United Kingdom | Publication | December 2020
In response to the Paris Agreement1, governments and intra-governmental organisations launched a number of measures to promote sustainable finance. To date, these have focused on voluntary measures, relying on businesses and investors to self-monitor in this area. As the global move towards a more sustainable economy gathers pace, and the need to respond to the risks presented by climate change becomes more urgent, these measures are beginning to be transposed into legislation and regulation. While many financial institutions have already implemented internal systems for assessing and monitoring the sustainability of their businesses, the introduction of regulatory frameworks focused on sustainable finance should lead to standardisation in this diverse area, requiring financial institutions to assess and report on sustainability issues within their existing governance and risk management structures.
This briefing will outline global and EU initiatives in sustainable finance, as well as the current approach in the UK.
Sustainable finance2 refers to the integration of environmental, social and governance (ESG) criteria by financial institutions into business or investment decisions. Its prominence has increased as a result of climate finance (referred to under the Paris Agreement as ‘finance to fund activities that reduce greenhouse gas emissions or help in adapting to the impact of climate change’), although the scope of sustainable finance is broader, and links also to the UN Sustainable Development Goals. In addition to environmental issues, such as reducing environmental impact, protecting natural capital, minimising waste and reducing greenhouse gas emissions, sustainable finance also includes social factors, such as working conditions, local communities, conflict and human rights, and governance matters, such as executive pay, bribery and corruption, board structure and tax strategy, within financial decision-making.
Investment criteria are often focused on short-term results. To properly assess environmental and social risk factors, which are more apparent only in the long-term, requires the finance sector to develop an investment framework which takes into account long-term risks. To encourage this shift towards a more resilient, longer-term view, governmental and inter-governmental initiatives are increasing, to encourage financial institutions to include sustainability issues in their governance and risk management functions3.
Initiatives have focused on risk disclosure, to provide greater transparency for investors. Financial institutions are encouraged to inform investors of the environmental impact of their investments, and to disclose their method of environmental risk assessments. Existing measures have concentrated on environmental, rather than social or governance-related risk disclosure, but this is likely to broaden, given the new proposals on the horizon. By encouraging financial institutions to implement sustainability risk disclosure initiatives, the aim of regulators has been to increase voluntary climate-friendly investing, reducing the need for legislative intervention in this area. The concern with this approach is that a lack of standardisation in risk assessment and labelling creates a system that is opaque to investors and regulators alike. This places the onus on the investor to satisfy themselves that a particular investment is sustainable and does not allow direct comparison between different investment opportunities. It has also not produced the increased flow of funds to sustainable investments, which is required if countries are to meet their Paris Agreement commitments.
The Financial Stability Board, an international body established by the G20, responsible for monitoring the global financial system, established the Task Force on Climate-related Financial Disclosures (TCFD), which published its final recommendations4 for effective disclosure of climate-related risks in June 2017.
The TCFD recommendations are applicable to financial-sector organisations, including banks, insurance companies, asset managers and asset owners. Although only a voluntary framework, the recommendations are drafted to be widely adoptable, to be useful to both investors and lenders and solicit forward-looking information on financial impacts. To these ends, the report focuses upon, from broad to specific:
The Climate Disclosure Standards Board5 has outlined certain challenges in implementing such recommendations, including a lack of internal and investor engagement, a lack of education at board level, difficulty adapting to longer-term horizons and outdated risk management and financial modelling tools. As a result, the extent of implementation varies widely (from no engagement in Russia and Saudi Arabia to encoding into law in France) and while there has been an increase in regulatory guidance at the national level, the aim of the TCFD is to facilitate an approach driven by the private sector.
The United Nations is also providing guidance to the financial sector in transitioning to a green economy. In May 2019, the United Nations Environment Programme Finance Initiative (UNEP FI) published a report on a pilot project on TCFD6 adoption, together with leading banks.
The UNEP FI also launched the Principles for Responsible Banking7, now with 197 banks collectively representing 40% of the banking industry, signed up. The Principles include a requirement to set targets to drive alignment with appropriate Sustainable Development Goals, the goals of the Paris Agreement, and other relevant international, national or regional frameworks.
