Mandatory climate reporting: ESG now a licence to do business?

On 9 September 2024, the Treasury Laws Amendment (Financial Market Infrastructure and Other Measures) Bill 2024 (Cth) passed Parliament. This bill introduced a mandatory climate reporting (‘MCR’) regime. ASIC Chair, Joe Longo, has stated that ESG disclosures represent ‘the biggest changes to financial reporting and disclosure standards in a generation’, and the MCR regime is a key framework for this.

Mandatory climate reporting

The MCR regime mandates that a sustainability report be prepared by certain entities as a new annexure to their annual financial reports. While ‘S’ and ‘G’ considerations are arguably already entrenched in Australia’s corporate regulatory framework and the Modern Slavery Act 2018 (Cth) (‘Modern Slavery Act’), ‘E’ matters are often seen as a new consideration for entities. Directors have had decades to become familiar with the robust disclosure standards required for annual reports, but directors will have a far shorter period to become comfortable with these new sustainability reports. Directors will need to:

• understand what the MCR standards require;
• understand the pertinent climate-related risks and opportunities that are relevant to their business;
• understand what their entity is implementing to address climate-related risks and opportunities; and
• ensure that climate-related risks and opportunities are reflected in the entity’s long-term strategy.

The criteria are prescriptive. There are over 60 MCR standards detailing governance, strategy, risk management, and metrics and targets criteria for entities. The standards go beyond a box ticking exercise; they aim to ensure the right information is collected, and that information is proactively integrated into the running of the business.

The four categories of the MCR standards are:

Governance

The processes, controls and procedures used to monitor and manage climate-related risks and opportunities. This includes disclosure of the oversight and responsibility of individuals (and management) for climate-related risks and opportunities.

Strategy

The approach used to manage climate-related risks and opportunities as they relate to the entity’s overall strategy. This includes considering the impacts of physical risks (acute or chronic weather-related risks for example) and transition risks (policy and legal, technological, market or reputation for example). These impacts should be considered through the lens of financial planning over the short, medium and long term. Entities must also describe the resilience of their strategy considering at least two scenarios: one aligned with 1.5°C warming and one where warming ‘well exceeds’ 2°C.

Risk management

The processes used to identify, assess, prioritise and monitor climate-related risks. This includes the parameters used to assess these risks, how the entity considers the nature, likelihood and magnitude of these risks, and how these risks are prioritised in the overall risk management processes.

Metrics and targets

Performance in relation to climate-related risks and opportunities, including progress towards any targets set and assessment against climate-related metrics. This category includes the disclosure of Scope 1, 2 and 3 greenhouse gas emissions and identifying the areas of the business which are vulnerable to climate-related risks.

Learnings from the modern slavery regime

There are parallels between the MCR and modern slavery regimes. Both regimes mandate the consideration of certain E, S and G risks in a new way. There are key learnings from compliance with the modern slavery regime that may be applicable to MCR compliance including the common compliance shortfalls, the pressures from reporting entities that effectively make compliance a licence to do business, the lead time for tier 1 engagement, and the reputational impacts from independent assessments.

Common compliance shortfalls

The Modern Slavery Act requires reporting entities to undertake due diligence on their supply chains, remediate identified risks and assess the effectiveness of their due diligence. Reporting entities must prepare a modern slavery statement which covers their actions taken to assess and address modern slavery risks. Compliance with the Modern Slavery Act was a catalyst for many entities implementing their first systematic due diligence frameworks for suppliers.

However, a review (‘Review’) by Professor John McMillan AO in 2023 of the Modern Slavery Act demonstrates the continuing shortfalls of reporting entities over the three reporting years of the regime. Common weaknesses included:

• failing to address known modern slavery risks;
• failing to describe modern slavery risks beyond tier 1 suppliers;
• providing only a basic or unclear description of modern slavery risks; and
• giving inadequate explanations of risk assessment methods and grievance mechanisms.

These shortfalls highlight the lead time required to identify and address modern slavery risks, engage with tier 1 suppliers (and beyond tier 1 suppliers) and embed any learnings into existing risk assessment frameworks. All of these will be required for comparable MCR standards.

Licence to do business

The Review recommended an introduction of penalties to enforce compliance. While that may be an effective approach, it is also important to recognise the impacts of mature reporting entities on other entities. For reporting entities assessing new suppliers, the procurement stage is a natural filter that allows those entities to build supply chains of suppliers with capabilities to comply with the modern slavery regime. This can involve requesting suppliers share their due diligence measures to identify modern slavery risks or requiring confirmation of certain actions and procedures in contractual arrangements. This, in turn, helps reporting entities satisfy their obligations.

