Why Businesses Should Focus on ESG?

The world has changed in many fundamental ways especially in the last 25 years. I am not referring to technology-led transformation or geopolitical shifts, this piece is about Environmental, Social and Governance criteria – collectively referred to as “ESG”.

Environmental Criteria

 

Environmental costs, which were for long viewed by economists as “externalities”, are now an important consideration in decision-making by governments and business leaders. Given the devastating effects of widespread environmental degradation and climate change, countries around the world are taking concrete actions to limit further damage; many are setting “net zero” emission targets for individual sectors over the next couple of decades. As a result, new legislations are being enacted that require businesses to act in certain ways and desist from other kinds of actions. Arguably, this is the biggest facet of change globally.

Social Criteria

 

The second area of change is that various forms of social injustice are no longer being tolerated. While there were always rules against such inequities, there is now a greater cost imposed on organizations that violate these rules- not just by governments and regulators, but also by consumers, who choose to shift loyalties towards brands that exhibit greater sensitivity to social causes. By definition, social injustice covers a broad range of issues that includes exploitation of children, women or certain races (e.g., the Uighurs); not providing employees good working conditions (physical environment, denying employees time for bio-breaks and rest, harassment at the workplace etc.); discrimination against people with disabilities, gender, age or marital status; even selling goods that are not safe or bad for health arguably fall under this category.

Governance Criteria

 

The thrust on “governance” is the third major driver of change. It is not as if rules and regulations did not previously exist to prevent breakdowns in governance. Yet, there are a number of examples from around the world that showcase bad governance: from companies in South Korea, Japan, the USA and Europe to the ongoing matters at the NSE and BharatPe in India.

 

Why ESG Adoption is Crucial?

 

In recent years, various members of business ecosystems worldwide, including enterprises, investors, regulators and the general public have become far more aware of the importance of compliance with “ESG” norms and standards. They are much less willing to tolerate breaches in an organization’s “ESG” conduct.

At one level, companies that do not do well on “ESG” parameters are more likely to face explicit financial penalties (e.g., carbon taxes). But just as important are the hidden costs that will increasingly need to be borne by ESG laggards. Perhaps the most important is the reduced access to capital because both banks and PE/VC firms are incorporating ESG criteria into their funding/ portfolio strategies.

On the demand side, many consumers (especially from the younger generations) are more conscious of brands that fare better in terms of their commitment to ESG and this, in turn, shapes their purchase decisions. Brands can quickly lose market share if they do not raise their ESG game.

As shown in the chart below, data over the past decade reveals that companies that have successfully implemented ESG strategies have consistently performed better than other global companies that have not paid as much attention to ESG.

 

Source: Stoxx.com quoted in https://sphera.com/spark/the-importance-of-esg-strategy/

This out-performance can be attributed to a combination of factors, including faster top-line growth, sustained cost reductions, higher employee productivity and reduced employee attrition and of course, fewer instances of fines/penalties for non-compliance. Investment decisions and technology choices that are guided by ESG considerations will drive a more efficient allocation of capital; in turn, this will boost ROCE (Return on Capital Employed).

While it is convenient to look at the three strands of ESG separately, in reality, they are closely intertwined. The sooner business leaders acknowledge that ESG is not a fad or a feel-good factor, but in fact, makes sound business sense, the better it is for the world as a whole.

 

Start Your ESG Journey Right Away

 
Someone quipped that the best time to plant more trees was years ago, but the second-best time is now! It’s not too late for you to begin your ESG transformation. But make sure you do it as a well-structured program, and not merely a hotch-potch of initiatives that have no clear owners, goals or measures and therefore cannot be sustained.

 

To report ESG performance, you can take the help of commonly used frameworks such as the following:

  • UN Sustainable Development Goals (SDGs)
  • Global Reporting Initiative (GRI)
  • Sustainability Accounting Standards Board (SASB)
  • Climate Disclosure Standards Board (CDSB)
  • Task Force on Climate-related Financial Disclosures (TCFD)

Image Credits: Photo by Photo Boards on Unsplash

While it is convenient to look at the three strands of ESG separately, in reality, they are closely intertwined. The sooner business leaders acknowledge that ESG is not a fad or a feel-good factor, but in fact, makes sound business sense, the better it is for the world as a whole.

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Intensifying Social Accountability of Corporates in India

In a bid to make companies progressively accountable in the social panorama, the government has been modifying the provisions of Corporate Social Responsibility (“CSR”) ever since its introduction. Amendments have been made in section 135 of the Companies Act, 2013 (“the Act”), The Companies (Corporate Social Responsibility) Rules (“the Rules”) and Schedule VII (“Schedule”) of the Act by the Ministry of Corporate Affairs (“MCA”), from time to time.