In 2006, some 13 years before the PRB, the UN-supported Principles for Responsible Investment8 (PRI) were launched. There are over 3,000 signatories to the PRB from over 70 countries representing over USD$80 trillion of assets (as reported in 2020). Amongst other things, the signatories to the PRI agree to factor in ESG issues when making investment decisions. Additionally, the recommendations of the TFCD have been incorporated into the PRI9.
Separately, the Sustainable Banking Network (SBN) is a unique global initiative comprising a voluntary community of regulatory agencies and banking associations, established to facilitate the collective learning of its members and to provide support in the development of initiatives aimed at promoting sustainable investing. In October 2019, the SBN published its Global Progress Report10, evaluating sustainable finance policies in 38 member countries and suggesting practical indicators and tools which members can apply to their own domestic markets. These largely echo the TCFD indicators, as:
The Network for Greening the Financial System similarly comprises a group of central banks and supervisors to green the financial system with the aim of enhancing the role of the financial system to manage risks and to mobilise capital for green and low-carbon investments in the broader context of environmentally sustainable development, by promoting best practice and commissioning analysis.
The International Platform on sustainable finance was launched in October 2019 by public authorities from Argentina, Canada, Chile, China, India, Kenya, Morocco and the European Union, representing almost half of the world’s greenhouse gas emissions. The aim of the platform is to promote best practice in sustainable finance, and enhancing coordination where appropriate.
Attention is also turning to measures required to protect biodiversity and ecosystems. World Bank’s Mobilising Private Finance for Nature Report11 highlights five “big ideas” to mobilise private finance to protect nature:
Committed to becoming a global leader in sustainable finance, the European Commission (Commission)’s Action Plan on Sustainable Finance was adopted in March 2018, informed by the recommendations of the High-Level Expert Group on Sustainable Finance (HLEG). The Action Plan on Sustainable Finance has three main objectives:
The Action Plan on Sustainable Finance included the following key policy actions:
Not all areas have been implemented in full. A Renewed Sustainable Finance Strategy is due to be published in the beginning of 2021 which is expected to make proposals to build on the 2018 Action Plan and identify further areas for reform. This includes the proposed adoption of an EU Green Bond Standard and the establishment of an ecolabel for retail investment products.
We consider below the action and progress towards implementation of EU sustainable finance policy to date.
A cornerstone of the EU Green Deal13 is the target of achieving climate neutrality for EU member states as a whole by 2050. This objective is proposed to be implemented via a proposed European Climate Law14. EU leaders have also agreed an interim emissions reduction target of 55 percent by 2030 as a checkpoint to the 2050 target. The targets are not only intended to mitigate the effects of climate change, but to achieve economic growth, transitioning all aspects of the EU economy toward sustainable methods.
In tandem, the European Commission launched the European Green Deal Investment Plan15 (also known as the Sustainable Europe Investment Plan) to mobilise EU funding and create an enabling framework to facilitate and stimulate the public and private investments toward an climate-neutral, green, competitive and inclusive—in short, a sustainably financed—economy.
The European Investment Bank will play an important role in delivering the Sustainable Europe Investment Plan. In November 2019, it approved a new climate strategy and energy lending policy16 which has at its heart the aim of mobilising €1 trillion into climate action and environmental sustainable investment up to 2030 so that by 2025, 50 percent of its operations will be dedicated to supporting sustainable financing. The bank has also committed to aligning all of its financing principles to reflect the goals of the Paris Agreement from the end of 2020.
A central aspect of the Action Plan on Sustainable Finance was to develop a taxonomy for climate change and environmentally and socially sustainable activities which would provide a legal basis for using this classification system across different areas (e.g. standards, labels, green-supporting factor for prudential requirements, sustainability benchmarks).
The Taxonomy Regulation (EU) 2020/852 was published in the Official Journal on 18 June 2020. This was supported by the Technical Expert Group’s (TEG) report on the EU Taxonomy, published in March 2020, prepared to support the Commission in the development of future delegated acts.
