1 Legal and enforcement framework
1.1 What regulatory regimes and codes of practice primarily govern environmental, social and governance (ESG) regulation and implementation in your jurisdiction?
In the United Kingdom, ESG is not (as of yet) considered a standalone concept in terms of regulation and codes of practice. There is a comprehensive, and growing, body of the regulatory requirements, voluntary disclosures and industry initiatives; but there is no single body or framework that covers all aspects of ESG.
One of the primary drivers of the United Kingdom's focus on ESG is climate change. The Climate Change Act 2008 sets out the United Kingdom's statutory net zero carbon target for 2050. The main areas of regulation contributing towards this net zero goal include:
- the UK Emissions Trading Scheme;
- the climate change levy;
- climate-related disclosures;
- the Energy Savings Opportunity Scheme; and
- energy efficiency in buildings and products.
The recent Environment Act 2021 also includes provisions which seek to increase the onus on large UK businesses to ensure that local laws are complied with to prevent them from using commodities derived from illegal deforestation from their international supply chain.
Large employers (with at least 250 employees) are subject to mandatory gender pay gap reporting under the Equality Act 2010. Large commercial businesses (with a total turnover of £36 million or more) must also publish a statement annually on modern slavery within their business and supply chains to conform with the Modern Slavery Act 2015.
The UK Corporate Governance Code applies to companies with a premium listing (whether they are incorporated in the United Kingdom or in another country). It sets out principles of good governance and stretches into other areas of ESG such as a company's contribution to ‘wider society'; and it places an emphasis on stakeholder engagement.
The UK Stewardship Code is another code that provides for good practice for institutional investors. The 2020 version of the code sets out an expectation that signatories will take account of ESG matters and ensure that investment decisions are based on their clients' needs.
In addition, the Companies Act 2006, related regulations, the Listing Rules and the Disclosure Guidance and Transparency Rules all require specific companies to report annually on environmental, climate-related and other non-financial matters (eg, social and employee-related matters) in their directors' reports, strategic reports and elsewhere in their annual reports. The UK government is rolling out mandatory climate-related disclosures for large companies and financial institutions across the United Kingdom.
1.2 Is the ESG framework in your jurisdiction primarily based on hard (mandatory) law and regulation or soft (eg, ‘comply or explain') codes of governance?
As can be ascertained from question 1.1, the ESG framework in the United Kingdom contains some mandatory laws and regulations. Historically, however, the investment management industry has tended to focus primarily on a ‘comply or explain' basis.
For example, the Listing Rules require UK listed companies to include in their annual corporate reports and accounts a disclosure statement setting out:
- how they have applied the relevant principles;
- whether they have complied with the provisions of the Corporate Governance Code; and
- justifications for any non-compliance.
The UK Stewardship Code provides for ‘apply or explain' principles, with reporting expectations. In applying the principles, signatories should consider (among other things) environmental and social issues, including climate change.
It is anticipated that there will be a shift over time towards a more formal, mandatory regulatory position for ESG.
1.3 Which bodies are responsible for implementing and enforcing the rules and codes that make up the ESG framework? What powers do they have?
At present, the body with the greatest responsibility for implementing and enforcing the rules associated with ESG in the United Kingdom is the Financial Conduct Authority (FCA), the financial regulator. The FCA sets the aforementioned Listing Rules and the Disclosure Guidance and Transparency Rules. The Listing Rules set out the requirements for the admission of securities, listing particulars and the ongoing obligations of issuers.
The UK government is proposing Sustainable Disclosure Requirements (SDRs) for companies, with a consultation process open until 7 January 2022. The proposals include requirements that companies make disclosures in their annual report which show alignment of their activities with the UK Green Taxonomy. The proposed rules and a second consultation on those rules are due in 2022. Again, the FCA, along with the UK Treasury, will be responsible for the implementation of the SDRs.
Where climate-related disclosures are concerned, from April 2022 large UK businesses will be required by law to include climate risks and opportunities in their annual reporting. These disclosures will be in line with the recommendations of the Task Force on Climate-related Financial Disclosures and implemented by the FCA.
Outside of the FCA, the Advertising Standards Authority (ASA) and the Competition and Markets Authority (CMA) are other regulators that have focused their sights on ESG – in particular, ‘greenwashing' claims (see question 1.4).
