ESG Regulation - Where to Start?

In 1900, Lord Kelvin stated that “there is nothing new to be discovered in physics.” That same year Max Planck discovered something new in physics: the quantum nature of electromagnetism, which gave rise to the field of quantum mechanics and a new era of scientific discovery.

Much like the field of physics 100 years ago, until recently, after a millennium or so of refinement, there seemed to be nothing new to discover in relation to the law either—the field had more or less crystallized into equilibrium, save for the occasional tweak. Then the financial crisis occurred and an unprecedented volume of new law was unleashed in a truncated time frame in the form of financial regulation.

And yet, this seemed to be a blip. A decade after the financial crisis and it appeared that the law was once again settling down with the flow of financial regulation finally starting to abate. The U.S. even entered into a deregulatory cycle.

Then came another crisis: a rapid increase in the rate of climate change, which has triggered another frenzy of new financial regulation; this time focused on environmental considerations, together with social and governance factors, collectively referred to as "ESG" or its synonym "sustainability."

This regulatory onslaught, estimated at over 2000 developments globally in the last few years alone according to one study, is about to deliver investment firms another payload of regulatory joy/misery.

At present, the EU has the most advanced and abundant suite of ESG regulatory measures and the aim of this article is to provide an easily accessible entry into that nascent regime. First, to provide some context, several precursors to the regulatory developments are considered in order to set the scene.

Precursors

Voluntary, cross-sectoral, non-governmental ESG-related reporting has been around since the first Global Reporting Initiative (GRI) standards were published in 1997. These have since been followed by the Sustainable Accounting Standards Board’s standards, the Climate Disclosure Standards Board framework, and a host of other competing models.

Supplementing and to a degree supplanting many of the voluntary initiatives, the United Nations (UN) adopted sustainable development goals (SDGs) as part of a 2030 agenda for sustainable development Resolution in 2015. Within two months of the passing of this resolution; and in relation to SDG 13 on "Climate Action," the Paris Agreement was also adopted by the UN.

Two years later and two decades after the inaugural GRI standards in 2017, the G20’s Financial Stability Board jumped into the frame with its industry-led Task Force on climate-related financial disclosures, which published voluntary recommendations for climate-related financial reporting. Not to be outdone, the Basel Committee on Banking Standards (BCBS) announced  its own task force earlier this year but with a focus on climate-related financial risks rather than disclosures.

Against this backdrop of voluntary measures, mandatory legal and regulatory measures also began to emerge as did a host of commercial ‘solutions’ such as ESG standards, scores, and methodologies, developed to meet the growing demands of investors for ESG-aligned products.

This proliferation of governmental, non-governmental, transnational, and commercial measures has led to significant market fragmentation and an acute dissonance in methodologies with a single corporate often attracting "sustainability" scores across the spectrum, from good to bad, depending on the methodology used.

Such a fragmented landscape serves as an ideal breeding ground for greenwashing, a phenomenon that is threatening to undermine ESG-related political commitments and especially the goal  of channeling private investment towards genuinely sustainable economic activities.

Consequently, policy drivers are now seeking to harmonize measures through initiatives such as the Network for Greening the Financial System; a group of leading central banks and related institutions, such as the BCBS. 

In the EU, policy drivers have deemed this fragmentation and the concomitant threat of greenwashing as a sufficiently acute threat to their goal of channeling private investment into sustainable economic activities that an entire ESG regulatory regime is warranted.

This is one of the two principle drivers of the new regime; the other being mitigation of the risks that ESG factors present to investments and the solvency of financial firms and the threat that investments pose to ESG factors (the so-called “double materiality perspective”).

The Current EU ESG Regulatory Regime

The EU measures can be separated into two types: prudential and conduct based. The prudential measures cover both credit institutions and investment firms and involve the integration of ESG risk into the broader prudential risk management framework along with credit, market, liquidity, operational, and other risks. The new prudential measures also involve integrating ESG risk into "Pillar III" disclosures.

The bulk of these prudential rules will be phased in from 2021 with a pipeline of additional measures to be rolled out on an ongoing basis for the rest of the next decade. More details on these measures can be found in FactSet’s Guide to the EU ESG Regime.

