More regulators pick up the ESG baton

We noted in our 2019 report that voices around the globe were demanding climate-aware investing and carbon reduction, the ethical treatment of employees, customers and other stakeholders, and well-managed companies.

The pandemic has accentuated those trends. It has highlighted that all 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. Labor inequality and human rights are to the fore.

Investor demand remains the key driver of change, worldwide, but regulators are catching up. The regulatory initiative that started in the EU is now spreading, worldwide. Consistency of definitions and data remain elusive, though.

Corporates are responding to asset owners and activist investors, by improving their ESG (environmental, social, governance) disclosures and credentials. Accountancy bodies and standard setters have joined forces to strive for consistency in financial and non-financial reporting.

The global Task Force on Climate-related Financial Disclosures (TCFD) was established in December 2015 and tasked with monitoring and making recommendations on risks to the global financial system. Its June 2019 status report delivered a robust message: disclosures have increased since 2016, but are still insufficient for investors. Michael Bloomberg, TCFD Chair said, "Today's disclosures remain far from the scale the markets need to channel investment to sustainable and resilient solutions, opportunities, and business models".

Earlier, in a speech in April 2019, the Chair of the International Accounting Standards Board, Hans Hoogervorst observed "there are simply too many standards and initiatives in the space of sustainability reporting. This leads to a lot of confusion among users and companies themselves." Various initiatives are underway, seeking to address these concerns. The TCFD's recommendations are being incorporated into local binding requirements. In September 2019, participants in the Better Alignment Project of the Corporate Reporting Dialogue reported high levels of alignment between their reporting frameworks.

The European Commission is reviewing the Non- Financial Reporting Directive to ensure a minimum level of comparability, relevance and reliability of current ESG disclosures. ESMA¹ 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.

In addition to reporting requirements, listing rules and stewardship codes are being enhanced with explicit references to climate-change related financial disclosures. For example, Chinese listed companies have been mandated to make environmental disclosures from this year and the SFC² found that most Hong Kong-registered asset management firms were in favor of strengthening ESG disclosure rules for listed companies, as proposed by the Stock Exchange in May 2019.

The UK Financial Reporting Council's revised Stewardship Code, which took effect from January 2020, includes new expectations about how investment and stewardship is integrated, including ESG matters. A revised Japanese Stewardship Code was issued in March 2020. It emphasizes engagement on issues related to sustainability. It includes disclosure of the reasons for voting decisions, disclosure of proxy advisory processes, direct and proactive engagement with investee companies, and stewardship activities aiming for the medium- to long-term increase of corporate value and the sustainable growth of companies.

Such surging demand for responsible investments is critical to help meet the Paris Agreement and the UN Sustainable Development Goals, but it also speaks to the need for shared regulations and guidelines to channel capital effectively.

Asset managers are at the center of this challenge but face diverse approaches and inconsistent definitions of sustainability concepts by asset owners, jurisdictions, business sectors, and professional or industry standard-setting bodies. It is therefore difficult to determine the data required to set comparable targets, monitor investments, and measure and compare performance against peers, let alone across the financial services sector, industries, and national or regional borders.

Asset managers must perform this in-depth data collection to satisfy their own corporate reporting requirements, to conduct appropriate investment and risk management decisions, and to make disclosures to clients and fund investors. The challenge is compounded by the fact that, for a typical asset manager that invests in multiple asset classes, industries and geographies, there are various ESG considerations, which depend on underlying data for informed and accurate decision-making.

IOSCO's³ April 2020 report indicated a "broad acknowledgment among regulators, industry participants and other parties that climate-related risks can be material to firms' business operations and investors' decisions" but raised concerns over the diverse range of sustainability standards. Firms may be subject to different regulatory regimes or participate in multiple initiatives, which can have inconsistent objectives and requirements.