The Taxonomy Regulation establishes a unified and consistent system of indicators to classify and compare which economic activities and investments are deemed “environmentally sustainable”. These must contribute substantially to one or more of the following objectives whilst (i) not significantly harming any other objectives, (ii) meeting minimum social safeguards, and complying with the technical screening criteria:
The technical screening criteria against which these are judged are established through delegated acts. The European Commission published the draft delegated act setting out technical screening criteria on climate change mitigation and adaptation on 20 November 2020 for a four-week consultation period. The deadline for the Commission to adopt the delegated acts is 31 December 2020. The remaining delegated acts are expected to be finalised by the end of 2021. By June 2021, the European Commission will also adopt a delegated act specifying the extent to which companies must disclose their adherence to environmentally sustainable taxonomies.
The Taxonomy Regulation is, with its delegated acts, a work in progress. Notably, it does not provide a comprehensive list of “green” activities, much less a separation of ‘good’ and ‘bad’ economic activities and investments. Rather, it provides a common set of principles to be observed by investors, financial institutions, companies and issuers in line with their own ESG commitments and the mobilisation of capital toward more sustainable financing. To do so, the technical screening criteria makes reference to where greener alternative practices exist in order to meet the outlined criteria and objectives. For this reason, some industries such as aviation and maritime shipping are not yet included for lack of technological and economically-feasible alternatives—but this will be reviewed as credible thresholds become apparent.
One application of the taxonomy is in a Green Bond Standard being considered by the Commission to label financial products. Whilst the precise legal format is yet to be determined, the TEG, in publications in June 201917 and March 202018 recommended a voluntary scheme built upon ‘best practices’ and verifiable “use of proceeds” to financing green projects. A legislative proposal laying down a framework for an EU green bond standards is expected in Spring 2021. In addition, the Commission is considering the establishment of an Ecolabel for retail investment products. In this context, the European Commission Joint Research Centre (JRC) published the third version of its technical report on the requirements for an ecolabel on retail investment products in October 2020. The Annex to the report provides the draft conditions and thresholds for investment funds to be labelled with an Ecolabel.
Another action was to create a new category of low-carbon and positive carbon impact benchmarks (the Regulation on low carbon and positive impact benchmarks). In September 2019, the TEG published its final report on climate benchmarks and benchmarks’ ESG disclosures, recommending minimum technical requirements for the methodologies of sustainability benchmarks to address the risk of greenwashing. The Disclosures Regulation (EU) 2019/2088, most provisions of which will apply from March 2021, and amended Benchmark Regulation (EU) 2016/1011 (Low Carbon Benchmarks Regulation), which applied from April 2020, have been introduced. The former imposes new disclosure requirements on all financial market participants regarding sustainability risks in their decision-making processes, and how sustainability objectives are intended to be applied. The latter, meanwhile, defines two new types of climate benchmark: the EU Climate Transition Benchmark, labelling portfolios on a ‘decarbonisation trajectory’ toward the Paris Agreement objectives, and the EU Paris-Aligned Benchmark, labelling those which are already aligned with the objectives of the Paris Agreement insofar as the carbon emissions savings of each underlying asset exceeds its carbon footprint. The delegated acts underpinning the Low Carbon Benchmarks Regulation were published in the Official Journal of the EU on 3 December 2020.
The HLEG recommendations included assessing the fitness for purpose of the current legislative framework, including the Non-Financial Reporting Directive 2014/95/EU, in line the EU’s Taxonomy Regulation. On 18 June 2019, the European Commission published new, non-binding, guidelines19 for company reporting on climate-related information. The guidance applies to large listed companies, banks and insurance companies with more than 500 employees. It proposes ways by which to assess climate change impacts on the financial performance of companies, and incorporates the recommended disclosures of the TCFD. It is expected to be strengthened and updated by the Renewed Sustainable Finance Strategy, making it easier for investors and companies to identify sustainable investments and ensure that they are credible and enable climate and environmental risks to be managed and integrated into the financial system.20
The European Securities and Markets Authority (ESMA) published its own strategy on sustainable finance on 6 February 2020. ESMA will take into account sustainable business models and integrating ESG related factors across its activities, including the implementation of the EU Single Rulebook, supervisory convergence, direct supervision and risk assessments. ESMA’s key priorities include completing the regulatory framework relating to transparency obligations arising under the Disclosure Regulation (EU) 2019/2088, and to work with the European Banking Authority and European Insurance and Occupational Pensions Authority to produce draft technical standards on this subject. ESMA will also include a dedicated chapter on the risks related to sustainable finance in its biannual reports on trends, risks and vulnerabilities (TRV), which it has published twice (February21 and September 202022) since adopting this policy. It will also analyse the financial risk from climate change, including climate-related stress testing, foster a supervisory convergence of EU law in the ESG area, focus on mitigating the risk of greenwashing, prevent mis-selling and misrepresentations, and improve transparency and reliability in reporting non-financial information. It also has a role on the Sustainable Finance Platform to maintain EU taxonomy and monitor capital flows to sustainable finance.