Turning to the conduct measures, the first ESG-related legislative text to be enacted was the Non-Financial Reporting Directive (Directive 2014/95/EU – NFRD), which went live in 2017, and which requires large EU corporates (including financial services firms) to disclose data on their firm’s impact on ESG factors and vice versa, among other requirements.

The NFRD data, together with other datasets, will be used to evaluate whether an investment meets the criteria for "environmental sustainability" set out in the proposed Taxonomy Regulation. This criteria is to be carefully delineated and exacting in terms of its requirements with the current proposals set out in a lengthy technical expert report. In addition to environmental criteria, the taxonomy classification requirements include strict "minimum" social and governance "safeguards" and adhere to the principle of "do no harm" to the other "environmental objectives" established under the proposed taxonomy regulation.

Any firms with products that meet the taxonomy criteria and market their products as environmentally sustainable and any firms that promote the ESG features of their financial products and services will be subject to the sustainability disclosure regulation (regulation (EU) 2019/2088 – SDR), which introduces strict disclosures for products marketed in this way.

The SDR also has more general product and firm-level ESG disclosure rules that require in-scope investment firms to analyze the risks the investments they manage present to ESG factors, and vice versa (the "double materiality perspective"). The bulk of these rules are set to go live in 2021.

Where applicable, several of the SDR disclosures must present ESG-related performance against relevant benchmarks including where relevant, climate benchmarks. The new EU Climate Benchmarks Regulation (regulation (EU) 2019/2089 - CBR), imposes strict methodology and disclosure obligations on benchmark administrators for climate-benchmarks, which must be classified as either Paris-Aligned Benchmarks (PABs) or the less-ambitious "Climate Transition Benchmarks"(CTBs).

More generally, the CBR contains ESG-disclosure obligations for all benchmarks, save for FX and interest rate benchmarks. The first CBR rules went live in early 2020.

Finally, in terms of conduct measures, buy-side firms must integrate ESG considerations into their investment strategies and engagement activity under the Second Shareholder Rights Directive (Directive (EU) 2017/828 – SRD II), which went live in mid-2019.

The Future EU ESG Regulatory Landscape

The measures outlined above are expected to be followed by rules establishing an EU Ecolabel for financial services under the pre-existing EU Ecolabel Regulation and requirements for an EU Green-Bond Stand (EU-GBS), each of which links back to the taxonomy standards.

Meanwhile, the EU political institutions continue to publish further proposals for ESG-related regulations with recent examples including expansion of the NFRD reporting requirements to meet the taxonomy regulation criteria (summarized in our March 2020 regulatory update) and measures to tackle "Undue Short-Term Pressures on Corporations," (as summarized in our January 2020 regulatory update). Other proposals under consideration include the integration of ESG factors into risk management and suitability evaluations within existing EU investment management regulations (such as MiFID II and UCITS).  

Conclusion

In Europe, the ESG zeitgeist now competes with (and appears set to overtake) the topics of Brexit and MiFID II in terms of attention from regulators and policy drivers as evidenced by the subject’s prominence in the European Commission’s 2020 Work Programme, ESMA’s recent sustainable finance strategy, and the EBA’s action plan on sustainable finance.

Moreover, the measures outlined above are just the tip of the iceberg, principally comprising "framework" (Lamfalussy, Level 1) legislative texts. Over the next half a decade and more, these measures will be supplemented by an abundance of more detailed level 2 delegated legislation and level 3 supporting material, after which the rules will likely be re-calibrated and extended.

Outside of the EU, new measures are being published all the time and with greater frequency. Even in the U.S., which is in a deregulatory cycle overseen by a climate-skeptic administration, there has recently been announced a consultation on greenwashing.

The scale of the ESG regulatory phenomenon is such that it is on the cusp of modifying the traditional categories of financial regulation, which are currently separated as follows:

1. Prudential Rules
2. Conduct Rules
3. Financial Crime Rules
4. Payments and Market Infrastructure Rules.

With the current pipeline of regulations and proposed initiatives, it seems that ESG will inexorably become the fifth pillar of financial regulation.  

For a full breakdown of the EU ESG regulations and proposals, you can access FactSet’s Guide to the EU ESG Regulatory Regime here.