The Green Claims Code was launched by the CMA in September 2021 following consultation with businesses and consumers around green marketing. It applies throughout the supply chain, including to manufacturers, wholesalers, distributors and retailers, and to both goods and services during the whole lifecycle of a product. It is based on six key principles:
- Claims must be truthful and accurate: Broad terms such as ‘green' and ‘eco-friendly' may be deemed unclear and risk creating a more favourable impression than is justified.
- Claims must be clear and unambiguous: When using terms such as ‘biodegradable' and ‘recyclable', it must be made clear whether these refer to the product or the packaging, and to which parts.
- Claims must not omit or hide important relevant information: QR codes could be used to give more detailed information.
- Comparisons must be fair and meaningful: Comparative claims should be capable of being substantiated by transparent and accurate evidence that consumers can verify, and comparators should meet the same needs or be for the same purpose.
- Claims must consider the full lifecycle of the product or service: If it is stated that a product has "33% lower carbon impact", this must be based on the entire lifecycle (eg, including transportation).
- Claims must be substantiated: When using terms such as ‘cleanest' or ‘best', this must be backed up with evidence.
The CMA will be looking not just at consumer-facing activities: its remit extends to business-to-business sales where the principles should also be applied.
1.4 What is the regulators' general approach to ESG and the enforcement of the ESG framework in your jurisdiction?
Enforcement of the ESG framework in the United Kingdom has still to take shape, particularly for climate and non-financial related disclosures. However, ClientEarth has reported two UK listed companies (Just Eat Takeaway.com NV and Carnival plc) to the FCA for failing to report on climate change risk to their investors in their 2020 annual reports, and has asked the FCA to refer both companies for investigation.
In other areas, attempts are being made to provide more substantive enforcement capabilities to regulators.
For example, the requirement for a modern slavery statement. under the Modern Slavery Act, setting out steps taken to address modern slavery risks in a company's operations and supply chains, has historically been poorly adhered to by qualifying businesses. Only 60% of companies to which the legislation applies report on modern slavery and the majority fail to disclose risks in their sectors, meaning that responses are often formulaic and a tick-box exercise.
The UK anti-slavery commissioner reported last year that with an estimated 16 million victims of modern slavery working for the private sector globally, it is the responsibility of businesses to ensure that their commercial practices are not fuelling exploitation at home or abroad. The UK government have proposed amendments to the legislation. Proposals include:
- mandatory issues which must be covered in a modern slavery statement; and
- the inclusion of public bodies with a budget of £36 million or more, as well as qualifying private companies.
A private members bill introduced on 15 June 2021 would establish criminal offences for making false or incomplete modern slavery statements, with the potential for individual liability. Anyone responsible for a modern statement could potentially be liable, including a director. A defence would be available if all reasonable steps were taken to ensure the statement was accurate.
The bill proposes a fine of up to 4% of global turnover or £20 million, whichever is lower, and/or imprisonment of up to two years for the relevant individual. The legislation also proposes the same level of fine if a company received a warning from the commissioner but continued, for example, to source from suppliers which have failed to meet minimum levels of transparency. Currently, there is no financial penalty for failure to comply with the Modern Slavery Act. The penalty is limited to the secretary of state being empowered to bring proceedings for specific performance, but these powers have not been used since the act was passed in 2015.
In January 2022, plant-milk brand Oatly was ordered by the ASA not to repeat misleading ads and social media posts. The ads claimed that "Oatly generates 73% less CO₂e vs. milk" but this was only accurate when comparing with Oatly Barista Edition and not all Oatly products. The ASA had received 109 complaints about the advertising.
Pepsi also had an ASA complaint against it upheld. A bus shelter advert for Lipton Ice Tea included the words "Deliciously Refreshing, 100% Recycled*" and shots of the bottles with a recycling logo and text stating, "I'm 100% recycled plastic." The asterisk in the first statement led to text at the bottom of the poster which stated that the cap and label were excluded; but the ASA found that due to the small size of the text and its placement, it could be overlooked and the overall impression was that the whole bottle was made from recycled materials.
January 2022 also saw the CMA launch its first sector compliance review under its new Green Claims Code, spotlighting fashion retail. This sector accounts for approximately £54 billion of spending in the United Kingdom annually and is estimated to be responsible for between 2% and 8% of global carbon emissions.
Other sectors potentially up for review include:
- travel and transport; and
- fast-moving consumer goods (food and beverages, beauty products and cleaning products).
The CMA has warned, however, that it will take appropriate action against any non-compliant business even while reviews are ongoing.
Looking to the future, it is clear that regulatory bodies will be taking more action against businesses that make misleading environmental claims.