IOSCO warned that the "wide variety of regulatory regimes and initiatives …. may prevent stakeholders from fully understanding the risks and opportunities that sustainable business activities entail". The diverse and voluntary nature of ESG disclosure frameworks risks reducing the reliability and usefulness of those disclosures. The report found a lack of a common understanding of what is meant by sustainable investments and sustainability risks, highlighting the challenges around taxonomies and the lack of agreed globally-accepted definitions. This risks confusion for regulators, firms and investors, and could aggravate the issues of "cherry picking" of frameworks and "greenwashing".⁴

IOSCO has established a board-level task force on sustainable finance, to play a driving role in global efforts to address these issues. The task force's work includes improving sustainability-related disclosures made by issuers and asset managers, and collaborating with other international organizations and regulators to avoid duplicative efforts and to coordinate supervisory approaches.

Concerns about climate change took top place in the new European Commission President, Ursula von der Leyen's agenda. The Commission issued a strategy document, followed by its Sustainable Europe Investment Plan, and consulted until July 2020 on a renewed Sustainable Finance Strategy, which includes 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 proposes that asset and fund 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, across all portfolios and funds. The industry has expressed concerns that this would remove choice for investors and contradict a manager's fiduciary duty to those clients.

The proposals would go further than the Sustainable Finance Disclosure Regulation (SFDR), which must be implemented on dates ranging from March 2021 to end-2022 and is one part of a wider package of new rules. The SFDR applies to asset managers, managers of UCITS⁵ and all forms of AIFs, insurance companies that provide insurance-based investment products, occupational pension funds, personal pension providers and financial advisers (that have more than three employees).

It requires disclosures about whether and how ESG factors are integrated into investment decisions, and by end-2022, whether and how adverse impacts are considered. These disclosures must be included in pre-contractual documents, periodic reports and on firms' websites. Also, firms must include in their remuneration policies an explanation of how the policies are consistent with the integration of sustainability risks and publish the policies on their websites.

The ESAs⁶ are consulting until September 2020 on Level 2 rules to underpin the 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 labor 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 criticized by MEPs⁷ 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.

• Define the strategic approach and ambition level 
• Analyze market trends and regulatory landscape 
• Track and predict the ESG expectations of asset owners 
• Conduct peer review and benchmarking 
• Analyze gaps between your current and desired approaches to ESG

• Prepare an ESG roadmap 
• Design your ESG governance structure
• Prepare action plans and key performance indicators (KPIs) 
• Implement principles and approaches across asset classes, funds and mandates 
• Incorporate ESG principles into operational processes 
• Educate and train your people

• Assess reporting needs and requirements 
• Implement effective data collection and reporting systems

• Review ESG processes and KPIs 
• Review ESG policy statements and governance 
• Stress test investment portfolios 
• Review risk assessment processes 
• Assess reporting

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 recognize, 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, three other parts to the current legislative package will be implemented. The Taxonomy 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. The Commission will later expand the scope of the Taxonomy Regulation to identify socially sustainable activities.

The amended Benchmark Regulation creates two new categories of benchmark: low-carbon benchmarks and positive carbon impact benchmarks. Administrators of benchmarks with ESG objectives must provide an explanation of how the key elements of the methodology reflect the ESG factors. The final part of the current package are rules to require distributors to enquire of and take into account clients' ESG wishes when undertaking suitability assessments and classifying investment products.

There is more to come. The Commission is working on an EU ecolabel for retail financial products and on mandatory standards for "green" bonds. The Second Technical Report of the Commission's Joint Research Centre proposed mandatory criteria for determining whether retail financial products can use the ecolabel, which it tested against the 400 or so existing funds that are currently advertised as green or sustainable:

• bond funds should be at least 70 percent-invested in bonds that comply with the future Green Bond Standard
• equity funds should be subject to a "three-pocket" approach, which distinguishes companies investing principally in green activities
• mixed funds should apply the above two criteria to the underlying assets
• funds of funds should be at least 90 percent-invested in funds that have been awarded the ecolabel
• feeder funds must be invested in a master that has been awarded the label
• the use of derivatives should be in line with the fund's environmental investment policy

Ever since the "COP 21" meeting in Paris in late 2015, France has been at the front of the pack for rule-making. In 2020, it adopted measures to prevent what it calls "ESG-washing", defined as broader than greenwashing. The AMF⁸ believes a principles-based approach is no longer suitable and now requires managers' communications on funds for which ESG factors are central  - through names of funds, KIIDs/KIDs or prospectuses  - to comply with a set of standards and thresholds.

