ESG investing first appeared on the global stage in 2004 when former UN Secretary-General Kofi Annan wrote to over 50 CEOs of prominent financial institutions urging them to integrate ESG into the capital markets. Since then, ESG has moved to the forefront of the political stage as noted by the UN adoption of Sustainable Development Goals and the subsequent landmark signing of the UN Paris Agreement in 2016. The recent avalanche of sustainable finance legislation by governmental organisations marks a shift from voluntary guidance to mandatory measures; reflecting, in particular, the urgency of global climate concerns. These regulatory measures are focused on creating an equilibrium in the financial services sector, by necessitating industry-wide harmonization on how ESG factors are measured and incorporated into the existing governance and risk framework of financial institutions.
Greenwashing
Adopting ESG policies has demonstrated financial benefits for firms, with evidence suggesting that companies integrating sustainable practices outperform companies that do not consider environmental or social factors. In one meta-analysis, 88% of studies found that companies with an ESG framework demonstrated better operational performance, and 80% of studies showed a positive effect on their stock price4. In addition, 71% believe companies that focus on the environment and social factors will yield better returns.
Following this increase in demand from investors on ESG considerations, there is a risk that products and services are being presented as more environmentally friendly than they actually are – this is known as “greenwashing”. Greenwashing is the marketing tactic of falsely conveying or exaggerating the environmental characteristics of a service or product, with the intention to deceive investors. Similar concerns arise about over-selling of products focused on social benefits.
Investors and investment advisers are very alert to the risks to them of green- (or social-) washed investment products. If a product is not as green as it was sold as being, there is a risk that the market value of the product may be negatively affected. Furthermore, such washing may mislead investors as to the resilience of the underlying business and assets to ESG-related risks. Many are improving their due diligence and research capacities and demanding better-quality disclosure by corporates with clear and measurable information about ESG performance.
Regulatory developments in the EU
The introduction of the EU’s Sustainable Finance Disclosure Regulation 2019/2088 (SFDR) and Taxonomy Regulation 2020/852 (TR) will introduce objective ESG metrics and indicators. The aim of these incoming Regulations is to actively combat greenwashing and misleading marketing claims, providing clarity to the endinvestor. Financial Market Participants (FMPs) will be subject to rigorous reporting requirements at both product and entity level to avoid falling foul of the Regulations. Consequently, this is likely to limit willingness of FMPs to engage in greenwashing tactics for fear of being liable for mis-selling.
Overview of the Sustainable Finance Disclosure Regulation and the Taxonomy Regulation
The development of a coherent framework for sustainable investing is a priority on the EU’s agenda for financial services regulation. To this end, the SFDR and TR form part of the European Commission’s action plan on sustainable finance.
SFDR
The SFDR imposes ESG-related disclosure requirements on FMPs and financial advisers (FAs), including asset managers, AIFMs and insurance undertakings, even those which do not have an ESG-focus.
The SFDR aims to harmonize and standardize ESG-disclosures across the EU in order to make it easier for investors to identify impacts of their investments on sustainability factors and the associated risks and opportunities. Broadly, firms subject to the SFDR will be required to: (i) disclose and maintain certain information on their website; (ii) provide ESG-related pre-contractual disclosures to investors; and (iii) include ESGrelated disclosures in periodic reports provided to investors. These key disclosures will apply: (i) at a firm level; (ii) in respect of any financial products that they make available, even where the products do not have an ESG-focus; and (iii) at an enhanced level in respect of financial products which have an ESG-focus. The manner in which these requirements apply to firms that are subject to the SFDR will depend on whether the firm constitutes an FMP and/or FA.
Taxonomy Regulation
The TR complements and amends certain provisions in the SFDR on environmentally sustainable activities. Similarly, this regulation applies to and prescribes disclosure requirements for: (i) FMPs that make available financial products described as environmentally sustainable; and (ii) entities which are subject to non-financial statement requirements under the Accounting Directive.
The TR establishes the criteria to determine which economic activities qualify as environmentally sustainable to make it easier for investors to compare different investment opportunities. This includes whether the activity does not significantly harm or contribute to specified environmental objectives. Although the scope of the TR currently applies to environmental objectives, it is envisaged that the scope of the TR may be expanded beyond environmentally sustainable activities, including social objectives.
Timeline
On 10 March 2021, the majority of Level 1 SFDR requirements begin to come into effect. This includes obligations on FMPs to publish how they integrate sustainability into their risk framework and to provide sustainability-related pre-contractual disclosures. Certain provisions requiring disclosure of adverse sustainability impacts will come into effect after this date.
The TR entered into force on 12 July 2020 but many key provision will not apply until a later date and will be further developed by delegated acts. The majority of obligations apply from 1 January 2022. From this date, the first two climate change-related objectives (climate change mitigation and climate change adaptation) will apply. The remaining four environmental objectives will apply from 1 January 2023.
Regulatory Technical Standards Delay
On 20 October 2020, the EU Commission confirmed in a letter that the regulatory technical standards (RTS) which supplement the SFDR disclosure requirements will be delayed due to the economic and market stress caused by the COVID-19 crisis. The RTS will specify requirements on the content and presentation of the SFDR disclosures, and clarify the standards of the underpinning methodologies. The letter does not specify the revised compliance date for the RTS, although this is widely thought to be in early 2022. Importantly, however, the application dates under the SFDR remain in effect and therefore FMPs and FAs that are subject to the SFDR will need to comply with its principle based requirements from 10 March 2021.
