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ESG (Environmental, Social and Governance) is becoming an increasingly important area of regulatory compliance, with mandatory reporting growing in prevalence globally. This report will look at examples of approaches to ESG regulation around the globe, highlighting some of the primary compliance challenges for firms, including new regulatory developments
Why you should care about ESG reporting
ESG ratings are a hot topic for lenders, borrowers and regulators right now, with an increased focus on steering business towards a more transparent, environmentally and socially responsible way of working. Though not mandatory in many countries, according to the KPMG Survey of Sustainability Reporting in 2020, 78% of the 100 largest companies in the world produced sustainability reports in 2020. The World Economic Forum’s latest Global Risks Perception Survey identified “climate action failure” as a top 2 risk, by both likelihood and impact. And last year saw a marked shift in investments to more ESG-focused offerings, with issuance of sustainable bonds up 96% compared to the same period in 2019. The number of social bonds issued was also eight times higher.
To put that into context, Tesla’s valuation is now higher than the valuation of the five largest European oil and gas companies, including BP and Shell. “We are seeing a green revolution,” says Adeline Diab from Bloomberg Intelligence, “which is, in my opinion, the biggest disruptive trend maybe since the internet.” This shift in priorities means that how your firm reports and records its ESG data has never been more important - not just in terms of attracting investment, but also in relation to the additional regulatory burden. When you think of ESG risks, your first thought is likely to be about industries such as coal or oil extraction. But the financial services industry also has considerable exposure to ESG risks because of the industries it funds, the companies and individuals it provides services to - and of course its own carbon footprint.
Creating a successful ESG compliance programme
A successful ESG compliance programme must adopt a holistic approach to ESG, integrating it into the entire regulatory compliance framework so that all risks can be aligned with the relevant ESG regulation. Firms should be mindful of not prioritising any one of the three pillars which comprise ESG. The environment, societal factors and adequate governance and oversight need to be managed synergistically, without one compromising either of the others.
There are several voluntary guidelines available for banks to follow in relation to ESG risk management, such as those published by the World Economic Forum, and currently adhered to by 61 global companies, employing a combined total of seven million people. Despite these frameworks not being mandatory, it would serve firms well to implement them now so they are well placed to meet the inevitable regulatory challenges on the horizon.
Investors have long lamented inconsistency in sustainability reporting requirements, making it extremely difficult to make fair decisions based on a company’s ESG credentials. As such, it’s likely that a much-anticipated standardised approach is in the pipeline. The International Financial Reporting Standards Foundation (IFRS) and the European Financial Reporting Advisory Group are in discussions with the aim of reaching this goal in the not-too-distant future; and have published proposals to create a new, global Sustainability Standards Board. Larry Fink, CEO of BlackRock, whose open letter in January 2020 was a turning point for the ESG movement, expressed his desire for a standardised approach in his 2021 letter: “We strongly support moving to a single global standard, which will enable investors to make more informed decisions about how to achieve durable, long-term returns,” he wrote.
UPCOMING REGULATORY DEVELOPMENTS
The EU’s Sustainable Finance Disclosure Regulation (SFDR) is the first part of a tranche of regulation designed to refocus capital flows towards a more sustainable future - part of the EU Action Plan for financing sustainable growth. The SFDR came into play in December 2019 and a number of key provisions must be implemented by March 10th of this year. It aims to mainstream sustainability into the risk management process and encourage transparency and long-termism in the financial sector.
The EU Taxonomy Regulation establishes standardised criteria for identifying whether an economic activity qualifies as environmentally sustainable for investment purposes, with the hope of providing clarity for investors looking to fund these types of activities. The Taxonomy lists six objectives: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, pollution prevention and control, protection of healthy ecosystems, and the transition to a circular economy. Under the Taxonomy, an activity can be deemed environmentally sustainable if it meets one of the six objectives, does not significantly harm any other objectives, complies with minimum social and governance safeguards, plus technical screening criteria. The Taxonomy was published on 22 June 2020 and came into force on 12 July 2020, but will not start applying on a practical level until 1 January 2022 at the earliest.
Also part of the EU initiative is the Non-Financial Reporting Directive (NFRD) which requires companies with 500 employees or more to disclose their social and environmental impact, including non-financial disclosures and diversity information. Qualifying companies must provide information on: environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption & bribery and diversity on company boards. This regulation is not new but is currently under review “to ensure that investors, civil society and other interested parties have access to the information they need, while not imposing excessive reporting obligations on companies.”
The European Commission closed its consultation on sustainable corporate governance on February 8th. The consultation was focussed largely on the role of directors in maintaining sustainable growth, including their duties of care, remuneration practices and the presence of sustainability expertise on boards. It also looked at strengthening supply-chain due diligence measures. The consultation will lead to regulatory change in the EU, and so the UK is likely to follow suit
The People’s Bank of China (PBOC) has said it is accelerating the development of a set of green financial standards. The regulator is currently undertaking a comparative study of EU and Chinese financial standards ahead of the launch of a China-EU Shared Classification Catalogue for Green Finance later this year. The bank also recently announced it was working towards standardising mandatory environmental information disclosure requirements as part of a wider drive to strengthen supervision over financial institutions.
Mandatory ESG disclosure requirements were announced by the Korea Exchange in January 2021. The new rules require companies listed on the main Kospi market with over US$1.8 bn in assets to disclose ESG reports by 2025. The requirements will be extended to all companies by 2030. Under the mandatory system, disclosure reports will be made more simple in order to reduce the burden on reporting companies and to provide greater clarity for retail investors. Korea’s electronic disclosure system, DART (Data Analysis, Retrieval and Transfer System) will also be updated to improve usability.