1.5 What private sector initiatives have been launched in your jurisdiction to complement the ESG framework?
Numerous ESG private sector initiatives have been launched, some examples of which are given below.
The British Standards Institute (although partly funded by the UK government) is developing a Sustainable Finance Programme which aims to encourage the wider uptake of sustainable finance practices, behaviours, thinking, products and services, while helping organisations from the financial sector to align themselves with the global UN Sustainable Development Goals.
The CFA Institute is a not-for-profit association of investment professionals. It published its Global ESG Disclosure Standards for Investment Products in November 2021, setting out principles for greater transparency in ESG disclosures and consistency of product-level disclosures.
2 Scope of application
2.1 Which entities are captured by the rules and codes that make up the principal elements of the ESG framework in your jurisdiction?
To implement the climate-related and environmental disclosure regime, the Financial Conduct Authority (FCA) has adopted a phased approach, with the largest firms needing to comply with the new ESG rules first. Different reporting requirements apply to different companies, depending on various factors:
- More detailed requirements apply to:
- quoted companies;
- premium listed companies; and
- large companies; and
- Less detailed requirements apply to medium-sized and small companies.
For asset managers and certain advisers with more than £50 billion assets under management, the UK Task Force on Climate-related Financial Disclosures (TCFD) disclosure requirements came into force on 1 January 2022. For other asset managers and certain advisers with more than £5 billion assets under management, the rules will apply from 1 January 2023.
There is also now a greater onus on pension scheme trustees in relation to disclosure requirements. They must now disclose information about their investment policies and the implementation of them. This includes:
- the account taken of ESG factors such as climate change; and
- information about stewardship policies and engagement activities.
These schemes must also:
- incorporate climate change risks and opportunities into their governance systems; and
- make specific disclosures about climate change targets and policies.
This is based on the TCFD.
2.2 How are entities in your jurisdiction that are not subject to specific rules or codes implementing ESG?
There is an increasing trend towards businesses that are not subject to specific rules or codes in the United Kingdom still seeking to develop environmental policies and ESG strategies, while voluntarily reporting on relevant ESG activity.
This is seen by companies as a form of futureproofing from eventual regulation and managing their corporate reputation. Given the increased scrutiny from stakeholders surrounding sustainable business practices, and in particular a company's reporting on climate change, engaging with ESG (whether voluntarily or not) is now seen as imperative.
There is also a trend towards ESG due diligence in transactions, whether from the parties involved or through the considerations of lenders when assessing exposure to future risk. Businesses are also seeking to enter into sustainability agreements on projects to ensure that ESG or sustainability goals are mutually achieved.
2.3 What are the principal ESG issues in your jurisdiction that are either part of the ESG framework or part of the implementation of ESG?
Asset managers are naturally trying to better integrate ESG concerns into their investment processes – to demonstrate how the investments they make can both mitigate ESG risks on the downside and capture ESG upsides, creating opportunities and supporting the transition to lower-carbon intensity.
This sits alongside the assessment of their own business operations from:
- an environmental perspective – mainly focused on net zero paths for both investment portfolios and for them as corporates; and
- a social perspective – significant awareness regarding the lack of diversity across gender, ethnicity and demographics. Much work has now been done on the gender side and ethnicity is now probably the greatest priority.
ESG performance is evaluated through ESG ratings provided by ratings agencies. However, one of the main issues here is that there are differences between how specific agencies weight aspects of sustainability; and companies/financial instruments may also not be comparable enough to measure each against another. It is quite clear that a key challenge for the implementation of ESG in the United Kingdom is the interchangeable use of key sustainable finance and ethical terms and the lack of agreed definitions.
The FCA is starting to focus on understanding ratings and has made it a priority to get to grips with the transparency of the methods surrounding such ratings.
3 Disclosure and transparency
3.1 What primary disclosure obligations relating to ESG apply in your jurisdiction?
The shift to hard (mandatory) law from soft (‘comply or explain') regulation/best practice can be seen in a number of key instruments:
- The Markets in Financial Instruments Directives (I and II) are key pieces of regulation in investment management – a legislative framework from the European Union to regulate markets and protect investors. These have been replicated and onshored in the United Kingdom as part of the Brexit transition.
- The EU Sustainable Financial Disclosures Regulation (SFDR) was introduced as part of the European Commission's Action Plan on Sustainable Finance (alongside the Taxonomy and Low Carbon Benchmarks Regulation). It is designed to provide a template so that asset managers can report on ESG integration/application at both a product and a corporate level. The United Kingdom is looking to implement its own Sustainable Disclosure Requirements, which are designed to retain parity with SFDR requirements.