Changes are also being introduced to affect how company disclosures are interpreted and relied upon. In 2019, ESMA published a Technical Advice paper23 and Final Report24 on the Credit Rating Agency Regulation (EU) 462/2013 pertaining to the relevance of sustainable finance in the credit rating market. These documents suggested that a ‘good practices’ document should be published collating the disclosure requirements that are applicable to credit ratings’ press releases and reports—as they pertain to investors. This would aim to also improve the transparency of credit rating actions concerning the extent to which sustainability factors have been key driving factors.
Measures were also proposed in relation to including ESG considerations into the advice that investment firms and distributors offer clients. The Commission published delegated legislation amending the Markets in Financial Instruments Directive 2014/65/EU and Insurance Distribution Directive (EU) 2016/97. Through these actions, investment firms and insurance distributers are obliged to take into account sustainability issues when providing advice to their clients. This ensures that the information disclosed by companies reach the end-consumers in a format they understand from the advice they receive.
The introductions of and revisions to the EBA Regulation (EU) No 1093/2010, Capital Requirements Regulation (EU) No 575/2013 and Directive 2013/36/EU, Investment Firms Regulation (EU) 2019/2033 and Directive (EU) 2019/2034, and the European Commission’s Action Plan on Sustainable Finance have mandated the European Banking Authority to promote sustainable finance models. It is expected to deliver much of this work between now and 2025, but will see ESG risks integrated into the oversight of institutions’ risk management policies, national regulators evaluation processes, and stress-testing methodologies to identify climate-related risk, exposures, and other vulnerabilities. To this end, in November 2020 the EBA published a discussion paper on the management and supervision of ESG risks for credit institutions and investment firms, setting out how ESG factors and ESG risks are identified and explained, giving particular consideration to risks stemming from environmental factors and especially climate change.
The Commission is also expected to clarify the role of fiduciary duties of institutional investors and asset managers in relation to sustainable finance as part of the Renewed Sustainable Finance Strategy ahead of regulatory reform. In March 2019, EU policy makers achieved political agreement on requiring ESG integration by financial market participants such as institutional investors and asset managers. This is expected to change the language of current requirements, making it that they “must” consider risks and “opportunities” pertaining to sustainably financing, and requiring greater disclosure and reference to sustainability targets and objectives.25
A similar approach toward prudential oversight and duties is taking place in the pensions sector. In 2019 the European Insurance and Occupational Pensions Authority submitted advice to the Commission, of which a key recommendation was the integration of sustainability concerns in their investment decisions and underwriting practices. It suggests careful embedment of this advice under Solvency II Directive 138/2009/EC and the Insurance Distribution Directive (EU) 2016/97 to emphasise these risks but the legislative language ends which will be adopted remains to be seen.
The UK is committed to helping drive the transition to a lower-carbon economy and to the delivery of sustainable development goals. As one of the prominent players in this area, the UK government has introduced measures to better integrate sustainable investing concerns into the decision making frameworks of businesses. Measures already adopted include amendments made in 2013 by the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 (SI 2013/1970), which require certain companies to disclose ESG matters, including their greenhouse gas emissions, in their directors’ report or, if of strategic importance, in their strategic report.
In June 2018, the House of Commons published its Green Finance Report aimed at embedding sustainability in financial decision making. In doing so, businesses and regulators must factor long-term environmental risks into financial decision making. Rather than legislative intervention, its recommendations encourage the cooperation of the government, regulators and the private sector. This same approach is adopted by the Green Finance Taskforce (GFT), launched in 2017, to help accelerate the growth of green finance in the UK. Its own report was published in March 2018 and recommended:
Despite the UK’s exit from the EU, the UK government has announced its intention to maintain an equivalence regime to manage cross-border green finance activities. This will take a technical, outcomes-based approach prioritising certainty, predictability, and transparency, with package decisions being granted before the end of the transition period and beyond, in maintaining dialogue with the EU26.
