Greening Finance: a Roadmap to Sustainable Investing", the UK government's new policy paper from HM Treasury, has arrived, providing the UK its map for the next few years, and setting out the next stages of the UK's ESG journey.
The Roadmap introduces disclosure requirements designed to "set the record straight on what is sustainable, and which companies are competently managing the transition to a sustainable economy." At COP26, Rishi Sunak promised to make the UK the world's first "net zero-aligned financial centre." The rhetoric is clear: the UK Government's ultimate aim is to ensure that financial institutions and other investors deploy capital to help the UK meet its net zero commitments and wider sustainability objectives. It expects investment decisions and financial flows to be the carrot and stick that guide the UK economy towards such goals. New regulation is designed to enable and equip that transition but what does it mean for registered providers (RPs)?
All RPs, large and small, will soon be required by law and/or investors to make 'sustainability disclosures' at some level. These disclosures will be confirmations about their business and its impact on climate change and other sustainability issues. Any RP which seeks funding will ultimately need to show, in a measurable way, that they are having a positive impact on the UK's sustainability agenda.
"Greening the Financial System" in three phases:
The Roadmap has 3 phases to 'green the financial system'. All will require legislation:
Phase 1 is ensuring that investors have 'decision-useful' information about sustainability from the entities that they finance or invest in. The Roadmap raises concerns about greenwashing and notes that voluntary sustainability disclosure regimes are currently widespread but often inconsistent; information from different organisations is not always comparable. The focus is on decision-useful, comparable disclosure which shows a positive ongoing impact on sustainability. This is regarded as crucial and underpins much of the Roadmap. Disclosure will sit within a framework known as the Sustainability Disclosure Requirements or SDR which will bring together existing sustainability-related disclosure requirements in a targeted, specific and integrated way. Whilst a degree of interpretation on a sector-wide basis may be useful, ultimately each RP will be responsible for its own compliance.
Phase 2 is a call to action, to ensure that business and financial decisions are made using SDR and with sustainability in mind.
Phase 3 focuses on investor stewardship, ensuring that financial flows have indeed shifted to help the UK meets its net-zero commitment and wider sustainability targets.
Whilst this note focuses on Phase 1, it is important to be aware of all three, as the targets set by Phase 3 will inform how Phase 1 is shaped and implemented. The ultimate aim is to ensure that businesses take sustainability into account in all of their decision making, and that they are able to report this in a consistent and uniform way, which investment managers and investors can then use to ensure that capital is applied to sustainability goals.
The Roadmap aims to help businesses prepare for what they will need to report, and when by. RPs will need to have strong governance and risk policies in place, which are understood and operate throughout their businesses, to be confident they can meet and report to the requirements.
SDR disclosure will be applied to RPs in three ways:
- Corporate disclosures - for the moment, it is unclear whether RPs will be directly regulated (this position should be monitored as legislation evolves). As is currently the case, most RPs will need to include sustainability disclosures in annual reports. Irrespective, the SDR will apply to any RP who contractually agrees in its finance arrangements to comply with SDR obligations (which is likely to become the norm). Further, the Roadmap states that, subject to consultation, SDR will apply to all companies within 2-3 years. We expect this means all companies, unless they are exempt from producing statutory accounts, which would mean that almost all RPs will be subject to the new requirements.
- Asset manager and asset owner disclosure - those who manage or administer assets on behalf of clients and consumers (including RPs) will need to disclose how they take sustainability into account, in order to help consumers decide whether their assets are being managed according to their sustainability preferences. Therefore sponsors, arrangers and funders, including pension funds, will need information from issuers and borrowers to be able to make such SDR disclosures; which will bring issuers and borrowers into the SDR disclosure regime through this indirect route.The Government intends SDR to change the flow of capital to positively impact and promote sustainability. Loans and other financial products typically include terms that allow them to be packaged up and sold to other investors. To ensure debt remains saleable, funding agreements are likely to oblige borrowers and issuers to report in the same/similar way to disclosures by larger entities.
- Investment product disclosure - creators of investment products will be required to report on the sustainability of that product. The FCA is consulting on a new sustainable investment labelling regime, designed to help consumers select investment products. The corporate disclosures (i.e. those provided by issuers and borrowers, as set out above) will be used to provide the information to consumers, based on their sustainability characteristics.
In summary: Accordingly, ll RPs should expect to be required to make SDR disclosures within the medium term.
How will SDR be formulated? What is the detail of SDR?
- ISSB-led: SDR will be based on global standards. The UK Government intends to adopt and endorse standards to be issued by the International Sustainability Standards Board (ISSB), which was established by the International Financial Reporting Standards (IFRS) Foundation in November 2021. The ISSB will develop an international climate disclosure standard in early 2022 (based mostly on the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations), which the Government proposes to incorporate into the SDR and then develop disclosure standards for broader sustainability factors. Disclosure against established voluntary standards is encouraged for the time being. To avoid double reporting, regulation will be needed to ensure disclosure under ISSB standards is consistent with existing and future requirements.