The International Sustainability Standards Board was founded in 2021 and sets out and approves sustainability disclosure standards. It is still developing, but aims to work towards global sustainability standards.
3.2 What voluntary ESG disclosures are also commonly made in your jurisdiction?
Historically, the investment management industry has tended to focus on codes of governance – in particular, the Financial Reporting Council Stewardship Code, which is built on 12 principles as follows:
- Purpose and governance:
- Purpose, strategy and culture;
- Governance, resources and incentives;
- Conflicts of interest;
- Promotion of well-functioning markets;
- Review and assurance;
- Client and beneficiary needs;
- Stewardship, investment and ESG integration; and
- Monitoring of managers and service providers.
- Collaboration; and
- Exercise of rights and responsibilities:
- Exercise of rights and responsibilities
The application and reporting requirements to become a signatory to the UK Stewardship Code became much more rigorous in 2021.
Equally, initiatives and memberships are an important but voluntary aspect of changing behaviour by corporates (the Shareholder Rights Directive – now in its second iteration – is a little different).
3.3 What role is played in this regard by (a) the board and (b) other corporate bodies and/or officers?
The board is ultimately responsible for the accuracy and completeness of any disclosures made by a company. Legal, finance, compliance and risk functions are likely to be heavily involved in the sign-off processes.
In investment businesses, chief investment officers will assume responsibility for setting investment strategies and ensuring that these are followed; and will be answerable to the boards they report to, clients and customers and other stakeholders.
Chief risk officers may also have specific responsibilities in relation to the identification, assessment and management of specific risk, which might well include the development of an ESG policy and its suitability for specific customers and investors.
Trustees will also need to be aware of the extent to which funds for which they have regulatory responsibility, such as pension funds, are being managed in a way that is consistent with ESG. In such circumstances, trustees must ensure that they are receiving adequate reports in relation to ESG on:
- the impact of these issues– favourable and unfavourable – on the funds;
- the associated risks; and
- the steps taken to mitigate them.
3.4 What best practices should be considered in relation to ESG reporting and disclosure?
Best practices should include the following:
- a focus on aligning corporate objectives with investor requirements and expectations;
- greater transparency and alignment for asset owners and managers through the use of frameworks such as the Financial Reporting Council's 12 principles;
- an understanding of materiality and where the greatest impacts can be achieved, which is crucial for effective reporting;
- advice from relevant advisers on any areas of doubt as to what market expectations are;
- benchmarking of the company's reporting against that of similar businesses in the relevant sector;
- a focus in ESG disclosure on the company's risks and opportunities with sufficient potential to impact its long-term operational and financial performance in light of its business;
- clear definition in ESG reports of technical terms and terms that do not have a universally accepted definition;
- the flexibility to determine which ESG factors and related metrics are relevant to the company and what disclosure is meaningful for stakeholders;
- an explanation in ESG reports on why the company has selected the metrics and topics it ultimately discloses, including why management believes those metrics and topics are important to the company; and
- potentially, the inclusion in voluntary ESG reports of a description of the company's internal review and audit process or any external verification of the information.
4 Strategy and governance
4.1 How is ESG strategy typically designed and implemented in companies in your jurisdiction?
For asset managers, ESG strategy has mainly been designed at a process and product level. It is now recognised and understood that ESG concerns should be considered at a board level. However, ESG is often still approached as a separate concern/standalone issue, rather than one which is central to the company's mission or different imperatives (eg, regulatory, ethical, financial, people).
4.2 What role is played in this regard by (a) the board and (b) other corporate bodies and/or officers?
The board is ultimately responsible for approving the company's strategy and overseeing its implementation. Various internal functions will be involved in developing and proposing strategy. These apply to the company's overall corporate strategy, of which the ESG strategy will be part. It will be the board's decision as to how and in what way the ESG strategy will develop, and how much focus ESG will receive.
Pension fund trustees will need to ensure that they are fully cognisant of:
- the extent to which ESG concepts are followed;
- the impact – favourable and unfavourable – on the funds;
- the associated risks; and
- the steps taken to mitigate those risks.
4.3 What mechanisms are typically utilised to monitor the implementation of ESG strategy in your jurisdiction?
Internal monitoring will be conducted by management committees to ensure that corporate functions meet their agreed objectives. To the extent that the stated ESG strategy has been set objectives and targets, these should flow through management reporting. Committees such as investment committees, risk committees and audit committees are likely to be involved. This might involve input from other functions, such as compliance, risk and internal audit.
