There is an increasing global awareness that is forcing companies to formulate, implement and monitor Environmental, Social and Governance (ESG) policies. It is mainly driven by stakeholders’ expectations, government regulations, and the urge for greater transparency and accountability from corporations.

With regulators like SEBI requiring entities to report on ESG policies, RBI recommending banks to include norms for measuring ESG effects in borrowers’ credit evaluation, ICAI framing standards for environmental sustainability and processes for social audit, India has seen a major uptick in implementing ESG policies. All these are definite early indicators that non-implementation of ESG policies may take the colour of non-compliance in the years to come.

Large entities are working and redeploying their resources to adopt, comply and monitor these policies. This will necessarily have implications for other players in the market, upstream and downstream participants in the supply chain of such entities to implement ESG policies in the due course of time.

The general perception is that these policies are esoteric and do not impact the MSME segment in a big way. Contrary to such perceptions, the impact on MSME is quite strong and sometimes even existential. For example, The government’s ban of single-use plastic had a cascading effect of pushing costs on the entire value chain. While small entities with good cash flow and credit limits managed this situation by moving to alternate products, others were forced to shut down. The other instance where some States in India banned or restricted the bursting of firecrackers during Diwali. This impacted the firecrackers industry, especially the MSMEs that did not have other business verticals to diversify their business. Consumers being aware of the environmental effects started avoiding bursting crackers.

Planning ahead

This article attempts to focus on the implications of ESG policies on MSMEs. Carbon reporting follows the Green House Gases Protocol which divides carbon emissions into three categories of emission: Scope 1, Scope 2 & Scope 3.

Scope 1 emissions are direct emissions from company-owned and controlled resources. It includes stationary combustion, mobile combustion, fugitive emissions, and process emissions. Scope 2 emissions are indirect emissions from the generation of purchased energy in the form of electricity, steam, heating and cooling. Scope 3 emissions are all indirect emissions that occur in the value chain of the reporting company. The upstream activities include purchased goods and services, capital goods, leased assets, fuel, transportation, waste, and employee commuting. The downstream activities include distribution, processing of products, use of sold products, investments and franchises.

When large entities start implementing ESG policies, they initially start the efforts by targeting Scope 1 and Scope 2 emissions but policies demand that the approach have to be balanced. It is not long before they start moving their focus on reducing their Scope 3 emissions. This is when the impact will be begun to be felt as most of the MSME entities are in one way or another will be a supplier of raw materials or distributors of the production of such listed entities falling in the Scope 3 category. They would run the serious risk of losing their business if they fail to adopt, or that point of time would entail very high costs, of such ESG policy to lower its’ carbon emissions.

Strategic decisions

RBI, in its survey on climate risk and sustainable finance, indicated the banks have a mechanism for overseeing and scaling up initiatives relating to climate risk, ESG and sustainability. In other developed countries, banks are giving loans to borrowers based on their ESG performance, eventually, implementation of the same in Indian banks is not so far. For most of the MSME entities credit facilities extended by banks are their vital source of finance. RBI may mandate the banks to include parameters for assessing borrowers’ ESG performance while lending loans, at such time MSME entities which are early adopters of ESG policies may not face challenges but other entities could be serious.

The most important thing in this highly competitive world is action, and you just need to take matters in your hand, be proactive and handle the situation strategically.

(The writer is with RVKS & Associates, Chartered Accountants.)