The US has been at the epicentre of a number of human rights-related movements which, alongside the Covid-19 pandemic, have served as a catalyst for the uptake of ESG initiatives globally. The election of Joe Biden as president is also predicted to have an impact on ESG regulation. The so-called “ESG Rule”, Financial Factors in Selecting Plan Investments, has already been selected for review by Biden’s team.
The New York State Department of Financial Services was the first US financial regulator to publish guidelines in relation to climate change risk management in 2020. The US Federal Reserve became part of the Network of Central Banks and Supervisors for Greening the Financial System last year and addressed climate change risks in its financial stability report for the first time.
The SEC is also expected to move towards a more ESG-friendly stance with a Biden-selected chair. Mary Shapiro, former chair of the SEC and head of the secretariat for the Task Force on Climate-related Financial Disclosures, has said she believes the regulator “should and will move to mandatory disclosure” for climate-related issues.
The Securities and Exchange Board of India (SEBI) published a consultation paper last year on business responsibility and sustainability reporting. The proposals, once finalised, would apply to the top 1,000 listed companies in India, and are based on the National Guidelines on Responsible Business Conduct published by the Ministry of Corporate Affairs last year. The new requirements include disclosure on redressal procedures in the processing of complaints and grievances; amount spent on research and development for better environmental and social outcomes; details of employee skills, provisions for maternity/paternity pay and childcare facilities; energy and water consumption; and details of recyclable materials used in comparison to raw materials.
The UK’s Financial Conduct Authority published a new policy statement in December 2020: Proposals to enhance climate-related disclosures by listed issuers and clarification
of existing disclosure obligations. It details a new listing rule which marks the start of a tougher approach to climate-related disclosure requirements from the regulator. The new requirements are aligned with global recommendations made by the Task Force on Climate-related Financial Disclosures (TFCD) and apply to all companies with a UK premium listing. As of January 2021, all such companies must include a statement in their annual financial report setting out how they adhere to recommendations made by the TFCD; if they have not met any TFCD requirements an explanation of why and a description of remedial steps; plus details of where any other relevant documentation can be found if not included in the financial report. Though the rule currently only applies to premium listings, the FCA will consult on extending the rule to include other entities in the first half of 2021.
As ESG ratings hold increasing weight in investor decision making, “greenwashing” - where a firm deliberately overstates or overvalues its green credentials - has become a growing problem. Many large firms including BMW, Ryanair and Shell have had advertisements banned for exaggerating the environmental benefits of their products and services.
There is a danger that the ESG message is being used as a marketing ploy by some firms, creating a false sense of progress and putting smaller firms, who are perhaps less adept at spinning data, at a disadvantage. The upsurge in regulation in this area is aimed at tackling the problem of greenwashing, but as the regulation is still evolving, there is plenty of wriggle room for companies looking to game the system. One example of this is in the setting of ESG/sustainability targets. A company that consistently hits or exceeds their targets may appear to have better credentials than one which consistently misses them. However, “the former may be setting soft goals, while the latter could be pushing itself ever harder,” said Aberdeen Standard Investments in a recent report on greenwashing. The same could be said for the other elements of ESG (i.e. not just green goals, but targets related to diversity, social impact and governance), so it’s important to ensure you are setting meaningful benchmarks which are assessed regularly to see where improvements can be made.
Climate and environment-related topics seem to be the main focus of ESG regulation, closely followed by governance, but as a result of the Black Lives Matter (BLM) movement, there is now growing pressure on companies to provide greater transparency around their diversity demographics. Many companies, including US retail and tech giants Target and Apple, pledged money towards BLM-affiliated initiatives and thousands of companies published messages of support and made promises to take action. But to avoid an approach that could be seen as marketing-driven, diversity-focussed regulation is likely to be the next key area of focus for regulators.
“Something we are going to spend a lot of the next proxy season engaging on is getting better workplace demographic disclosure so we can actually hold companies accountable,” Katie Koch, a managing director at Goldman Sachs Asset Management, told a conference in September. In the US, companies are already required to submit diversity data to the US Equal Employment Opportunity Commission, but the information is currently only made public on a voluntary basis.
Gender-related regulation is also evolving to meet demands for firms to improve diversity. For example, New York’s Women on Corporate Boards Study Act came into effect in June 2020, requiring all public and private for-profit companies authorised to conduct business in New York State to disclose the number of female directors on their board. Other US states which have taken similar action (or are preparing to) include California, Illinois, New Jersey, Pennsylvania, Michigan, Colorado, Hawaii, Massachusetts, Washington State, Ohio, and Maryland.
A firm’s approach to other areas of diversity, including their treatment of the LGBTQ community and religious groups will also feed into its ESG ratings and its reputation more generally. ESG is so wide reaching as an investment concept, the best risk mitigation method is to stay ahead of the curve and address issues before they are highlighted by regulatory breaches. Setting your own exacting standards is the best way to ensure you are ready to meet those set by the regulators, investors and the wider public.
EU taxonomy for sustainable activities
Larry Fink’s 2021 letter to CEOs
Sustainability & ESG Year in Review: Key Takeaways
ESG for asset managers: 10 things you need to know
Greenwashing: what it is and how to tackle it
The UK FCA’s proposals to enhance climate-related disclosures
IASB Chair speech: What sustainability reporting can and can’t achieve https://www.ifrs.org/news-and-events/2019/04/speech-iasb-chair-on-sustainability-reporting/
Economic Times report on SEBI guidelines
Black Lives Matter provokes change on Wall Street, Financial Times
The World Economic Forum’s Measuring Stakeholder Capitalism Report