4.4 What role is played in this regard by (a) the board and (b) other corporate bodies and/or officers?
The board will ultimately be responsible for the achievement of the overall corporate strategy, of which the ESG strategy is part. This will be done through the board's role of overseeing corporate performance, so any divergence from strategy should eventually be flagged at board level. Other functions – including legal, finance, compliance, risk and internal audit – are likely to be involved in inputting into the achievement of the agreed strategy, including ESG strategy.
Pension fund trustees will have similar responsibilities and will need to seek advice from investment advisers, investment managers and audit and risk specialists.
4.5 How is executive compensation typically aligned with ESG strategy in your jurisdiction?
We are just starting to see examples of this emerge in investment management in the United Kingdom, which will follow in the footsteps of multinationals. For example, Apple introduced a modifier to executives' bonus pay-outs, adjusting them by up to 10% based on performance with respect to ‘Apple Values', including:
- diversity and inclusion;
- privacy; and
- supplier responsibility.
Shell – which in 2018 became the first oil major to link ESG to pay – in 2021 increased the weighting of the long-term targets around reducing its net carbon footprint to 20% from 10%.
4.6 What best practices should be considered in relation to the design and implementation of ESG strategy?
Businesses must ensure that the strategy comes from the board and is clearly articulated. The board then needs to engage stakeholders across the business to secure buy-in. What principles will the business stand for – and, just as importantly, what will it not stand for?
The board might start by looking at each of the ‘E', ‘S' and ‘G' elements in turn and trying to understand:
- which might be hygiene factors;
- where there are opportunities to influence;
- which will have tactical impact; and
- where the business wants to be transformative.
The strategy should strike a balance of aspiration with authenticity, and – absolutely essential – be built on a genuine understanding of sustainability issues. Combine focusing on areas where the business can truly make a difference with a better understanding of corporate responsibility:
- corporate social investment;
- corporate social responsibility; and
- creation of shared value.
This strategy should also be considered in the context of building competitive advantage and as a key pillar of long-term business planning.
5.1 What is the general approach of lenders towards ESG in your jurisdiction? What internal and external information regarding a prospective borrower will they typically consider in this regard?
Lenders in the United Kingdom fully recognise the importance of ESG in relation to their lending decisions. While environmental factors have been relevant in the UK finance market for some time, the COVID-19 pandemic particularly highlighted issues associated with disadvantaged social and economic circumstances. The effects of global temperature rises are also known also to disproportionately adversely affect those on lower incomes. Accordingly, there is a natural virtuous circle in lending that takes into account both social responsibility and benefits to the natural environment.
In addition, funders, corporate borrowers and investors and sponsors know that there is, and will continue to be, greater accountability imposed on them in respect of their ESG profiles. As a result, they are looking to improve environmental performance and outcomes, and achieve socially beneficial results from their businesses. Funders are seeking to meet their investment and return objectives while encouraging and rewarding positive borrower behaviours; and borrowers are looking to access the benefits available in the market (eg, the availability of facilities specifically tailored for green or social projects, as well as improved financial terms) by demonstrating that their business activities will be carried on in an ESG-positive manner.
Two types of loans have emerged in the market to deal with these considerations:
- facilities which have as their key characteristic a requirement for the proceeds of the loans to be applied for a particular and restricted purpose. In this category, there are two distinct products – green loans and social loans; and
- loans which indirectly focus on the sustainability characteristics of the borrower's business – sustainability-linked loans.
Green and social loans may be utilised to finance, for example:
- products that aim to control pollution;
- clean energy projects;
- affordable housing; or
- access to vocational training for those from disadvantaged socio-economic backgrounds.
The funding usually may be used only to fund the agreed green or social project.
Sustainability-linked loans usually have no restrictions as to the use of proceeds. Their purpose is to encourage (through opening access to credit on improved commercial terms) the achievement of sustainability, positive governance or beneficial environmental effects. However, the proceeds may be used for general corporate purposes, capital expenditure or future acquisitions.
The type and scope of information that lenders will require from borrowers will depend on which of these two types of loans is involved. For green and social loans, there will be very close scrutiny of information in order to ensure that the relevant eligibility criteria can be met – in particular, around the use of proceeds. A borrower will need to provide information relating to:
- its green and sustainability, or social, objectives;
- the process by which it determines how the project to be financed fits within one of the eligible categories set out in the Green Loan Principles or Social Loan Principles (on which see further below); and
- the related eligibility criteria.
