Sustainable finance: regulatory intervention on the horizon (Part 2)

Publication | December 2018

In our April banking reform updater¹ we discussed initiatives to embed sustainable finance principles in the fabric of financial institutions. In doing so, we considered global initiatives such as the Financial Stability Board (FSB) Taskforce on Climate-Related Financial Disclosures, and examples of leadership such as the Sustainable Banking Network and the European Commission’s Action Plan on financing sustainable growth.

Since our April updater much has happened, this banking reform updater takes readers through the developments.

European Commission initiatives

As mentioned in the April updater, the Commission adopted an Action Plan on financing sustainable growth in March. This plan was based on the priority recommendations put forward by the High-Level Expert Group on Sustainable Finance and consisted of three main objectives which were to

Reorient capital flows towards sustainable investment, to achieve sustainable and inclusive growth.
Manage financial risks stemming from climate change, environmental degradation and social issues.
Foster transparency and long-termism in financial and economic activity.

Two months later in May the Commission adopted measures implementing a proposal for a regulation on the establishment of a unified taxonomy for environmentally sustainable economic activity, and on disclosure obligations relating to sustainable investments and risks². The Commission also proposed

Amending the EU Benchmarks Regulation³ to create a new category of low-carbon and positive carbon impact benchmarks.
Including environmental, social and governance (ESG) considerations into the advice that investment firms and distributors offer clients.
Clarifying how asset managers, insurance companies, and investment or insurance advisors should integrate sustainability risks into their business decisions.
Revising the guidelines on non-financial information to provide a methodology for disclosure of climate-related information, in line with Task Force on Climate-related Financial Disclosure (TCFD) and the EU’s climate-related metrics.

The Commission’s Action Plan included a timetable for all actions that will be rolled out by the second quarter of 2019. In terms of next steps, the proposals mentioned above will be discussed by the European Parliament and the Council, with a unified EU classification system in place by June 2022 (under the current proposals). With regards to the proposals on disclosure and taxonomies, delegated acts will further specify presentation and content of the information. These delegated acts will be adopted between end-2019 and mid-2022⁴.

EU-level regulation in this area is considered necessary due to the divergent attitude of Member States towards environmental issues. As with other legislators, the EU hopes to encourage voluntary sustainable investing, rather than regulating extensively in this area.

PRA activity

In its report published in September 2018 on the financial risks facing the UK banking sector as a result of climate change⁵, the PRA identified two risk factors which manifest as increasing credit, market and operational risk

Physical risks – arising from climate and weather-related events, potentially resulting in large financial losses and impairing the creditworthiness of borrowers.
Transition risks – arising from the process of adjustment towards a low-carbon economy (for example policy and technological changes).

The PRA’s findings revealed that UK banks, building societies and regulated asset managers have begun transitioning from viewing climate change primarily through the lens of corporate social responsibility policy to viewing it as a financial risk to their business. Some 60 per cent of the UK banking sector surveyed had begun considering the most immediate physical risks to their business models and were beginning to factor transition risks into decision making, albeit from a relatively narrow and a short-term perspective of 3-5 years. Only 10 per cent of those surveyed were taking a strategic view, engaging at board level to manage the long-term financial risks and an orderly transition to a low-carbon economy. Based on these findings, the PRA decided to consult on supervisory expectations on how a financial institution’s governance, strategy and risk management frameworks need to incorporate climate-related risks.

Building on the September report, the PRA is now developing supervisory expectations for banks⁶, with the purpose of encouraging them to reflect on their current approach to governance and risk management structures in responding to the financial risks arising from climate change. In October 2018, the PRA published a consultation paper on a draft supervisory statement (Statement) on banks'⁷ approaches to managing the financial risks from climate change⁸. The Statement is informed by the PRA’s report noted above and is intended to complement existing policy material. The desired outcome is to encourage banks 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 Statement sets out the PRA’s proposed expectations, with views sought by January 15, 2019. Under the Statement, firms will be expected to

