Companies Challenged to Crack Code of ESG, Inflation

Analysis

Photo by Panchenko Vladimir / Shutterstock.com

This year brings familiar but no less troubling concerns for businesses looking to operate in Hungary or across its borders in the form of inflation and getting acquainted with the workings of ESG. Ever-expanding environmental, social and corporate governance regulations pose a challenge not only for the companies that are supposed to observe them but also the lawyers trying to keep up with the changes.

Even if the economic outlook offers more promise than it did just a short while ago, the operation of businesses comes with multiple significant challenges that permeate every facet of commerce domestically and internationally.

While falling, inflation is still the highest in the European Union; the latest reading published by the Central Statistical Office (KSH) shows a 20.1% year-on-year increase in the headline figure. The government and the National Bank of Hungary (MNB) forecast a significant reduction in prices, with a drop to single digits by the end of the year, possibly as soon as October.

This will potentially bring down procurement costs for all industries. Nonetheless, the measures enacted by the government and the steps taken by the MNB to reign in prices will take longer, potentially years, to be fully felt, assuming there are no additional external economic shocks.

Some areas of commerce can also expect increased scrutiny from the authorities. The central bank and the government have stated that the steep rise in prices is only partially due to organic developments, such as base effects or imported inflation coming on the back of changes in energy prices.

There is also the suspicion that some companies are deliberately hiking their prices to improve their margins, blaming it on inflation. As such, the Hungarian Competition Authority (GVH) has started probes on producers and vendors to determine whether they are claiming an unfair advantage from the situation.

Maintain Focus

“The government has taken every step to reduce inflation, so it is crucial to maintain focus on the observance of fair competition practices and to enforce the decisions made to keep inflation at bay,” said the head of the Prime Minister’s Office, Gergely Gulyás.

The demands of ESG are one of the most hyped issues, required to uphold a company’s image, make it compliant with a developing regulatory environment and ultimately, ensure it can ascertain the fresh capital needed for its operation. New reporting standards and an overall revision of operating strategies to better accommodate environmental and inclusivity matters may become the necessary competitive edge.

“ESG compliance accounts for 10-15% of our aggregate compliance and regulatory-related workload. However, ESG will increasingly influence companies and decision-makers due to the recently adopted corporate sustainability reporting directive to be implemented into Hungarian law in 2024,” Erika Papp, managing partner of CMS Hungary, told the Budapest Business Journal in an earlier survey.

A U.K. study conducted by Butterfield Mortgages Limited found that 25% of investors intend to make ESGinvestments by 2025. However, 30% said such investment opportunities are not easy to find. For a firm to be ESG-compliant, it must consider ESG aspects when making decisions on new investments and manage its supply chains or overall operations based on ESG frameworks and standards. There must also be clear reporting on all these issues.

Accordingly, companies will also need to up their ESG game if they are looking to secure financing for their operations and growth. The global trend points to a set-up when even countries looking to conduct issuances on international finance markets will have to present their environmental efforts.

Despite all that, however, a study by the Hungarian central bank also underlined that the broader economic challenges are, for now, forcing ESG-related efforts into the background.

Underperforming Funds

“Funds covering ESG issues closed a bad year in 2022,” the MNB points out. After five successful years, ESG fund performance in 2022 underperformed, as did the S&P 500 stock index, mainly due to energy prices. The crisis has meant record profitability for the fossil fuel industry and, consequently, rising share prices. The impact of this has not been felt by ESG funds, which typically avoid such companies.

Loans financing energy production and agriculture are the most exposed to transition risks. A look at the central bank’s report shows that the corporate loan portfolio considered “risky” is steadily increasing.

This is because financing for investments with high levels of greenhouse gas emissions remains relatively stable, increasing in volume and keeping pace with the steady growth in the total corporate loan portfolio. While at the end of 2021, the stock of loans considered to be risky was between HUF 924 billion and HUF 1.56 trillion, by 2022, it had risen to between HUF 1.06 tln and HUF 1.773 tln, representing an increase of 13.7-14.7%.

Nonetheless, the expectation is that the area will see a surge in interest, stoked and supported by authorities, as well as service providers like law firms.

“Some sectors and clients are more advanced in this process, while others are currently picking up, and we lawyers must help clients understand where, why, and how ESG may be relevant for them. We see a rapid increase in client interest and expect a significant volume of related work in the coming years,” said Ákos Fehérváry, Budapest office managing partner at Hegymegi-Barakonyi and Partner Baker & McKenzie Attorneys-at-Law.

This year, the MNB intends to issue guidance to supervised institutions on a number of issues. The central bank announced that to clarify the domestic sustainable financial framework and support the green transition of institutions, it plans to extend its guidance on climate-related and environmental risks for credit institutions. At the same time, auditing practices will also be revised to account for ESG considerations.

This article was first published in the Budapest Business Journal print issue of July 28, 2023.

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