The information should be contextualised within the group's overall sustainability strategy, policy and objectives. Lenders should also be provided with detail of relevant certifications or industry standards that are relevant to the borrower's application and/or proposed project.
For sustainability-linked loans, borrowers should clearly communicate to lenders:
- the rationale for the selection of key performance indicators (KPIs) on sustainability, which will be used to determine the pricing applicable to the loan; and
- their motivation for sustainability performance targets (SPTs) (ie, ambition level, consistency with overall sustainability objectives, benchmarking approach and how the borrower intends to achieve such SPTs).
Again, borrowers will be expected to:
- position this information within the context of their overarching sustainability strategy, policy and objectives; and
- disclose to lenders any sustainability standards or certifications to which they are seeking to conform.
5.2 Are bonds/loans that are marketed as green bonds/loans, social bonds/loans, sustainability bonds/loans or similar a feature of the markets in your jurisdiction?
Yes, ESG-related loans, specifically marketed as such, are a feature of the UK finance market. Question 5.1 outlines the broad features of this type of finance product.
5.3 What key developments have taken place in the structuring of these instruments in your jurisdiction?
Industry-wide guidance: A number of key guidance documents applicable to the UK ESG finance have been produced:
- The UK Loan Market Association (LMA), the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association have published (and maintained and updated) the Green Loan Principles; and
- The LMA has also issued similar principles relating to social loans (the Social Loan Principles) and sustainability-linked loans (the Sustainability Linked Loan Principles).
Each of these sets of principles contains market standards and guidelines and recommended best practices for the relevant lending products. They also complement the earlier International Capital Market Association's bond principles for each credit category. The loan and bond principles are designed to ensure consistency across the wholesale loan and bond markets, to allow for refinancing between the different markets, among other things.
Documentation: While there is currently no LMA standard drafting on ESG loans, there have been some attempts to introduce standard terms and guidance has been provided on certain key documentation points. As a useful example, reference should be made to The Chancery Lane's Green Loan Starter Pack, which has recommended drafting guidance and suggested ESG-related definitions and clauses, designed to be integrated into the LMA facility templates (Green Loan "Starter Pack" | The Chancery Lane Project).
As a result, common features in UK ESG-related financings include the following:
- Designated accounts for proceeds: A green or social loan may take the form of one or more tranches of a loan facility. In such cases, the relevant tranche must be clearly designated, with proceeds usually being credited to a separate account.
- Margin ratchets: Sustainability-linked loans typically include a margin ratchet, which is linked to the performance of the borrower against predetermined KPIs. If the borrower meets the SPTs based on the agreed KPIs, the margin will decrease. Pricing adjustments are often two-way so that if a borrower fails to meet the SPTs, the margin will increase.
- Reporting: For green and social loans, borrowers should keep up-to-date information on the use of proceeds which should be renewed at least annually and as necessary in the event of material developments.
- Events of default: It is generally accepted that there should be no breach/lender acceleration rights following directly from a breach of any agreed ESG-related terms. However, inaccurate reporting (or failure to deliver information) – including on SPTs, for example – might constitute a breach as part of the facility's general information package undertakings and representations.
5.4 What best practices should be considered in relation to ESG in the financing context?
The most useful guide currently available on best practice is the LMA and the European Leveraged Finance Association's combined Best Practice Guide to Sustainability Linked Leverage Loans. While this is restricted to leveraged finance and the specific application of the Sustainability Linked Loan Principles to that market, it is a very useful guide to the general principles to be adopted in ESG-related financings generally. Key themes identified include the following:
- transparency and integrity of the loan product – leading to the recommended use of external ESG rating providers, consultants, sustainability coordinators and reviewers. This is focused on addressing so-called ‘greenwashing' or ‘sustainability-washing';
- early and full disclosure of ESG-related diligence information;
- measurement of sustainability performance against predefined SPTs, by reference to predefined KPIs. SPTs should be ambitious; and KPIs should be material to the borrower's core sustainability and business strategy, and address relevant ESG challenges of the industry sector.
6 ESG activism
6.1 What role do institutional investors and other activist shareholders play in shaping ESG in your jurisdiction?
Ultimately, regulation and investor behaviour are the two levers which force asset managers to change. Interpretation and understanding of fiduciary duties are evolving, especially within the context of climate change and its likely – potentially drastic – impacts on asset prices in the long term. Environmental responsibility is increasingly considered and institutional investors expect asset managers to have clear fiduciary cultures and board-level sustainability strategy.
