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ESG and regulation – carrot or stick?

18 February 2021

Phil LloydHead of Market Structure & Regulatory Customer Engagement

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John Stevenson-HamiltonLIBOR Client Strategy & Engagement

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Other insights

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8 minute read

With the post financial crisis wave of regulation largely implemented one could be forgiven for expecting the regulatory waters to be a little calmer.

But maybe not...step forward ESG (Environmental, Social & Governance for those whose inboxes are not yet filled with this and plenty more new acronyms).

ESG is hardly a new topic, there has been a huge amount written on it in the last few years, and indeed we have some terrific articles covering many aspects of ESG on our hub for those unfamiliar with the subject (start here).  But one thing that does seem to be becoming more insistent is the regulatory tone. 

We've seen the carrot of encouraging firms to 'do the right thing', and quite rightly many would want to be better in this space and encourage the right behaviour around sustainable finance.  But do I hear the swish of the regulatory stick as well?

Below and in future pieces through the year we will start to take a look at the regulatory aspects of ESG, drawing comparisons with how it all played out in other regulatory initiatives we know and love.  Global standards, regional differences, new product governance, lots of disclosures and reporting, building a taxonomy, the shadow of capital charges or other costs...and of course the alphabet soup that all new regulation brings with it!

Who are the Market Participants and how do they interact?  

The ESG landscape has become very crowded and grown organically. The Global Regulators are clearly trying to define some of the boundaries and ensure momentum is maintained but also controlled.  The below gives a flavour around some of the interactions, noting it will evolve.

 

As the above shows, this is a complex space with many participants all playing their part in assessing risks, new product creation and regulatory intervention. How the blocks interact and develop will be crucial if a 'fair outcome' for all is to be maintained while not stifling innovation in a crucial space. 

How are the regulators driving change?

Firstly let's understand what's out there:

So what's being asked of the market?

As per the first diagram above the regulatory focus, unlike post financial crisis, will be much wider than just the banks.  The PRA & ECB have both set out their expectations, and in early February ESMA published a statement on ESG ratings.

The PRA through what's known as SS3/19 has focused on financial markets to fully understand and embed climate risks into their risk frameworks. While this is focused on banks & insurers it shouldn’t be missed that part of this governance and framework is to engage the wider market and client base on the risks of climate change.

The ECB is pushing a similar agenda closely liaising with the European Commission (EC) and the European Banking Authority (EBA) on this topic and will continue to develop its supervisory practices based on future regulatory developments. For example, the EBA is currently examining how environmental, social and governance risks can be considered in the prudential framework.

On Monday 1st February, The European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, wrote to the EC sharing its views on the main challenges in the area of ESG ratings and assessment tools. ESMA highlights the need to match the growth in demand for these products with appropriate regulatory requirements to ensure their quality and reliability.   

'BES' - Climate Stress Test for UK Banks & Insurers  

In the context of banks engaging the wider market, the BoE will use its 2021 Biennial Exploratory Scenario (BES) survey to explore the resilience of the largest banks and insurers to future potential scenarios for the climate - a sort of climate stress test.

Recognising that climate-related risks can have a very different impact on companies even within the same sector and geographies, the BES exercise requires banks to model these risks at the individual counterparty-level. The BoE has written to banks stating:

We expect firms to have conversations with clients and counterparties about potential current and future impacts of the physical and transition risk factors. Insurers and banks need to engage with their clients and counterparties to develop the data infrastructure required to measure the risks.”

Disclosures, standards and recommendations – a busy space

The Financial Stability Board (FSB) recognised that failure to quantify the financial risks arising from climate change could negatively impact financial stability due to ‘mispricing of assets and misallocation of capital’. Whilst in most G20 countries, companies with public debt or equity are required to disclose material risks, including climate change related ones, there is no standard framework for doing so. Clearly, this means it is difficult to assess the exposure of companies in relative terms and aggregate exposures.

