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After several months focusing on the impacts of COVID-19, regulators are returning to climate change risks and sustainable finance.

International bodies are issuing analyses, EU ESG (environment, social, governance) rules are increasing, and supervisors are setting out their expectations.

The pandemic has highlighted that business sectors are deeply interconnected across borders, that societies of all types and wealth levels are vulnerable, and that the environment is under increasing strain. Labour inequality and human rights are to the fore. Around the globe, investor and customer demand remains a key driver of change, but the regulatory initiative that started in the EU is spreading.

Impact of climate change risk on equity markets

The IMF Global Financial Stability Report of April 2020 said "Disasters as a result of climate change are projected to be more frequent and more severe, which could threaten financial stability." The report finds the impact of large physical disasters on equity markets generally to have been modest over the past 50 years. It notes that high levels of insurance penetration and sovereign financial strength can help preserve financial stability in the face of climatic disasters.

However, aggregate equity valuations as of 2019 did not reflect the predicted changes in physical risk under various climate change scenarios, which suggests that investors do not pay enough attention to these risks. The report argues that better disclosures and stress testing for financial firms can help preserve financial stability and should complement policy measures to mitigate and adapt to climate change.

NGFS recommendations to supervisors

  • Determine how climate-related and enviromental risks transmit to the economy and financial sectors in the jurisdiction and identify how they are likely to be material for supervised entities.
  • Develop a clear strategy, establish an internal organisation and allocate adequate resources to address these risks.
  • Identify the exposures of supervised entities that are vulnerable to these risks and assess potential losses should they materialise.
  • Set supervisory expectations to create transparency for financial insitutions in relation to the supervisors' understanding of a prudent approach to these risks.
  • Ensure adequate management of these risks by financial institutions and take mitigating action where appropriate.

Prudential risks for banks

In April 2020, the Basel Committee published a stocktake report prepared by its high-level Task Force on Climate-related Financial Risks. The report noted that most BCBS members are undertaking regulatory and supervisory initiatives on climate-related financial risks, and that future work includes analytical reports and developing effective supervisory practices.

In May 2020, the Central Banks and Supervisors Network for Greening the financial System (NGFS) published a guide for supervisors on integrating climate change into prudential supervision. It provides a snapshot of the state-of-play in several countries and sets out five non-binding recommendations for supervisors, intended to co-ordinate a common regulatory response to climate-related and environmental risks.

The ECB is consulting until September 2020 on a guide on how it expects banks to manage climate-related and environmental risks safely and prudently and to disclose these risks transparently under the current prudential framework. The guide includes supervisory expectations on governance and risk management frameworks, the formulation and implementation of business strategies, and enhanced disclosures.

Significant institutions are expected to review and, where needed, adapt their practices. As part of the supervisory dialogue, from end-2020 significant institutions will be asked to inform the ECB of any divergences of their practices from the supervisory expectations described in the guide.

The ECB acknowledges that the management and disclosure of climate-related and environmental risks, and the methodologies and tools used to address them, are currently evolving and are expected to mature over time.

The UK regulators are also requiring firms to reflect ESG factors in their risk frameworks and disclosures, but are not proposing new rules and are leaving detailed guidance to the industry.

More detailed rules on ESG

The ESAs are consulting until September 2020 on Level 2 rules to underpin the Sustainable Finance Disclosure Regulation (SFDR), focusing on "E" and "G". The proposals include mandatory indicators that firms should always consider as principal adverse impacts (such as greenhouse gas emissions and lack of adherence to fundamental labour conventions), together with a non-exhaustive set of indicators that might be helpful in identifying, assessing and prioritizing additional principal adverse impacts. The draft definition of fossil fuels was criticised by MEPs for excluding oil and gas.

The ESAs will draw up a mandatory reporting template and specify where firms should place disclosures on their websites. Integration of ESG factors into investment processes will not be sufficient to describe a product as promoting environmental or social characteristics, but only where selection criteria for underlying assets apply on a binding basis.

The proposals are prescriptive and will present significant challenges for firms, especially in current operating conditions, but there is no indication that implementation will be delayed. 

The ESAs recognise, though, that firms will face several practical difficulties:

  • Lack of data, especially on principal adverse impacts.
  • That Level 2 rules under the Taxonomy Regulation are still under discussion (see below).
  • Fitting the additional disclosures into products with length-constrained pre-contractual information documents.
  • For portfolio managers with separately-managed accounts, balancing the website disclosure requirements with client privacy and data protection rules.
  • Smaller firms may struggle with compliance costs, due to lack of economies of scale.

In 2021, the ESAs will draft rules on social issues - the "S". Meanwhile, the Commission consulted for one month on draft delegated acts on the integration of sustainability factors under UCITS, AIFMD, MiFID II, the Insurance Distribution Directive and Solvency II. The rules require firms to consider clients' ESG preferences in suitability assessments and to embed consideration of ESG factors into their product governance and risk management processes.

Consistency of definitions and data remain elusive

Without consistent definitions and disclosures, it is difficult for regulated firms to determine the data required to measure ESG risks and exposures or to satisfy their own corporate reporting requirements. Corporates are responding to asset owners and activist investors by improving their ESG disclosures and credentials. Accountancy bodies and standard setters have joined forces to strive for consistency in financial and non-financial reporting.

The European Commission is reviewing the Non-Financial Reporting Directive to ensure a minimum level of comparability, relevance and reliability of current ESG disclosures. ESMA has called for general principles and disclosures to be specified, for non-financial statements in companies' annual reports to be subject to assurance and for consistency with the Transparency Directive.

Meanwhile, debates about the Taxonomy Regulation continue. The Regulation establishes a pan-European classification system to identify which economic activities are environmentally sustainable. The Regulation is, in effect, the dictionary for firms when implementing the requirements of other regulations, such as the SFDR. Level 2 rules are awaited and the Commission will later expand the scope of the Regulation to identify socially sustainable activities.

More EU rules to come…

The Commission is consulting until July 2020 on a renewed Sustainable Finance Strategy, which includes proposals that climate and environmental risks should be fully managed and integrated into financial institutions, and that social risks should be considered where relevant.

The Commission suggests that asset owners and asset managers should be required, as part of their fiduciary duty, to consider whether their investments are having a negative impact on the environment or society. This would go further than the SFDR requirements and the industry has expressed concerns that it would remove choice for investors and contradict a manager's fiduciary duty to those clients.

The Commission is working on an EU Eco-label for investment products [see the January edition (PDF 963 KB)] and is consulting until October 2020 on an EU Green Bond Standard (GBS) and whether a similar standard should be developed for social bonds. The proposed contents of the Green Bond Framework and of the "allocation" and "impact" reports are as recommended (PDF 3.2 MB) by the Technical Expert Group in its detailed report of March 2020. The GBS would apply to any type of issuer: listed or non-listed, public or private, European or international.

The Commission is also considering rules requiring the incorporation of ESG factors into banks' risk assessment frameworks and on gender diversity. The Commission's five-year Gender Equality Strategy includes a proposal for a Directive to introduce binding measures on improving the gender balance on corporate boards. Such measures already exist in a small number of European countries.

The GBS is based on four components:

  1. Alignment of the use of the proceeds from the bond with the EU Taxonomy.
  2. The publication of a Green Bond Framework.
  3. Mandatory reporting on the use of proceeds (allocation reports) and on environmental impact (impact report).
  4. Verification of compliance with the Green Bond Framework and the final allocation report by an external registered/ authorised verifier.

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