6.2 How do activist shareholders typically seek to exert influence on corporations in your jurisdiction in relation to ESG?
Take voting seriously! The focus on voting records from asset managers should be increased through greater visibility and evidence of reporting and action taking. Engagement policies and examples are expected. More collaborative action from these same asset managers is also happening – consolidation across the investment industry is creating scale that can then be exerted on corporates. We are also seeing activist shareholders flex their influence beyond voting to affect change at board level of corporations, including forcing reshuffles of executive teams.
6.3 Which areas of ESG are shareholders currently focused on?
This varies significantly around the world. In the United Kingdom and across Europe, the focus is more on environmental issues. This is most clearly seen in climate change, but increasingly biodiversity as well. Climate change tends not to be a political issue, which makes driving change easier. Corporate issues such as fraud are beginning to come to the fore as shareholders start to understand their impacts more clearly. The pandemic has clearly had an impact on the level of activism generally, with levels having dipped; but they are on the rise again, with other issues coming to the fore including human rights and workplace safety.
6.4 Have there been any high-profile instances of ESG activism in recent years?
North Sea oil and gas company Hurricane Energy's relationship with activist investor Crystal Amber has been notably challenging. In 2021 Crystal Amber (with a 28.2% stake in the company) made a requisition notice calling for the ousting of five non-executive directors, claiming they had "demonstrably failed to protect" shareholders' interests. The directors left of their own accord but more recently Crystal Amber has requested further changes at the top, requiring an executive team reshuffle.
In the run-up to COP26, which took place in Glasgow in November 2021, Police Scotland prepared for major civic disruption, which failed to materialise. However, at the same time, the civil courts in Scotland saw increased activity directly related to the climate change debate. Greenpeace brought and ultimately lost a legal case in the Court of Session against the UK government challenging a permit issued to develop an oil field, claiming myriad failures in the public consultation process.
Along with Greenpeace, other activists – including Extinction Rebellion and Insulate Britain – have used civil disobedience to affect civic disruption, with activities including people gluing themselves to buildings and roads.
6.5 Is ESG activism increasing or decreasing in your jurisdiction? How and why?
It is increasing, with a pronounced uptick arising from the COVID-19 pandemic. Developing regulation and a need for transparency are feeding and inflaming already informed and prepared activists (both shareholder activists and campaigning non-governmental organisations), requiring corporations to be prepared also. Organisations such as ShareAction are starting to demonstrate the power of collaborative action for investors. The conversation is beginning to shift from divestment to engagement – an evolution which recognises the complexities and nuances involved in trying to transition to a greener economy.
7 Other stakeholders and rights holders
7.1 What role do stakeholders or rights holders (eg, employees, pensioners, creditors, customers, suppliers, and Indigenous communities) play in shaping ESG in your jurisdiction? What influence can they exert on a company?
The increasing popularity of licences and accreditation such as B Corp status has led to the inclusion of a much wider range of stakeholders in decision making than ever before.
ESG is heavily impacting the buyer/supplier relationship as organisations seek to ensure that they have an ethical supply chain. ESG compliance is becoming a common requirement in procurement processes and recognised accreditations – such as B Corp status or International Standards Organization certification – can be critical to winning work and new customers. Market leaders in ESG are also asking bidders to provide ratings from external platforms, such as EcoVadis, as part of the evaluation criteria.
Employees increasingly have a powerful voice in shaping the direction that a business takes and the impact of this is influencing recruitment and retention strategies. There is pressure in particular from millennials and Generation Z, who have demonstrated a strong social conscience and are telling employers that they expect more. Clearer messaging around companies' ESG activities is featuring in recruitment to attract new talent, and employee benefits are being refreshed to include more sustainable elements such as electric vehicle allowances and access to personal carbon trackers. Following the pandemic, wellbeing has risen up the ESG agenda and how companies treat their people is coming under greater scrutiny.
The customer experience is crucial and there is a growing expectation that organisations will improve their ESG credentials. Social media and technology have effectively turned everyone into journalists, so customers can share negative experiences with ease, giving them greater exposure than previously possible. Society is also holding those who fail to meet their expectations to account, with an increase in consumers formally reporting greenwashing to the Advertising Standards Authority – for example, Pepsi and Oatly in relation to misleading sustainability statements made in their advertising (see question 1.4).
8 Trends and predictions
8.1 How would you describe the current ESG landscape and prevailing trends in your jurisdiction? Are any new developments anticipated in the next 12 months, including any proposed legislative reforms?