We consider the action and progress towards the implementation of these policies below.
The Green Finance Report suggested making clear the fiduciary duties of pensions schemes and company directors to protect long-term value and considering environmental risks in light of this. It suggested that all companies and investors should report on their TCFD alignment on a ‘comply or explain’ basis. The Green Finance Report also recommended that the government should work with the Committee on Climate Change to produce policy/scenarios that can be utilised by companies and asset owners. It should be made clear to all financial entities that companies are already required to report on climate change where it is a material risk to business under the Companies Act 2006 (see paras 51–59, 73–79 of the report).
The FCA published a consultation paper proposing to introduce a new Listing Rule for companies with a UK premium listing, requiring them to state whether they comply with TCFD-aligned disclosures, and to explain any non-compliance. Separately, it is due to release a Technical Note with further guidance on existing FCA disclosure obligations for issuers to apply to a disclose climate risks.
In November 202027, the Chancellor pledged to go further than a ‘comply or explain’ obligation, making TCFD-aligned disclosures mandatory across the UK economy by 2025, with a significant portion of mandatory requirements in place by 2023. The joint Government Regulator TCFD Taskforce published its interim report and a roadmap for implementing mandatory disclosures.
The regulatory focus is primarily on climate risk management. A number of initiatives, described below, have focused on the need to identify, assess, manage, report and disclose climate-related financial risks and to embed them in associated governance and control structures.
Whilst these initiatives are being implemented under a number of regulatory frameworks, to help build capacity and share best practice across financial regulators and industry to respond to the financial risks arising from climate change, the PRA and FCA have established a Climate Financial Risk Forum28, aimed at improving data and furthering the development of climate-related scenario planning.
In September 2018, the Prudential Regulatory Authority (PRA) published a report on the financial risks facing the UK banking sector as a result of climate change29. The report identified two risk factors which manifest as increasing credit, market and operational risk:
In April 2019 the PRA published policy statement (PS11/19) and supervisory statement (SS3/19) Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change, with the purpose of encouraging firms to reflect on their current approach to governance and risk management structures in responding to the financial risks arising from climate change. The SS was informed by the PRA’s report noted above and was intended to complement existing policy material. The desired outcome was to encourage firms to strategically manage the financial risks from climate change, by taking account of current and future risks, and actions required to mitigate those risks. The SS set out the PRA’s proposed expectations:
The PRA required firms to have an initial plan in place to address the expectations and submit an updated Senior Management Function form by October 2019.
In a ‘Dear CEO Letter’, published by the PRA in July 202030, observed that “most firms are making good progress in developing approaches to identify, assess, manage, report and disclose climate-related financial risks” but that that “best practice continues to evolve”. The PRA made it clear that firms should expect climate-related financial risk to be integrated within the full range of regular supervisory activities. For further details, please see our briefing.
In addition, in a Dear CEO letter on the PRA’s 2021 priorities for International Banks Supervision, published in December 2020, the PRA advised that, although its expectations apply to UK-incorporated firms, it is important that branches of international banks also focus on climate change, which it sees as a vital element of sound risk management. The PRA will be increasing our engagement with Home State Supervisors on this issue over the coming year.
The Financial Conduct Authority (FCA) has also been looking into these issues. In October 2018, the FCA published a Discussion Paper31 on the impact of climate change and green finance on financial services, setting out how the impacts of climate change are relevant to the protection of consumers and market integrity. The FCA also considered the opportunities for financial services, as a result of the transition to a low carbon economy, including the opportunity to grow as a centre for green finance, but noted that there was currently no minimum standards and guiding principles for measuring performance and impact of green finance products.
In October 2019, the FCA published a feedback statement (FS19/6) setting out its proposals to improve climate change disclosures by issuers, regulated firms’ integration of climate change risk and opportunities into their decision-making, and consumers’ access to green financial products and services. The feedback statement summarised the responses the FCA received from stakeholders to its discussion paper DP18/8 and set out the FCA’s actions and next steps. This included further consultation, focused on new disclosure rules for firms, and enhanced governance in relation to ESG and stewardship policies.