The new investor information "doctrine" was unveiled in March 2020 to help investors  - particularly non-professional investors  - understand sustainable funds.

It requires consistency between what is said within marketing material and what is done in terms of ESG portfolio management. Measurable objectives for sustainability criteria must be included in regulatory documents. Only funds making a "significant commitment" to sustainability themes  - measured by reference to the quantitative thresholds of the French SRI (socially responsible investment) label  - can present sustainability as a central element of product communication or in the fund name.

The doctrine applied with immediate effect to new funds, modified funds or foreign-domiciled funds registered for sale in France. For products already on sale, the naming, marketing documentation and KIID9 must be updated by end-November 2020. The AMF may later address issues such as the quality and relevance of the non-financial data used or the measurement of the potential impacts of the strategies implemented.

As part of its new #Supervision 2022 strategy, the AMF inspected five management companies to assess their SRI management systems. Its July 2019 report found the firms' current practices to be lacking in certain areas and reminded all managers of the AMF's requirements.

In Germany, BaFin¹⁰ conducted a consultation from September to November 2019 on sustainability risks. It subsequently made non-binding recommendations, making clear that supervised companies are free in the choice of their approaches and methods in handling sustainability risk. It issued a sustainability leaflet as a guide to good practice but indicated it could become binding. The leaflet effectively translates recommendations by the Network for Greening the Financial System to integrate climate-related risks into supervision and to underline regulatory expectations of minimum requirements for risk management. The leaflet emphasizes that sustainability risks are not an independent risk, but factors or drivers of well-known risk types such as credit risk, liquidity risk and market risk.

The Dutch AFM¹¹ signaled in its Trend Monitor 2020 the transition to a sustainable economy and society. It identified certain risks in sustainable finance: a green bubble (more demand than supply) and the associated greenwashing and misuse. It said it will act against parties trying to mislead investors. A focus of the regulator is the availability and quality of information in the entire sustainable financing chain. It seeks a careful and transparent integration of sustainability in the asset management sector. Managers of funds providing sustainable solutions must closely monitor these developments and take this theme into account when providing information.

In October 2019, the Polish government adopted the Capital Market Development Strategy. The strategy was drafted with support of the European Bank for Research and Development and the European Commission and is part of wider plans to encourage Poland's economic development and turn the country into a regional economic leader. Among planned activities is a sustainable financing initiative.

In speeches outlining its regulatory focus in 2020, the CBI¹² has mentioned sustainable finance and ESG as a regulatory trend.¹³ It is focused on climate change for a number of reasons, including risks related to the ongoing soundness and stability of Irish financial firms, a substantial conduct perspective which should be considered as part of the transition to financing a sustainable economy, and risks to consumer and investor protection arise from the "greenwashing" of financial products.

Switzerland is working on a total revision of its CO2 Act and created a working group of government departments and financial regulators to assess measures to be taken. The Federal Council decided there was sufficient legal basis for all financial market players to be obliged to take into account all material ESG risks and that consideration of climate risks in supervisory law could also be strengthened by more specific regulation. Implementation of such requirements is seen as paramount for the competitiveness of the Swiss financial services sector. The government, regulator and industry are drawing up recommendations. Topics covered will include governance, risk management, investment policy and strategy, implementation of ESG criteria in the investment process, monitoring, transparency and reporting.

The federal government is providing methodologies and tools for the 2020 climate compatibility test. The test is conducted on a voluntary, anonymous basis and is free of charge. It is open to asset managers for the first time, including managers of real estate funds. The data entry phase ran from March to May 2020. Individual test reports are expected to be sent to test participants in September 2020, and a report on the aggregated, anonymized data will be published at the same time.

The FCA¹⁴ said in March 2020 it was considering how it could enhance environmental disclosure requirements for UK asset managers. Given that the EU rules mentioned above do not apply until March 2021 at the earliest, the UK will not be obliged to implement them. The FCA is considering a comply-or-explain regime rather than rules, but it has encouraged firms to take steps to improve their disclosures and reporting.

