This article has been written by Pradeep Gopalakrishnan pursuing a Training program on Using AI for Business Growth from Skill Arbitrage.

This article has been edited and published by Shashwat Kaushik.

External factors influencing ESG considerations

Climate change has become a reality. Globally, countries have become aware of and realise the need to get together and address the basic issues. The realisation has dawned that human intervention in the environment is threatening the fine balance of the ecosystem. Climate change is a fact which can no longer be ignored. This realisation has resulted in all the countries of the world meeting annually under the aegis of the United Nations Framework Convention for Climate Change (UNFCCC), commonly referred to as a Conference of the Parties (“COPx”), where “x” signifies the sequential meeting number. The first such meeting was held in Berlin in 1995 and the last meeting was held in Dubai in 2023, called as COP28

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The COP 21 held in Paris is of significance. It had concluded with a “legally” binding agreement by the participating countries to contain “the increase in the global average temperature to well below 2 deg C above pre industrial levels and pursue efforts to limit the temperature increase to 1.5 deg C above pre industrial levels” by 2030.

As a result, governments have committed to meeting certain self declared goals, initially by 2030 and also by 2050. Annually, each country submits their national climate action plans, known as “nationally determined contributions.“

While environmental issues threaten the very existence of life on planet Earth, there remain vast differences within human society itself. The severe issues affecting sections of society on a daily basis are humongous. Certain basics of life, which are taken for granted by some, continue to elude a vast majority. The United Nations Foundation has come up with 17 Sustainable Development Goals, which cover various factors of human life, from basic needs to basic rights. Countries have taken up these SDGs for development and report on the progress made on an annual basis.

While the governments make the policy decisions, the actual implementation on the ground level requires business organisations to incorporate the policies into their operations. Also to be noted is the fact that in the modern world, most businesses are privately owned. Till now, businesses, have largely focused on profitability on their books rather than on environmental or social requirements. To bring about the results as per the commitments made by the governments, legislative guidelines are being passed by the governments through law and through their institutions, which bind the businesses to incorporate the changes within their own organisations.

The CSR guidelines introduced by the Government of India in 2009 and further enacted by law in 2014 sought to bind companies to take proactive action towards society.

The SEBI issued guidelines in 2021 which are mandatory to the top 1000 listed companies to report their Business Responsibility and Sustainability Report (BRSR). Essentially, this covers the ESG aspects.

Further, there are several other laws and judicial legislations which have bearing on the ESG scope on businesses for example

  • Prevention of Sexual Harassment at workplace “POSH” Act.
  • The new labour laws, comprising Code on Social Security 2020, Occupational Safety, Health and Working Conditions Code 2020, Industrial Relations Code 2020 and Code on Wages 2019.
  • The National Environmental Policy, with focus on Extended Producer Responsibility (“EPR”),

The above are just some of the various laws that have significance under the overall ESG umbrella. It has been seen that misappropriation and embezzlement in various manners have been resorted to by leaders of certain business organisations. The “Satyam” scam, The Sahara India scam, and the Nirav Modi scam on Punjab National Bank are scams perpetrated by corporations which have huge downside to the general public at large and, more specifically, to stake holders, including but not limited to shareholders.

Scams of such extent require interventions from the government and also result in laws and rules to prevent the reoccurrence of similar events.

Requirement of independent directors on board of a company and also to be the head of the audit committee within the board is one such rule enacted by law.

Thus, it can be seen that there is growing pressure from administrative side through various laws enacted to pressure the company boards to implement and report their Environmental, Social and Governance goals, status and deviations, if any.

The internal factors

Even while external factors are bringing about compliance requirements for organisations, certain companies have long realised that ESG considerations during business decision making are essential for long term sustainable operations. Such decisions clearly bring the following benefits:

  • Increased savings and thus profitability
  • Attract talent and reduce employee turnover
  • Avoid business risks related to environment
  • Positive engagement with society
  • Compliance to laws related to Pollution, labour, Corporate, safety, etc
  • Enhance brand image
  • Attract investments
  • Improve sales

Any additional investment costs are more than offset in the long term by the benefits that evolve from following an ESG compliant business. The avoidance of risks associated with environmental issues. Penalties due to non compliant behaviour are obvious. Not so apparent are the positive aspects. More and more talent is attracted to join companies that have a positive ESG footprint, quite often at a lower salary. In a globalised world, supply chains work across countries and continents. When most European Union mandates require companies to follow ESG mandated levels, the same becomes mandatory to their supply chain partner, which may be in another country, including developing countries. Many purchase decisions are made for the positive brand image of a company producing goods with ESG considerations.

Moreover, there is additional profit to be made through carbon trading and offset.

However, considering the above benefits, quite often many of the “claims” by organisations are being challenged, and “Greenwashing” as a term is getting far too common. It is against this backdrop that audit of the ESG compliance in an organisation take prominence

Role of internal audit

The stated role of Internal audit is to provide independent assurance of an organization’s adherence to the governance framework, risk management and internal controls.

The steps for implementing the above can be broadly segregated into following:

  • Design a framework along with policies and procedures.
  • Communicate the same across the organisation.
  • Implementation, along with governance oversight.
  • Periodical monitoring.

