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As financial institutions get to grips with the opportunities and challenges presented by the constantly evolving ESG landscape, we set out below the top five trends that we are seeing in this space. Firms should take note of these trends as they are likely to influence the ESG agenda into 2023 and beyond.
Trend 1 – Impact of the energy crisis on the ESG agenda
The global economy is facing an energy crisis, exacerbated by the war in Ukraine and Russia's shutdown of gas supplies into Europe. And the crisis is expected to worsen as winter approaches. Europe's energy security, or lack thereof, has been in the spotlight in particular, after years of reliance on Russian gas. Natural gas has been a key part of European countries' energy make-up and, given its status as a so-called 'transitory' fuel, has played a key role in their sustainability plans.
Following the shutdown in supply, Europe now has to look elsewhere to meet its needs. Hence the shift to thermal coal (at least for a period), reversing a long period of decline in European coal imports. In September 2022, the UK also lifted the moratorium on shale gas fracking and confirmed support for a new round of oil and gas licensing to be issued by the North Sea Transition Authority in October 2022.
The bottom line is that emissions and reliance on fossil fuels may increase for the foreseeable future, which calls into question countries' abilities to meet their net zero commitments.
Whither the ESG agenda?
With the energy crisis in mind, there is a sizeable elephant in the room, namely: what about the ESG agenda? Will governments and regulators de-prioritise, at least in the short term?
There has been some nervousness surrounding the new UK Government's commitment to sustainability, particularly in light of the news on fracking and the North Sea licenses. The sustainability views of some members of the cabinet have also raised some eyebrows, although this has been tempered to a degree by Chancellor Kwasi Kwarteng's involvement in the UK's Net Zero Strategy and the energy transition more broadly. There has been a general nervousness in the industry that the focus on "economic growth" and deregulation by the new government may result in ESG regulation being perceived as yet more red tape hampering growth. The cost of living crisis will also impact how budgets are prioritised at least in the short term and moving to a green economy comes at a price (the Committee on Climate Change estimates that UK low-carbon investment each year will have to increase from around £10 billion in 2020 to around £50 billion by 2030 to deliver).
The industry's nervousness culminated in a letter signed by one hundred UK business and finance leaders last month, which put forward the economic case for prioritising net zero.
On the regulatory front, whilst it is not expected that Prime Minister Truss will reverse the UK's net zero commitment or that regulatory developments will be halted altogether, we have not yet seen the long-awaited consultation on the Sustainability Disclosure Requirements ("SDR") – due autumn 2022 – or the anticipated consultation on technical screening criteria" ("TSC") for the first two of the six environmental objectives under the UK Green Taxonomy, on which consultation was expected to be held this year. (There is a possibility that publication may be delayed: In its Advice on the development of a UK Green Taxonomy published on 10 October 2022, the Green Technical Advisory Group ("GTAG") recommends that the UK Government reconsiders its original timeline so that when the UK Green Taxonomy is published for consultation, the amendments outlined in its advice and subsequent GTAG advice papers, regarding issues such as do no significant harm and missing TSC, can be fully addressed.) There have also been rumours that the UK Green Taxonomy TSC may potentially emerge in the form of a voluntary code.
Nevertheless, there has been some recent movement in the UK with the publication of a call for evidence, published on 29 September 2022 by the Department for Business, Energy and Industrial Strategy ("BEIS"), seeking input on the UK Net Zero Review. Whilst not focused on financial services specifically, it provides an opportunity for engagement and the deadline for feedback is coming up quickly, on 27 October 2022.
In short, the future of ESG is not plain sailing and we should expect some bumps along the way.
One such bump at the moment is the discontent within Mark Carney's Glasgow Financial Alliance for Net Zero ("GFANZ"), whereby it has been reported that some key US banks are threatening to leave on the basis that there is a potential risk that they may be in breach of certain competition laws if they collectively decide to stop financing fossil fuels. Similar fears of so-called "covert green cartels" are also being raised in Europe, a charge recently levelled at Race to Zero, a UN-backed body that sets the standards for the major corporate net zero alliances.
Another possible bump may arise if investors and portfolio managers begin to re-evaluate their ESG priorities. The energy crisis has arguably highlighted the fact that greater capital expenditure in fossil fuels is needed, and, ultimately, who will finance this?
