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ESG Assurance 101 - How does it work (and why does it matter)?

As the requirements on the granularity and the transparency of disclosures continue to rise, ensuring the truthfulness, accuracy, and reliability of ESG information will be the next major challenge in the development of ESG. We believe that ESG assurance will become an essential part of ESG information disclosure in the future.

Fay Wu, Jiaye Pan2022-12-15
ESGAssurance

Internationally, ESG reports have emerged as crucial reference materials, alongside financial statements, for institutional and individual investors, financial analysts, and the general public seeking insights into the performance of publicly traded companies. The sustainability practices of businesses are increasingly impacting their standing in capital markets. Furthermore, retrospective analyses and real-world applications have demonstrated that strategies integrating ESG principles can yield additional returns. Consequently, a comprehensive and trustworthy ESG report is now deemed as essential as a company's financial disclosure.

Exhibit: ESG reporting rate of A-share companies

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Source: MioTech Research

The release of standalone ESG reports by listed companies is a well-established practice. In 2021, our research revealed that 1,412 A-share listed companies published ESG/CSR/sustainability reports, representing 30% of all A-share listed entities, with 281 companies introducing their reports for the first time that year.

While most reports adhere to regulatory standards, some also align with globally recognized disclosure frameworks like GRI, ISSB (SASB), TCFD, and CDP. Disparities in disclosure quality often arise from varying levels of understanding among listed companies regarding ESG guidelines and information management, leading to some companies approaching ESG reporting in a more procedural manner.

Financial regulators are increasingly advocating for stricter and more refined ESG disclosure requirements, superseding industry autonomy in recent times.

On March 21 of this year, the U.S. Securities and Exchange Commission (SEC) unveiled a new climate disclosure proposal mandating public companies to reveal climate-related data, including direct (Scope 1) and indirect (Scope 2) greenhouse gas emissions.

In Hong Kong, the Stock Exchange of Hong Kong stipulates ESG information disclosure for all listed companies in the Appendix to the Main Board Listing Rules since 2015. The HKEx further issued Environmental, Social, and Governance Reporting Guidelines in December 2019, encouraging independent verification of ESG disclosures by listed companies.

As demands for detailed and transparent disclosures escalate, ensuring the accuracy, reliability, and integrity of ESG information emerges as a pivotal challenge in the ESG landscape. We anticipate that ESG assurance will evolve into a crucial component of ESG information disclosure in the future.

What is ESG Assurance

According to International Auditing and Assurance Standards Board (IAASB), the assurance on an ESG report is a testimonial statement provided by the third-party professional assurer on a stated subject (e.g., key data disclosed in an ESG report) in accordance with an assurance engagement standard. The assurance is intended to enhance the level of confidence in the attested object by intended users. To avoid conflicts of interest, the assurance service provider should be a third-party professional body, so that an effective assurance can ensure the impartiality and reliability of its report.

With the corporate ESG information disclosures becoming increasingly common nowadays, regulators and asset managers have begun to realize the importance of the quality assurance of information disclosure, and thereby ESG third-party assurance has received more attention.

SBTi and Third-Party Validation of Decarbonization Targets

The SBTi (Science Based Targets Initiative) is a global initiative launched by the World Resources Institute (WRI), the World Wide Fund for Nature (WWF), the Carbon Disclosure Project (CDP), and the United Nations Global Compact (UNGC). If a target is set that is consistent with the level of carbon reduction needed to keep the increase in global temperature below 2°C above pre-industrial levels and to pursue efforts to limit the increase to 1.5°C, it is called the Science-Based Carbon Targets (SBT).

Independent of ESG assurance, SBTi provides validation of a company's proposed carbon reduction targets. According to the SBTi’s latest update in July 2022, carbon reduction targets must be consistent with a global warming scenario of 1.5°C (the previous minimum requirement was to meet a 2.0°C scenario). Carbon reduction targets must cover both Scope 1 and Scope 2 emissions, and for companies with Scope 3 emissions that account for more than 40% of their total emissions, the targets must cover Scope 3 as well. Any carbon offset-type reductions cannot be counted toward the reduction targets. Renewable energy-based instruments (e.g., I-REC) can only be used for Scope 2 emissions reductions.