Although ESG has been around for some time, it has evolved at pace and is fast becoming recognised as something that should sit on every corporate board agenda – whether documented formally as ESG or under other guises such as ‘sustainability', ‘corporate social responsibility', ‘staff wellbeing' or ‘net zero'.
Firms that are taking ESG seriously have heavily invested in their ESG credentials, with a growing trend for B Corp or International Standards Organization-type certifications; and there has been an increase in dual or dedicated ESG roles at senior management or board level. Separate ESG reports to demonstrate willingness and a commitment to ESG goals are also beginning to feature more regularly as part of the annual reporting process.
Looking forward, disclosure requirements for public companies continue to be become increasingly robust; those for private companies lag some way behind, but are nonetheless evolving. The proposed Sustainable Disclosure Requirements are still to be published; although, with a second consultation required on the final rules, it is unlikely they will be introduced within the next 12 months.
The Financial Conduct Authority has issued new rules for listed companies to improve transparency on the diversity of company boards and executive management. Listed companies will need to report on the representation of women and ethnic minorities on their boards and executive management and performance against diversity targets, including an explanation of why any targets have not been met. The new rules will apply to annual reports for financial years starting on or after 1 April 2022.
Modern slavery will come back into the spotlight this year with proposed changes to the Modern Slavery Act 2015 expected to come into force before the September 2022 reporting deadline. Avoiding claims of greenwashing will also be a strong focus – not least since the Competition and Markets Authority's introduction of the Green Claims Code with offences and penalties for companies that fall foul of the required principles.
From 2023, UK financial institutions and listed companies will be required to publish net-zero transition plans under rules being developed by the UK Transition Plan Taskforce. These plans will provide details on how companies will approach decarbonisation as the UK economy moves towards its 2050 net zero target.
9 Tips and traps
9.1 What are your top tips for effective ESG implementation in your jurisdiction and what potential sticking points would you highlight?
Making a success of ESG involves looking at the longer term and perhaps taking difficult decisions about how to change a business dramatically. This in itself requires very careful analysis and forecasting. The remit of a board is vast, the common board agenda is already very crowded and ESG can be linked to many standing agenda points such as workforce, culture and risk. The pressure to cover operational matters often means there is less time to focus on ESG strategy and this can be swept into broader topics rather than being looked at specifically and holistically.
For any board, achieving a balance between operational review and strategic development is essential, with ESG as a critical element of that strategy. Operational review is about processes to protect value; while strategy is focused on growing value. Both are important; but without forward-looking analysis, the value protected by compliance can easily be eroded. It is paramount to take a longer-term view and embed ESG fully into the corporate strategy to minimise risk and ensure good governance. Identifying a role with a focused responsibility for ESG will also ensure that this remains a priority, and that the strategy is driven forward across the business.
Achieving wide-ranging diversity within a board – having the right mix of people that can optimise decision making – will also benefit an ESG strategy, as well as the organisation's own ESG credentials. Diversity on boards is a much-discussed topic, with a strong focus on gender and ethnicity. However, there are advantages of having an even wider range of diversity represented on a board. In particular, age diversity is increasingly recognised as a positive way to enhance a board's performance, with the need to understand customers' needs becoming increasingly important in the digital age and following the COVID-19 pandemic. Demand patterns are continually shifting and becoming less predictable, so fully understanding what the end customer wants is critical to success, in both the short and longer term. It is often the younger generations that are effectively driving the ESG agenda, so their input is all the more critical.
When taking ESG-related decisions for the long term, the quality of information shared with the board is important, as they need to fully understand the issues and the implications of their decisions. Board packs can be challenging due to the volume of information they need to cover, so it's essential to review how best to get quality information into the boardroom. As the pressure on directors' time increases, the need for high-quality information that can be easily digested becomes all the more essential. With markets changing in response to different factors, standard monthly management information may no longer be sufficient; so taking a forward-looking approach to consider what is coming down the line is as important as historical data.
Forward planning for changes to regulations and new developments can also be beneficial. Taking early action can help with integrating them into long-term strategy and understanding how they may impact on an organisation. This is particularly relevant where they may have an operational impact on the business, such as net-zero plans, which will require work to be done to be compliant.
Don't get stuck on the ‘E'. The climate crisis has brought environmental impact and net-zero commitments to the fore, and the urgent need to reduce carbon emissions and improve sustainability means that this is often the dominating factor of ESG. However, it is important to ensure that your ESG approach is balanced, with appropriate focus applied to all areas.
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