The FCA's Business Plan 2020/21 includes climate change as a cross-sectoral priority. It recognizes that all sectors need to adapt to manage the physical and transition risks that climate change poses. Initiatives in Q1 2020 included final rules to facilitate investment in patient capital opportunities, further analysis on greenwashing, and more engagement with other regulators and industry groups to explore collaboration opportunities.

Following the development of the Green Fund designation in 2018, the Guernsey Financial Services Commission intends to endorse the EU Taxonomy Regulation as an additional permitted standard for adoption by a Guernsey Green Fund.¹⁵ Also, in June 2020, "We are Guernsey" issued Green Private Equity Principles. The principles, which are voluntary and written largely from a general partner perspective but also applicable to limited partners, are based on a two-pillar framework: "process" (governance, culture and transparency); and "portfolio" (risk assessment, assets, taxonomy, measurement and reporting).

New Zealand and Singapore will join the International Platform on Sustainable Finance, which was launched in October 2019 and is supported by a number of global and European bodies. The two countries join existing members Argentina, Canada, Chile, China, India, Indonesia, Morocco, Norway and Switzerland. The forum facilitates exchanges and coordinates efforts on initiatives, such as taxonomies, standards and labels, and disclosures. 

In Australia, APRA¹⁶ wrote to all regulated institutions outlining its plans to develop a prudential practice guide focused on climate-related financial risks, as well as a climate change vulnerability assessment. In addition, it said it would update its superannuation guide on investment governance, which will include information relating to ESG investments.

The Australian Securities and Investments Council (ASIC) considered how risk appetite statements were being used to assist boards in overseeing and monitoring non-financial risk. It observed that risk appetite and metrics for such risks were immature compared to those for financial risks.¹⁷ The regulator said management was operating outside board approved risk appetites for non-financial risk for months or years at a time and that risk metrics often failed to provide a representative sample to the board of the level of exposure. Furthermore, board engagement was not always evident. Material information about non-financial risk was often buried in dense board packs and reporting often did not identify a clear hierarchy or prioritization. Undocumented board sessions and informal meetings between directors created asymmetric information at board level.

From March to September 2019, the SFC conducted an industry-wide survey to understand how and to what extent asset management firms and institutional asset owners in Hong Kong (SAR), China consider ESG risks, particularly those relating to climate change. The report, published in December 2019, found that 65 percent of the asset management firms did not have any oversight measures in place. Although 660 firms reported they consider ESG factors, 68 percent of them said information about their own ESG practices was not available. Most of the asset owners surveyed indicated that asset managers do not engage with them to understand their ESG investment preferences. The survey also highlighted differences between locally-owned and foreign-owned firms.

The SFC therefore intends to target three outcomes in the near term:

• Set expectations of asset management firms in areas such as governance and oversight, investment management, risk management and disclosure, focusing on environmental risks with an emphasis on climate change
• Provide practical guidance, best practices and training in collaboration with the industry and relevant stakeholders to enhance the capacity of asset management firms to meet those expectations
• Establish an industry group to exchange views between the SFC and experts in environmental and climate risks, and sustainable finance

These outcomes will complement the actions already taken by the SFC under its Strategic Framework for Green Finance. Its April 2019 circular provided guidance to make disclosures by SFC-authorized green funds more transparent and comparable. A central database of these funds has since gone live on the SFC's website. 

In China, the banking and insurance regulator told financial institutions in January 2020 that they should establish and improve their environmental and social risk management system, incorporating ESG requirements into their credit processes and strengthening the disclosure of ESG information to stakeholders. It further encouraged financial institutions to establish their own green finance business departments. 

The MAS¹⁸ announced in November 2019 that it had set up a USD 2 billion Green Investments Program to accelerate the growth of Singapore's green finance ecosystem and to try to generate long-term sustainable returns for the MAS's investment portfolio. Under the program, funds will be mandated to asset managers that are committed to drive regional green efforts and to contribute to the MAS's other green finance initiatives, which include developing green markets and managing environmental risks. 