While the earlier amendments to section 135 of the Act and the Rules were mostly clarificatory in nature or were relating to the inclusion of certain activities relating to COVID – 19 as the contribution made towards  CSR, the amendments to section 135 of the Act inserted by the Companies (Amendment) Act, 2019 and the Companies (Amendment) Act, 2020 and notification of The Companies (Corporate Social Responsibility) Amendment Rules, 2021 (“the Amended Rules”), both effective from January 22, 2021, has brought about a radical change in the treatment of unspent CSR amount, among other amendments, which is dealt with in this write-up.

  1. CSR applicability extended to newly incorporated companies as well:

Sub-section (5) of section 135 provides that every company crossing the threshold limits prescribed in section 135(1) has to necessarily spend at least 2% (two percent) of the average net profits of the company made during the immediately preceding three financial years. By way of inclusion to section 135 (5), newly incorporated companies that cross the threshold limits prescribed under section 135(1) of the Act have also been brought within the ambit of compliance with CSR provisions.

  1. Compliance in respect of unspent CSR amount:

A brief outline of the amendments relating to the treatment of unspent amount is provided below:

 

  1. Penalty for non-compliance of sub-sections (5) or (6) of section 135 of the Act:

The newly-inserted sub-section (7) of section 135 of the Act deals with a penalty for non-compliance of provisions of sub-section (5) or (6). It is pertinent to note that the provisions of Companies (Amendment) Act, 2019 had prescribed for imprisonment for a term extending to three years, apart from a fine that may be imposed, on the failure of a company to comply with the provisions of sub-sections (5) or (6) which relates to transfer of unspent amount other than ongoing project and transfer of amount towards ongoing project respectively.

Understandably, there were apprehensions over the proposed implementation of penal provision with imprisonment for CSR activity, and after deliberations, the provision was replaced with a provision in the Companies (Amendment) Act, 2020 which provides only for penalty without imprisonment for non-compliance of sub-section (5) or (6) of section 135 of the Act.

Penalty for the company – twice the amount required to be transferred by the company to the Fund specified in Schedule VII / unspent CSR account (or)

INR 1,00,00,000/- (Indian Rupees One Crore only), whichever is less.

Penalty for every officer of the company who is in default –

one-tenth of the amount required to be transferred by the company to such Fund specified in Schedule VII / unspent CSR account (or) INR 2,00,000/- (Indian Rupees Two Lakhs only), whichever is less.

  1. Power to give general or special directions:

As per sub-section (8) which has been inserted, the Central Government may give general or specific directions to a company or a class of companies, as necessary, which are required to be followed by such company/class of companies.

  1. Constitution of CSR Committee:

CSR committee is not required to be constituted by a company, where the amount it has to spend towards CSR activities is not more than INR 50,00,000/- (Indian Rupees Fifty Lakhs only) and the functions of the CSR committee shall be discharged by the Board of Directors of the company.

  1. Other notable changes in Amended Rules:
  • Registration under sections 12A and 80G of the Income Tax Act, 1961 has been made mandatory for CSR implementation entities (Rule 4(1) of the Amended Rules).
  • Every CSR implementation entity has to file Form CSR – 1 and obtain CSR registration number compulsorily from April 01, 2021 (Rule 4(2) of the Amended Rules).
  • Chief Financial Officer or any person responsible for financial management shall certify that the funds disbursed have been utilized for the purposes and manner as approved by the Board (Rule 4(5) of the Amended Rules).
  • In case of ongoing project(s), the Board shall monitor its implementation and shall make necessary modifications, as required (Rule 4(6) of the Amended Rules).
  • The CSR Committee shall formulate and recommend an annual action plan in pursuance of its CSR policy to the Board comprising the particulars as specified in Rule 5(2) of the Amended Rules, which may be altered at any time during the financial year, based on a reasonable justification.
  • Surplus earned from CSR activities shall be ploughed back into the same project or transferred to the “unspent CSR account” and spent as per the CSR policy and annual action plan or shall be transferred to the Fund specified in Schedule VII of the Act but shall not form part of the business profit of a company (Rule 7(2) of the Amended Rules).
  • The CSR amount may be spent by a company for the creation or acquisition of a capital asset, which shall be held by a CSR implementation entity specified in Rule 4, which has CSR registration number, or beneficiaries of the CSR project or a public authority (Rule 7(4) of the Amended Rules).
  • Annual report on CSR to be in the format specified in Annexure-II of the Rules, in respect of board’s report for the financial year commencing on or after April 01, 2020 (Rule 8 (1) of the Amended Rules).
  • Companies having an average CSR obligation of INR 10,00,00,000/- (Indian Rupees Ten Crores only) or more in the three immediately preceding financial years has to undertake an impact assessment of CSR projects, having an expenditure of INR 1,00,00,000/- (Indian Rupees One Crore only) or more and which have been completed not less than one year before undertaking the impact study, through an independent agency (Rule 8(3) of the Amended Rules).