In December 2019, the Bank of England (BoE) published a discussion paper which set out its proposed framework for the 2021 Biennial Exploratory Scenario exercise. The objective of the exercise is to test the resilience of the largest banks, insurers, and firms to the physical and transition risks associated with different possible climate scenarios, and the financial system’s exposure more broadly to climate-related risk over a 30-year period. The launch date has been confirmed for, June 2021. The BoE is working with the Climate Financial Risk Form to publish practicable guidance for firms to implement changes with this in mind.32
The government is also reviewing the regulatory regime to enhance the UK’s position as a global finance and investment hub.
In November 2020 the Chancellor announced that the UK Government would issue its first Sovereign Green Bond in 2021, setting the groundwork for future issuances to meet demand. The bonds will be ring-fenced to tackling climate change, infrastructure investment, and creating green jobs.
To support the growth of the Green Bond market, the UK plans to introduce its own green taxonomy, taking the scientific metrics from the EU taxonomy and reviewed by a UK Green Technical Advisory Group. In much the same way, this will establish a common understandings of firms’ activities and investments, as the UK becomes a more sustainable economy. In support of this, the UK will also join the International Platform on Sustainable Finance.
A National Infrastructure Bank is to be established to support investment in UK infrastructure and a Long-Term Asset Fund is planned to be launched within a year to encourage investment in long-term, illiquid assets such as infrastructure and venture capital.33
The policy landscape is expected to change significantly in the run up to COP 26 in November 2021. Market participants will be actively engaging with the UK government and regulators. An example the publication of a White Paper on Sustainable Finance by UK Finance, representing more than 250 banking and finance firms across the industry. This sets out UK Finance’s recommendations on principles that should underpin the measurement of multi-year commitments to sustainable finance. For further information, please see our briefing.
Linked to these initiatives are moves by the finance market to develop sustainable finance focused products in order to better measure, assess and enable the disclosure of assets by a regulated firm.
A number of voluntary guidelines have emerged to encourage transparency and disclosure, and promote the development of the green products market. Examples of these initiatives include:
These principles are being adopted in a number of markets, including in aviation finance (see our briefing here) and in Islamic finance, where the market for green sukuks (green Islamic bonds) is growing.
As regional and national sustainable finance initiatives develop, these market-led standards are likely to be hybridised to take account of emerging sustainable finance regulation. For example, the Green Loan Principles (GLP) is a global framework, and so not necessarily aligned with the EU Taxonomy Regulation. However the GLP themselves note that definitions of green and green projects may vary depending on sector and geography, opening the way for the emergence of an EU taxonomy-compliant green loan. This hybridisation is likely to develop as investors need to disclose based on EU taxonomy alignment. Whilst a green loan may not need to incorporate the EU taxonomy to comply with the Green Loan Principles, a market participant offering a financial product into the EU will need to make disclosures about Taxonomy alignment and therefore will be keen to ensure compliance within the loan product itself.
The direction of travel is clear: financial institutions and investors will increasingly be required to assess, monitor and disclose the sustainability of their investments. While regulatory intervention is increasing in some markets, voluntary initiatives are being adopted in others. Although measures are likely to represent an increased cost to businesses, they also present an opportunity for the development of new products and services. In the face of climate risk, the financial market has an opportunity to innovate which, within the appropriate framework, can drive value as well as further climate-related and ESG objectives.
For further information on ESG and sustainable finance, please subscribe to our Global Regulation Tomorrow blog.
Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures (June 2017)
For a comparison between the PRB and PRI, see Article: LegalEase with LexisPSL – Principles for Responsible Banking (PRB) and Principles for Responsible Investment (PRI) (2019) 11 JIBFL 776.
Publication
EU Member States may allow companies from countries that have not concluded an agreement guaranteeing equal and reciprocal access to public procurement (public procurement agreement) with the EU to participate in public tenders, provided there is no EU act excluding the relevant country.
Subscribe and stay up to date with the latest legal news, information and events . . .
© Norton Rose Fulbright LLP 2023