ESG efforts in Japan have been boosted by the country's flagship GPIF pension fund, which has invested over USD 500 million in green bonds issued by the global and regional issuers, such as the World Bank. The governor of the Malaysian central bank announced in September 2019 that the bank would work with the industry to implement the TCFD disclosure recommendations. It also called on venture capital and private equity firms to create innovative investment solutions. 

In Brazil, ESG is moving center stage for many participants in the asset management industry, especially for private equity firms, wealth managers and multi-family offices. The regulator plans to create a new category of funds under the FIDC¹⁹ umbrella, specifically for ESG investments. FIDC are widely used in Brazilian credit markets and by international investors and hedge funds.

US CFTC Commissioner Rostin Behnam said in February 2020²⁰ that the Climate Related Financial Market Risk Subcommittee, which was established in November 2019, would produce policy recommendations by summer 2020. He went on to say that "Climate change is a risk management challenge that presents uncertain and potentially severe consequences over time". However, SEC chairman, Jay Clayton has expressed concerns that imposing a uniform, mandatory disclosure framework for ESG disclosures runs the risks of sacrificing what may be the more relevant, company-specific disclosure for the potential for greater comparability across companies.²¹

Within the ESG panoply, diversity is also a hot topic. Good diversity practices are viewed as risk-reducing for both investment firms and investment funds. To date, disclosure of diversity policies or reporting of pay information is mainly voluntary and often spear-headed by industry associations. However, regulation has been introduced in a small but growing number of jurisdictions. The recovery phase of the pandemic is likely to raise additional equality and potential discrimination issues. As firms re-introduce office working, there will be specific issues to consider, such as access by disabled staff, treatment of expectant mothers or staff with medical conditions, parenting considerations and, if relevant, the selecting of personnel to be laid off.

Back in 2015, the SEC and five other federal financial agencies published a standard on the assessment of diversity policies. US regulated entities, including asset managers, are asked, voluntarily, to publish their diversity policies, practices, and workforce data. The SEC is reported to be seeking to improve the response rate. Meanwhile, in February 2020, the Institutional Limited Partners Association published a "road map" of best practices that private equity firms and their investors can use to improve diversity and inclusion.

In Ireland, the CBI has highlighted the importance of diversity and inclusion to the culture and resilience of financial services firms.²² It will continue to place a spotlight on diversity in the financial services sector. In a speech at an Investment Association event in June 2019, the UK FCA threatened not to approve the appointment of white male senior managers if there is not sufficient diversity in a regulated firm's leadership team. The FCA had previously made clear that the SMCR (see Chapter 4 of the full report) aims not only to hold individuals accountable but also to change firms' culture, including by increasing diversity.

The Investment Association's June 2019 report, "Black Voices: Building black representation in investment management", published in conjunction with #talkaboutblack, showcased the experiences of black professionals working in the UK industry and black students considering these careers. The report found that less than one percent of investment managers are black.

It recommended steps that firms can take to create more diverse and inclusive workplaces, including documenting experiences and opinions of black professionals, and providing training to reduce unconscious bias. The report also references the lack of data and clear targets for ethnic diversity, and strongly supports a government plan to require firms to publish an ethnicity pay gap.

The pandemic has led regulators around the globe to give concessions against reporting deadlines. One such concession was provided by the UK government to the reporting required under the Gender Pay Gap Regulation, which came into force in April 2017. There will be no enforcement action against firms that do not file their 2019/2020 reports in time, but about one-quarter of the employers expected to file gap reports this year have already done so.

The Chartered Institute for Personnel and Development urged companies to delay rather than avoid reporting. It said, "The Coronavirus stands to have a disproportionate impact on women in the labour market, because of the high proportion of women working in retail and hospitality. This makes it more important than ever that we don't take our eye off the ball and risk losing momentum in our efforts to close the gender pay gap."²³

In France, the obligation for boards to have at least 40 percent female members was extended in January 2020 from listed companies to companies with at least 250 employees and the sanctions for not abiding by the rules were strengthened.

EU rules on gender diversity are being drawn up. 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.