Ambiguities in the recent amendments:

  1. Whether unspent amounts of previous years have to be transferred?

Although, it has been specifically provided in some of the Amended Rules (viz., implementation of CSR provisions through specified entities, reporting of CSR as provided in Annexure provided in the Amended Rules) that the said amendments are applicable on or after April 01, 2021, the time period from which the provisions relating to the transfer of unspent CSR amount to “unspent CSR account” / Fund is applicable, i.e. whether the unspent CSR amounts relating to the past financial years (from the date of applicability of the CSR provisions to the company) are required to be transferred to the “unspent CSR account” / Fund or only the CSR amount remaining unspent as on March 31, 2021, has to be transferred, has not been explicitly provided in the Act or the Amended Rules.

  1. Whether the outstanding amount of provision created for the unspent amount must be transferred?

The amended provisions do not stipulate whether unspent CSR amounts of the previous financial years have to be transferred to the designated account / Fund in case a company has created a provision in the books of accounts for such unspent amount for the relevant financial years.

The foregoing matters require suitable redressal by the MCA in the form of clarifications or FAQs or amendments to the existing provisions, which will offer a much-needed clarity on these matters.

Conclusion:

With the recent amendments, the CSR provisions have undergone a paradigm shift from “Comply or Explain” to “Comply or Pay” regime as they provide for penalties on failure to transfer unspent CSR amount to the specified account / Fund, whereas earlier, providing reasons for not spending CSR amount was considered adequate compliance. Hence, the said amendments have placed additional responsibilities on corporates.  Having introduced the concept of penalty, it is only appropriate that the MCA addresses the obscurities arising from the amendments at the earliest so that corporates are not caught off-guard in complying with the CSR provisions.

Image Credits: Photo by Tim Marshall on Unsplash

the CSR provisions have undergone a paradigm shift from “Comply or Explain” to “Comply or Pay” regime as they provide for penalties on failure to transfer unspent CSR amount to the specified account / Fund, whereas earlier, providing reasons for not spending CSR amount was considered adequate compliance.

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Corporate Social Responsibility (CSR) during Covid-19

The novel coronavirus (“COVID-19”) was declared as a pandemic by the World Health Organization on March 11th, 2020 and subsequently, the Government of India decided to treat it as a notified disaster.  Accordingly, the Government took various steps to curb the spread of the disease as well as minimize the impact on the economy. While businesses were grappling with the new reality of this global uncertainty, their support and participation was considered imperative to manage the current situation. To encourage entities and garner their cooperation, the Government decided to treat funds spent on activities relating to COVID-19 as part of CSR performance. Additionally, the Ministry of Home Affairs of India issued directions to lockdown all the states in India till 20.05.2020 (“Lockdown Period”) and has come up with various notifications with respect to payment of salaries/ wages to employees.

Under section 135 of the Companies Act, 2013 (“Act”), every company having a net worth of Rs. 500 Crores or more, or turnover of Rs. 1000 Crores or more or a net profit of Rs. 5 Crores or more during the preceding financial year shall constitute a CSR Committee. This CSR Committee shall formulate and recommend a CSR policy for the activities to be undertaken by the company, recommend the amount of expenditure to be incurred on the activities and monitor the CSR policy of the company from time to time. The company shall spend, in every financial year, at least 2% of its average net profits made during three immediately preceding financial years or since incorporation, whichever is applicable. Moreover, the CSR expenditure shall include projects and programs specified under Schedule VII of the Act.

Keeping in mind the requirement under the Act, the Ministry of Corporate Affairs (“MCA”) issued a General Circular No. 10/2020 dated 23.03.2020 (“General Circular”) on the spending of CSR funds for COVID-19. The MCA has clarified that spending of CSR funds for COVID-19 is an eligible CSR activity. The MCA through the General Circular has included the promotion of health care including preventive health care and sanitation, and disaster management to the list of CSR activities under Schedule VII. Furthermore, it is pertinent to note here that as per General Circular No. 21/2014 dated 18.06.2014 issued by MCA, the entries in Schedule VII are broad-based and must be interpreted liberally so as to capture the essence of the subjects therein. With this change, Schedule VII now recognizes any contribution to incubators funded by Central or State Government or any Government agency engaged in conducting research in science, technology, engineering, and medicine as falling within the ambit of CSR. 