While the first and second steps are one time exercises with periodic updates and corrections, the implementation is an operational aspect.

The inherent characteristic of operations is that many regularly occurring risks get overlooked.

Also, if there are malevolent elements in the system, they would definitely be well aware of the system and its ways. They would be quite adept at finding the weak spots to carry out their misappropriation.

Further, quite often, once a system has been designed and implemented, it is left alone without the necessary timely modifications that would be required due to changing internal and external factors.

The internal audit function is uniquely positioned to provide a constant watch on the operations. Their independence in approach tends to bring out risks which need to be corrected. As they are expected to be updated on the latest compliance requirements, they can easily identify potential areas which need updating

A constant monitoring and reporting mechanism can easily and effectively be implemented through the internal audit.

A company that is part of the global supply chain of another company that is, say, based in the European Union would be under a mandate to keep their ESG thresholds under constant check. This can be effectively monitored through internal audit

Often, ESG centric aspects can be included in the non ESG focused audits. Most ESG related risks and aspects that are relevant to an organisation would already be part of various departments across the organisation. Any non conformance should immediately raise a red alert.

The internal audit reports are generally reported to the audit committee. The audit committee, by itself, is part of the board of directors and headed by an independent director. This inherent structure allows the independent directors on the board to directly feel the pulse of the organisation. They are then uniquely positioned to suggest and enforce corrective actions

Risk assessment and management

Internal audit plays a vital role in assessing and managing ESG-related risks that could have a significant impact on an organization’s reputation, financial performance, and stakeholder trust. The audit process involves identifying and evaluating ESG risks, such as climate change, resource scarcity, and social inequality, that are relevant to the organization’s industry and operating context. The audit team then assesses the effectiveness of existing internal controls and governance mechanisms in mitigating these risks. Based on their findings, the audit team provides recommendations for strengthening the organization’s risk management framework, including implementing new controls, enhancing risk monitoring processes, and improving risk reporting.

Monitoring ESG initiatives

Internal auditors monitor the implementation of ESG initiatives and programs to ensure that they are aligned with the organization’s strategic objectives and are being executed effectively and efficiently. The audit process includes reviewing the design and implementation of ESG initiatives, assessing the effectiveness of internal controls over ESG-related processes, and evaluating the achievement of intended outcomes. The audit team also provides recommendations for improving the effectiveness and efficiency of ESG initiatives.

Data integrity and reliability

Ensuring the accuracy, completeness, and reliability of ESG data is critical for effective ESG reporting. Internal audit plays a key role in reviewing data collection processes, evaluating the effectiveness of internal controls over ESG data, and identifying areas for improvement. The audit process includes assessing the design and implementation of data collection systems, testing the accuracy and completeness of ESG data, and reviewing the processes for aggregating and reporting ESG data. The audit team also provides recommendations for strengthening data integrity and reliability.

Stakeholder engagement

Effective communication and engagement with stakeholders, including investors, customers, and regulators, is essential for building trust and maintaining a positive reputation. Internal audit facilitates effective stakeholder engagement on ESG-related matters by reviewing the organisation’s stakeholder engagement strategy, assessing the effectiveness of stakeholder communication channels, and evaluating the organization’s responsiveness to stakeholder concerns. The audit team also provides recommendations for improving stakeholder engagement.

Reporting and disclosure

Internal audit plays a critical role in reviewing the organisation’s ESG reporting processes and ensuring compliance with regulatory requirements and frameworks, such as the Global Reporting Initiative (GRI) and the Task Force on Climate-related Financial Disclosures (TCFD). The audit process includes assessing the completeness, accuracy, and consistency of ESG information disclosed in the organisation’s annual report, sustainability report, and other public disclosures. The audit team also provides recommendations for improving the transparency and comparability of ESG reporting.

Ethical conduct and governance

Evaluating the organisation’s ethical culture and adherence to ESG principles is essential for maintaining a strong reputation and fostering trust among stakeholders. Internal audits review policies and procedures related to business conduct, human rights, and environmental stewardship to ensure that they are aligned with ESG principles. The audit process also includes assessing the effectiveness of the organisation’s governance structure and oversight mechanisms in promoting ethical conduct and ESG compliance.

Continuous improvement

Internal audit promotes a culture of continuous improvement in ESG performance by conducting periodic reviews to assess the effectiveness of ESG initiatives and recommend enhancements. The audit process includes reviewing the organisation’s ESG performance against established targets and benchmarks, identifying areas for improvement, and developing recommendations for enhancing ESG performance. The audit team also provides support to management in implementing ESG improvement initiatives.

In summary, internal audit plays a multifaceted role in elevating ESG maturity and transparency in Indian organizations. By providing independent assurance, monitoring ESG initiatives, and promoting ethical conduct, internal audit helps organizations enhance their ESG performance, build trust among stakeholders, and contribute to sustainable growth.

Conclusion

Internal Audit is uniquely positioned to play a pivotal role in the organization’s adherence to ESG goals. An independent, updated audit team is an essential tool for the organisation, providing the necessary reading based on which decisions can be taken to correct and take remedial action where required.

References

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