It remains to be seen what effect, if any, the energy crisis will have on the EU and UK's ESG agenda, particularly as the focus for governments will continue to be to secure energy crisis packages. Meanwhile, across the Atlantic, President Joe Biden's Inflation Reduction Act has paved the way for $369bn in climate and energy funding, in addition to the $110bn of funding secured last year.
Trend 2 – Increasing focus on the 'S' and 'G' in ESG
In a nutshell
Despite the uncertainties caused by the energy crisis, we are nevertheless seeing some positive developments, in particular increasing focus on the 'S' (social) and 'G' (governance) in ESG. To date, the focus has been on the 'E' (environmental) and in particular climate change, illustrated by initiatives such as the EU Taxonomy, EU Sustainable Finance Disclosure Regulation ("SFDR") and the Low Carbon Benchmarks Regulations, which the UK helped put together prior to Brexit.
However, we are now seeing increasing emphasis on the 'S' and the 'G' and a shift in the 'E' as well.
The 'E' is moving beyond just climate change to areas such as biodiversity, supply chain concerns and deforestation. For example, on 13 September 2022, the European Parliament adopted amendments to the European Commission's proposal for a so-called Deforestation Regulation, which is now expected to capture financial institutions, and according to the current version would prohibit them from doing business with any company/group involved in deforestation, whether inside or outside of the EU. Meanwhile, work continues by the EU Platform on Sustainable Finance on the TSC for the other four environmental objectives in EU Taxonomy (Sustainable use and protection of water and marine resources; Transition to a circular economy; Pollution prevention and control; and Protection and restoration of biodiversity and ecosystems). The Taskforce on Nature-related Financial Disclosures ("TNFD") published a beta version of its nature-related risk-management and disclosure framework in March 2022 and is currently planning on publishing its final recommendations in September 2023.
Various factors – such as Covid-19, the energy and cost of living crisis, high inflation, the human impact of climate change and the transition to a green economy – have shifted the focus to social issues such as human rights, workers' rights and wellbeing across the supply and value chains. And the impact of the climate transition on emerging markets is well understood, as demonstrated by the commitments made during COP26 to support emerging market communities in the process.
In February 2022, the EU Platform on Sustainable Finance published its final report on a social taxonomy, which set out a proposed structure for a social taxonomy, along similar but not identical lines to the environment-focused EU Taxonomy.
EU regulators have also proposed the Corporate Sustainability Reporting Directive ("CSRD") and Corporate Sustainability Due Diligence Directive ("CSDDD"). Broadly speaking, the CSRD – which will be formally adopted in the next two to three months – extends the scope of non-financial reporting requirements, provides a common standard for EU sustainability reporting and introduces an EU-wide assurance requirement. The CSDDD on the other hand imposes due diligence requirements on large EU companies and non-EU companies with significant EU activity to address adverse human rights and environmental impacts in their operations, subsidiaries and value chains. The European Financial Reporting Advisory Group ("EFRAG") is also currently working on standards including those in relation to own workforce, workers in the value chain and other work-related rights.
In the UK, the Financial Conduct Authority ("FCA"), Prudential Regulation Authority ("PRA") and Bank of England are showing greater focus on diversity & inclusion ("D&I"), having published a discussion paper in July 2021 with the aim of kickstarting discussion on how the financial services sector alongside the regulators can "accelerate the pace of meaningful change" in improving D&I in financial services firms. The FCA and PRA have since noted that they intend to consult on more detailed proposals and publish a policy statement in 2022.
In April 2022, the FCA also published its final rules requiring listed companies to report information and disclose against targets on the representation of women and ethnic minorities on their boards and executive management, making it easier for investors to see the diversity of their senior leadership teams.
On governance, we are seeing a shift from regulating to ensure transparency through disclosures, to a focus on how financial services organisations integrate ESG in their investment decisions-making, systems and controls, governance and prudential frameworks.
In August 2021 the EU introduced six delegated regulations and directives integrating sustainability into the UCITS Directive, AIFMD, MiFID II, Solvency II and the IDD. At its core, the legislation integrates sustainability issues into the decisions made by financial institutions.