Moreover, the Government of India has set up a public charitable trust under the name of Prime Minister’s Citizen Assistance and Relief in Emergency Situations Fund (“PM CARES Fund”) to deal with any kind of emergency or distress situation, like the one posed by the COVID-19 pandemic. In view of this, the MCA issued Office Memorandum F. No. CSR-05/1/2020-CSR-MCA dated 28.03.2020 which provides that any contribution made to the PM CARES Fund shall qualify as CSR expenditure under item No. (viii) of the Schedule VII of the Act, which reads as under:

(viii) contribution to the prime minister’s national relief fund or any other fund set up by the central govt. for socio-economic development and relief and welfare of the schedule caste, tribes, other backward classes, minorities and women

The MCA issued further clarifications vide General Circular No. 15/ 2020 dated 10.04.2020 (“New Circular”) due to several queries on the eligibility of CSR expenditure related to COVID-19 activities. The following are the clarifications issued in the New Circular:

  1. The contribution made to the PM CARES Fund shall qualify as CSR expenditure under item no. (viii) of Schedule VII of the Act as stated above.
  2. Any contribution to ‘Chief Minister’s Relief Fund’ or ‘State Relief Fund for COVID-19’ is not included in Schedule VII of the Act and therefore, it shall not qualify as CSR expenditure.
  3. As provided in the General Circular, contribution made to State Disaster Management Authority to combat COVID-19 shall qualify as CSR expenditure under item no. (xii) of Schedule VII of the Act which reads as under:

(xii) disaster management, including relief, rehabilitation and reconstruction activities

  1. Funds spent on various activities related to COVID-19 under the items of Schedule VII with respect to the promotion of health care including preventive health care, sanitation, and disaster management shall qualify as CSR expenditure.
  2. The payment of salary/wages to employees and workers during the lockdown period is a moral obligation of the employers, as they have no alternative source of employment or livelihood during this Lockdown Period. Therefore, payment of salary/wages to the employees and workers during the Lockdown Period shall not qualify as admissible CSR expenditure. Moreover, payment of wages to temporary or casual, or daily wage workers during the Lockdown Period shall also not count as CSR expenditure as this forms a part of the contractual or moral obligation of the company and is applicable to all companies irrespective of whether they have any legal obligation for CSR contribution under section 135 of the Act.
  3. In case of any ex-gratia payment made to temporary/ casual workers/ daily wage workers over and above the payment of wages, specifically for the purpose of fighting COVID-19, the same shall be considered CSR expenditure. It is pertinent to point out that this payment shall be admissible as a one-time exception provided there is an explicit declaration to that effect by the Board of the company, which is duly certified by the statutory auditors.

 

To sum it up, the MCA has clarified that the expenses made by the corporate entities with regard to COVID-19 shall be construed to be part of the CSR responsibilities under the Companies Act, 2013 if the activities and expenses include the following:

  1. Contribution to PM CARES Fund;
  2. The contribution made to State Disaster Management Authority; and
  3. Funds spent on activities relating to the promotion of health care including preventive health care, sanitation, and disaster management.

Further, to put rest to the discussions pertaining to payment of salaries and wages to the employees or contract workers, the MCA has also clarified that payment of salaries and wages are moral obligations of a company irrespective of the CSR contribution. Therefore, payment of salaries and wages do not form part of CSR expenditure. However, MCA has provided a one-time exception for ex-gratia payment to the temporary or casual workers for fighting COVID-19.      

Corporates are opting for a hybrid approach where they are partly contributing to the various funds and simultaneously directly getting involved in the process of fighting the disease by manufacturing equipment, making quarantine facilities, and distributing free rations. The key here is to fight the disease from all possible fronts with the help of all possible avenues. Corporates taking an active part reflects their values and shall positively impact their reputation management efforts. However, had the payment of wages been included in the CSR activity, employees who are losing their job could see some respite. That said, the one-time exception for temporary and casual workers is definitely a positive step that goes a long way in resolving the economic distress that is affecting individuals and businesses alike.

ACTIVITY

COUNTS AS CSR?

Contribution to PM CARES

Yes

Contribution to State Disaster Management Authority

Yes

Payment of Salaries/Wages

No

Ex-Gratia Payment Above Wages to Temporary/Casual Workers for Fighting COVID-19

Yes, One Time

COVID-19 Related Activities Under Schedule-VII

Yes

Contribution to Chief Minister Relief Fund

No

Contribution to State Relief Fund for COVID-19’

No

 

 

Image Credits:  Photo by cottonbro from Pexels

Such measures from the Government will certainly create a positive sentiment and a sense of tax certainty amongst the investors and hopefully, help in attracting incremental foreign investment into the country, that will play an important role in promoting faster economic growth and development.

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