To start the SBTi process, a company must first formally commit to join SBTi. After registration, there is a two-year period to develop SBT targets and send final documentation for SBTi validation and approval. Registered companies are required to calculate their current GHG emissions as a baseline, define their business-as-usual scenario and develop a decarbonization pathway. After receiving SBTi verification, the company can announce its targets and notify stakeholders.

In 2021, the number of companies committing to SBTi doubled to 2,253, with 1,082 companies receiving validated SBT targets and 1,171 companies committing to establish science-based targets. These companies cover 70 countries and 15 sectors, with an average of 110 new companies per month in 2021, compared to 31 in 2020.

Companies committing to SBTi are required to provide emissions and reduction progress data to the SBTi organization, but this data will not be made publicly available through SBTi. In addition, SBTi does not require these emissions data to be verified by a third party, and SBTi does not conduct its own verification.

Few mainland Chinese companies have joined SBTi, with Lenovo, LONGi, and Chongqing BOE being the main ones so far.

The significance of ESG assurance

Recently, more and more greenwashing incidents have surfaced. Established financial management institutions such as Goldman Sachs and Deutsche Bank’s asset management unit also caught in the storm.

As the importance of ESG-related performance continues to emerge, investors and stakeholders are increasingly expecting reliable, consistent, and high quality ESG information and data that will stand up to scrutiny in ESG reports. Engaging a third-party organization to provide forensics on an enterprise's ESG report can enhance the credibility and transparency of the ESG report (or its key data).

Assurance can effectively improve the credibility and transparency of the ESG report. In this way, it helps listed companies improve the quality of ESG information disclosure, better respond to the concerns of investors and stakeholders. It also helps investors and other intended users of the report to access ESG information more effectively.

On the other hand, ESG assurance can also help companies review their information disclosure processes and contents from an independent third-party perspective. This sheds light on the calibre of the company’s ESG data disclosure. Company could use the result to determine whether the ESG-related internal control is rigorous and whether there are loopholes in the existing management system.

Program criteria and scope of ESG assurance

Enterprises can voluntarily choose whether to carry out third-party assurance; meanwhile, the scope of assurance work are bounded by assurance standards the third-party firms opt to adopt.

At present, the International Auditing and Assurance Standards Board (IAASB)’s International Standards on Assurance Engagements No. 3000 (Revised Edition) - Assurance Engagements Other than Auditing or Review of Historical Financial Information (hereinafter referred to as "ISAE 3000 revised") is currently the most widely used Assurance standard used. According to stats, 94% of assurance works from accounting firms and 39% of that from other provided assurance services are based on ISAE 3000 revised, and the rest mainly use AA1000AS as assurance standard.

In April 2021, IAASB published Non-authoritative Guidance on the Application of ISAE 3000 in Sustainability and Other External Reporting Assurance Engagements to assist assurers in performing assurance engagements based on ISAE 3000 revised for companies of all sizes. At the same time, HKEx encourages assurers to refer to this non-authoritative guideline when conducting assurance business on ESG information.

In addition, for the assurance of greenhouse gas emissions, IAASB's International Standards for Assurance Engagement No. 3410 - Greenhouse Gas Emission Statement Certification Agreement(hereinafter referred to as "ISAE3410") is the main standard used.

Level of assurance issued by the third-party agency is mainly divided into two audit levels. Under the ISAE 3000 standard, reasonable assurance and limited assurance are generally issued, while under the AS11000AS regime, those can be divided into high assurance and moderate assurance. Reasonable and high assurance provide higher assurance levels than Limited and Moderate assurance. According to the statistics of AICPA and CIMA, 97% of audit firm-related engagements resulted in limited assurance reports. In contrast, 59% of engagements conducted by other service providers resulted in limited assurance, while moderate assurance (23%) and reasonable assurance (18%) were also prevalent.

The AICPA and CIMA study data also show that 89 percent of companies provide at least some information in each of the four categories - greenhouse gases, environmental, social and governance. However, only 43% of firms provided attestation for all four categories. The most common area for independent assurance is greenhouse gases (95%). In addition, according to statistics, 80% of companies are using multiple disclosure frameworks or standards.