To take the changes to MiFID II as an example, changes were made to require sustainability considerations to be embedded in the organisational, risk management and conflicts frameworks of firms, as well as in their product governance and suitability assessment frameworks (see related HSF briefing on practical steps that firms should take in implementing the changes to MiFID and IDD here). The MiFID II suitability requirements applied from 2 August 2022 whilst the product governance requirements apply from 22 November 2022. Relevant firms should also note ESMA's recently published guidelines in respect of suitability requirements and current consultation on MiFID II product governance guidelines.
One example from the UK is HM Treasury's ("HMT") Roadmap to Sustainable Investing published in October 2021 which stressed the importance of investor stewardship in holding companies to account for the feasibility and credibility of their net-zero commitments, and their transition strategies to align their business models with a net-zero economy.
There has also been a real focus on transition plans both in the UK and the EU. With the UK including these within the proposed SDR and the EU within the CSDDD, regulators and investors can scrutinise how firms are implementing their ESG strategies. However, to what extent are regulatory approaches aligned?
Trend 3 – Divergence and Convergence in international approaches
We are seeing various attempts to standardise approaches to ESG on an international level. ESG is a global issue, after all.
Efforts on international consistency and harmonisation can be seen in the work of the Task Force on Climate Related Financial Disclosures ("TCFD"), the International Financial Reporting Standards ("IFRS"), International Sustainability Standards Board's ("ISSB") and GFANZ. But these are for the most part mere voluntary standards. In reality, divergence is the norm.
Distinct approaches to the regulation of ESG have emerged in the UK and EU. Broadly speaking, the EU have taken an expansive and prescriptive approach, pushing through an initial sustainability package including the EU Taxonomy, SFDR and Low Carbon Benchmarks Regulations, in addition to more recent initiatives such as the CSRD and CSDDD.
Whilst it initially played a role in designing the EU framework, the UK has not onshored all EU rules in this space. It has instead opted for a more targeted approach by initially focussing on voluntary disclosures – for example via the TCFD – and then moving to a more mandatory approach with TCFD reporting for listed companies and for certain fund managers from January 2022, with the TCFD eventually becoming mandatory for large companies and financial institutions by 2025; as noted above, the next push is to implement the SDR framework as well as a UK Green Taxonomy – so the direction of travel is for more mandatory sustainability requirements some of which will be modelled to an extent on the EU versions.
However, the trend for divergence between the UK and EU is likely to continue.
Whilst parts of the EU Taxonomy have been onshored, the UK is designing its own version. The GTAG Advice from 10 October 2022 suggests divergence in targeted areas between the EU and eventual UK TSC on the first two UK Green Taxonomy objectives. It remains to be seen whether HMT's eventual consultation will take that on board but it is likely that it will given that the GTAG was launched by the UK government in 2021 with the express purpose to provide independent advice to the government on developing and implementing the UK Green Taxonomy.
So whilst there will be a degree of convergence between the EU and UK green Taxonomies (in particular as regulators recognise that divergence creates a fragmented regulatory landscape), divergence will remain a trend. In the context of the SDR, which will be loosely modelled on the EU SFDR, the FCA has acknowledged that many UK firms and products are subject to SFDR in respect of their cross-border EU business and, in its discussion paper on the SDR and investment labels, stated its willingness to consider the extent to which its rules can "remain as consistent as possible with SFDR, while reflecting the needs of the UK market". That said SDR will not be a match for match with the EU SFDR. Also, the UK Government has expressly stated that it will not adopt the CSDDD and it awaits to be seen whether the UK will follow suit and upgrade the existing Non-Financial Reporting Directive ("NFRD") requirements in a similar vein to the CSRD upgrade in the EU.
Such fragmentation will lead to a complex patchwork for global financial institutions to navigate.
Overlapping regimes could lead to difficult situations, for example rules that apply in one country may have implications for an institution in another, either through direct extraterritorial impact or where business is conducted on a cross border basis (e.g. EU SFDR). There may also be indirect impact through investor pressure to comply with rules, even where not directly applicable, or pressure from the value chain to provide information.
The unenviable task of understanding, monitoring, and indeed complying with, the myriad applicable rules should be at the top of firms' agendas, particularly global institutions with global compliance frameworks.
