takes up both the external stakeholders and the internal employees to evaluate their performance in management of environmental, social and governance risks.
An ESG audit would ideally seeks to answer the following questions:
What environmental, social and governance issues are relevant for the organisation?
What are the specific risks associated with these issues?
What is the organisation’s strategy to manage these risks?
Does the company have an ESG policy and risk management system?
Good quality ESG audit will help an organisation to track progress of its ESG initiatives, improve on weak areas and identify opportunities.
Importance of ESG audit
Investors are no longer looking only for good financial returns. A large number of socially motivated investors now want their money to fund companies that are committed to creating a better world through a more sustainable business. In this way they want to encourage companies to act responsibly in addition to delivering financial returns. So ESG audit is important for them as it provides insight into the company’s approach towards these risks and how prepared they are to manage risk. It is also important for the public and helps attract better employees. Such audit is definitely beneficial for the companies as it helps them look at their supply-chain risks and risk management capabilities. Also, the consumers look for products and services that have complied with environmental, social and governance practices and reject those that have not. It is important for banks and financial institutions as before funding a business they would like to assess the risks associated with such funding.
To use an economics term, ESG Audit has a definite signalling strength. A company that conducts a regular ESG audit without being mandatorily required to do so gives the message to its stakeholders that it is concerned about the ESG risks and is prepared for any emerging risks.
Examples of areas evaluated in an ESG audit
Here are some examples:
Environment – Environmental standards, environmental management systems, energy saving initiatives, compensation for environmental damage.
Social issues – Organisation’s performance on social issues like human rights, employee compensation, their working conditions, employee satisfaction, diversity and labour laws
Governance – Corporate transparency and compliances
Buildings – Construction in an environmentally friendly way
Carbon footprint – Plan for monitoring carbon emissions.
Recycling – water management and chemical management
Reporting – How promptly and completely organisations report on activities impacting the environment and society.
Waste management – Efforts towards reducing waste during all stages of production and management of waste generated.
Hazardous materials – Usage of such materials in products and treatment of any hazardous waste generated.
ESG Audit vs. Sustainability Audit
While ESG audit focuses on the environmental, social and governance risks associated with doing business, sustainability audit is aimed at evaluating how environmentally friendly and socially responsible a company is. The latter doesn’t have anything to do with risks.
Mandatory ESG audit – the position in India
A study conducted by the European Corporate Governance Institution (ECGI) identified 25 countries that introduced different mandates for disclosure of ESG information between 2000 and 2017. So as on date ESG Reporting is mandatory in many countries but ESG Audit seems more voluntary in nature. For example in the European Union (EU) it is mandated under Directive 2013/34/EU. The Non-Financial Reporting Directive of the EU that came into effect in all the member states in 2018 requires companies to reveal all material environmental, social, and employee-related problems, like bribery, corruption, and human rights issues and how the same were dealt with. In the United Kingdom under the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013, listed companies are required to provide a report on annual greenhouse gas emissions, diversity and human rights issues. ESG Reporting is also mandatory under FRC’s Stewardship Code. In Australia ESG Reporting is mandated under ASX Corporate Governance Council’s CG50 Guidelines, in Canada under the IIRC’s Corporate Governance Guideline-2.1, in New Zealand under NZX’s Corporate Governance Disclosure Guideline, in Norway it is required under SSM’s Guidance on environmental reporting and in the United States it is mandated under SEC Regulation. China has as many as seven regulations mandating sustainability disclosures. In Indonesia, since 2020 the Indonesia Financial Services Authority has mandated all listed companies to publish Sustainability Reporting. In Brazil ESR reporting is mandatory under CVM Instrução 569, in Chile under CNMC Resolution N#105, in South Africa under PAS 55 and in Mexico under CNBV’s Recommendation on Sustainable Development.
In India under SEBI’s BRSR mandate, ESG reporting will be mandatory for the top 1000 listed companies based on #marketcapitalisation from FY 2023-24 onwards. With this India has joined the worldwide ESG bandwagon. However, ESG Audit hasn’t been mandated yet. But ESG Reporting in itself will involve additional costs, time and effort and it totally makes sense for companies to spend a little more of all of that to get a voluntary #ESGAudit done in order to ensure that the steps taken are in the right direction and to correct any mistakes before they go out of control.
Concluding observation
In view of certain factors like increased urbanisation, increasing population, extensive usage of natural resources, climate change and depletion of forest cover around the world as also as a natural consequence of increasing concerns towards social responsibility of corporate citizens, the recent mandate on ESG Reporting by SEBI is in the right direction. However, such a requirement without any mandatorily prescribed audit runs the risk of ending up being a compliance only in letter and not in spirit. While many companies would definitely go for voluntary ESG Audit, if made mandatory such audit would increase the effectiveness of the ESG Reporting manifolds.