- Build on the TCFD: these new ISSB standards are expected to build on the four pillars currently set by the TCFD. Whilst there is currently no mandatory requirement for RPs to report on the TCFD, the sector's Sustainability Reporting Standard for Social Housing (SRS) includes provision for RPs to report on TCFD alignment. Compliance with the ISSB standards will require strong governance related to sustainability, together with a strategy and risk management regime for identifying and dealing with risks, opportunities and impacts related to sustainability. Metrics should be used with reporting on the performance of targets. As the UK Government has previously stated that it intends to make TCFD-aligned disclosures fully mandatory across the UK economy by 2025, readying reporting in this direction already seems necessary.
- ...add the UK Taxonomy: the UK will then build on the ISSB standards (and TCFDs), which focus on information that is material to investors, by requiring disclosure within SDR on how entities impact the environment, using the UK's Green Taxonomy (the UK Taxonomy), which is in the process of being developed. It appears that the UK Taxonomy will be based on existing international taxonomies, including the EU's Green Taxonomy, although this may change over time. Like the SRS, the UK Taxonomy will seek to promote consistency and clarity of climate-related information, and reduce risks of greenwashing.
- "E" first: whilst the initial focus will be on climate change disclosures and the governance needed to be able to comply, broader sustainability goals, the UK Taxonomy and the ISSB standards are expected to expand to include wider sustainability goals, plus the "S" over time.
- Consistent across all sectors: SDR will use the same framework and metrics for disclosures on sustainability, across the economy, to apply to all sectors in a consistent way.
In summary: the new rules will be based on an internationally focused non-sector specific regulatory framework and in many cases, compliance will be effectively mandatory rather than voluntary (even before direct application) as it will be applied indirectly downstream by the financial markets. The Roadmap wants it to be "a fully integrated regime that works smoothly across all sectors of the economy"; watch this space.
SDR will also require "certain firms" to publish detailed and credible climate transition plans to reach net-zero emissions by 2050 (or explain why they have not done so). The Roadmap states the Government's expectation that the publication of climate transition plans will "become the norm across the economy".
Long-term reporting is nothing new for RPs. As the net-zero deadline of 2050 now falls within 30 year business plans, it seems sensible for RPs to incorporate their climate transition plans into these documents; particularly given the business critical nature of the risks posed by climate change and transition planning.
The EU has already developed an equivalent of the SDR and its own taxonomy (the EU SFDR and EU Taxonomy). The UK regime is likely to be similar, but the regimes may well diverge as they evolve.
RPs are not yet directly regulated by the EU SFDR but indirect regulation is likely to arise where European regulated entities hold an RP's debt. Therefore, RPs are likely to be indirectly regulated by the EU SFDR and EU Taxonomy in the same way as described for the UK regime at paragraphs 2 and 3 of "SDR disclosure will be applied to RPs in three ways" above.
Application of SDR and EU SFDR to existing funding arrangements
RPs should carefully consider how they could be affected by this legislation now, and how it might evolve in the future. For example, certain finance facilities have provisions which could be used by funders who no longer wish to hold debt where the borrower/issuer is insufficiently compliant with regulations going forwards. As well as considering reputational risk, RPs should take care to maintain their relationships with funders in this regard and consider whether compliance with legislation is prudent, irrespective of the exact requirements to comply.
The only firm timetable released for SDR so far is the consultation timetable at page 19 of the Roadmap. RPs should diarise these now. It is critical the sector responds to such consultations (either individually or through representative groups such as the NatFed and the SRS) as any standards adopted will be non-sector specific by design.
Affordable housing is increasingly seen as "low hanging fruit" for the financial markets to meet sustainability obligations. It is therefore critical that the sector participates in the process to these positive environmental, social and governance changes.
Regulation of ESG data and ratings providers
Given the concerns about greenwashing and desire for comparable information, the Government also notes in the Roadmap that it is considering bringing ESG data and rating providers into the scope of FCA authorisation and regulation. More information is to be made available in 2022. In summary, the Government's concerns seem to focus on data gaps and broad assumptions in existing opinions; the aim will be to tighten up opinions and provision of ESG data.
What should RPs do now?
Governance is key, as is having a strategy to identify, assess and manage sustainability related risks and goals. Metrics and targets will need to be understood and applied throughout the business. RPs will need to understand SDR and the UK Green Taxonomy and how they relate to their own business. Very soon, it will no longer be possible to consider compliance with ESG criteria as a voluntary matter or a 'nice to have'; it will need to be business as usual. All entities, including RPs, should be collating data and readying operational systems and business teams to prepare and easily access the information that will be required for this enhanced disclosure, if they have not already done so. RPs should keep working with advisors who can apply the requirements to decision making throughout their businesses.
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