Trend 4 – The ESG Data Challenge
For the ESG agenda to succeed, the industry needs good data.
In the early days of ESG regulation, there was a lack of data to support many of the reporting requirements being put in place. However, this issue is slowly being addressed as mandatory disclosure regimes begin to mature and apply across the value chain. We are now at the other end of the spectrum, with a veritable explosion of data which can be hard for regulators and the industry to digest.
The first ESG data challenge therefore relates to scale. In order to track the data provided by market participants, industry and regulators are responding by doubling down on their ESG budgets, by developing new tools and hiring appropriately skilled staff.
The second ESG data challenge relates to quality. ESG data providers have a variety of approaches and tools and it is difficult to ascertain provenance, accuracy, reliability and quality of data. Hence the main regulatory development in this space is the proposed regulation of ESG data providers, both in the UK and EU.
The UK Government is expected to bring ESG data and ratings providers within the scope of authorisation and regulation in due course, further information on which is expected to be published this year, following various signals provided by the FCA over the summer. The FCA is in the meantime supporting the development of a voluntary code of conduct informed by International Organization of Securities Commissions' ("IOSCO") recommendations on ESG ratings and data products providers.
Similarly, ESMA published the findings of its call for evidence on the same topic in June 2022, noting that the market is "immature but growing". Regulatory safeguards, including possibly a voluntary code, are expected to be proposed in due course.
Trend 5 – Greenwashing and ESG enforcement
The quality of data and ESG ratings leads to our last theme: greenwashing and ESG enforcement. A persistent feature in the ESG space has been the example of a fund manager promoting supposedly "green" products based on negative screening, for example by excluding exposures to tobacco or arms manufacturers, whilst at the same time investing in coal or oil.
So what are the regulators doing about it?
Clamping down by regulation
In the UK, the issue was dealt with head-on in the FCA's Dear CEO Letter to fund managers in July 2021. Greenwashing in the UK is also being dealt with by the application of the TCFD to large fund managers from the beginning of 2022, and the future implementation of the SDR and investment labelling regime as well as the UK Green Taxonomy will also likely help.
The EU, of course, has the well-known EU Taxonomy and SFDR, which play a key role in combatting greenwashing in Europe. Greenwashing has been on the European radar for a while and ESMA identified the fight against greenwashing as a key priority in its sustainable finance roadmap. ESMA's recent supervisory briefing on sustainability risk and disclosures in the area of investment management contains useful examples of greenwashing practices. In June, the European Commission published a request for input to the European Supervisory Authorities ("ESAs") on greenwashing risks and the supervision of sustainable finance policies, which will ultimately result in the publication of a final report by each of the ESAs.
...and by enforcement
Greenwashing is also being tackled by enforcement, with several news stories recently highlighting ESG-related raids and investigations, from Germany to the US. Other authorities are also getting in on the action, including the Advertising Standards Authority in the UK.
Clamping down on greenwashing through regulation and through enforcement action is a trend that is set to continue. There is also of course certain litigation risk, especially in the form of group claims brought by shareholders against companies and its directors. However, this is currently a less pertinent risk as compared to enforcement, as there are some significant hurdles to overcome, in English law at least – for example, demonstrating reliance on the misleading information for a claim under section 90A of the Financial Services and Markets Act 2000 ("FSMA") and proving causation of the losses for both sections 90 and 90A FSMA may be challenging.
We should note that it isn't just the usual authorities that are stamping out greenwashing – market participants can, and are doing so, too. Infamous short-seller Carson Block, founder of hedge fund Muddy Waters, recently quipped that the clean energy sector is "filled with lies and bull*" and recently took a large short position against a US residential solar power provider. Hindenberg Research has similarly taken a large short position on two electric vehicle manufacturers.
Firms therefore need to pay attention, from all angles, to the risks associated with calling themselves "sustainable".
Key dates in 2023
These five trends are set to continue into 2023. To help firms keep track of the regulatory developments in this space, we have set out below a non-exhaustive list of key developments to keep an eye on in the next coming months. For a more detailed timeline on sustainability and other regulatory developments please see our financial services regulation timeline.
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