Embed consideration of financial risks from climate change in their governance arrangements (including, clear roles and responsibilities at board level and, where appropriate, evidence of how firms monitor and manage such risks).
Incorporate such risks into their existing risk management practices (such as inclusion of any material exposures in the Internal Capital Adequacy Assessment Process or the Own Risk and Solvency Assessment) and to provide information on exposure to climate-related risk to board and relevant management committees.
Use scenario analysis (assessing both short and long term outcomes) to inform strategy setting and risk assessment.
Develop an approach to disclosure of such financial risks that takes into account the interaction of risk categories as well as their distinctive elements. The PRA expects firms to consider disclosure in the context of existing disclosure requirements on material risks under Pillar 3 disclosures of the Capital Requirements Regulation and Solvency II, and on principal risks and uncertainties in the strategic report required under the Companies Act 2006. The PRA also expects firms to engage in wider initiatives such as the TCFD.

Banks are assessing the proposals carefully and considering the changes required to governance and management practices should the Statement be adopted.

FCA activity

The FCA is also looking into these issues. In October 2018, the FCA published a Discussion Paper on the impact of climate change and green finance on financial services⁹, setting out how the impacts of climate change are relevant to the protection of consumers and market integrity. The FCA is also considering 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 notes that there are currently no minimum standards and guiding principles for measuring performance and impact of green finance products. Feedback is sought by January 31, 2019.

The Discussion Paper also identifies four areas requiring greater regulatory focus

In relation to pension investments, given the time periods these products are held for, the FCA proposes addressing the recommendations of the Law Commission’s report on Pension Funds and Social Investment by consulting on rule changes and guidance on assessing and reporting on financial and non-financial factors, including climate change.
The development of specialist green products, enabling innovation in this area and ensuring these markets work well and deliver good outcomes for all consumers. The FCA sees two potential ways to further enable innovative models in green finance and ethical investing. Firstly, building on its 2018 proposal to create a global regulatory sandbox utilising its collaboration with the Global Financial Innovation Network (GFIN) to provide more efficient ways for innovative firms to interact with financial services regulators and navigate between countries when seeking to scale up ideas. GFIN will also create a new framework for co-operation between regulators on innovation related topics. Secondly, GFIN could also be used to explore, share ideas and experiences (including barriers to market) and/or collaborate on green finance. In this context, the FCA announced the Innovate Green FinTech Challenge, calling for the development of innovative financial products and services to assist in the transition to a low carbon economy. As mentioned above, innovation in green products is already taking place within voluntary frameworks such as the Green Loan Principles and the Climate Bonds Initiative.
The FCA is also considering whether a framework is needed for issuers of securities to give investors appropriate information about climate-change related factors when securities are issued and on an ongoing basis. It explores one method of encouraging consistency by requiring companies with premium listed equity shares to provide a statement to investors explaining whether or not they have followed the TCFD recommendations in preparing their disclosures, and if not, why not (applying the “comply or explain” principle mentioned above). The FCA is also seeking feedback on whether issuers require greater clarity as to what is expected of them, but notes that it is already committed to consulting on guidance to issuers on how the current regulatory regime might be interpreted to apply to climate-related risks. This approach relflects the FCA’s view that existing disclosure obligations would capture the reporting implications of climate change on a business where it is material to the company’s prospects.
More broadly, the FCA is also seeking views on whether a requirement for firms to report on climate risks would be valuable, how this might be structured and who might be required to compile such a climate risk report.

What does the future hold?

The direction of travel is clear: financial institutions and investors will increasingly be required to assess, monitor and disclose the sustainability of their investments. In the UK regulatory intervention is increasing, albeit within existing supervisory frameworks. Although measures are likely to represent an increased cost to businesses (with additional assessment, disclosure, monitoring and reporting obligations), they also present an opportunity for the development of new products and services. In the face of climate risk, the market has an opportunity to innovate which, within the appropriate framework, can create value as well as further climate-related risk management and ESG objectives. The private sector is already moving to develop sustainable finance focused products. These initiatives include voluntary guidelines to encourage transparency and disclosure, and the development of the green products market, such as the emergence of green loans and green bonds¹⁰.