The pressures from reporting entities effectively pull suppliers (whether or not they are reporting entities) into the regime. This encourages other entities to consider the relevant regime, consider the steps needed to align with the obligations or even voluntarily report to position themselves well for tenders or other commercial arrangements with reporting entities.

MCR obligations are already forming part of the procurement of large entities by the imposition of metrics and targets on their own supply chains. There are examples of entities mandating that a percentage of their supply chain will be aligned with the Science Based Target initiative’s criteria by a future date. Like modern slavery compliance, environmental supply chain targets will also drive compliance for those seeking to enter tenders for reporting entities.

Lead time for tier 1 engagement

While procurement is an effective filter for new suppliers, reporting entities under the modern slavery regime are encouraged to use their influence to educate, develop capabilities and encourage compliance for existing suppliers that are unfamiliar with the regime. This engagement prolongs the process for a reporting entity to be able to effectively report its risks.

In the MCR regime, for entities to report on their scope 3 emissions (the greenhouse gas emissions of suppliers), they must first obtain their tier 1 suppliers’ calculations of their own emissions. This requires tier 1 suppliers to have the capability to calculate their own emissions. As these calculations are new for reporting entities, it is also likely to be new for those entities making up their supply chain. There is no direct equivalent from the modern slavery regime that encourages entities to upskill their supply chain to report on their own emissions, however, a deficit in the data required is likely to impact the scope 3 emissions for reporting entities. Accordingly, reporting entities should start their scope 3 engagement early – despite the one-year legislative buffer for scope 3 reporting.

Reputational impacts from independent assessments

Lastly, the reputational impacts of independent reviews and publications in the ESG space can have powerful impacts on consumer sentiment. This includes significant detrimental outcomes from negative reporting, a fact which often drives compliance.

Industry specific certifications, and publications comparing businesses and their ethical compliance are on the rise. For example, in the financial services industry, the Responsible Investment Association of Australasia’s comparison website, ‘Responsible Returns’, now profiles over 300 certified products for comparison on a range of ethical criteria. In the garments industry, organizations such as Baptist World Aid and Tearfund New Zealand’s Behind the Barcode project seek to increase the transparency of the fashion sector by publishing annual Ethical Fashion Reports. These reports publicly assess brands against various criteria to empower consumers to purchase ethically. Consumer activists are also increasingly using a name and shame approach.

As environmental metrics and targets are comparable by nature (for example, net zero, SBTi alignment or carbon neutral mandates), it is likely that similar independent comparisons may emerge.

Integration of ESG

While MCR and the modern slavery regime are separate frameworks, it is important for entities to recognise the clear intersection of modern slavery risks and environmental risks. Environmental consequences of climate change already disproportionately impact vulnerable populations. As reported in the 2023 Global Slavery Index published by the Walk Free foundation, impacts such as ‘resource scarcity, loss of livelihoods, increases in poverty, and unequal access to health and education, push millions of people into precarious situations, and [magnify] drivers of modern slavery’.

Accordingly, ‘E’, ‘S’ and ‘G’ risks for an entity tend to be an indicator for one another. A business’ impacts on the environment and the environment’s impacts on individuals must be considered simultaneously to holistically understand an entity’s risk exposure. The integration of environmental risks in an entity’s modern slavery risk analysis is therefore an indicator of maturity in their risk framework.

A holistic approach is also practically more feasible. Entities integrating their modern slavery governance, risk assessment and strategy in their broader governance, risk framework and strategy generally have better compliance outcomes as the relevant considerations become BAU.

• For governance and strategy, the tick-a-box approach of implementing a committee that lacks resources or appropriate oversight is simply not effective. The appropriate skills and capabilities should be implemented with clear reporting lines to, and oversight from, the board.
• For risk management, a siloed approach does not provide realistic recommendations as proposed steps may not appropriately consider the magnitude of the risks in the context of the entity’s overall priorities. Siloed assessments may also ignore the interconnectedness of E, S and G risks which could increase the magnitude of those risks. This is another reason for integrating with existing risk frameworks or developing those frameworks to effectively assess ESG risks.
• For compliance generally, data informed decisions will underpin most (if not all) of the decisions made under the modern slavery regime and the MCR regime. Having a centralized approach to data collection and management is crucial. For example, if an entity needs information for both regimes from a tier 1 supplier these should be collected simultaneously. This will improve engagement with suppliers and the speed of compliance. Data to comply with both regimes is abundant with thousands of data points that reside in all areas of the business from accounts, human resources, procurement, product, and management. Having an integrated, BAU, centralized approach is invaluable.

As entities embark on their MCR obligations, whether for legal or strategic purposes, we hope to see an increasing trend in entities taking a holistic view of their ‘E’, ‘S’ and ‘G’ risks.

Barbara Vrettos is a Senior Associate at Cowell Clarke Commercial Lawyers.