Consequently, the FSB set up the Task Force on Climate-related Financial Disclosures (TCFD) in 2015 to develop a set of recommendations for a standard approach towards making financial disclosures. The task force produced its final report in June 2017 and it is this framework which will form the basis for the disclosure regulation being introduced by G20 countries.

The TCFD looks at:

  1. Climate related risks: policy, technology, market / reputational / physical risks
  2. Climate related opportunities: resources efficiency, energy source, products & services, markets and resilience
  3. Financial impacts: income and balance sheet

The EU gave a high priority to implement the TCFD recommendations and in 2019 provided a useful summary of progress and next steps. 

On 10 March 2021 the new EU rules requiring funds to disclose details on how their funds meet ESG-related characteristics and objectives under The Sustainable Finance Disclosure Regulation (SFDR) will come into effect. Here in-scope firms must publish on their website a statement confirming whether they consider “principal adverse impacts on sustainability factors” and their due diligence policies with respect to those impacts, or clear reasons why adverse impacts are not considered

Only recently The Joint Committee of the three European Supervisory Authorities delivered to the European Commission (EC) the Final Report, including the draft RTS, on the content, methodologies and presentation of disclosures under the EU Regulation on SFDR.  

Taxonomy alignment surely will help

The Taxonomy Regulation was published in the Official Journal of the EU on 22 June 2020 and entered into force on 12 July 2020. It establishes the framework for the EU taxonomy by setting out four overarching conditions that an economic activity has to meet in order to qualify as environmentally sustainable.

The regulation initially focused upon a few items requiring a delegated act for the Regulatory Technical Standards (RTS) be adopted by December 2020, with RTS to be adopted for the other items a year later. As with the disclosure regulation 2019/2088, there is no firm date for taxonomy RTS for climate change entering into EU law.

In the UK, the chancellor's statement that accompanied the roadmap noted that the UK would take the EU taxonomy as its scientific basis for its own taxonomy, but would review this in detail to determine how suitable it was for implementation in the UK.

What about the US under Biden?

Clearly, the US is a key member of the FSB and was a first mover with derivatives reporting. It seems likely that with a Biden administration, it will earnestly adopt the TCFD recommendations in the same way as the EU and UK. Only recently Biden’s Acting SEC Chair indicated they want mandatory ESG Reporting

In its latest Financial Stability Report, the U.S. Federal Reserve released a statement in support of climate risk disclosure. It anticipates that banks “have systems in place that appropriately identify, measure, control and monitor all of their material risks, which for many banks are likely to extend to climate risks.”

In the US they are already taking steps to reverse Trump policy re. retirement money flow to ESG funds. Expect to see progress at a rapid rate despite the 50-50 split in the Senate that may leave Biden unable to enact sweeping legislation. We may instead see a spate of orders and increased regulation aimed at tackling climate issues.

Final thoughts

The work around TCFD has given a new dimension towards an international approach for addressing the impact of climate change. The fundamental purpose of the FSB is to recognise issues that may have adverse effects upon the global financial system and propose approaches to avoid or alleviate these.

In following this remit in 2009 following the financial crash, it was responsible for prompting detailed regulations for reporting derivatives and SFTs. It is not yet possible to determine if widespread trade reporting will prevent similar crashes, but it may be argued that regulators are better placed to identify systemic risk issues than they were 10 years ago.

Whilst the FSB does not hold the direct responsibility for addressing all of the concerns about climate change, or other aspects of sustainable finance, it seems probable that the detailed disclosure regulations that will be put in place as a result of the TCFD Final Report can only raise awareness and ethical standards. Firms cannot ignore the initiative without attracting regulatory sanction, and perhaps more importantly loss of competitive advantage.

The rate at which ESG is gaining focus is remarkable, with so many market participants striving to move the needle forward. How they work together and to what end is something we will be watching closely.  Watch out for more carrots and sticks. 

ESG/Sustainability
Regulation
Green


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