Unlike financial report audit, which expresses opinions on the overall financial report, the ESG assurance business scope generally does not cover the overall report, but only covers elements that can be objectively assessed. This is because ESG reports usually contain both objective and subjective information, and subjective information may not be applicable to the requirements of assurance engagement standards. In our sample of companies, environmental and climate-related content was more often assured than social and governance-related content.

ESG Assurance - Global Coverage

At present, regulatory agencies in major countries around the world have not issued mandatory requirements of ESG assurance. But relevant proposals are being drafted lately. In April 2021, the European Commission adopted the draft of the Corporate Sustainability Reporting Directive (CSRD),[1] which puts forward mandatory audit requirements for ESG disclosure information. In March 2022, the U.S. SEC also put forward a consultation draft[2] to enhance the standardization of climate disclosure, requiring companies to disclose Scope 1 and Scope 2 emission data to be verified and certified by an independent third party.

The proportion of listed companies around the world that provide assurance for ESG information continues to rise. According to the latest report from AICPA & CIMA, the proportion of companies undertaking assurance on their ESG reports in 2020 increased from 51% in 2019 to 58%. Double-digit increases were noted in Australia, Brazil, Canada, Italy, Russia, Turkey, and the U.K.

Compared with domestically operated enterprises, large multinational companies are more common to conducting ESG assurance. In another study on US listed companies[3], only 39% of the 99 companies headquartered in the United States obtained third-party assurance for their ESG reports, compared to 78% of the 95 companies with global operations based in other countries.

Internationally, the Big Four accounting firms are the most dominant assurance service providers. However, there are significant differences in the types of companies that provide ESG assurance services across countries. According to the statistics of AICPA and CIMA, from 2019 to 2020, in G20 countries and China, Hong Kong and Singapore, the proportion of ESG assurance business conducted by accounting firms and their affiliates decreased slightly, from 63% to 61% %. The U.S. figure rose, but only from 11.1 percent to 16.2 percent. In the UK, this fell from 53.5% to 42.3%. Most assurance engagements conducted in Hong Kong SAR, Mainland China, India, Indonesia, Korea, the United Kingdom and the United States are not conducted by accounting firms.

Among companies that audit financial reports and ESG reports at the same time, the average interval between the issuance of financial audit reports and ESG assurance reports spans ~54 days. The average internal varies by country, with an average interval of 2 days in Italy and closer to 110 days in the US. This is partly due to the differing requirements for statutory and voluntary disclosures in different jurisdictions.

ESG assurance standards are currently not uniformly standardized. The ISAE standards led by IAASB, which is homologous to financial auditing standards, are currently the most widely used. In the research study on US listed companies, 65% of the companies have adopted the ISAE 3000/ISAE 3410 standards issued by the IAASB. The ISO 14064-3 and Accountability ‘s AA1000AS each accounted for about 15% of the market share.

Only a minor portion of companies conduct ESG assurance in Greater China

Compared with the global average, the proportion of ESG assurance in Greater China is still lagging. As of December 31, 2021, there were 4,681 A-share listed companies, of which 1,412 companies disclosed their 2021 ESG reports, a disclosure rate of 30%. However, there are only 54 audited ESG reports, which accounts for only 3.8% of companies that has published ESG reports.

For comparison, the rate of publishing independent ESG reports in HKEX is lower (109, corresponding to 4.26%), while the number of audited ones is 69, and the assurance rate is over 63%. It is noteworthy that among all the SSE STAR board (Sci-tech Innovation Board) listed companies, 95 companies have separately disclosed ESG reports, but none of them had their ESG reports assured by the third-party.

Listed companies in the financial sector, especially banks, account for half of the assured ESG report. Industrial, information technology and raw materials sectors also had relatively higher assurance ratio. In consumer goods, public utilities, communications, and healthcare sectors, only ~1-2 companies had their ESG reports assured. None of the companies in the real estate sector employed third-party assurance on their ESG reports.

References
[1] Corporate sustainability reporting (europa.eu)
[2] SEC.gov | SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors
[3] Kathleen M. Bakarich, Devon Baranek, Patrick E. O’Brien; The current state and future implications of ESG assurance. Current Issues in Auditing 2022; doi: https://doi.org/10.2308/CIIA-2022-012