Non-Financial Reporting Directive, EU
There is industry concern about the level and type of ESG information that is currently available to FMPs in light of the extensive disclosure requirements imposed by the SFDR and the Taxonomy Regulation, and the reliance that FMPs will need to place on corporates in order to comply with those requirements. Many financial institutions have said that it will be challenging to comply with these requirements if the information that they need cannot be consistently obtained from their investee companies and clients.
The Non-Financial Reporting Directive (NFRD) has been predominantly held out as one of the key ways for FMPs to obtain the data that they will need to enable them to make the relevant disclosures under the SFDR and the TR. The NFRD requires companies that fall within its scope to report on ESG information, both in terms of how sustainability issues impact them and also on how they impact such issues.
However, at present, the NFRD applies to EU public interest corporates (which can include organizations in the financial and non-financial sectors) that have more than 500 employees and are therefore considered as “large”. As a result, there is a gap between those who are subject to the NFRD and the data disclosed pursuant to the NFRD, with the requirements of the SFDR and the TR. As such, the European Commission launched a consultation in February 2020 which proposes to significantly expand the scope and content of the NFRD in an attempt to reconcile the disclosure requirements of the NFRD with the disclosure requirements of the SFDR and TR. Amending the NFRD in the proposed manner could result in additional ESG information being made available to FMPs by corporates, as more listed and unlisted companies would fall within its scope.
However, some of the responses to the consultation paper identified a timing discrepancy between the application deadlines for the SFDR and the TR, and the anticipated timing of the first reporting cycle under any amended NFRD. Currently, the Commission expects to adopt a proposal regarding the NFRD in the first quarter of 2021. Even with the proposed timing, it seems likely that the data gap, the mismatch between the SFDR and Taxonomy deadlines, and any revisions to the NFRD are not going to be rectified any time soon. This ultimately leads to a significant outstanding question amongst FMPs on how they are going to satisfy their own disclosure obligations given their reliance on information being made available from investee companies and clients.
Brexit
SFDR
As it currently stands, the transition period under the UK’s Withdrawal Agreement is due to end on the 31 December 2020, with the SFDR coming into effect after this date. The government is still considering its wider approach to sustainable finance disclosures and will set this out in due course.
In October 2020, the draft Securities Financing Transactions, Securitisation and Miscellaneous Amendments (EU Exit) Regulations 2020 (Draft EU Exit Regs) provides that certain articles of the SFDR which were inserted as a result of the TR are “omitted”. Additionally, the Financial Services Bill 2019 – 2021 (FS Bill) which was published in October 2020, does not contain any references to the SFDR.
On this basis, it seems unlikely that the SFDR will become part of UK law following its departure from the EU.
UK firms may nonetheless wish to include certain SFDR-related disclosures on a voluntary basis while they await details of the approach that the UK will take to sustainable finance disclosures. Such an approach would enable UK firms to remain consistent with any EU group companies and conversely with EU competitors, which is particularly important given the increasing investor pressure on firms to provide sustainability-related disclosures. Otherwise, UK firms will need to consider the practical and reputational implications if they choose not to adopt any of the disclosure requirements under the SFDR.
TR
The Draft EU Exit Regs contain minor amendments to the TR. The explanatory memorandum to the Draft EU Exit Regs provide that elements of the TR which will form part of retained EU law are those that relate to the criteria for the future development of green performance thresholds for specific economic activities. The Draft EU Exit Regs provide that the implementation of certain provisions relating to such criteria will be delayed in the UK by two years, to allow adequate time to consider whether they are appropriate for the UK.
On 9 November 2020, Chancellor of the Exchequer Rishi Sunak MP announced the UK’s green ambitions for the future and confirmed that the UK will implement a green taxonomy which will introduce a common framework for determining which activities can be defined as environmentally sustainable. The UK taxonomy will take the scientific metrics in the TR as its basis and a UK Green Technical Advisory Group will be established to review whether these metrics are appropriate for the UK market. The Chancellor also announced that the UK will become the first country in the world to make Task Force on Climate-related Financial Disclosures (TCFD) fully mandatory across the economy by 2025.
In addition, the FCA announced that it will introduce rules requiring premium listed companies to make better disclosures about how climate change affects their business in accordance with recommendations made by the TCFD and will also consult on extending the rules to apply to asset managers, life insurers and pension providers in the first half of 2021.
Accordingly, the Chancellor’s announcement is a clear indication that the UK will diverge with the EU on its implementation of the TR, however, the extent of any divergence is unclear. However, the work which the UK Green Technical Advisory Group has been tasked with suggests that any deviation is unlikely to result in a reduction of disclosure requirements for the UK. As such, given the UK’s green ambitions announced by the Chancellor, it is possible that the UK may introduce disclosure requirements that go beyond those of the TR.
Authored by Andrew Carey, Sukhvir Basran, Dominic Hill, Rita Hunter and Paida Manhambara.
